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    Managing Audits to Manage Earnings: The Impact of Diversions...
    research summary posted July 23, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 06.06 Earnings Management 
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    Title:
    Managing Audits to Manage Earnings: The Impact of Diversions on an Auditor’s Detection of Earnings Management.
    Practical Implications:

    Diversions can have important practical implications beyond the setting of deliberate earnings management. Managers may divert auditors from higher risk areas to accounts that they believe are not at risk of misstatement. The findings suggest that auditors would be susceptible to these diversions as well. However, to the extent that errors can occur anywhere, managers might mistakenly direct auditors’ attention to an area with errors, which could backfire on managers. Even more broadly, managers may inadvertently direct auditors’ attention from an account that materially misstates earnings to another account that does not. No matter the cause of the diversion, the results demonstrate that such diversions significantly influence an auditor’s detection of a material misstatement of earnings elsewhere in the financial statements. 

    Citation:

    Luippold, B. L., Kida, T., Piercey, M. D., & Smith, J. F. 2015. Managing audits to manage earnings: The impact of diversions on an auditor’s detection of earnings management. Accounting, Organizations & Society (41):39-54.

    Keywords:
    earnings management, audit management, decision making, material misstatements
    Purpose of the Study:

    This study discusses an aspect of earnings management called audit management. The authors define audit management as a client’s strategic use of diversions to decrease the likelihood of auditors discovering managed earnings during the audit. Evidence from prior studies suggests that managers strategically attempt to conceal earnings management. This study investigates whether managers who manipulate earnings can successfully employ diversions to influence auditors’ detection of unusual fluctuations during analytical review. That is, the authors investigate whether diversionary statements made by the client (i.e., identifying areas of risk in the financial statements to lure the auditor away from managed earnings) affect an auditor’s detection of managed earnings contained elsewhere in the financial statements.

    Managers may be motivated to divert auditors to areas that contain, or do not contain, other errors. If managers point auditors to ostensibly risky areas that are clean, auditors may conclude that the client’s accounts are likely to be accurate in other areas as well. Conversely, management may want to direct auditors to areas that contain other errors, thinking that these other errors may occupy their attention, leading auditors to feel satisfied that they are detecting misstatements, resulting in auditors feeling less compelled to discover other errors. However, auditors are also trained to practice professional skepticism, and the diversion to the other errors should elevate their sensitivity to the risk of material misstatement in the remainder of the financial statements, resulting in greater overall audit effort and a greater likelihood that they would find the earnings manipulation. The authors therefore investigate the impact of management intentionally directing auditors to both clean accounts and accounts containing errors.

    Design/Method/ Approach:

    A representative from each of the Big Four and other audit firms identified auditors with sufficient knowledge to perform the task. Seventy-six auditors, with an average of four years of audit experience, took part in the study. The experiment required that auditors complete analytical review procedures on the financials statements of a hypothetical client. The study employed a 2x2 experimental design. The evidence was collected prior to February 2015.

    Findings:

    The results suggest that diversions to clean accounts and diversions to accounts containing other errors have different effects on auditors’ detection of earnings management. The authors find that auditors’ detection of earnings management was worst when they were diverted to clean financial statement accounts, and best when they were diverted to accounts containing other errors, with earnings management detection in between these levels when no diversions were used (whether other errors were present or not). Overall, these results suggest that if management directs auditors to accounts that contain errors, the discovery of those errors heightens their sensitivity to errors in other areas of the audit. However, if auditors are directed to clean accounts, the use of diversionary statements can deter auditors from finding earnings management. Managers can potentially exploit an audit management tactic as simple as a diversion to a clean area because such a diversion reduces auditors’ effectiveness at detecting earnings management elsewhere in the financial statements.

    Category:
    Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Earnings Management