The Effects of Mandatory Earnings Forecasts and Auditor's Legal Regimes on Manager's and Auditors' Behavior - Theory and Experimental Evidence

Abstract

This study reports the results of an experiment designed to examine whether a regulation system that consists of a mandatory earnings forecast imposing on the manager together with a strict legal regime imposing on the auditor may effectively motivate manager's and auditor's desirable behavior. The experimental results show that the proposed regulation system forms a dynamic interactive process in which a strict legal regime enhances auditor independence, which in turn forces the manager to report realized earnings truthfully. Since the manager is mandated to make earnings forecast and there are costs associated with forecast errors, the manager has to undertake more investment to increase the probability of generating high realized earnings, which in turn improves forecast accuracy despite the fact that audit effort also decreases. In addition, I investigate and show that the mandatory forecast mechanism gives rise to a forecast accuracy concern (i.e., the consistency between forecasted earnings and audited earnings), which significantly encourages the manager to undertake more investment under the condition that the manager cannot manage earnings. This forecast accuracy concern not only enhances earnings forecast accuracy, but also prevents inappropriate use of investor funds. The implications and contributions of these results are discussed.