Intended and Unintended Consequences of Continuous Auditing PerformanceBased

Intended and Unintended Consequences of Continuous Auditing & Performance-Based Incentives on Managers’ Judgments Presented by: Elaine Mauldin Co-Authors: Jim Hunton & Pat Wheeler

Motivation ¢ ¢ Organizations use combinations of incentives and monitoring to align agents’ (division managers) and principals’ (top management) interests. Continuous Auditing is monitoring that can increase internal audit timeliness and coverage, but l l ¢ Internal management support is sometimes an obstacle to more widespread implementation. Kogan, Sudit, and Vasarhelyi (1999) suggest there may be unintended effects on managers. We explore how CA interacts with bonus incentives to provide some evidence about both intended and unintended effects of CA.

Theory – Interaction of Incentives and Monitoring ¢ Common agency problem is managerial myopia (Graham et al. 2005): l Desire to achieve higher current earnings at the expense of longer-term total earnings. • Real earnings management decisions (Bushee 1998). • Project investment decisions (Bhojraj and Libby 2005). ¢ ¢ Incentives and monitoring have been found, individually and jointly, to impact managerial myopia, positively or negatively. We focus on interaction effects.

Interaction Effects ¢ ¢ Both monitoring and incentives are generally implemented – Part of Agency Contracting. Interaction effects between monitoring and bonus incentives are unclear: l Banker et al. (1996): short-term bonus incentives are less effective at improving performance with high levels of supervisory monitoring • Suggest monitoring can reduce incentive effects l Frederickson et al. (1999): outcome evaluation schemes more effective when reporting feedback is more frequent • Suggest monitoring can enhance incentive effects

H 1 a/b: Intended Effects Reduced Earnings Management ¢ ¢ Short term incentives commonly implemented to encourage high effort also increase earnings management behavior (e. g. , Gaver et al. 1995), unlike Long term Incentives Increased frequency of monitoring decreases earnings management l Increased transparency

H 2 a/b: Unintended Effects Risky Project Continuation ¢ ¢ Short term incentives less willingness to continue risky projects than long term incentives. Increased audit frequency increases risk aversion and managerial myopia, most severely when combined with short term incentives.

Method ¢ 2 × 2 between-participants experiment: Auditing frequency - periodic or continuous. l Incentive horizon - short-term or longterm. l ¢ Evaluate a project and make two decisions: Change quality control expenditures (earnings management setting). l Recommend continuing/discontinuing the project. l

Demographic Profile (Table 1) 72 Managers Mean Std. Dev. Age 40. 57 6. 10 Yrs of experience 16. 38 6. 08 Yrs in current position 8. 79 5. 67 Level of current position: Middle manager Upper manager # 31 41 % 43 57 Current job function: General management Finance/accounting/internal audit 39 33 54 46 Industry: Manufacturing Retail Transportation Other 25 19 16 12 35 26 22 17 Size of employer: Large Medium Small 39 27 6 54 38 8

Willingness to Change Quality Control Expenditures (Figure 1)

Willingness to Continue or Discontinue the Project (Figure 2)

Debriefing Items (Table 5) Mean (Std. Dev. ) ANOVA Periodic Continuous P Job Stress 0. 17(0. 38) -2. 59(1. 14) . 01 Trust in Supervisor 3. 31(1. 21) -3. 68(1. 00) . 01 Evaluation Apprehension 0. 43(0. 61) -3. 51(1. 17) . 01 Managerial Autonomy 3. 03(1. 15) -3. 57(1. 07) . 01 Short-term/Long-term Focus 3. 00(1. 00) -3. 78(1. 08) . 01 Motivation to Work Hard 2. 66(0. 94) -1. 16(2. 21) . 01 Risk Taking Propensity 2. 82(0. 94) -3. 70(0. 97) . 01 Organizational Commitment 0. 09(0. 28) -1. 59(0. 83) . 01

Contributions ¢ Demonstrate that more frequent internal reporting can trigger suboptimal resource allocation: l ¢ Contribute to managerial research in incentives: l ¢ Extends Bhojraj and Libby (2005): more frequent external reporting induced suboptimal resource allocation in the presence of stock market pressure. Reveal heretofore unexplored interactions between continuous auditing and incentive horizon. Extend the auditing and accounting IS literatures: l l l Revealing both positive and negative ramifications of implementing the processes and technologies involved with continuous auditing. Redesign incentives. Training.