How Changing Economic Conditions Over Multiple Periods Affect Earnings Overstatements, Audit Risk, and Market Prices

Abstract

In this study, we consider how changing expectations of earnings affect a dishonest manager’s strategy to overstate earnings and an auditor’s strategy to exert effort in a two-period setting. We model the manager type as either honest or dishonest, which allows us to differentiate audit risk from audit effort. Researchers typically assume audit effort and audit risk are negatively associated, which we find for changes in our period 2 payoff parameters, but we find the association can be positive, specifically with changes in our period 1 game parameters. Further, by dichotomizing, we show that the directional change in market price does not necessarily follow the directional change in audit effort as the prior literature suggests, because market price also adjusts for expected bias through changes in the intercept. A key finding is that when period 1 expected earnings increase, the probability that the manager is dishonest decreases, which allows the auditor to reduce audit effort. This finding suggests that observations of earnings that just meet or beat an earnings target and suspected of being managed may not be indicative of an audit failure, but indicative of an efficient allocation of effort. Finally, our multiperiod setting demonstrates that the effects from a change in the manager’s or auditor’s incentives in period 1 may reverse in period 2. Studies typically examine the contemporaneous effects of these changes on market price and/or audit risk, but fail to identify the cross-temporal effects we document in our study.