SUMMARY Real earnings management (REM) is an increasingly common method of manipulating financial results, yet little research examines auditors' perceptions of and responses to REM. Using the auditor comfort framework (Pentland 1993; Carrington and Catasús 2007), we examine the extent to which REM impacts auditor comfort and how, in the presence of REM, auditors rely on comfort-building strategies in trying to move from a state of discomfort (i.e., fear of failing to identify misstatements) to comfort. Based on in-depth interviews of 20 experienced auditors, we find that auditors are aware of REM and often identify REM through formalized protocols that include analytical procedures, discussions with management, or their knowledge of the business. Formal audit procedures play a role when trying to address, “rationally,” the risk of REM, but we also find that auditors use emotive phrases and references to body senses related to discomfort, indicating that there also is an emotional component to dealing with REM (Guénin-Paracini, Malsch, and Marché-Paillé 2014). Most of the interviewees have concerns about REM (i.e., it threatens comfort), largely because they believe that it is indicative of management's desire to meet short-term targets (i.e., poor management tone), and that it may signal the use of other, less acceptable earnings management methods (i.e., accruals-based earnings management) to meet those targets. Interviewees respond to the discomfort caused by REM in many ways, including engaging in discussions with the client, increasing skepticism, and altering audit procedures and risk assessments. Auditors may even go as far as resigning from an engagement because of REM. Our analysis reveals that REM is a significant source of auditor discomfort and that auditors use both their rationality and their emotions/body senses to identify and try to alleviate that discomfort.

Recent research reveals that accruals-based earnings management (AEM) is decreasing while real earnings management (REM) is increasing, suggesting the correlation is due to regulatory scrutiny. However, based on Correspondent Inference Theory, we predict and find that when management uses REM, auditors are more restrictive of management's subjective estimates, making it more difficult for management to use income-increasing AEM. Our experiment manipulates the presence versus absence of REM, and whether the audit difference potentially impacts the client's ability to meet an earnings target. Using a serial mediation model, we find that when auditors observe REM, they perceive these operating decisions as aggressive, leading them to perceive management as aggressive, ultimately causing greater proposed adjustments on an unrelated audit difference. We contribute to the literature by demonstrating that when auditors observe REM, their altered perceptions about management can cascade, affecting how they respond to management estimates in unrelated financial statement accounts.

Audit firms are investing billions of dollars to develop artificial intelligence (AI) systems that will help auditors execute challenging tasks (e.g., evaluating complex estimates). Although firms assume AI will enhance audit quality, a growing body of research documents that individuals often exhibit "algorithm aversion"-the tendency to discount computer-based advice more heavily than human advice, although the advice is identical otherwise. Therefore, we conduct an experiment to examine how algorithm aversion manifests in auditor judgments. Consistent with theory, we find that auditors receiving contradictory evidence from their firm's AI system (instead of a human specialist)

Differentiating real earnings management (REM) from normal business decisions poses a unique challenge for auditors, researchers, and investors. The ambiguity associated with REM, and the fact that REM does not violate GAAP, may explain why its use is on the rise. While some assert that auditors are not, and should not be, concerned with REM, recent research suggests that REM may influence some auditor judgments. Using Correspondent Inference Theory (CIT) as our theoretical framework, we extend REM research by investigating the ways in which auditors respond to REM and how auditors deal with the intrinsic ambiguity associated with REM. We administer a 3×2 between‐subjects experiment to 113 highly‐experienced auditors, manipulating the level of ambiguity surrounding the observed REM (Explicit REM, Potential REM, or No REM) and the earnings context in which the client engages in REM (the client beat or missed the consensus earnings forecast). We find that auditors respond to REM by lowering assessments of management tone (i.e., management's commitment to a culture of high ethical standards), being more likely to discuss the issue with the audit committee, and being less likely to retain the client. Auditors respond to Explicit REM regardless of the earnings context, but respond to Potential (i.e., ambiguous) REM only when the client beats the forecast. Finally, we find that management tone mediates the relation between REM and auditor responses, even after controlling for various audit‐related risks. Thus, for auditors, REM appears to be primarily a “people” issue, as REM provides a negative signal about management.

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