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    Real Activities Manipulation and Auditors’ C...
    research summary posted October 22, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.06 Resignation Decisions, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management 
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    Title:
    Real Activities Manipulation and Auditors’ Client-Retention Decisions
    Practical Implications:

    The results of this study are important for auditors, investors, clients’ audit committees, and regulators. Disclosure about auditor resignations may reveal useful information about clients’ financial reporting practices. Since auditor resignations potentially signal risk arising from clients’ opportunistic financial reporting behavior, investors can make more informed decisions when they understand the linkage between RAM and auditor resignations. The findings of this study also have an important implication for clients’ audit committees, because these committees can help to avoid potential negative consequences associated with RAM and auditor resignations by overseeing management reporting practices. Further, the results of this study are important for regulators because they are concerned about auditor changes that are triggered by management opportunism.

     

    For more information on this study, please contact Yongtae Kim.

    Citation:

    Kim, Y., and M. Park. 2014. Real Activities manipulation and auditors’ client-retention decisions. The Accounting Review 89 (1): 367-401.

    Keywords:
    Real activities manipulation; auditors’ client retention decision; auditor resignation
    Purpose of the Study:

    Although earnings management through accounting choices is receiving considerably more attention in the literature, survey results show that executives are more willing to take real actions than accounting actions to meet earnings benchmarks. Despite the pervasiveness of real activities manipulation (RAM) and considerable attention to auditor switches, especially in the post-SOX era, there is little evidence for the implication of RAM for auditors’ client-retention decisions.

    Auditors are concerned about client’s abnormal operating practices for the following reasons. First, RAM has a negative impact on cash flows and future performance. Deterioration of the client’s performance and financial health limits an auditor’s future business opportunities with the client. Second, clients’ poor financial performance often leads to auditors being held liable for clients’ stakeholder losses, even if the auditors are not directly responsible. Thirds, RAM can result in inventory build-up and increase in receivables, both of which increase audit risk. Finally, aggressive RAM reflects the management’s opportunism in financial reporting and the discovery of opportunistic operating decisions that dissipate firm value casts doubt on the integrity of management and its financial statements.

    Facing resource constraints, auditors may drop clients with limited future opportunities and greater risk. Since auditors cannot effectively control the clients’ RAM, they attempt to adjust their client portfolios by resigning from risky engagements. The authors examine whether auditors are more likely to resign when clients engage in RAM aggressively.

    Design/Method/ Approach:

    The research evidence is collected from a sample of auditor changes between 2000 and 2010. Following prior literature, the authors estimate and examine three types of activities manipulation: (1) sales manipulation, (2) overproduction, and (3) reduction of discretionary expenses. To mitigate the concern that clients’ financial performance may explain the relation between RAM and auditor resignation, the authors construct performance-adjusted RAM measures, explicitly control for the client’s financial performance by including several proxies of the client’s financial performance in the regressions, and employ a performance-matched control sample.

    Findings:
    • Clients’ opportunistic operating decisions, proxied by abnormal cash flows and abnormal discretionary expenses, are positively associated with the likelihood of auditor resignations.
    • Abnormal production costs are not significantly associated with the likelihood of auditor resignations.
    • The results are robust to three sets of control samples: client-initiated auditor changes, all continuing audit clients, and performance-matched continuing audit clients.
    • Clients whose auditors resign tend to engage in RAM more aggressively to meet or beat earnings benchmarks prior to auditor changes. Auditors are especially sensitive to clients’ RAM to just meet or beat earnings benchmarks in their client-retention decisions, with the exception of RAM through overproduction.
    • Clients whose auditors resign from engagements tend to employ non-Big 4 auditors as successor auditors and that these clients engage in RAM more actively than other clients whose incoming auditors are Big 4.
    • The association between RAM and the likelihood of auditor resignation is especially prevalent for small clients and during the post-Sarbanes-Oxley Act of 2002 period.
    • Clients’ abnormal cash flows and abnormal discretionary expenses are significantly associated with litigations against auditors.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Resignation Decisions