The Role of Reporting Incentives and Quantification in Auditors' Evaluations of Earnings Fluctuations

Abstract:     
Company managers frequently provide explanations in response to auditor inquiries about unexpected earnings fluctuations. Client-inquiry is particularly common when the financial statement account causing the fluctuation is subjective and involves estimates, as the ability to obtain reliable evidence from other sources often is limited in these situations. In this study, we examine two factors that we expect to affect how auditors evaluate client-provided explanations for an important account that requires significant estimation (i.e., revenue): the client manager's incentives to manage earnings and whether the explanation is quantified (i.e., put into numbers). We expected that auditors' evaluations of client-provided explanations would be a joint function of management's incentives and the type of explanation provided to the auditor. Instead, we found that auditors' views of the persuasiveness of client explanations are primarily affected by the manager's incentives to manage earnings. Focus on client manager incentives is consistent with auditors' and regulators' recent and vociferous concerns about earnings management. However, such a focus implies that when the likelihood of earnings management is low, auditors may underestimate the reliability of quantified explanations that demonstrate how the client's explanation fully accounts for the earnings fluctuation.

Keywords: Earnings management; Quantification; Auditing

JEL Classifications: M41, M43, M49

Working Paper Series