In this paper we seek to document errors that could affect studies of earnings management. The book income adjustment (BIA) of the alternative minimum tax (AMT) created apparently strong incentives to manage book income downward in 1987. Five earlier papers using different methodologies and samples all conclude that earnings were reduced in response to the BIA. This consensus of findings offers an opportunity to investigate our speculation that methodological biases are more likely when there appear to be clear incentives for earnings management. A reexamination of these studies uncovers potential biases related to a variety of factors, including choices of scaling variables, selection of affected and control samples, and measurement error in estimated discretionary accruals. A reexamination of the argument underlying these studies also suggests that the incentives to manage earnings are less powerful than initially predicted, and are partially mitigated by tax and non-tax factors. As a result, we believe that the extent of earnings management that occurred in 1987 in response to the BIA remains an unresolved issue.

This paper reports the results of an experiment that investigates how external audit planning is affected when internal auditors have incentives and the opportunity to bias their evaluations. Specifically, we draw on attribution theory to examine how internal auditor eligibility for incentive compensation and participation in consulting (i.e., two factors that provide incentives to bias audit evaluations) affect external audit planning. In addition, we examine the effects of incentive compensation and a consulting role across two routine internal audit tasks — an objective tests of controls task and a subjective inventory valuation task — to evaluate whether their effects are contingent upon task subjectivity (i.e., opportunity to bias audit evaluations). Seventy-six external auditors from four Big 5 public accounting firms participated in an experiment that manipulated internal auditor compensation (fixed salary versus incentive compensation), the type of work that the internal auditors routinely perform (primarily auditing versus primarily consulting), and audit task subjectivity (objective tests of controls versus subjective inventory valuation). Our results suggest that the nature of internal auditors' compensation and work affect audit planning recommendations differently. The opportunity to receive incentive compensation results in less reliance on internal auditors' work and greater budgeted audit hours, but only for the subjective task. Although a consulting role decreases perceived internal auditor objectivity, it has a limited effect on planning recommendations. Specifically, consulting has no effect on reliance, and leads to greater budgeted audit hours only when incentive compensation is available. We discuss potential explanations for the results as well as implications for audit research, practice, and regulation.

Abstract This paper reports the results of an experiment that investigates how external audit planning is affected when internal auditors have incentives and the opportunity to bias their evaluations. Specifically, we draw on attribution theory to examine how internal auditor eligibility for incentive compensation and participation in consulting (i.e., two factors that provide incentives to bias audit evaluations) affect external audit planning. In addition, we examine the effects of incentive compensation and a consulting role across two routine internal audit tasks — an objective tests of controls task and a subjective inventory valuation task — to evaluate whether their effects are contingent upon task subjectivity (i.e., opportunity to bias audit evaluations). Seventy‐six external auditors from four Big 5 public accounting firms participated in an experiment that manipulated internal auditor compensation (fixed salary versus incentive compensation), the type of work that the internal auditors routinely perform (primarily auditing versus primarily consulting), and audit task subjectivity (objective tests of controls versus subjective inventory valuation). Our results suggest that the nature of internal auditors' compensation and work affect audit planning recommendations differently. The opportunity to receive incentive compensation results in less reliance on internal auditors' work and greater budgeted audit hours, but only for the subjective task. Although a consulting role decreases perceived internal auditor objectivity, it has a limited effect on planning recommendations. Specifically, consulting has no effect on reliance, and leads to greater budgeted audit hours only when incentive compensation is available. We discuss potential explanations for the results as well as implications for audit research, practice, and regulation.

Abstract In this paper we seek to document errors that could affect studies of earnings management. The book income adjustment (BIA) of the alternative minimum tax (AMT) created apparently strong incentives to manage book income downward in 1987. Five earlier papers using different methodologies and samples all conclude that earnings were reduced in response to the BIA. This consensus of findings offers an opportunity to investigate our speculation that methodological biases are more likely when there appear to be clear incentives for earnings management. A reexamination of these studies uncovers potential biases related to a variety of factors, including choices of scaling variables, selection of affected and control samples, and measurement error in estimated discretionary accruals. A reexamination of the argument underlying these studies also suggests that the incentives to manage earnings are less powerful than initially predicted, and are partially mitigated by tax and non‐tax factors. As a result, we believe that the extent of earnings management that occurred in 1987 in response to the BIA remains an unresolved issue.