Real Earnings Management: A Threat to Auditor Comfort?

Real earnings management (REM) is an increasingly common method of manipulating financial results, yet little research examines auditors' perceptions of and responses to REM. Using the auditor comfort framework (Pentland 1993; Carrington and Catasu's 2007), we examine the extent to which REM impacts auditor comfort and how, in the presence of REM, auditors rely on comfort-building strategies in trying to move from a state of discomfort (i.e., fear of failing to identify misstatements) to comfort. Based on in-depth interviews of 20 experienced auditors, we find that auditors are aware of REM and often identify REM through formalized protocols that include analytical procedures, discussions with management, or their knowledge of the business. Formal audit procedures play a role when trying to address, "rationally," the risk of REM, but we also find that auditors use emotive phrases and references to body senses related to discomfort, indicating that there also is an emotional component to dealing with REM (Guenin-Paracini, Malsch, and Marche-Paille 2014). Most of the interviewees have concerns about REM (i.e., it threatens comfort), largely because they believe that it is indicative of management's desire to meet short-term targets (i.e., poor management tone), and that it may signal the use of other, less acceptable earnings management methods (i.e., accruals-based earnings management) to meet those targets. Interviewees respond to the discomfort caused by REM in many ways, including engaging in discussions with the client, increasing skepticism, and altering audit procedures and risk assessments. Auditors may even go as far as resigning from an engagement because of REM. Our analysis reveals that REM is a significant source of auditor discomfort and that auditors use both their rationality and their emotions/body senses to identify and try to alleviate that discomfort.