How Changes in Expectations of Earnings Affect the Associations of Earnings Overstatements and Audit Effort with Audit Risk and Market Price

65 Pages Posted: 11 Oct 2019 Last revised: 14 Apr 2020

See all articles by Evelyn Patterson

Evelyn Patterson

Indiana University-Kelley School of Business

Reed Smith

Kelley School of Business

Samuel L. Tiras

Indiana University - Kelley School of Business

Date Written: April 13, 20

Abstract

In this study, we consider how changing expectations of earnings affect a dishonest manager’s strategy to overstate earnings and an auditor’s strategy to exert effort in a two-period setting. We model the manager type as either honest or dishonest, which allows us to differentiate audit risk from audit effort. Researchers typically assume audit effort and audit risk are negatively associated, which we find for changes in our period 2 payoff parameters, but we find the association can be positive, specifically with changes in our period 1 game parameters. Further, by dichotomizing, we show that the directional change in market price does not necessarily follow the directional change in audit effort as the prior literature suggests, because market price also adjusts for expected bias through changes in the intercept. A key finding is that when period 1 expected earnings increase, the probability that the manager is dishonest decreases, which allows the auditor to reduce audit effort. This finding suggests that observations of earnings that just meet or beat an earnings target and suspected of being managed may not be indicative of an audit failure, but indicative of an efficient allocation of effort. Finally, our multiperiod setting demonstrates that the effects from a change in the manager’s or auditor’s incentives in period 1 may reverse in period 2. Studies typically examine the contemporaneous effects of these changes on market price and/or audit risk, but fail to identify the cross-temporal effects we document in our study.

Keywords: overstaement of earnings, economic conditions, firm value

JEL Classification: M42

Suggested Citation

Patterson, Evelyn and Smith, J. Reed and Tiras, Samuel L., How Changes in Expectations of Earnings Affect the Associations of Earnings Overstatements and Audit Effort with Audit Risk and Market Price (April 13, 20). Available at SSRN: https://ssrn.com/abstract=3462651 or http://dx.doi.org/10.2139/ssrn.3462651

Evelyn Patterson (Contact Author)

Indiana University-Kelley School of Business ( email )

801 West Michigan
Indianapolis, IN 46202
United States
317-278-7843 (Phone)

HOME PAGE: http://kelley.iupui.edu/faculty/FacultyProfile.cfm?netid=evpatter

J. Reed Smith

Kelley School of Business ( email )

801 W Michigan Street
BS 4002
Indianapolis, IN 46202
United States
317-274-0867 (Phone)
317-274-3312 (Fax)

Samuel L. Tiras

Indiana University - Kelley School of Business ( email )

801 W. Michigan Street
Indianapolis, IN 46202
United States
(317) 274-3420 (Phone)

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