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    Regulation and the interdependent roles of managers,...
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 14.0 Corporate Matters, 14.01 Earnings Management, 14.11 Audit Committee Effectiveness 
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    Title:
    Regulation and the interdependent roles of managers, auditors, and directors in earnings management and accounting choice.
    Practical Implications:

    This review paper provides an overview of how financial reporting, auditing, and corporate governance regulations influence the earnings management and accounting choice decisions of key stakeholders. The paper provides a summary of key insights (summarized above) of interest to practitioners, researchers, and regulators. Further, the paper highlights the key benefits of experimental and survey work in terms of identifying causal mechanisms and investigating the impact of potential regulatory actions not yet in existence.

    Citation:

    Libby, R., K. Rennekamp, and N. Seybert. 2015. Regulation and the interdependent roles of managers, auditors, and directors in earnings management and accounting choice. Accounting, Organizations and Society 47: 25-42.

    Keywords:
    Earnings management, earnings quality, accounting choice, financial reporting, auditing, corporate governance, experimental design, surveys, regulation
    Purpose of the Study:

    This paper reviews recent experimental and survey studies of key stakeholders decisions that influence earnings management and accounting choice, and how financial reporting affects these decisions. The authors summarize the contribution of the studies, directions for future research, and key methodological recommendations for researchers doing experimental and survey work. The authors define earnings management and accounting choice broadly to include: 1) choices of accounting methods; 2) implementation decisions related to estimates, classifications, levels of detail, and display format used in mandatory disclosures; 3) the frequency, timing, and content of voluntary disclosures; and 4) investment, financing, and operating choices based on their accounting consequences. The focus of this review is on the determinants (rather than consequences) of accounting choice. In examining the effects of regulation on managers’, auditors’, and directors’ (or audit committee members’) judgments and decisions with respect to earnings management, the study focuses on three types of regulation: 1) financial reporting regulations, 2) auditing regulations, and 3) other corporate governance regulations.

    Design/Method/ Approach:

    The paper focuses on studies published in Accounting, Organizations, and Society, Contemporary Accounting ResearchJournal of Accounting Research, and The Accounting Review from 2008 through 2014. Relevant working papers from SSRN and select older papers that provide motivation for more recent work are also discussed.

    Findings:
    • Financial reporting regulation:
      • Effects of rules- versus principles-based standards on reporting choices:
        • Overall, evidence indicates the ability of a principles-based standard to constrain aggressive reporting is likely limited.
        • Joint goals of reducing the complexity of standards while also constraining aggressive reporting will only be met where a less-stringent set of rules is replaced with a more-stringent general principle.
      • Effects of information quantity or information location on reporting choices:
        • Overall, research suggests when more detailed information about estimates or economic events must be reported, managers will engage in a lower level of misreporting and auditors will scrutinize the numbers to a greater extent.
        • Effect is dampened when information appears in a footnote disclosure rather than on the face of the financial statements.
      • Effects of reporting frequency and accruals timing on investment choices:
        • Overall, research demonstrates how reporting differences such as reporting frequency, expense deferral, and impairment reversibility can alter project choices, investment location, and investment magnitude.
        • These decisions have direct immediate and/or future real economic consequences and represent a tradeoff between short-term reporting issues and long-term firm value.
    • Auditing regulation:
      • Overall, research suggests the effects of regulations are complicated.
      • Both increased auditor independence and increased auditor accountability can fail to produce desired outcomes and even lead to unanticipated consequences.
      • Open question as to which types of regulation might successfully shift auditors’ incentives away from pleasing client management and towards pleasing other non-client stakeholders.
    • Corporate governance regulation:
      • Overall, research suggests audit committee involvement has improved in recent years and more knowledgeable and independent directors have been more likely to support correction of discovered errors and constrain earnings management.
      • In some cases, however, directors are not as effective at helping auditors to reign in within-GAAP earnings management.
    Category:
    Corporate Matters, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Earnings Management