This study uses a unique institutional setting in China to investigate empirically the association between the organizational form of CPA firms (unlimited liability versus limited liability) and the reporting conservatism of auditors. Based on a sample of 5,007 audits of Chinese listed companies from the period of 2000 to 2004, we find that auditors in unlimited liability partnership firms are more likely to issue modified audit opinions than are auditors in limited liability CPA firms. This auditor conservatism stems from distressed firms with going-concern opinions, and we find no statistical evidence that partnerships give more modified opinions for non-distressed firms. In addition, auditors are less likely to issue modified reports after they incorporated the firm in the limited liability form. These analyses support our hypothesis that a limited liability regime induces lower auditor reporting conservatism. Our study contributes to the broader debate on liability reform in the auditing profession.

Boards of directors and compensation committees predominantly use financial measures reflecting executive managerial duties as inputs to executive compensation decisions. Yet, despite the fact that Holmstrom (1979) suggests that any readily available performance measure should be considered in executive compensation decisions, there is little research on the link between executive compensation and non-financial performance measures. We develop and test a model of chief financial officer (CFO) compensation with specific emphasis on the link between the disclosure of internal control material weaknesses (ICMW), a non-financial performance measure reflecting CFO fiduciary duties, and CFO compensation. Since internal controls are under the direct responsibility of the CFO, the disclosure of an ICMW reflects poorly on his/her performance. As a baseline, we find that ICMW disclosures lead to decreases in CFO compensation (bonus, equity, and total). Of greater interest, we find that CFOs at firms with stronger governance experience larger compensation decreases upon ICMW disclosures compared to CFOs at firms with weaker governance. In addition, CFOs at firms with greater costs of financial statement misreporting experience larger compensation decreases upon ICMW disclosures compared to CFOs at firms with lower costs of misreporting. Taken together, these results contribute to the relatively sparse literature on CFOs by illustrating the importance of CFO fiduciary duties and the interaction of those duties, in terms of firm governance and misreporting costs, with changes in CFO compensation.

Despite a recent focus on the ethics of earnings management, research has generally not examined the specific ethical dilemma that arises when a choice to engage in earnings management results in positive organizational consequences. This study focuses on the consequences of earnings management behavior in response to the question: Do the ends of positive organizational consequences justify the means of earnings management? We investigate manager evaluations of, and reactions to, a scenario in which a hypothetical employee makes a choice whether or not to engage in earnings management behavior, with consequences that are either favorable or unfavorable to the organization. Two hundred and sixty-four experienced managers provided responses to the scenario in a controlled experimental research design. The results indicate that managers may be motivated to discount the ethical impact of earnings management behavior when the consequence has a favorable impact on the organization—implying that the ends justify the means. This finding, in turn, suggests that incrementalism, or the ethical “slippery slope” of overlooking seemingly minor ethical breaches, can undermine efforts to establish a strong ethical tone throughout the organization. Implications of these findings for corporate governance and future research are discussed.