Auditor Sensitivity to Real Earnings Management: The Importance of Ambiguity and Earnings Context

ABSTRACT Differentiating real earnings management (REM) from normal business decisions poses a unique challenge for auditors, researchers, and investors. The ambiguity associated with REM, and the fact that REM does not violate GAAP, may explain why its use is on the rise. While some assert that auditors are not, and should not be, concerned with REM, recent research suggests that REM may influence some auditor judgments. Using Correspondent Inference Theory (CIT) as our theoretical framework, we extend REM research by investigating the ways in which auditors respond to REM and how auditors deal with the intrinsic ambiguity associated with REM. We administer a 3×2 between‐subjects experiment to 113 highly‐experienced auditors, manipulating the level of ambiguity surrounding the observed REM (Explicit REM, Potential REM, or No REM) and the earnings context in which the client engages in REM (the client beat or missed the consensus earnings forecast). We find that auditors respond to REM by lowering assessments of management tone (i.e., management's commitment to a culture of high ethical standards), being more likely to discuss the issue with the audit committee, and being less likely to retain the client. Auditors respond to Explicit REM regardless of the earnings context, but respond to Potential (i.e., ambiguous) REM only when the client beats the forecast. Finally, we find that management tone mediates the relation between REM and auditor responses, even after controlling for various audit‐related risks. Thus, for auditors, REM appears to be primarily a “people” issue, as REM provides a negative signal about management. RÉSUMÉ La sensibilité de l'auditeur à la gestion du résultat réel : importance de l'ambiguïté et du cadre contextuel des résultats La distinction entre la gestion du résultat réel (GRR) et les décisions d'affaires courantes soulève une difficulté particulière pour les auditeurs, les chercheurs et les investisseurs. L'ambiguïté associée à la GRR et le fait que la GRR ne contrevienne pas aux PCGR peuvent expliquer pourquoi son usage est à la hausse. Même si d'aucuns affirment que la GRR ne préoccupe pas ni ne devrait préoccuper les auditeurs, de récentes études semblent indiquer que la GRR peut influer sur les jugements de certains auditeurs. Utilisant l'inférence correspondante comme canevas théorique, les auteurs poussent plus loin la recherche sur la GRR en analysant de quelle façon les auditeurs y réagissent et gèrent l'ambiguïté intri