The effect of real earnings management on auditor scrutiny of management’s other financial reporting decisions

Recent research reveals that accruals-based earnings management (AEM) is decreasing while real earnings management (REM) is increasing, suggesting the correlation is due to regulatory scrutiny. However, based on Correspondent Inference Theory, we predict and find that when management uses REM, auditors are more restrictive of management’s subjective estimates, making it more difficult for management to use income-increasing AEM. Our experiment manipulates the presence versus absence of REM, and whether the audit difference potentially impacts the client’s ability to meet an earnings target. Using a serial mediation model, we find that when auditors observe REM, they perceive these operating decisions as aggressive, leading them to perceive management as aggressive, ultimately causing greater proposed adjustments on an unrelated audit difference. We contribute to the literature by demonstrating that when auditors observe REM, their altered perceptions about management can cascade, affecting how they respond to management estimates in unrelated financial statement accounts.