Executives with high accounting competence could be an overlooked risk

Executives experienced in accounting and auditing were more likely to misreport financial results when their companies offered compensation incentives, MU study finds

March 8th, 2018

COLUMBIA, Mo. – 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. Now, a new study from the University of Missouri suggests auditors are overlooking a key risk factor. Researchers have found that executives with high accounting competence are more likely than their less-competent counterparts to make accounting misstatements when financial incentives encourage them to misreport.

“Competence, alone, is a great thing,” said Elaine Mauldin, a professor of accountancy in the Robert J. Trulaske, Sr. College of Business. “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 at MU, reviewed executives’ past managerial experience in accounting and auditing as an indicator of competence. Using financial statements from 2004-2013 that were issued by 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 was indicated by past discretionary reporting decisions that increased earnings.

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. 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 said. “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 study, “Do Auditors Recognize the Potential Dark Side of Executives’ Accounting Competence?” is forthcoming in The Accounting Review. In addition to Mauldin and Newton, Anne Albrecht of Texas Christian University worked on the study.