Given that REM often causes significant auditor discomfort, the authors’ paper provides broader REM and auditor comfort-related questions pertaining to the effects of management’s focus on short-term results, the extent to which REM is a problem that can or needs to be fixed, and the possibility that REM is a gateway to more serious forms of accounting manipulation.
Commerford, B. P., D. R. Hermanson, R. W. Houston, and M. F. Peters. 2016. Real Earnings Management: A Threat to Auditor Comfort? Auditing: A Journal of Practice and Theory 35 (4): 39 – 56.
The findings have important implications for auditors and other individuals responsible for assessing fraud risk and detecting and preventing fraud. First, for certain types of organizations aggregate fraud levels can vary tremendously over time. Furthermore, the effectiveness of mechanisms to prevent and detect fraud can be contingent on the type of organization and related individual susceptibilities to social influence. Therefore, it may be inappropriate for auditors to evaluate fraud prevention and detection mechanisms in a uniform manner. The results suggest that the same fraud prevention and detection mechanisms implemented in a similar manner in two different organizations cannot be expected to be equally effective without considering the average susceptibilities to social influence of the individuals therein.
Davis, J. S., and H. L. Pesch. 2013. Fraud dynamics and controls in organizations. Accounting, Organizations & Society 38 (6/7): 469-483.
These results increase the understanding of how an authority figure’s directions to misreport impact the rationalizations and resulting reporting decisions. Situational inducement can be a powerful force on behavior and affect. The authors show that the situational inducement of being told to misreport enables individuals to mitigate the emotional cost of misreporting. The authors document the apparent ease with which misreporting individuals rationalize misreporting behavior in the presence of authority. This result can also be prevented by a good culture and leadership.
Mayhew, B. W., & Murphy, P. R. 2014. The Impact of Authority on Reporting Behavior, Rationalization and Affect. Contemporary Accounting Research 31 (2): 420-443.
The study extends the fraudulent financial reporting literature by formulating fraud incidence as a function of performance outcomes using peer performance as a reference point. By testing CPT's individual-level behavioral implications on firm-level archival data, the study re-conceptualizes the investigation of fraudulent financial reporting in terms of risk attitude and extends prior investigations of CPT from laboratory experiments to a real-world setting of fraudulent financial reporting.
Fung, M. K. 2015. Cumulative Prospect Theory and Managerial Incentives for Fraudulent Financial Reporting. Contemporary Accounting Research, 32 (1): 55-75.
The phenomenon of co-offending is an important key to understanding fraudulent behavior. Understanding co-offending is best approached through a study of social ties. The reasons for co-offending vary according to the type of bond that exists between the co-offenders. Internal controls, such as job rotation policies, mandatory holidays with role replacement, forensic audits and surprise audits, that are specifically geared toward unraveling organizational cliques and subcultures help uncover fraudulent activities within a firm. This research suggests that the fraud triangle presents an overly parsimonious explanation of offending, and should incorporate materialistic, cultural, and affective considerations.
Free, C., & Murphy, P. R. 2015. The Ties that Bind: The Decision to Co-Offend in Fraud. Contemporary Accounting Research 32 (1): 18-54.
These findings suggest that regulators, audit committees, and other stakeholders should consider ways to improve IAF quality, specifically IAF competence, and IAFs improve corporate governance by assisting audit committees in monitoring management. This study provides empirical evidence consistent with the proposition that IAF quality and competence deter management misconduct. IAF quality and, particularly, IAF competence are important in deterring observable instances of management misconduct, both accounting- and nonaccounting-related. These findings are important because in the early 2000s, regulators responded to public outcry over observable management misconduct, yet IAF quality was largely left out of the regulatory debate and reforms that followed.
Ege, M. S. 2015. Does Internal Audit Function Quality Deter Management Misconduct? Accounting Review 90 (2): 495-527.
The evidence indicates that tone manipulation succeeds in misleading investors, and that this effect is incremental to the effect of accruals management. An abnormally positive tone incites an overly optimistic immediate stock price response to the earnings announcement and a subsequent return reversal. The evidence indicates that abnormal positive tone contains negative information about future firm fundamentals, that firms tend to engage in tone management particularly when incentives to manipulate investor perceptions are high, and that investors are misinformed by tone management.
Huang, X., Teoh, S. H., & Zhang, Y. 2014. Tone Management. Accounting Review 89 (3): 1083-1113.
The results of the study identify two points where decision aids are likely to be successful in improving audit quality—when developing a mental representation of the “tone at the top” and/or when establishing a preliminary assessment of control environment effectiveness. Although developing an understanding of the client’s “tone at the top” requires retrieval of positive evidence supportive of “tone at the top” effectiveness, the process of doing so may undermine auditors’ efforts at incorporating negative evidence into their mental representations. Structuring decision aids, working papers, and reviews to ensure that the relatively abundant positive “tone at the top” information does not suppress the negative information would alleviate a favorable bias in the auditors’ “tone at the top” mental representations. This is critical given that “tone at the top” mental representations permeate subsequent audit decision making.
For more information on this study, please contact Regan Schmidt.
Schmidt, R.N. 2014. The effects of auditors’ accessibility to “tone at the top” knowledge on audit judgments. Behavioral Research in Accounting 26 (2): 73-96.
The research helps identify conditions under which financial statement users are more likely to detect accounting and disclosure choices that are seemingly intended to misrepresent firms’ financial positions. The evidence indicates that participants in the experiment do not naturally adjust for financial statement impact. These participants perceive a deficiency in management credibility only when they understand both the financial statement impact of an incentive-consistent accounting choice and believe that management has not been forthcoming about that choice. The research suggests that investors make credibility judgments based on the forthcomingness of corporate disclosure as well as on what they understand about managers’ choices from the broader information environment.
For more information on this study, please contact Susan Krische.
Krische, S. D., P. R. Sanders, and S. D. Smith. 2014. Management credibility and investment risk: An experimental investigation of lease accounting alternatives. Behavioral Research in Accounting 26 (1): 109-130.
We focus on the business risk associated with controversial corporate activities. By examining a wider range of controversial corporate activities, we are able to conduct a broader investigation into the association between auditor business risk and audit fees. Our study finds that adverse social performance arising from controversial activities affects firms’ audit fees. Specifically, our results indicate that auditors charge fee premiums ranging from 5.4% to 13.2% for clients that are involved with controversial activities related to consumers, employees, the community, and the environment. We also find that corporate controversial activities are associated with higher risks of financial misstatement and adverse financial performance. These results provide triangulation on our inference that auditors’ raise their assessment of clients’ business risks when their clients are involved in controversial activities, and charge such clients higher audit fees.
For more information on this study, please contact Kevin Koh.
Koh, K. and Y. H. Tong. 2013. The Effects of Clients’ Controversial Activities on Audit Pricing. Auditing: A Journal of Practice and Theory 32 (2): 67-96.