Earnings Management, Audit Differences, and Analysts' Forecasts

Abstract

This paper reports results of two experiments aimed at (1) assessing whether companies are less willing to record immaterial income decreasing audit differences when the adjustment causes the company to report earnings below the consensus analyst forecast and (2) determining whether implementation of proposed auditing standards aimed at this phenomenon will affect the willingness to record such audit differences. In the experiments, Big Five audit managers estimated the portion of an immaterial audit difference a client would choose to record in various circumstances. Our managers expected their clients not to record immaterial audit differences when such differences caused them to report earnings below the consensus forecast. This behavior was expected to be particularly prevalent when the misstatement amount was less objectively determined. Our results also suggest that the proposed auditing standards will be only minimally effective in promoting the recording of immaterial audit differences in general, and ineffective in reducing the use of unrecorded audit differences to meet the forecast. Even when the related error was objectively determined and the proposed auditing standards were in effect, no more than 30% of clients were expected to book an adjustment that would cause them to miss the forecast.