Determination of Segment Reporting Manipulations and Auditor Responses

We investigate the relationship between audit fees and segment-level manipulations to see how sensitive auditors are to manipulative financial reporting. Because of the discretion allowed to management under existing laws, segment reporting provides an interesting context for examining auditor risk assessments. Shifting earnings from one sector to another is referred to as segment manipulation. It is not a violation of accounting standards per se, but it does go against the spirit of faithful representation by misrepresenting the performance of one subset of the reporting unit at the expense (or profit) of another. Because analysts and investors use disaggregated data in bottom-up forecasting, these distortions can damage firm value even if they have no impact on bottom-line net income. To proxy for segment manipulation, we use cost shifting between core operating segments and non-core segments as a proxy for categorization smoothing. Audit fees, a commonly used proxy for auditors’ risk assessment, are found to have a positive relationship with segment-level manipulations. Higher audit fees, according to subsequent research, are also related to the extra effort required in the case of segment-level manipulations. Furthermore, we demonstrate evidence of a positive relationship between restatements and segment-level manipulations, so auditors look justified in charging greater costs to clients that engage in segment manipulations. These findings imply that auditors are aware of the danger posed by corporations that engage in segment-level manipulations, and that auditors respond appropriately by demanding higher fees and completing more labour. Additional research shows that auditors take longer to finish audits for organisations that engage in segment manipulation, implying that the auditor is doing more effort, and that future restatements are positively associated with segment manipulations.

Author(S) Details

David Hurtt
Baylor University, USA.

Bradley E. Lail
Baylor University, USA.

Jason MacGregor
Baylor University, USA.

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