This study identifies conditions under which the audit risk model does, and does not, describe audit-planning (investment and pricing) decisions. In an experiment, audit partners and managers examined one of two cases where a material misstatement—error or irregularity—was discovered. The auditors assessed the elements of the audit risk model, assessed business risk and provided recommendations for the audit investment and fee. When the likelihood of an error was high, the audit risk model dominated business risk in the explanation of the audit investment, and the fee did not contain a risk premium. When the likelihood of an irregularity was high, business risk dominated the audit risk model in the explanation of the audit investment, and the fee contained a risk premium. These results suggest that the ability of the audit risk model to describe auditor behavior and the inclination of auditors to charge a risk premium depend upon the nature of the risks present in the audit. In the presence of errors, the audit risk model adequately described audit-planning decisions; in the presence of irregularities it did not.

We examine how shareholders' trust in managers is affected by (i) the outcome of earnings management (inconsistent vs. consistent with shareholders' interests) and (ii) the method of earnings management (accruals vs. real methods). Using a controlled experiment, we predict and find that trust is impaired when the outcome of earnings management suggests that managers have put their interests above shareholders' interests and/or when the method of earnings management suggests that managers misreported the firm's economic performance. We argue that shareholders assess managers putting their interests above shareholders' interests as a signal of untrustworthiness because it involves a transfer of the firm's resources away from shareholders to managers. We argue that shareholders also assess managers' use of accruals to manage earnings as a signal of untrustworthiness because, in this instance, managers misreport the firm's economic performance. Finally, we show that trust mediates the combined effects of the outcome of earnings management and the method of earnings management on investment decisions. Our study incrementally contributes to the literature by highlighting the adverse implications of managers' use of accruals to manage earnings even when its outcome serves shareholders' interests.

In this study we conduct an experiment to examine how qualifying an income‐decreasing accounting change in years of strong financial performance affects financial report users' assessments of strategic reporting, current financial performance, and future financial performance (performance over the next three years). We find that without the qualification, users viewed the income‐decreasing accounting change as relatively nonstrategic and that user assessments of current and future performance were not different. In the presence of the qualification, users believed that the accounting change was relatively strategic, and they discounted the income effect of the accounting change. We find further that their assessments of future performance were below their assessments of current performance but no different from the assessments of future performance in the absence of the qualification. Although our findings suggest that audit qualifications encourage users to be skeptical of income‐decreasing accounting changes, we find no evidence that they impose negative consequences on management in terms of lower assessments of financial performance.

Based on data collected from 616 experienced financial officers who use U.S. GAAP or IFRS and are domiciled in the U.S., Europe, or Asia, we examine how reporting standards (U.S. GAAP versus IFRS) and domicile (U.S. versus non-U.S.) affect earnings management (real versus accrual). U.S. firms using U.S. GAAP rely more heavily on real methods than non-U.S. firms that use either IFRS or U.S. GAAP and U.S. firms using IFRS. U.S. firms using U.S. GAAP operate in an environment that encourages real over accruals methods; specifically, U.S. GAAP facilitates detection of earnings management, and enforcement is more effective in the U.S. Further, the likelihood and amount of earnings management do not differ across conditions, suggesting that firms using less accruals earnings management tend to fully compensate by increasing real methods. So stronger reporting environments do not necessarily reduce total earnings management, but instead encourage substitution of real for accruals methods.

In this study we report the results of an experiment that examines how relatively sophisticated financial statement users interpret management stock option compensation disclosures under SFAS No. 123 and SFAS No. 123R. We predict and find that mandated income statement recognition, as required under SFAS No. 123R, leads to higher user assessments of reliability than either voluntary income statement recognition or voluntary footnote disclosure, options allowed under SFAS No. 123. Users view voluntary footnote disclosure as the least reliable reporting alternative. We also examine the amount users invest in response to these accounting treatments, and find that users invest more in a firm when management chooses income statement recognition than when management chooses footnote disclosure. We find no difference in investment amounts between mandated recognition and either voluntary recognition or footnote disclosure. Finally, although we find that these results are insensitive to whether management explicitly disavows the reliability of stock option expense, we present evidence that, in side-by-side comparisons, where one firm disavows and the other does not, disavowals may affect user judgments and decisions.