The Impact of Financial Statement Audits on Non-Income-Increasing Misreporting: Evidence from Restatements

52 Pages Posted: 7 Feb 2017 Last revised: 30 Sep 2018

See all articles by Jeffrey Pittman

Jeffrey Pittman

Memorial University of Newfoundland (MNU) - Faculty of Business Administration

Yuping Zhao

University of Houston

Date Written: September 22, 2018

Abstract

Extant evidence implies that managers rely on a variety of non-income-increasing techniques to manipulate earnings. However, prior research finds that the auditor is more likely to discipline firms against practicing income-increasing (II) earnings management due to its higher litigation and reputation risk, although it remains silent on whether the auditor also constrains non-income-increasing (NII) misreporting. Exploring the nature of NII misstatements, we first find that a significant portion of NII misstatements could have valuation implications. In analyzing the role that financial statement audits play in preventing NII misstatements, we find that the auditor exerting more effort reduces the likelihood of II misstatements, but has no perceptible impact on the likelihood of NII misstatements. Annual audits significantly reduce the probability that accounting mistakes are carried from quarterly reports to annual reports for II misstatements, but have minimal economic impact on NII misstatements. The lower audit efficacy over NII misstatements is more pronounced for those that do not impact net income. Further, we find that the asymmetric audit quality for II and NII misstatements is attributable to lower likelihood of detection of NII misstatements along with the lower likelihood of correction of detected NII misstatements as shown in prior research. Our research sheds lights on whether financial statement audits are effective at constraining NII misstatements, which is an important issue given that NII misstatements have become the most prevalent type of financial misreporting in recent years.

Keywords: Financial Report Misstatements; Audit Quality; Litigation and Reputation Costs; Investor Reactions to Restatements

JEL Classification: M49

Suggested Citation

Pittman, Jeffrey A. and Zhao, Yuping, The Impact of Financial Statement Audits on Non-Income-Increasing Misreporting: Evidence from Restatements (September 22, 2018). Available at SSRN: https://ssrn.com/abstract=2912478 or http://dx.doi.org/10.2139/ssrn.2912478

Jeffrey A. Pittman (Contact Author)

Memorial University of Newfoundland (MNU) - Faculty of Business Administration ( email )

St. John's, Newfoundland A1B 3X5
Canada
709-737-3100 (Phone)
709-737-7680 (Fax)

Yuping Zhao

University of Houston ( email )

334 Melcher Hall
Houston, TX 77204
United States
713-743-2166 (Phone)
713-743-4828 (Fax)

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