Evidence from auditors about managers' and auditors' earnings management decisions.

I. INTRODUCTION

Earnings management can be defined as non-neutral financial reporting in which managers intervene intentionally in the financial reporting process to produce some private gain (Schipper 1989). Managers can intervene by modifying how they interpret financial accounting standards and accounting data, or by timing or structuring transactions (Healy and Wahlen 1999). (1) Because many such interventions are difficult to distinguish from appropriate applications of GAAP, the definition of earnings management hinges fundamentally on managerial intent, which is difficult to assess using ex post accounting information (Dechow and Skinner 2000). As a consequence, researchers have struggled to identify earnings management, and accounting research has not provided much evidence about the characteristics of accounting standards that encourage earnings management, or about the extent to which various aspects of the financial reporting process discourage earnings management (Healy and Wahlen 1999).

This paper reports analyses of data obtained using a field-based questionnaire in which 253 audit partners and managers from one Big 5 firm recalled and described 515 specific experiences they had with clients who they believed were attempting to manage earnings. Auditors are required by GAAS to understand their clients' incentives and to search for differences between actual and expected performance that may indicate misstatements, so the auditors who participated in our study were relatively well positioned to identify specific instances of earnings management. Because respondents provided transaction-level data about attempts covering a range of financial accounting transactions, including attempts that are purely judgmental as well as attempts that involve transaction structuring, these data allow us to examine how attempts are affected by the precision of financial accounting standards (2) and by other characteristics of attempts. Unlike studies that focus on only post-audit information, we consider separately managers' decisions about how to attempt earnings management and auditors' decisions about whether to require adjustments. (3) Thus, our study provides evidence about how a key feature of accounting standards (precision of rules) and a key feature of the financial reporting process (activity of external auditors) influence earnings management.