This study examines the effect of auditing and the integral approach to interim reporting on cosmetic earnings management, referred by Kinnunen and Koskela as earnings manipulative behavior to report earnings numbers to achieve key cognitive reference points represented by N×10k.
Using Benford's Law, the analysis employs 182,278 positive quarterly earnings observations and 103,470 negative quarterly observations for all publicly listed US companies from 1993 to 2003.
The empirical results show that firms tended to engage in cosmetic earnings management in each of the four fiscal quarters. More importantly, it was found that the degree of cosmetic earnings management is significantly less severe in the fourth fiscal quarter, which is the only quarter audited, than any of the previous quarters. This result suggests that the auditor plays an important role in reducing the cosmetic earnings manipulative behavior.
The findings of the study add more evidence to the ongoing debate about the effectiveness of auditing in preventing earnings management.
