Auditors and the Deterrence of Operational Opportunism: The Importance of Communication to the Board and Consistency with Peer Behavior

Buchanan, Jessica
Commerford, Benjamin
Wang, Elaine
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Research indicates that managers are willing to make opportunistic operating decisions to meet short-term targets. In this study, we investigate when and how auditor actions can help deter this opportunistic behavior, commonly known as real earnings management (REM). Informed by Perceptual Deterrence Theory, we conduct three experiments with corporate managers as participants. In Experiment 1 we predict and find that REM can be deterred when managers expect auditors to increase scrutiny (i.e., increased inquiry and testing) and discuss their observations with the board. However, this effect occurs only when managers’ operational decisions are inconsistent (as opposed to consistent) with peer behavior. Experiment 2 results suggest that, when communication to the board is not expected, increased auditor scrutiny alone is not likely to deter REM. Experiment 3 findings suggest that when paired, increased auditor scrutiny and communication to the board can be an effective deterrent for both REM and accounting-based earnings management (AEM). However, without communication to the board, auditor scrutiny alone deters AEM, but also appears to induce more REM. Our findings highlight the importance of communication between auditors and the board, but also the limitations of auditor scrutiny as a deterrent to manager opportunism. We provide evidence that, under certain conditions, the benefits of auditor scrutiny can extend beyond the traditional domain of financial statement assurance and improve the quality of managers’ operating decisions.
Auditor scrutiny, peer behavior, manager opportunism, perceptual deterrence theory, real earnings management
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