Auditors' response to management confidence and misstatement risk

Abstract

Corporate managers display varying degrees of confidence, but investors appear to have difficulty distinguishing when management's high confidence is warranted (i.e., when it signals accuracy and/or future positive outcomes). Archival research finds that the managers associated with proxies for high confidence are actually “overconfident” because their choices ultimately resulted in personal and shareholder losses, on average. Auditors are experienced in evaluating management and are trained to be professionally skeptical, and users rely on them to reduce the information risk around noisy signals in financial reporting. Therefore, we investigate whether and how management confidence impacts auditors' response to the risk of material misstatement (RMM). Audit standards are explicit that auditors should increase testing and acquire more reliable evidence as RMM increases. Accordingly, we conduct an experiment, varying management confidence in their explanations about an accounting estimate and RMM at the client. We find, consistent with the thought-suppression literature, that although auditors universally believe relying on management's explanations without corroboration is inappropriate and that high confidence signals management's desire to induce auditor reliance, they do not distinguish their response to RMM when management confidence is high. When management confidence is low, auditors appropriately perform more testing for clients where RMM is higher than lower. Auditors' testing judgements moderate their likelihood of pursuing inquiry evidence for higher than lower risk clients when management confidence is high versus when it was low. Our finding is troublesome because deceitful managers can readily manipulate confidence and influence the explanations and inquiry evidence presented to auditors. Thus, our research offers evidence that auditors' tendency to be influenced by high management confidence can play a contributing role in the observed association between high management confidence and biased financial reporting.