Auditor Actions and the Deterrence of Manager Opportunism: The Importance of Communication to the Board and Consistency with Peer Behavior

Abstract

Informed by Perceptual Deterrence Theory, we conduct multiple experiments to investigate when and how auditor actions can help deter manager opportunism. In Study 1, we conduct two experiments in which managers can use real earnings management (REM) to report more favorable earnings. Study 1A results indicate that REM can be deterred when managers expect auditors to increase scrutiny and communicate their observations with the board. However, this effect occurs only when managers’ operational decisions are inconsistent (as opposed to consistent) with peer behavior. Study 1B results suggest that without communication to the board, auditor scrutiny is not likely to deter REM, irrespective of consistency with peers. In Study 2, we conduct an experiment in which managers can choose to use either accruals-based earnings management (AEM) or REM that is inconsistent with peer behavior to report more favorable earnings. We find that increased auditor scrutiny with communication to the board effectively deters both AEM and REM, reducing the total level of manager opportunism. However, auditor scrutiny alone (i.e., without communication to the board) deters AEM, but also induces more REM, leaving the total level of manager opportunism unchanged. Our findings highlight the importance of auditor-board communication and demonstrate when and how auditor actions can contribute to the deterrence of both AEM and REM.