How Changes in Expectations of Earnings Affect the Associations of Earnings Overstatements and Audit Effort with Audit Risk and Market Price

79 Pages Posted: 11 Oct 2019 Last revised: 30 Aug 2021

See all articles by Evelyn Patterson

Evelyn Patterson

Indiana University-Kelley School of Business

Reed Smith

Kelley School of Business

Samuel L. Tiras

Indiana University - Kelley School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: August 30, 2021

Abstract

In this study, we provide theoretical guidance for both analytical and empirical research by considering 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 expect our study’s insights on changing economic conditions to help shape future research. We model the manager type as either honest or dishonest, which allows us to differentiate audit risk from audit effort. The key takeaways for future research are the insights on how changes in payoffs and expected earnings affect the associations that involve earnings overstatements and audit effort with audit risk and market price. For instance, researchers typically assume audit effort and audit risk are negatively associated, but we find the association can be positive, when, for example, the auditor chooses his period two strategy based on the changes in period one game parameters. The results of our study provide two additional key insights on the design of future empirical tests. First, by dichotomizing, we show the importance of estimating the intercept in the market pricing equation when studying earnings quality, because market price also adjusts for expected bias through changes in the intercept. Second, our multiperiod setting demonstrates that the effects from a change in the manager’s or auditor’s incentives in period one may reverse in period two. Empirical 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.

Keywords: Earnings expectations, changes in economic conditions, strategic outcomes, risk of material misstatement, cross-period strategic effects.

JEL Classification: M42

Suggested Citation

Patterson, Evelyn and Smith, J. Reed and Tiras, Samuel L., How Changes in Expectations of Earnings Affect the Associations of Earnings Overstatements and Audit Effort with Audit Risk and Market Price (August 30, 2021). Available at SSRN: https://ssrn.com/abstract=3462651 or http://dx.doi.org/10.2139/ssrn.3462651

Evelyn Patterson (Contact Author)

Indiana University-Kelley School of Business ( email )

801 West Michigan
Indianapolis, IN 46202
United States
317-278-7843 (Phone)

HOME PAGE: http://kelley.iupui.edu/faculty/FacultyProfile.cfm?netid=evpatter

J. Reed Smith

Kelley School of Business ( email )

801 W Michigan Street
BS 4002
Indianapolis, IN 46202
United States
317-274-0867 (Phone)
317-274-3312 (Fax)

Samuel L. Tiras

Indiana University - Kelley School of Business ( email )

801 W. Michigan Street
Indianapolis, IN 46202
United States
(317) 274-3420 (Phone)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
107
Abstract Views
808
rank
324,612
PlumX Metrics