Top

Review of Accounting Studies

Published in:

01-06-2010

The role of audit thresholds in the misreporting of private information

Author: Brian Mittendorf

Published in: Review of Accounting Studies | Issue 2/2010

Activate our intelligent search to find suitable subject content or patents.

search-config

AI-assisted search

Off

Abstract

The accounting profession has faced considerable criticism in recent years for failing to effectively combat reporting manipulation. A particular point of contention is the use of audit thresholds. The tendency for auditors to suppress inconsistencies that are deemed immaterial has been viewed as an open invitation for abuse. This paper revisits the effectiveness of audits and the misreporting of private information in light of audit thresholds. The paper demonstrates that while audit thresholds may create incentives for misstatements, the predictability of such misstatements may actually serve to promote efficiency. In effect, an environment in which parties are expected to systematically bias their reports can bring the threat of audit consequences for further exaggeration to the forefront. Such a consideration also suggests that more relaxed audit thresholds (and the ensuing increase in equilibrium misstatements) may be condoned by report recipients and can actually lessen inefficiencies wrought by adverse selection.

next article Accounting restatements and information risk

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Online-Abonnement

Mit Springer Professional "Wirtschaft+Technik" erhalten Sie Zugriff auf:

über 102.000 Bücher
über 537 Zeitschriften

aus folgenden Fachgebieten:

Automobil + Motoren
Bauwesen + Immobilien
Business IT + Informatik
Elektrotechnik + Elektronik
Energie + Nachhaltigkeit
Finance + Banking
Management + Führung
Marketing + Vertrieb
Maschinenbau + Werkstoffe
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Springer Professional "Wirtschaft"

Online-Abonnement

Mit Springer Professional "Wirtschaft" erhalten Sie Zugriff auf:

über 67.000 Bücher
über 340 Zeitschriften

aus folgenden Fachgebieten:

Bauwesen + Immobilien
Business IT + Informatik
Finance + Banking
Management + Führung
Marketing + Vertrieb
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Available only for authorised users

In particular, on the latter front the SEC issued SAB 99 seeking greater control over materiality thresholds. Subsequently, the Auditing Standards Board passed SAS 89 and 90, which require closer scrutiny of waived adjustments by both auditors and management.

While the setting entails a privately informed party who is tempted to overstate its cost, one can readily extend the results to analogous settings where the privately informed party is tempted to overstate profitability. For example, an empire building tendency may lead entrepreneurs to overstate project value to generate an influx of capital (e.g., Deng 2007). In this sense, the results speak more about the magnitude than the particular direction of endogenous misstatements.

For more on this means of classifying equilibrium misstatements, see Arya et al. (1998). When the report cannot be used as the agent's message, the equilibrium outcome is typically identified either by (i) adding a (costless) direct channel to elicit the agent's message so as to apply the revelation principle to communications through that channel or (ii) finding the optimal reporting under the existing (restricted) reporting channel. While the present paper employs the latter approach, one can readily verify that the equilibrium solution identified here would also arise under the former approach.

This commonplace assumption is satisfied for a variety of distributions, including uniform, normal, logistic, chi-squared, exponential, and Laplace (Bagnoli and Bergstrom 2005; Laffont and Tirole 1994).

Technically, the probability has a ceiling value of one; to ensure a nondegenerate probability in equilibrium, assume \(\pi < 1/({\bar{c}}+\tau)\) throughout the analysis.

Note that the analysis does not consider the issue of measurement errors that can create concerns of false positives that can arise in the course of an audit. The possibility of these errors can place an additional burden of proof on auditors and can also point to a benefit of thresholds due to avoidance of costly type I errors.

The restriction Λ ≤ X ensures a nontrivial incentive problem. Absent such a limit on contractual penalties, the first best outcome can be achieved (e.g., Antle and Fellingham 1997).

In this case, the monotonicity of the investment rule is not sufficient for limiting attention to "local" deviations. Thus, in contrast to related settings without auditing (e.g., Antle and Eppen 1985), considering the possibility of partial transfers (at proportional cost) in this setting does not yield an equivalent solution.

Of course, this formulation presumes there is no direct effect of thresholds on the chosen level of audit procedures or efforts. Section 3.4 expands the analysis to consider this possibility.

There may also be other downsides of thresholds, particularly when they induce equilibrium misreporting. For example, if there are individuals who rely on public reports but naively presume they are unbiased, such individuals are likely to be misled by threshold-induced misreporting. Collateral damage of this sort is often discussed in the context of analyst recommendations: while industry insiders claim that "hold" recommendations have widely been understood to be bad news, a trusting public who has taken such recommendations as neutral news has consistently suffered the consequences (Malmendier and Shanthikumar 2007). Regulators who are particularly concerned about the uninformed who rely on public reports would thus be reluctant to permit sizable misstatements in equilibrium.

As in previous sections, to ensure nondegenerate probability in equilibrium, \(\pi(\tau)<1/[{\bar{c}}+\tau].\)

As an aside, note in this case that the higher the potential penalty for detected misreporting, Λ, the more stringent the preferred threshold, i.e., τ* is decreasing in Λ. This example thus provides a caveat to the view that strict penalties and strict auditing rules are substitutes.

Antle, R., & Eppen, G. (1985). Capital rationing and organizational slack in capital budgeting. Management Science, 31(2), 163–174.CrossRef

Antle, R., & Fellingham, J. (1997). Models of capital investments with private information and incentives: A selective review. Journal of Business Finance & Accounting, 24(7), 887–908.CrossRef

Arya, A., Glover, J., & Sunder, S. (1998). Earnings management and the revelation principle. Review of Accounting Studies, 3(1), 7–34.CrossRef

Bagnoli, M., & Bergstrom, T. (2005). Log-concave probability and its applications. Economic Theory, 26, 445–469.CrossRef

Baron, D., & Besanko, D. (1984). Regulation, asymmetric information, and auditing. RAND Journal of Economics, 15, 447–470.CrossRef

Border, K., & Sobel, J. (1987). Samurai accountant: A theory of auditing and plunder. Review of Economic Studies, 54, 525–540.CrossRef

Braun, K. (2001). The disposition of audit-detected misstatements: An examination of risk and reward factors and aggregation effects. Contemporary Accounting Research, 18(1), 71–99.CrossRef

Cohen, D., Dey, A., & Lys, T. (2008). Real and accrual-based earnings management in the pre- and post-Sarbanes Oxley periods. The Accounting Review, 82(3), 757–787.CrossRef

Deng, M. (2007). Financial reporting, regulation, and information asymmetry. Columbia University Dissertation.

Fedyk, T. (2007). Discontinuity in earnings reports and managerial incentives. University of California, Berkeley Dissertation.

Goldman, E., & Slezak, S. (2006). An equilibrium model of incentive contracts in the presence of information manipulation. Journal of Financial Economics, 80(3), 603–626.CrossRef

Kessler, A., Lulfesmann, C., & Schmitz, P. (2005). Endogenous punishments in agency with verifiable ex post information. International Economic Review, 46(4), 1207–1231.CrossRef

Lacker, J., & Weinberg, J. (1989). Optimal contracts under costly state falsification. Journal of Political Economy, 97(6), 1345–1363.CrossRef

Laffont, J., & Tirole, J. (1994). A theory of incentives in procurement and regulation. Cambridge, MA: MIT Press.

Levitt, A. (1998). The numbers game. New York, NY: Remarks delivered at the NYU Center for Law and Business. September 28.

Maggi, G., & Rodriguez-Clare, A. (1995). Costly distortion of information in agency problems. RAND Journal of Economics, 26(4), 675–689.CrossRef

Malmendier, U., & Shanthikumar, D. (2007). Are small investors naive about incentives? Journal of Financial Economics, 85(2), 457–489.CrossRef

Messier, W., Martinov-Bennie, N., & Eilifsen, A. (2005). A review and integration of empirical research on materiality: Two decades later. Auditing: A Journal of Practice and Theory, 24(2), 153–187.CrossRef

Moran, J., & Morgan, J. (2003). Employee recruiting and the Lake Wobegon effect. Journal of Economic Behavior and Organization, 50(2), 165–182.CrossRef

Myerson, R. (1979). Incentive compatibility and the bargaining problem. Econometrica, 47(1), 61–74.CrossRef

Title: The role of audit thresholds in the misreporting of private information
Author: Brian Mittendorf
Publication date: 01-06-2010
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 2/2010
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-009-9088-5

Springer Professional

Abstract

Please log in to get access to your license.

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Springer Professional "Wirtschaft"

Other articles of this Issue 2/2010

Return predictability and shareholders’ real options

Inflation, earnings forecasts, and post-earnings announcement drift

Accounting restatements and information risk

Limited attention and the earnings announcement returns of past stock market winners

The effect of pension accounting on corporate pension asset allocation

Confidence and trading aggressiveness of naïve investors: effects of information quantity and consistency