Auditors’ Responses to Real Earnings Management: The Effects of Timing and Potential Consequences on Auditor Decision-Making

In this study, we investigate whether the timing and the potential consequences of a transaction influence auditors’ decisions regarding real earnings management (REM). Based on the results of an online experiment with 159 certified public accountant (CPA) participants, we find that the timing of a transaction acts as a signal of management’s intent that auditors use to infer REM. While the timing of the transaction helps auditors identify REM, whether auditors take confrontational actions (i.e., actions taken by auditors to confront a client for the final resolution of an REM issue) also depends on their evaluation of the transaction. We find that auditors are more likely to take confrontational actions when the transaction occurs at the end of the reporting period and is likely to result in more severe negative consequences to the firm’s future operations.