Evidence from Auditors about Managers' and Auditors' Earnings-Management Decisions

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Abstract
We report survey evidence about 515 experiences that auditors have had with clients who they identified as attempting to manage earnings. This approach enables us to analyze separately managers' decisions about how to attempt earnings management ("EM") and auditors' decisions about whether or not to waive adjustment of managers' earnings-management attempts ("EMAs"). We provide evidence that the likelihood that managers make EMAs (and auditors waive adjustment of EMAs) that involve transaction structuring varies with the precision of the related accounting standards. Managers tend to make EMAs that increase current-year income, but auditors are less likely to waive EMAs that increase current-year income. Managers are more likely to make EMAs that decrease current-year income with unstructured transactions and/or when standards are imprecise (presumably because the resulting "cookie jar reserves" are easier to harvest in future years if structuring is not necessary or the relevant standards are flexible). Auditors are more likely to waive EMAs that they identify as immaterial or that are attempted by large clients. These variables combine to affect the areas in which EMAs are attempted and waived to become EM in the audited financial statements.