Audit Committee Financial Expertise and Earnings Management: The Role of Status
Badolato, Patrick G.; Donelson, Dain C.; Ege, Matthew.n
Journal of Accounting & Economics. November 2014, Vol. 58 Issue 2/3, p208-230.
Regulatory pressure to increase both audit committee financial expertise and board independence has resulted in lower status for audit committees relative to management. This status differential is relevant because expertise and relative status are important determinants of each party's ability to influence outcomes, particularly when parties face conflicting goals. We find that audit committees with both financial expertise and high relative status are associated with lower levels of earnings management, as measured by accounting irregularities and abnormal accruals. These results speak to benefits and limitations of financial expertise, which have been the focus of considerable debate.
Does Intent Modify Risk-Based Auditing?
Kachelmeier, Steven J.; Majors, Tracie; Williamson, Michael G.
The Accounting Review. November 2014, Vol. 89 Issue 6, p2181-2201.
Risk-based auditing implies that auditors invest more (fewer) resources as reporting risks increase (decrease). We find from an interactive experiment that participants in an audit-like role reflect this reasoning to a lesser extent when risks arise from intentional actions of human reporters than when the same risks arise from an unintentional source. We interpret this pattern as reflecting an emotive ''valuation by feeling'' when risks arise from human intent, meaning that the presence of risk is more influential than the magnitude of risk, whereas unintentional risks reflect a ''valuation by calculation'' that conditions audit resources on risk magnitudes. Because our experiment constrains intentional and unintentional risks to have equivalent magnitudes, probabilities, and consequences, these results could seem irrational in a strict economic sense. Outside the laboratory, however, reporters can strategically increase the level of intent- based risk in response to the auditor's low-risk strategy, such that an audit strategy that is relatively insensitive to the level of intent-based risk would be less vulnerable to strategic exploitation.
Mental Accounting and Disaggregation Based on the Sign and Relative Magnitude of Income Statement Items
Bonner, Sarah E.; Clor-Proell, Shana M.; Koonce, Lisa.
The Accounting Review. November 2014, Vol. 89 Issue 6, p2087-2114.
Current financial reporting guidance allows managers flexibility as to whether to disaggregate income statement items. Such flexibility is problematic if managers prefer to aggregate in some situations and disaggregate in others because we conjecture that investors' evaluations of firms will predictably differ depending on whether performance information is shown in an aggregated or disaggregated fashion. We conduct a series of related experiments within the context of compound financial instruments to investigate whether managers' preferences follow the predictions of mental accounting theory; specifically, that presentation preferences vary as a function of the sign and relative magnitude of the income statement items. Results reveal that managers' disaggregation preferences reflect mental accounting. Further, the effects of mental accounting are moderated only when managers feel high pressure to report transparently. Finally, and most importantly, the preferred presentations of managers result in the highest firm valuations from investors, indicating that investors also rely on mental accounting. Our study has implications for standard setters, regulators, and researchers.
Pay Convexity, Earnings Manipulation, and Project Continuation
The Accounting Review. November 2014, Vol. 89 Issue 6, p2233-2259.
This paper studies the optimal design of long-term executive pay plans when boards of directors use accounting information for investment decision-making and executives can take costly actions to manipulate this information. The model predicts that a shift to more convex executive pay plans, such as equity plans that rely more on options and less on stock, is associated with higher levels of manipulation, lower reporting quality, and less efficient investment. When designing the optimal contract, the board trades off these effects with the cost of inducing executive effort. The paper also analyzes how the optimal pay convexity and the equilibrium level of manipulation change when the CEO's opportunistic reporting discretion changes. The model predicts that an increase in the CEO's marginal cost of manipulation increases the optimal level of pay convexity and first increases and then decreases the magnitude of manipulation.
Does Auditor Explanatory Language in Unqualified Audit Reports Indicate Increased Financial Misstatement Risk?
Czerney, Keith; Schmidt, Jaime J.; Thompson, Anne M.
The Accounting Review. November 2014, Vol. 89 Issue 6, p2115-2149.
According to auditing standards, explanatory language added at the auditor's discretion to unqualified audit reports should not indicate increased financial misstatement risk. However, an auditor is unlikely to add language that would strain the auditor-client relationship absent concerns about the client's financial statements. Using a sample of 30,825 financial statements issued with unqualified audit opinions during 2000-2009, we find that financial statements with audit reports containing explanatory language are significantly more likely to be subsequently restated than financial statements without such language. We find that this positive association is driven by language that references the division of responsibility for performance of the audit, adoption of new accounting principles, and previous restatements. In addition, we find that (1) ''emphasis of matter'' language that discusses mergers, related-party transactions, and management's use of estimates predicts restatements related to these matters, and that (2) the financial statement accounts noted in the explanatory language typically correspond to the accounts subsequently restated. In sum, our results suggest that present-day audit reports communicate some information about financial reporting quality.