BEHAVIORAL RESEARCH IN ACCOUNTING American Accounting Association

Vol. 35, No. 1 DOI: 10.2308/BRIA-2021-039

Spring 2023
pp. 67–80

Auditors’ Responses to Real Earnings Management:

The Effects of Timing and Potential Consequences
on Auditor Decision-Making
Fengchun Tang
Virginia Commonwealth University

Ling Yang
New Jersey City University

ABSTRACT: 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.
Keywords: real earnings management; timing; consequences; auditor judgment.

I. INTRODUCTION

R
eal earnings management (REM), the use of real business activities that depart from normal operational practi-
ces to influence financial reports, is increasingly being used by managers to manipulate earnings. Unlike accrual
earnings management (AEM), REM involves earnings management through “real” business activities for
short-term purposes and is thus more likely to damage firms’ long-term profitability and future operations (Tang, Eller,
and Wier 2016). Despite management’s pervasive use of REM, auditors’ examination and responses to REM are ambig-
uous given that Audit Standards do not explicitly address auditors’ responsibilities regarding REM (Commerford,
Hermanson, Houston, and Peters 2016).
Recent research, however, indicates that auditors do constrain clients’ use of REM (A. Choi, J. Choi, and Sohn
2018; Greiner, Kohlbeck, and Smith 2017; Kim and Park 2014; Commerford, Hatfield, and Houston 2018;
Commerford, Hermanson, Houston, and Peters 2019). For example, Commerford et al. (2018) and Commerford et al.
(2019) show that auditors take action in the presence of explicit REM. Furthermore, Commerford et al. (2019) suggest
that, when there is ambiguity around REM, auditors rely on earnings context as a cue to identify potential REM and
respond accordingly once the transaction is identified as REM. Whereas these studies indicate that auditors will always
respond once REM activities are identified, we posit that the identification of REM does not necessarily lead to audi-
tors’ responses and that auditors’ responses are also contingent on auditors’ evaluation of the transaction. Commerford
et al. (2016) propose that auditors’ decisions related to REM involve three steps: (1) identifying possible REM, (2)

We thank Charles D. Bailey (senior editor), Kris Hardies (editor), and two anonymous reviewers for their feedback. We also thank Bob Cochran and
the Virginia State Board of Accountancy for their assistance in obtaining participants.
Fengchun Tang, Virginia Commonwealth University, School of Business, Department of Accounting, Richmond, VA, USA; Ling Yang, New Jersey
City University, School of Business, Department of Accounting, Jersey City, NJ, USA.
Editor’s note: Accepted by Kris Hardies.

Submitted: July 2021

Accepted: November 2022
Early Access: April 2023

67
68 Tang and Yang

evaluating REM, and (3) responding to REM. Following this framework, we posit that auditors’ responses to REM
depend on not only the identification of REM but also their evaluation.
Prior literature has already provided empirical evidence showing that the identification of wrongdoings does not
necessarily lead to responses to the wrongdoing and that whether and how to respond is also dependent on the evalua-
tion of the wrongdoing. For example, some studies (Mesmer-Magnus and Viswesvaran 2005; Alleyne, Weekes-
Marshall, and Arthur 2013) find that people may choose to remain silent rather than blow the whistle against observed
misconduct if they perceive the personal costs of whistleblowing to be high. Evaluation of the wrongdoing also deter-
mines which actions people take in response to the identification of the wrongdoing. Some actions are more confronta-
tional than others and may be avoided by people if possible (e.g., requiring management to make adjustments in the
financial statements is more confrontational than simply requiring disclosure of the same amount). For example, prior
literature indicates that people tend to take less confrontational actions for less serious misconduct. Some studies
(Dworkin and Baucus 1998; Callahan and Dworkin 1992; Sampaio and Sobral 2013) find that people prefer to blow the
whistle internally rather than externally for less serious misconduct. Even with internal whistleblowing, people may
choose to report the issue at lower levels for less serious wrongdoings (Alleyne et al. 2013).
This study extends Commerford et al. (2018) and Commerford et al. (2019) by investigating additional contextual
factors that affect auditors’ identification and evaluation of potential REM and their impacts on auditors’ decisions
related to these types of transactions. We first investigate whether auditors use the timing of a transaction as a contex-
tual cue to identify potential REM. As REM involves real business activities that can be easily camouflaged as normal
business transactions, one significant challenge that auditors face is how to differentiate REM from normal business
transactions (Commerford et al. 2016; Commerford et al. 2018). Normal transactions differ from REM only in terms of
intent, which is not directly observable for auditors. Therefore, auditors must rely on indirect signals to identify manage-
ment’s intent. REM is often accomplished by strategically timing investment or operating decisions (Xu, Taylor, and
Dugan 2007) at the end of an accounting period. As such, we expect the timing of a transaction to be a key contextual
cue that auditors rely on to identify potential REM.
We also examine whether auditors’ reactions are contingent on another contextual cue—the potential consequences
of the transaction. Some transactions are likely to result in severe negative future performance, whereas others may not.
For instance, cutting research and development (R&D) for the development of core products could severely impair the
company’s future operation. In contrast, cutting R&D for the development of noncore products may not necessarily
result in negative future operating performance. We expect that auditors use the potential consequences of the transac-
tion as a cue to evaluate the transaction and respond accordingly.
Taken together, we examine the joint effect of the timing and the potential consequences of a transaction on audi-
tors’ identification and evaluation of REM. We conducted a two-by-two experiment to test our hypotheses. We obtained
the email addresses of certified public accountants (CPAs) licensed by the state board of accountancy in an east coast
state. The CPAs were asked to assume the role of an auditor working on an audit engagement. While conducting the
audit, they were told that a cut in R&D expense caught their attention. We manipulated the timing and the potential
consequences of the cut. Participants were prompted to provide their assessment about the cut and their related judg-
ments and decisions.
Based on Correspondent Inference Theory (Jones and Davis 1965; Jones and Harris 1967), we posit and find
that auditors rely on the timing of the transaction as a cue to identify REM. Specifically, the participants assess a
higher likelihood that the R&D cut is an attempt to meet analysts’ forecasts when the cut occurs at the end of a
reporting period than when the cut does not occur at the end of the reporting period. While the timing of the trans-
action helps auditors identify potential REM, the auditors’ confrontational actions also depend on their evaluation
of the transaction. Our results show that the auditors are more likely to take confrontational actions (1) if the cut
occurs at the end of a reporting period and (2) if the cut is likely to result in more severe negative consequences to
the firm’s future operations.
This study makes several contributions to the existing literature with respect to REM. First, prior literature
(Commerford et al. 2018; Commerford et al. 2019) assumes that auditors always respond to REM once the transac-
tion is identified as an REM transaction. We posit and find that the identification of REM does not necessarily lead
to auditor responses. Second, we contribute to the understanding of how auditors rely on different contextual cues
in various stages of the decision-making process when facing ambiguity around REM. Our results suggest that audi-
tors rely on the timing of the transaction as a cue to identify potential REM transactions, but auditors’ confronta-
tional actions are also determined by their evaluation of the transaction. Specifically, auditors are more likely to
take confrontational actions if the transaction occurs at the end of a reporting period and is likely to result in more
negative consequences.

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The Effects of Timing and Potential Consequences on Auditor Decision-Making 69

II. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

Real Earnings Management

REM is defined as “departures from normal operational practices, motivated by managers’ desire to mislead at least
some stakeholders into believing certain financial reporting goals have been met in the normal course of operations”
(Roychowdhury 2006, 337). Common forms of REM include accelerating sales by providing deep discounts, cutting or
delaying discretionary expenses such as R&D and advertising, overproducing inventory, and strategically timing invest-
ments or asset sales. Prior literature suggests that managers are willing to meet earnings targets by using REM even at
the expense of future operating performance. In a survey of over 400 executives, Graham, Harvey, and Rajgopal (2005)
find that 80 percent of the executives surveyed are willing to reduce discretionary expenditures such as R&D to meet
earnings forecasts. Wang and D’Souza (2006) find that managers are willing to cut R&D when accounting flexibility is
low.
Prior research has examined the impact of REM on firms’ future performance, and the results are mixed. Some
research suggests that many types of REM may result in negative future performance. For example, Gunny (2005)
examines the consequences of four types of REM and finds that all four types lead to negative future operating perfor-
mance. Kim and Sohn (2013) provide evidence showing that REM results in a significantly lower level of future cash
flow after controlling for other risk factors. Ge and Kim (2014) investigate the impact of REM on credit ratings and
bond pricing. They find that overproduction impairs credit rating and that sales manipulation and overproduction lead
to higher bond yield spreads. Bhojraj, Hribar, Picconi, and McInnis (2009) conclude that REM leads to depressed stock
market value and poorer operating performance in subsequent years.
By contrast, some research indicates that certain types of REM may not necessarily result in negative future perfor-
mance. For instance, Taylor and Xu (2010) find that firms that engage in REM to meet earnings forecasts do not experi-
ence any significant decline in their future operating performance. Cohen and Zarowin (2010) and Mizik and Jacobson
(2007) document that financial markets overvalue firms that engage in REM at the time of seasoned equity offerings.
Gunny (2010) finds that firms that engage in REM to surpass earnings benchmarks have relatively better performance
in subsequent periods than comparable firms that do not engage in REM.
Kothari, Mizik, and Roychowdhury (2016) note that, while GAAP provides a framework that effectively guides
auditors’ examination of and response to AEM, there is no such framework for auditors to look to when examining
REM, and the responsibility auditors have with regard to REM is vague. For example, in interviews with experi-
enced auditors conducted by Commerford et al. (2016, 45), one respondent stated, “I do think [searching for REM
is] part of our responsibilities. It helps drive our audit effort.” Another respondent said, “I would say yes [I look
for REM].” By contrast, another respondent had a different opinion, “I’m not sure that anybody has a particular
responsibility to look for [real practices] or to be aware of them…they’re just natural parts of running the
business.”
The existing research on auditors’ responses to REM is also inconclusive (Commerford et al. 2019). Some literature
suggests that firms increasingly engage in REM as regulators and auditors increasingly scrutinize AEM. Cohen, Dey,
and Lys (2008) find that the use of AEM is on the rise in the pre-Sarbanes-Oxley Act (SOX) era. With the passage of
SOX, the use of AEM decreases, whereas the incidence of REM increases. Zang (2012) and Cohen and Zarowin (2010)
find that firms are more likely to engage in REM when their auditors are more likely to critically scrutinize AEM. Chi,
Lisic, and Pevzner (2011) conclude that firms rely more on REM to manage earnings when their ability to manage
accruals is constrained by higher-quality auditors. This indicates that auditors either do not take actions against REM
or are unable to detect or respond to it (Commerford et al. 2019).
By contrast, some literature suggests that auditors do take action against REM. For instance, Kim and Park (2014)
find that REM is positively associated with auditor resignation. Greiner et al. (2017) document a positive association
between income-increasing REM and audit fees. Commerford et al. (2016) find that REM causes concerns to auditors,
and they may take various actions, including discussing REM with their client, requiring additional disclosures, or
resigning from the audit engagement. Commerford et al. (2018) find that explicit REM evidence can affect auditors’
responses in unrelated financial statement areas. Further, Commerford et al. (2019) show that auditors’ responses to
REM are contingent on the level of ambiguity around the transactions and the earnings contexts.
The mixed results prompt the need for more research to understand auditors’ decision-making processes regarding
REM and the underlying factors that may affect auditors’ identification and evaluation of REM and their responses to
it. In particular, more research is needed to understand whether and how auditors rely on various contextual cues in dif-
ferent stages of the decision-making process when there is ambiguity around REM and how such contextual cues differ-
ently affect auditor actions.

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70 Tang and Yang

The Timing of the Transaction—REM Identification

We first examine factors that may affect auditors’ identification of potential REM. One of the biggest challenges for
auditors is to distinguish REM from normal business activities (Commerford et al. 2016). As one respondent stated in
the interview conducted by Commerford et al. (2016, 47), “I think it is hard to tell [if REM is present] because [often] we
don’t know things they’ve decided not to do.” Auditors have to understand the true motivation underlying a business
transaction to determine whether the transaction is REM. One important indicator pointing to the manager’s real inten-
tion behind a transaction might be the timing of the transaction. As noted by Gunny (2010), managers use REM to
change the timing or structure of an operating, investing, or financing transaction to affect the financial results.
Consistent with this argument, Sellami (2015) summarizes REM as altering earnings through the timing or the magni-
tude of real decisions (operating, investing, or financing activities) to achieve the desired earnings target.
Managers are most likely to know whether they can meet their earnings targets at the end of an accounting period.
Therefore, managers are more likely to engage in period-end REM when they realize they are unable to meet earnings
expectations. Indeed, prior literature (Shon and Yan 2015) finds that R&D cuts are more prevalent at the end of an
accounting period. In addition, manipulations at the end of accounting periods are more likely to be reversed than are
similar manipulations that take place in other periods.
Auditors are also sensitive to the use of REM at the end of an accounting period. In interviews with 20 experienced
auditors, Commerford et al. (2016) cite various transactions that occur at the end of the reporting period as examples of
REM, such as engaging in nonmonetary transactions to increase revenue or opening purchase orders to increase the pro-
duction and shipment of inventory. Of interest to the current study, 14 of the 20 auditors interviewed cite the use of dis-
cretionary expenses as the most common form of REM. All of the evidence suggests that auditors consider the time at
which a transaction occurs as an important factor in identifying REM.
We contend that auditors are more likely to perceive a cut in R&D as an attempt to manipulate earnings when the
cut occurs at the end of a reporting period than not at the end of a reporting period. We apply Correspondent Inference
Theory (Jones and Davis 1965; Jones and Harris 1967) to explain the impact of timing on auditors’ identification of
REM. Correspondent Inference Theory proposes that people make inferences about others’ underlying dispositions or
intentions based on observed behavior (Jones and Davis 1965; Jones and Harris 1967; Commerford et al. 2019). For
example, if an individual observes someone striking another person, Correspondent Inference Theory suggests that the
individual will perceive the attack to be motivated by a desire to inflict harm. According to Correspondent Inference
Theory, intention or disposition inference involves two stages. First, the observer must decide whether the observed
behavior is caused by the actor. Only intentional behavior is informative about the actor’s disposition. Intentions can
only be inferred from the action if the actor is considered to have (1) behavioral freedom, (2) the ability to foresee the
consequences of the behavior, and (3) the ability to achieve the desired goals (Crittenden 1983). Second, the observer
seeks to infer the actor’s intentions or dispositions. Correspondent Inference Theory has been applied to understand
REM as it fits these descriptions (Commerford et al. 2018; Commerford et al. 2019).
In our context, before managers intend to cut R&D to manipulate earnings, they must fully expect that they are
most likely to miss earnings targets and have a clear understanding of how much to manipulate to reach the targets.
Managers are most likely to know whether they are able to meet earnings expectations and how much of an adjustment
is necessary to meet the expectations only if it is close to the end of a reporting period. In addition, as previously men-
tioned, past experiences will tell auditors that REM is most likely to occur at the end of a reporting period. Therefore,
auditors should be more likely to attribute a cut in R&D to an intent to manipulate earnings if the cut occurs at the end
of a reporting period. By contrast, if it does not occur at the end of a reporting period, managers are less likely to know
whether they will meet earnings targets. There should be less correspondence between motivation and behavior.
Consequently, auditors should be less likely to attribute a cut to an attempt to manipulate earnings. Based on the above
analysis, we provide the following hypothesis, and Figure 1 graphically represents our research framework:
H1: Auditors are more likely to identify a cut in R&D as REM if the cut occurs at the end of a reporting
period than if the cut does not occur at the end of a reporting period.

REM Consequences—REM Evaluation

Confrontation has been recognized as one of the five strategies for resolving conflict (Zammuto, London, and
Rowland 1979; Samson and Meidinyo 2016; London and Howat 1978) and is perceived to be the most frequently used
and most effective strategy (London and Howat 1978; Burke 1970). According to Samson and Meidinyo (2016, 257),
confrontation refers to “a face-to-face meeting or encounter where one party challenges the other to resolve conflict.”
Confrontation involves interactions of relevant parties to reach a solution acceptable to both parties and risks the

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The Effects of Timing and Potential Consequences on Auditor Decision-Making 71

FIGURE 1
The Research Framework
H2a
Potential
Identification of a H2b consequences of the
transaction as real
transaction
earnings management
H1

Confrontational actions (actions

Timing at which a
taken by the auditor to confront a
transaction occurs client for the final resolution of an
REM issue).

possibility of emotionally hurting oneself and others (London and Howat 1978). It consists of five elements: it (1) brings
the problem clearly into the open and carries it out to resolution, (2) faces the conflict directly, (3) confronts the issue
openly, (4) clearly expresses a point of view, and (5) does not drop until it is resolved (Daves and Holland 1989).
Correspondingly, we define confrontational actions as the actions taken by auditors to confront their clients for the final
resolution of the REM issue.
We expect that, in response to the identification of a suspicious REM transaction, auditors are likely to take actions,
including confrontational actions, to address the REM issue. In other words, identification of the transaction as REM
could mediate the relation between timing of a transaction and auditors taking confrontational actions. While auditing
standards do not directly address auditors’ responsibility regarding REM, they, collectively as a set of rituals, provide
guidance for auditors’ identification, evaluation, and response to REM (Commerford et al. 2016). For example,
PCAOB Auditing Standard No. 5 (Public Company Accounting Oversight Board (PCAOB) 2006) requires auditors to
evaluate the effectiveness of their clients’ internal control over possible fraud using a suitable, recognized control frame-
work (e.g., COSO framework). Applying the COSO framework, auditors must develop a thorough understanding of
their client’s control environment (e.g., management’s integrity, ethical value, management philosophy and style)
(Commerford et al. 2016). Although REM is not, per se, a violation of GAAP, it is an opportunistic behavior with the
intention to misstate financial reporting and reflects management’s tone and attitude toward financial reporting (Kim
and Park 2014). The existence of REM casts doubt on the integrity of management (Kim and Park 2014), and a lack of
management integrity could lead to fraudulent financial reporting. Auditing Standards 2110 (Public Company
Accounting Oversight Board (PCAOB) 2015) states that, “When the auditor obtains audit evidence during the course of
the audit that contradicts the audit evidence on which the auditor originally based his or her risk assessment, the auditor
should revise the risk assessment and modify planned audit procedures or perform additional procedures in response to
the revised risk assessments.” In other words, auditors are required to take additional steps to address the increased
risks. Therefore, the identification of REM is likely to increase auditors’ response to the transaction, including confron-
tational actions.
While the timing of a transaction may help identify potential REM, it may not be strong enough to motivate audi-
tors to take confrontational actions. We posit that auditors’ confrontational actions are also dependent on auditors’
evaluation of the transaction. As previously mentioned, prior literature (Mesmer-Magnus and Viswesvaran 2005;
Alleyne et al. 2013) suggests that the identification of wrongdoings does not necessarily lead to actions to address the
wrongdoing. Whether and how to take action also depend on the evaluation of the wrongdoing. For instance, people
choose not to take action or take less confrontational actions if the personal costs are too high (Dworkin and Baucus
1998; Callahan and Dworkin 1992; Sampaio and Sobral 2013). We posit that the potential consequences of the transac-
tion are other important factors that auditors evaluate to decide whether or not a confrontational action should be
taken.
High personal costs of confrontational actions may prevent auditors from taking such actions. Therefore, the driv-
ing force of confrontational actions must be strong enough to overcome the negative impact of personal costs. Prior lit-
erature suggests that perceived seriousness of wrongdoing is a reflection of whether the observed wrongdoing is
sufficiently serious to warrant actions to address the wrongdoing and therefore is the major driving force for the reac-
tions or the punishment for the wrongdoing (Miceli and Near 2005; Cassematis and Wortley 2013). According to the
prior literature (Warr 1989; Almond 2009; Cassematis and Wortley 2013), perceived seriousness of wrongdoings is

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72 Tang and Yang

evaluated based on the perceived wrongfulness and harmfulness of the wrongdoing. Wrongfulness is a judgment of
moral gravity, whereas harmfulness is a judgment of the consequences (Cassematis and Wortley 2013). Some behavior
could be perceived to be wrongful but not harmful, harmful but not wrongful, or both wrongful and harmful. Behaviors
that are viewed as both wrongful and harmful would be considered the most serious and are thus most likely to over-
come the negative impact of personal costs (Cassematis and Wortley 2013).
In the REM context, according to SAS No. 109 (American Institute of Certified Public Accountants (AICPA)
2006), auditors must make risk assessments in terms of likelihood and consequences. If a cut in R&D expenses occurs at
the end of a reporting period, auditors are most likely to view the transaction as an REM transaction. As the purpose of
REM is to manipulate earnings, auditors are most likely to perceive the cut to be wrongful. By contrast, if the cut does
not occur at the end of a reporting period, the likelihood of the cut being REM is low. Thus, auditors are most likely to
view the transaction as a normal transaction. In other words, the cut would not be viewed as wrongful. Similarly, if the
cut is perceived to severely affect the client’s future operation, the cut would be considered harmful. Conversely, if the
cut is not perceived to severely affect the client’s future operation, the cut would not be viewed as harmful.
As previously mentioned, behaviors that are viewed as both wrongful and harmful would be considered the most
serious and are thus most likely to overcome the negative impact of personal costs (Cassematis and Wortley 2013). In
the REM context, the cut that occurs at the end of the reporting period and that is likely to severely affect the firm’s
future operation should be viewed as both harmful and wrongful. In other words, it would be most likely to be consid-
ered sufficiently serious to warrant confrontational actions. By contrast, the cut that occurs at the end of the reporting
period and that is not likely to severely affect the firm’s future operation should be viewed as wrongful but not harmful.
According to Miceli and Near (1992), whether or not to take action against wrongdoings (e.g., whistleblowing) partly
hinges on whether the benefits of the action outweigh the costs. Given that auditors do not have clear responsibilities
regarding REM (Commerford et al. 2018), the cut may not be viewed as sufficiently serious to warrant confrontational
actions at the expense of irritating/losing their client. In other words, the costs of confrontational actions may outweigh
the benefits. Similarly, the cut that does not occur at the end of the reporting period and that is likely to severely affect
the firm’s future operation should be viewed as harmful but not wrongful. Alter, Kernochan, and Darley (2007) show
that wrongfulness outweighs harmfulness as the primary determinant of the punishment for wrongdoings. In fact, in an
interview conducted by Commerford et al. (2016, 45), an experienced auditor states that, “I’m not sure that anybody
has a particular responsibility to look for [real practices] or to be aware of them…they’re just natural parts of running
the business.” This indicates that auditors are unlikely to take confrontational actions against a normal business transac-
tion. Therefore, the cut may similarly not be viewed as sufficiently serious to warrant confrontational actions. As such,
we provide the following hypotheses:
H2a: The relation between timing of a transaction and auditors taking confrontational actions is mediated by
identification of the transaction as REM.
H2b: Perceived severity of the impact of identified REM moderates the effect of identifying an REM
transaction on auditors taking confrontational actions.

III. METHOD
We test our hypotheses using a 2
2 experimental design. The manipulations consist of two between-participant
variables: timing (the transaction occurred at the end of the year versus not at the end of the year) and potential conse-
quences (the transaction is related to the development of the core product versus a noncore product).

Participants
Participants are CPAs licensed by the state board of accountancy in an east coast state of the United States. We
obtained contact information for the CPAs from the state board and sent an email containing a hyperlink to the experi-
mental materials via the online tool Qualtrics.1 Two weeks later, another email was sent as a reminder.
A total of 159 respondents participated in and completed the experiment. The average age of the participants was
47 years with a range from 24 to 75 years, and 102 participants (67.5 percent) were men. The mean experience with
respect to auditing and accounting was nine and 15 years, respectively.2 Seventy participants had an undergraduate

1
Institutional review board (IRB) approval was obtained from Longwood University in 2017. Ling Yang was employed here at the time of the study.
2
Thirty-one participants do not have auditing experience. The results remain the same in significance tests except that the path for the effect of identifi-
cation on confrontation in Figure 2 becomes coeff. ¼ 0.16 and p ¼ 0.07 (one-tailed), and the path for the moderating effect of potential consequences
on the relationship between identification and confrontation becomes coeff. ¼ 0.62 and p ¼ 0.088 (one-tailed) if the participants who did not have
auditing experience are excluded.

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The Effects of Timing and Potential Consequences on Auditor Decision-Making 73

degree, 80 participants had a master’s degree or higher, and the remaining participants did not report their degree.
Thirty-two participants were managers, 35 were directors, 25 were partners, 24 were seniors, 2 were staff, and the
remaining participants responded “other.”

Task
Participants were randomly assigned to one of the four between-participant treatments and were provided with gen-
eral study instructions and a decision scenario. The participants were provided information about Beta, Inc., a technol-
ogy company that designs, develops, and sells consumer electronic devices such as cell phones, computers, and other
technologies. Beta’s products are very competitive in the market. Over the past few years, Beta’s financial performance
and share price have been improving steadily. Beta’s pre-tax EPS has increased by 4 percent in each of the last three years.
Consistent with this trend, Beta’s 2017 pre-tax EPS is expected to reach $1.75 per share, which is a 4 percent increase over
the 2016 pre-tax EPS of $1.68 per share. Beta’s internal controls are properly designed and operating effectively.
The case further states that Beta had a difficult year in 2017. Their unaudited financial statements indicate that they
ended the year with a pre-tax profit of $200,000, which barely meets analysts’ earnings forecasts. The auditor notices
that Beta cut R&D in 2017. Without the above-mentioned cut, Beta would not have met analysts’ expectations. Testing
with respect to R&D indicates that the expense is fairly stated with respect to the actual expenses incurred during the
year. A search for unrecorded liabilities provides no evidence of current year expenses being deferred into the subsequent
year. Participants were asked to assume the role of an auditor who works on the audit engagement. After reading the
case material, participants were asked to answer questions regarding their assessment of the cut and their response to it.

Independent Variables
Two independent variables, the timing of the cut (TIMING) and the potential consequences of the transaction
(CONSEQUENCES), were manipulated between subjects. We manipulated the timing of the cut at two levels. In one
treatment, participants were told that the cut in R&D occurred at the end of the year (End of Reporting Period condi-
tion). In the other treatment, participants were told that the cut occurred in the middle of the second quarter (Not End
of Reporting Period condition).
The manipulation of the potential consequences of the transaction was achieved by varying the nature of the cut. In
one treatment, participants were told that the cut was related to the development of a core product (Severe
Consequences condition). In the other treatment, participants were told that the cut was related to the development of a
product, which was not one of the core products (Minor Consequences condition). Prior literature suggests that the
introduction of products would significantly affect a firm’s future operating performance (Ofek and Sarvary 2003). Core
production activity allows companies to gain a competitive advantage, which is essential to a company’s success, espe-
cially in the technology industry (McIvor, Humphreys, and McAleer 1997; Quelin 2000). R&D expenditures have been
considered an investment rather than an expense (He and Tian 2014). Lee and Lo (2016) argue that investors will be
skeptical about firms’ financial status when there is no growth in core products, as R&D is associated with greater future
benefits and risks (Ciftci and Darrough 2016). Cutting R&D could have a significant negative impact on a firm’s future
profitability (Shon and Yan 2015; Sun 2021).

Dependent Variables
H1 focuses on auditor identification of REM. We asked participants, “How likely is it that the R&D expense was cut in
an attempt to meet analysts’ earnings forecasts?” (IDENTIFICATION). H2 focuses on auditors’ confrontational actions
(CONFRONTATION). We adapted three questions from Commerford et al. (2016) to measure CONFRONTATION:
(CA1) How likely is it that you will discuss management’s decision to cut R&D expenses with the audit committee? (CA2)
How likely is it that you will require management to provide additional disclosure regarding the cut in R&D expenses (e.g.,
discuss in the MD&A)? (CA3) How likely is it that you will require management to make adjustments to R&D expenses in
the financial statements. The responses were measured on a seven-point Likert scale where –3 represents “Extremely
Unlikely” and 3 represents “Extremely Likely.”3 The seven-point Likert scale used was fully labeled. CONFRONTATION
was calculated as the mean of the three questions. The Cronbach’s a for CONFRONTATION is 0.693, and the interitem cor-
relations are 0.580, 0.387, and 0.317, respectively.

3
The range of means for the three CONFRONTATION questions are 1.1–1.83, 0.53–1.30, and –1.08–0.00, respectively. The negative responses for
the last question suggest that participants in all conditions would prefer not to require management to make adjustments to R&D expenses in the
financial statements. This result is consistent with the findings of Commerford et al. (2016).

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74 Tang and Yang

IV. RESULTS

Manipulation Checks
We asked participants several questions to assess whether the manipulated independent variables were recognized
correctly. To assess whether the manipulation of timing was recognized correctly, participants were asked whether the
cut in R&D occurred in the middle of the second quarter or at the end of the year. Four participants failed this manipu-
lation check. To assess whether the manipulation of the potential consequences was recognized correctly, participants
were asked whether the cut in R&D was related to the development of a core product or a product that was not one of
the company’s core products. Eleven participants failed this manipulation check. Together, 13 participants failed the
manipulation check questions and are not included in the analysis.4
To further assess whether the manipulation of the potential consequences is successful, we asked participants, “To
what extent will the cut in R&D expense affect Beta’s future operating performance?” Responses were measured on a
seven-point Likert scale, where 1 represents “Extremely Positive,” and 7 represents “Extremely Negative.” A compari-
son of means across conditions reveals that there is a significant difference (F(1, 144) ¼ 3.64, p ¼ 0.05, two-tailed) in the
perceived impact of the cut on the firm’s future operating performance between participants in the Severe Consequences
condition (mean ¼ 4.53) and those in the Minor Consequences condition (mean ¼ 4.13). Further analysis shows that the
mean of the Minor Consequences conditions is not significantly different from the midpoint of 4 (t(83) ¼ 1.26, p ¼ 0.21,
two-tailed). By contrast, the mean of the Severe Consequences conditions is significantly (t(61) ¼ 2.66, p ¼ 0.01, two-
tailed) higher than the midpoint of 4. The manipulation of the potential consequences seems to be successful.

Hypothesis Testing
We posit that auditors use the timing at which the transaction occurs as a contextual cue to identify potential REM,
but that auditors’ confrontational actions are contingent on both the identification and the evaluation of REM. In other
words, IDENTIFICATION mediates the effect of TIMING on CONFRONTATION, and CONSEQUENCES moder-
ates the effect of IDENTIFICATION on CONFRONTATION. Following Hayes (2013), we conducted a moderated
mediation analysis using model 15 of the PROCESS macro in SPSS. The descriptive statistics are provided in Table 1,
and the results are summarized in Figure 2. As expected, the effect of TIMING on IDENTIFICATION is statistically
significant (coeff. ¼ 0.57, p ¼ 0.004, one-tailed). Consistent with our hypothesis, the results show that the transaction is
more likely to be viewed as REM when the transaction occurs at the end of the reporting period (mean ¼ 1.87) than
when the transaction does not occur at the end of the reporting period (mean ¼ 1.30). Thus, H1 is supported.
As shown in Figure 2, IDENTIFICATION has a significant, positive relationship with CONFRONTATION (coeff. ¼
0.21, p ¼ 0.02, one-tailed), suggesting that the identification of REM will increase auditors’ confrontational actions.
Moreover, the direct effect of TIMING on CONFRONTATION is insignificant (coeff. ¼ –0.27, p ¼ 0.31, two-tailed).
Thus, our results provide evidence to support H2a that the identification of the transaction as REM is the mediator
through which the timing of the transaction impacts auditors’ confrontational actions.
The results of the moderated mediation analysis also reveal that CONSEQUENCES moderates the effect of
IDENTIFICATION on CONFRONTATION (coeff. ¼ 0.76, p ¼ 0.03, one-tailed). In addition, the mediating effect of
IDENTIFICATION is contingent on CONSEQUENCES. When the cut does not severely affect the firm’s future opera-
tion, the mediation effect is not significant (95 percent confidence interval ¼ –0.016, 0.306). However, when the cut
severely affects the firm’s future operation, the mediating effect of IDENTIFICATION is statistically significant (95 per-
cent confidence interval ¼ 0.009, 0.417). Together, these results suggest that auditors are more likely to take confronta-
tional actions if (1) the cut occurs at the end of a reporting period and (2) the cut is likely to result in more negative
consequences to the firm’s future operations. Thus, H2b is supported. The index of moderated mediation is 0.06 (95 per-
cent confidence interval ¼ –0.140, 0.299).

Supplemental Analysis
We also conducted three separate moderated mediation analyses on each individual question of CONFRONTATION
using model 15 of the PROCESS macro in SPSS. Figures 3–5 depict the results. Consistent with the main analysis, TIMING
is significantly associated with IDENTIFICATION (coeff. ¼ 0.57, p ¼ 0.004, one-tailed), which has a significant, positive
relationship with CA1 (coeff. ¼ 0.25, p ¼ 0.03, one-tailed) and CA2 (coeff. ¼ 0.37, p ¼ 0.003, one-tailed). This result suggests

4
The results remain the same in significance tests except that the path for the moderating effect of potential consequences on the relationship between
identification and confrontation in Figure 2 becomes coeff. ¼ 0.63, p ¼ 0.056 (one-tailed), if the participants who failed the manipulation checks are
included in the analyses.

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The Effects of Timing and Potential Consequences on Auditor Decision-Making 75

TABLE 1
Descriptive Statistics

Panel A: IDENTIFICATIONa—Mean (Standard Deviation) fSample Sizeg

TIMINGb

CONSEQUENCESc Not End of Reporting Period End of Reporting Period Total

Minor Consequences 1.15 1.87 1.54
(1.50) (1.04) (1.31)
f39g f45g f84g
Severe Consequences 1.47 1.87 1.66
(1.48) (1.04) (1.29)
f32g f30g f62g

Total 1.30 1.87 1.59

(1.49) (1.03) (1.30)
f71g f75g f146g

Panel B: CONFRONTATIONd—Mean (Standard Deviation) fSample Sizeg

TIMINGb

CONSEQUENCESc Not End of Reporting Period End of Reporting Period Total

Minor Consequences 0.44 0.31 0.37
(1.25) (1.19) (1.21)
f39g f45g f84g
Severe Consequences 0.43 1.04 0.73
(1.39) (0.98) (1.24)
f32g f30g f62g

Total 0.43 0.60 0.52

(1.30) (1.16) (1.23)
f71g f75g f146g
a
Participants were asked “How likely is it that the R&D expense was cut in an attempt to meet analysts’ earnings forecasts?” The responses were
measured on a seven-point Likert scale, where –3 represents “very unlikely” and 3 represents “very likely.”
b
TIMING refers to the time at which the R&D was cut, where 0 represents that R&D was not cut at the end of the year and 1 represents that
R&D was cut at the end of the year.
c
CONSEQUENCES refers to how the cut is likely to affect the client firm’s future operation; 1 represents that the cut is related to the develop-
ment of a core product, and 0 represents that the cut is related to the development of a product that is not one of the core products.
d
Participants were asked (1) how likely is it that you will discuss management’s decision to cut R&D expenses with the audit committee? (2) How
likely is it that you will require management to provide additional disclosure regarding the cut in R&D expenses (e.g., discuss in the MD&A)?
(3) How likely is it that you will require management to make an adjustment to R&D expense in the financial statements? The responses were
measured on a seven-point Likert scale where –3 represents “very unlikely” and 3 represents “very likely.” CONFRONTATION was calculated
as the mean of the three questions.

that the identification of REM mediates the impact of TIMING on auditors’ decisions to discuss with the audit committee
and decisions to require management to provide additional disclosure regarding the transaction. The relationship between
IDENTIFICATION and CA3 is not significant (coeff. ¼ 0.001, p ¼ 0.50, one-tailed). Furthermore, the moderating effect of
CONSEQUENCES on CA2 is significant (coeff. ¼ 1.42, p ¼ 0.003, one-tailed) but on CA1 (coeff. ¼ 0.47, p ¼ 0.18, one-
tailed) and CA3 (coeff. ¼ 0.39, p ¼ 0.22, one-tailed) are not significant. The tests on indirect effects reveal that the indirect
effects on CA1 and CA2 are contingent on CONSEQUENCES. Specifically, when the cut does not severely affect the firm’s
future operation, the mediating effects on CA1 (95 percent confidence interval ¼ –0.024, 0.360) and CA2 (95 percent confi-
dence interval ¼ –0.041, 0.419) are not significant. However, when the cut severely affects the firm’s future operation, the
mediating effects of IDENTIFICATION on CA1 (95 percent confidence interval ¼ 0.015, 0.533) and CA2 (95 percent confi-
dence interval ¼ 0.022, 0.479) are statistically significant. The mediating effects on CA3 are not statistically different across
different levels of CONSEQUENCES. Overall, the results provide strong support for the moderated mediation on CA2,

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76 Tang and Yang

FIGURE 2
The Path Analysis on Confrontational Actions
The Indirect effect through Identification:
When potential consequences = 1, 95% confidence interval = [0.009, 0.417]
When potential consequences = 0, 95% confidence interval = [-0.016, 0.306]
Coeff. = 0.76, p = 0.03,
Identification b one-tailed
Potential
Consequences c

Coeff. = 0.57, p = 0.004, one-tailed

Coeff. = 0.21, p = 0.02,
Coeff. = 0.11, p = 0.48, one-tailed
two-tailed
Coeff. = -0.27, p = 0.31, two-tailed Confrontation d
Timing a

The path analysis was conducted using model 15 of the SPSS PROCESS macro.
a
Timing refers to the time at which the R&D was cut, where 0 represents that R&D was not cut at the end of the year and 1 represents that R&D
was cut at the end of the year.
b
Identification was measured by asking participants, “How likely is it that the R&D expense was cut in an attempt to meet analysts’ earnings
forecasts?” The responses were measured on a seven-point Likert scale, where –3 represents “very unlikely” and 3 represents “very likely.”
c
Potential Consequences refers to how the cut is likely to affect the client firm’s future operation; 1 represents that the cut is related to the develop-
ment of a core product, and 0 represents that the cut is related to the development of a product that is not one of the core products.
d
Confrontation was measured by asking participants (1) how likely is it that you will discuss management’s decision to cut R&D expenses with
the audit committee, (2) how likely is it that you will require management to provide additional disclosure regarding the cut in R&D expenses
(e.g., discuss in the MD&A), and (3) how likely is it that you will require management to make an adjustment to R&D expense in the financial
statements. The responses were measured on a seven-point Likert scale, where –3 represents “very unlikely” and 3 represents “very likely.” It
was calculated as the mean of the three questions.

FIGURE 3
The Path Analysis on CA1
The Indirect effect through Identification:
When potential consequences = 1, 95% confidence interval = [0.015, 0.533]
When potential consequences = 0, 95% confidence interval = [-0.024, 0.360]
Coeff. = 0.47, p = 0.18,
Identification b one-tailed
Potential
Consequences c

Coeff. = 0.57, p = 0.004, one-tailed

Coeff. = 0.25, p = 0.03,
Coeff. = 0.16, p = 0.42, one-tailed
two-tailed
Coeff. = -0.43, p = 0.67, two-tailed CA1 d
Timing a

The path analysis was conducted using model 15 of the SPSS PROCESS macro.
a
Timing refers to the time at which the R&D was cut, where 0 represents that R&D was not cut at the end of the year and 1 represents that R&D
was cut at the end of the year.
b
Identification was measured by asking participants “How likely is it that the R&D expense was cut in an attempt to meet analysts’ earnings fore-
casts?” The responses were measured on a seven-point Likert scale, where –3 represents “very unlikely” and 3 represents “very likely.”
c
Potential Consequences refers to how the cut is likely to affect the client firm’s future operation; 1 represents that the cut is related to the develop-
ment of a core product, and 0 represents that the cut is related to the development of a product that is not one of the core products.
d
CA1 was measured by asking participants “How likely is it that you will discuss management’s decision to cut R&D expenses with the audit
committee?” The responses were measured on a seven-point Likert scale, where –3 represents “very unlikely” and 3 represents “very likely.”

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The Effects of Timing and Potential Consequences on Auditor Decision-Making 77

FIGURE 4
The Path Analysis on CA2
The Indirect effect through Identification:
When potential consequences = 1, 95% confidence interval = [0.022, 0.479]
When potential consequences = 0, 95% confidence interval = [-0.041, 0.419]
Coeff. = 1.42, p = 0.003,
Identification b one-tailed
Potential
Consequences c

Coeff. = 0.57, p = 0.004, one-tailed

Coeff. = 0.37, p = 0.003,
Coeff. = -0.10, p = 0.63, one-tailed
two-tailed
Coeff. = -1.02, p = 0.004, two-tailed CA2 d
Timing a

The path analysis was conducted using model 15 of the SPSS PROCESS macro.
a
Timing refers to the time at which the R&D was cut, where 0 represents that R&D was not cut at the end of the year and 1 represents that R&D
was cut at the end of the year.
b
Identification was measured by asking participants “How likely is it that the R&D expense was cut in an attempt to meet analysts’ earnings fore-
casts?” The responses were measured on a seven-point Likert scale, where –3 represents “very unlikely” and 3 represents “very likely.”
c
Potential Consequences refers to how the cut is likely to affect the client firm’s future operation; 1 represents that the cut is related to the develop-
ment of a core product, and 0 represents that the cut is related to the development of a product that is not one of the core products.
d
Confrontation was measured by asking participants “How likely is it that you will require management to provide additional disclosure regard-
ing the cut in R&D expenses (e.g., discuss in the MD&A)?” The responses were measured on a seven-point Likert scale, where –3 represents
“very unlikely” and 3 represents “very likely.”

FIGURE 5
The Path Analysis on CA3
The Indirect effect through Identification:
When potential consequences = 1, 95% confidence interval = [-0.016, 0.388]
When potential consequences = 0, 95% confidence interval = [-0.187, 0.173]
Coeff. = 0.39, p = 0.22,
Identification b one-tailed
Potential
Consequences c

Coeff. = 0.57, p = 0.004, one-tailed

Coeff. = 0.001, p = 0.50,
Coeff. = 0.27, p = 0.18, one-tailed
two-tailed
Coeff. = 0.34, p = 0.32, two-tailed CA3 d
Timing a

The path analysis was conducted using model 15 of the SPSS PROCESS macro.
a
Timing refers to the time at which the R&D was cut, where 0 represents that R&D was not cut at the end of the year and 1 represents that R&D
was cut at the end of the year.
b
Identification was measured by asking participants “How likely is it that the R&D expense was cut in an attempt to meet analysts’ earnings fore-
casts?” The responses were measured on a seven-point Likert scale, where –3 represents “very unlikely” and 3 represents “very likely.”
c
Potential Consequences refers to how the cut is likely to affect the client firm’s future operation; 1 represents that the cut is related to the develop-
ment of a core product, and 0 represents that the cut is related to the development of a product that is not one of the core products.
d
Confrontation was measured by asking participants “How likely is it that you will require management to make an adjustment to R&D expense
in the financial statements?” The responses were measured on a seven-point Likert scale, where –3 represents “very unlikely” and 3 represents
“very likely.”

some support for CA1, and no support on CA3. The lack of support for CA3 is understandable as the prior literature sug-
gests that requiring financial statement adjustments is an action that auditors are unlikely to take. In an interview conducted
by Commerford et al. (2016), none of the interviewees would propose an adjustment to financial statements. In our study, the
fact that the means of CA3 across all conditions are below 0 is also consistent with this finding.

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78 Tang and Yang

V. CONCLUSION AND DISCUSSION

Regulators and researchers are increasingly concerned about firms’ use of REM to manage earnings. Unlike AEM,
REM entails real business transactions and is more likely to result in significant impacts on firms’ future operating per-
formance. While auditors play a critical role in constraining earnings management, the responsibility of auditors regard-
ing REM is ambiguous, and there is currently no framework to guide auditors’ decisions. It is unclear how auditors will
respond to REM. This paper examines factors in different stages of auditors’ decision-making processes regarding REM
and their impacts on auditor actions. We predict that auditors use the timing of the transaction as an important cue to
identify REM. We find that a transaction that occurs at the end of a reporting period is more likely to be viewed as
REM than a transaction that does not occur at the end of a reporting period. We also find that auditors’ confrontational
actions are determined by both the identification and the evaluation of the transaction. Specifically, auditors tend to
take confrontational actions only if the transaction occurs at the end of a reporting period and is likely to result in nega-
tive consequences to the firm’s future operations.
Our study is not without limitations. First, the experimental case is based on a cut in R&D. However, firms could
engage in other forms of REM, such as providing deep sales discounts to manipulate earnings. It is possible that the
results of this study may not be generalizable to other types of REM. There continues to be a need for additional
research to examine the factors that may influence decision-making related to other types of REM. Second, in this study,
we test our hypotheses by using experimental methodology with a hypothetical case that provides only limited informa-
tion about a firm. The experimental methodology gives researchers full control over the information that participants
receive and allows researchers to make causal inferences. While experimental methodology maximizes internal validity,
by nature, it is low in external validity. In a real audit, auditors would have access to more sources of information and
have more opportunities to communicate with management regarding REM. Future research could use different meth-
odologies to replicate our study in a richer context. Last, but not least, we did not directly assess auditors’ evaluation of
management’s integrity. Future research could examine whether the timing of the transaction affects auditors’ assess-
ment of management’s integrity.

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