The role of incentives to manage earnings and quantification in auditors' evaluations of management-provided information.

INTRODUCTION

Auditors must evaluate the information obtained at audit planning to determine the nature, extent, and timing of audit work to be performed. In many cases, planning information takes the form of explanations and other information from client management (Hirst and Koonce 1996). Management-provided information is especially important when the auditor investigates accounts that are subjective and based on estimates, because the auditor's ability to obtain reliable information from other sources is limited in such cases. Given the importance of subjective accounts and estimates in financial reports (e.g., FASB 2001a; Lev and Zarowin 1999; Lundholm 1999), the quality of earnings may be compromised if the auditor fails to appropriately evaluate management provided information.

In this paper, we experimentally examine the effects of two contextual factors on auditors' evaluations of the persuasiveness of a management-provided explanation for a significant fluctuation in an account that requires considerable estimation. These two factors are, first, whether the explanation is quantified (i.e., put into numbers) and, second, whether the client manager is likely to distort the information (i.e., the manager has incentives to manage earnings). These two factors were chosen because they provide important cues to the quality of management-provided information and, in turn, earnings quality. We draw on research on persuasion (Friestad and Wright 1994) to argue that these factors will jointly influence auditors' judgments.

Investigating this issue is important because we know little about how auditors respond to attempts by managers to persuade them as to the acceptability of their financial reports (however, see Nelson et al. 2002). Previous research from a persuasive perspective in auditing has focused on how auditors are persuaded by other audit-team members (e.g., Rich et al. 1997; Tan and Yip-Ow 2001), rather than by management. Previous research on auditors' reactions to management explanations for unexpected fluctuations has largely focused on steps that auditors can take to reduce the extent to which auditors are persuaded by management explanations. For example, Heiman (1990) demonstrated that providing auditors with alterative explanations reduces the persuasiveness of a management explanation. Koonce (1992) demonstrated that auditors are less persuaded after writing down reasons why management's explanation might be incorrect. While research has also examined how the accuracy (Bedard and Biggs 1991) and sufficiency (Anderson and Koonce 1998) of management representations influence auditor judgments, no auditing research that we are aware of manipulates features of the explanation, such as whether it is quantified, that management could use to influence persuasion.

In this study, we examine how auditors react to quantified versus non-quantified management representations for an important, subjective account. A quantified explanation provides potentially important information to the auditor about whether the explanation is sufficient in magnitude to be responsible for the fluctuation. We predict that whether the auditor is more persuaded by a quantified explanation will depend on management's incentives to engage in earnings management. In particular, when a manager has low incentives to manage earnings, we expect that auditors will view the potential for managers to misrepresent information as small. Because the quantified explanation shows sufficiency of the manager's explanation and is unlikely to be misrepresented in this setting, auditors should find a quantified explanation more persuasive than a non-quantified one. In other words, auditors are expected to reduce their judgments about misstatement risk and increase their willingness to rely on the manager's explanation for planning purposes in this case. In contrast, when the client manager has high incentives to manage earnings, we expect that auditors will be skeptical about the motives behind the quantified explanation and, as a result, will expect the numbers to have been manipulated to suit the manager's purposes. In this situation, we expect a quantified explanation demonstrating the sufficiency of the client's explanation will be no more persuasive than a non-quantified explanation. In other words, auditors are not expected to reduce their risk judgments nor increase their reliance on the manager's explanation for planning purposes in this situation because it is likely that the sufficiency information is not credible.

To test our predictions, we conducted an experiment in which 113 experienced auditors observed a significant increase in their client's revenues and inquired with a client manager as to the reason. The manager's explanation indicated that the increase in revenue was the result of a change in accounting estimate. We varied the form of the explanation provided by the manager (i.e., whether it was quantified or not) and the incentives of the manager to manage earnings (high versus low) between participants. Participants made audit-planning judgments about the likelihood of misstatement in revenue and gross margin and their willingness to rely on the manager's representation for purposes of planning the audit.

Our results show clear support for the notion that auditors are sensitive to the potential for earnings management. Specifically, auditors viewed the manager as more likely to be aggressive, possessing a greater desire to make the financial statements look good and a greater desire to get the auditor to accept the financial statements when incentives for earnings management were high, versus when they were low. Moreover, when incentives to manage earnings were high, auditors were less certain that information from the manager reflected his true beliefs and the underlying facts, and they believed that managers were more likely to manipulate the numbers in a quantified explanation. Our results also showed that auditors receiving a quantified explanation viewed it as more likely to be sufficient to explain the magnitude of the fluctuation than did auditors receiving a non-quantified explanation.