Review of Accounting Studies

, Volume 15, Issue 2, pp 243–263 | Cite as

The role of audit thresholds in the misreporting of private information



The accounting profession has faced considerable criticism in recent years for failing to effectively combat reporting manipulation. A particular point of contention is the use of audit thresholds. The tendency for auditors to suppress inconsistencies that are deemed immaterial has been viewed as an open invitation for abuse. This paper revisits the effectiveness of audits and the misreporting of private information in light of audit thresholds. The paper demonstrates that while audit thresholds may create incentives for misstatements, the predictability of such misstatements may actually serve to promote efficiency. In effect, an environment in which parties are expected to systematically bias their reports can bring the threat of audit consequences for further exaggeration to the forefront. Such a consideration also suggests that more relaxed audit thresholds (and the ensuing increase in equilibrium misstatements) may be condoned by report recipients and can actually lessen inefficiencies wrought by adverse selection.


Auditing Materiality Private information Reporting 

JEL Classification

D82 M42 M48 


  1. Antle, R., & Eppen, G. (1985). Capital rationing and organizational slack in capital budgeting. Management Science, 31(2), 163–174.CrossRefGoogle Scholar
  2. Antle, R., & Fellingham, J. (1997). Models of capital investments with private information and incentives: A selective review. Journal of Business Finance & Accounting, 24(7), 887–908.CrossRefGoogle Scholar
  3. Arya, A., Glover, J., & Sunder, S. (1998). Earnings management and the revelation principle. Review of Accounting Studies, 3(1), 7–34.CrossRefGoogle Scholar
  4. Bagnoli, M., & Bergstrom, T. (2005). Log-concave probability and its applications. Economic Theory, 26, 445–469.CrossRefGoogle Scholar
  5. Baron, D., & Besanko, D. (1984). Regulation, asymmetric information, and auditing. RAND Journal of Economics, 15, 447–470.CrossRefGoogle Scholar
  6. Border, K., & Sobel, J. (1987). Samurai accountant: A theory of auditing and plunder. Review of Economic Studies, 54, 525–540.CrossRefGoogle Scholar
  7. Braun, K. (2001). The disposition of audit-detected misstatements: An examination of risk and reward factors and aggregation effects. Contemporary Accounting Research, 18(1), 71–99.CrossRefGoogle Scholar
  8. Cohen, D., Dey, A., & Lys, T. (2008). Real and accrual-based earnings management in the pre- and post-Sarbanes Oxley periods. The Accounting Review, 82(3), 757–787.CrossRefGoogle Scholar
  9. Deng, M. (2007). Financial reporting, regulation, and information asymmetry. Columbia University Dissertation.Google Scholar
  10. Fedyk, T. (2007). Discontinuity in earnings reports and managerial incentives. University of California, Berkeley Dissertation.Google Scholar
  11. Goldman, E., & Slezak, S. (2006). An equilibrium model of incentive contracts in the presence of information manipulation. Journal of Financial Economics, 80(3), 603–626.CrossRefGoogle Scholar
  12. Kessler, A., Lulfesmann, C., & Schmitz, P. (2005). Endogenous punishments in agency with verifiable ex post information. International Economic Review, 46(4), 1207–1231.CrossRefGoogle Scholar
  13. Lacker, J., & Weinberg, J. (1989). Optimal contracts under costly state falsification. Journal of Political Economy, 97(6), 1345–1363.CrossRefGoogle Scholar
  14. Laffont, J., & Tirole, J. (1994). A theory of incentives in procurement and regulation. Cambridge, MA: MIT Press.Google Scholar
  15. Levitt, A. (1998). The numbers game. New York, NY: Remarks delivered at the NYU Center for Law and Business. September 28.Google Scholar
  16. Maggi, G., & Rodriguez-Clare, A. (1995). Costly distortion of information in agency problems. RAND Journal of Economics, 26(4), 675–689.CrossRefGoogle Scholar
  17. Malmendier, U., & Shanthikumar, D. (2007). Are small investors naive about incentives? Journal of Financial Economics, 85(2), 457–489.CrossRefGoogle Scholar
  18. Messier, W., Martinov-Bennie, N., & Eilifsen, A. (2005). A review and integration of empirical research on materiality: Two decades later. Auditing: A Journal of Practice and Theory, 24(2), 153–187.CrossRefGoogle Scholar
  19. Moran, J., & Morgan, J. (2003). Employee recruiting and the Lake Wobegon effect. Journal of Economic Behavior and Organization, 50(2), 165–182.CrossRefGoogle Scholar
  20. Myerson, R. (1979). Incentive compatibility and the bargaining problem. Econometrica, 47(1), 61–74.CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media, LLC 2009

Authors and Affiliations

  1. 1.Yale UniversityNew HavenUSA

Personalised recommendations