Earnings Management: do the type of GAAP, persuasive client explanation, and SEC notification influence the auditors' decisions?



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Texas Tech University


While many researchers have examined earnings management and the firm's motivation to manage earnings, few researchers have examined the role of auditors in potentially approving earnings management. Several factors influence the auditors' subjective judgment in evaluating the interpretation of generally accepted accounting principles (GAAP) by client management who may have incentives that bias the interpretation of GAAP to achieve target earnings. This study provides evidence that existing standards may actually facilitate earnings management. In addition, the conflicting influence of the client and the Securities Exchange Commission affect the auditors' decision making and interpretation of GAAP.

These issues were examined by providing auditors with a research instrument that required them to assess an accounting transaction that is used to manage earnings and determine the appropriate amount of expense. Three variables of interest were manipulated in this study: (1) the type of GAAP, (2) management explanation, and (3) the SEC notification of potential investigation due to earnings management. The client desired additional expenses in the current year to offset higher than expected revenues from a new product. The type of GAAP was operationalized as (I) a write-down of impaired assets which reflects a broad financial accounting standard and (2) the expensing of additional supplies that were acquired but unused which reflects a strict accounting principle, matching. Management explanation was operationalized as (1) a high persuasive explanation to record a large amount of loss or expense to achieve analysts' projections of earnings and (2) a low persuasive explanation to achieve steady long-term growth in earnings and fair presentation within the financial statements. The potential conflicting influence of the SEC was operationalized by the absence or presence of the January 22, 1999 notification of the SEC's intent to audit the financial statements due to asset write-downs, restructuring activities, or acquired in-process research and development.



Auditing -- Moral and ethical aspects, Analytical review, Auditors -- Professional ethics, Auditing, Business