Executives with high accounting competence are more likely than their less-competent counterparts to make accounting misstatements when financial incentives encourage them to misreport, new research suggests.
“…when both competence and financial incentives are present, this dark side of accounting competence emerges.”
When analyzing financial statements, auditors must be aware of a variety of risks associated with fraud or error. Managing these risks typically includes charging higher fees to certain companies or adjusting audit strategies. The new study, however, suggests auditors are overlooking a key risk factor.
“Competence, alone, is a great thing,” says Elaine Mauldin, a professor of accountancy at the University of Missouri. “Research has actually shown that, in general, it results in fewer misstatements. However, we found that when both competence and financial incentives are present, this dark side of accounting competence emerges.”
Mauldin and her colleagues, which included Nathan J. Newton, an assistant professor of accountancy, reviewed executives’ past managerial experience in accounting and auditing as an indicator of competence. Using financial statements from 2004-2013 from publicly traded firms, the researchers investigated the risk factors involved in significant misstatements that affected the reliability of financial reporting.
In particular, researchers focused on two main factors that, when combined with competence, influence the likelihood of misstatements. The first was compensation incentives, which reward executives financially for strong performance. The second was having an aggressive reporting attitude, which past discretionary reporting decisions that increased earnings indicated.
Together with competence, these factors form a fraud triangle in which each element of fraud—incentive, opportunity, and attitude—is present, with competence forming the “opportunity” side of the triangle. Researchers found executives were almost 30 percent more likely to make misstatements when they had both high accounting competence and compensation incentives. Without high competence, that number dropped to 4 percent.
This can make middle managers inflate success
Attitude also encouraged misstatements, but to a lesser degree. Paradoxically, audit firms charge lower fees to competent executives regardless of these other factors. According to Mauldin, this suggests competence reduces auditors’ responses to some risk factors.
“These executives have both the incentive and ability to change the books,” Mauldin says. “On the other hand, competence lulls auditors into a sense of security. Auditors need to be aware of the heightened risk these executives represent.”
The researchers report their findings in the Accounting Review. In addition to Mauldin and Newton, Anne Albrecht of Texas Christian University worked on the study.
Source: University of Missouri
