Research Brief: Changes in Audit Attitudes Keep Managers Honest

WHAT DID THE STUDY LOOK AT?

Earnings management, better known as “creative accounting,” refers to the manipulation or misrepresentation of reported income for any number of reasons: to convince investors that targets are being met, for personal benefits, or even for job security. For the last two decades, research has mainly focused on auditors’ ability to detect this sort of fraud rather than on their potential to proactively deter it — although the audit’s capacity for deterrence has long been touted as a key advantage of audited financial statements. This study examined how less predictable auditing practices and tougher auditor attitudes help discourage creative accounting and outright fraud.

HOW WAS THE STUDY DESIGNED?

This was an experimental study with a broad sample of 171 managers, drawn from a pool of EMBA and MBA alumni with significant organizational experience. Study participants were asked to imagine themselves as managers who are told that their division was undergoing a less rigorous audit than the previous year, and who subsequently learn from managers of other company divisions about their audit experience. The study participants were then given the chance to practise highly questionable and potentially fraudulent earnings management. Reactions to various scenarios were studied: the audit being the same as the previous year; an increase in the extent of audit testing (increasing the sample size); a change in the nature of evidence collected (seeking external verification of management’s claims); or more skeptical auditor attitudes towards managers.

WHAT DID THE STUDY FIND?

• Despite the fact that the managers’ own divisions would receive less attention from auditors than the previous year, when managers witnessed changes to the auditing style in surrounding divisions, potentially fraudulent earnings management was deterred or reduced. This was not true of situations in which audit conditions remained the “same as last year” or the number of audited projects was simply increased.
• A greater extent of audit testing or more critical auditor attitudes did not help prevent earnings management unless such unpredictable auditor actions and attitudes were put to work simultaneously.
• Even when it was unlikely that new audit methods would better detect accounting discrepancies, the simple act of varying approaches appeared to make managers think twice before practising creative accounting. 
• Having taken into account the individual “anticipated levels of earnings management” and “ethical dispositions” of the managers, the study showed that when conditions are ripe for earnings management, managers are usually more acutely aware of the unethical practices.

WHAT DO I NEED TO KNOW?

The authors stress that fraud begins with aggressive earnings management, and that “effective auditing should deter managers from starting on this slippery slope in the first place.” An implication of their study is that, in the case of auditing practices, changing the nature of evidence collected is a more effective deterrent than increasing the extent of evidence. While it is increasingly common for research to consider audits as effective means of fraud prevention as well as detection, this paper is among the first to present empirical evidence that changes in auditor actions and attitudes have a significant effect on managers’ tendencies to engage in earnings management in the first place. 

Title: Do changes in audit actions and attitudes consistent with increased auditor scepticism deter aggressive earnings management? An experimental investigation

Authors: Qiu Chen (Carleton University, graduate of Queen's School of Business doctoral program), Khim Kelly (University of Waterloo), Steven E. Salterio (Queen’s School of Business)

Published: Accounting, Organizations and Society (vol. 37, 95–115)

— Nick Walker