Moral Judgment Hypotheses:

Moral judgment is important to our understanding of managers’ honest reporting because many recent accounting scandals involve top management’s unethical reporting behavior (e.g., Enron and WorldCom). While prior auditing studies analytically examine the interaction between managers and auditors in strategic settings in which managers’ misreporting are exogenously determined (e.g., Fellingham et al. 1989; Newman et al. 1996;

Patterson and Noel 2003), few attempts explore how managers’ moral judgment affects their honest reporting.

This study contributes to the literature by adopting a psychological instrument to experimentally investigate managers’ moral propensity toward honest reporting under a strategic setting specified in Section 2.1.

Moral judgment is also important to auditor independence because prior research indicates that auditors’

ethical perspectives influence their independence (Jones and Ponemon 1993). Some experimental economists also suggest that variations across experimental markets and systematic deviations from model predictions may be attributable to differences in auditors’ ethical attitude (Calegari et al. 1998). Yet, despite the increasing importance of ethics in the auditing community, auditing studies that link both auditor independence and auditor

ethics are rare (e.g., Falk et al. 1999; Jones et al. 2003; Yu 2011). Previous auditing studies experimentally explore the association between moral reasoning and auditor independence using Rest’s (1979) Defining Issues Test (DIT) instrument under either a non-market (e.g., Falk et al. 1999; Ponemon and Gabhart 1990) or a market setting (e.g., Schatzberg et al. 2005; Yu 2011). However, these studies provide significant but mixed results.

They also fail to examine how auditors’ legal liabilities affect the association between managers’ and auditors’

moral judgment and their honest reporting under different regulation systems.

This study adopts Forsyth’s (1980) ethical ideology instead of DIT to measure subjects’ moral judgment for three reasons. First, prior ethics research in psychology finds that individuals rely on different strains of moral philosophy in making assessments of the ethical content and the rightness of a particular action (e.g., Forsyth 1980, 1985; Hunt and Vitell 2006). Therefore, compared with DIT, which measures individuals’ moral development stages when they determine right or wrong under given moral dilemma situations, ethical ideology seems a more appropriate measure for capturing subjects’ moral judgments because it determines people’s underlying ethical theory and attitude (Wotruba 1990). Second, one major problem of DIT is that it has been criticized as a poor measure of accountants’ ethics judgments due to its domain-specific feature (Fogarty 1995).

Another problem with DIT is that it does not provide consistent results in the predicted directions in an auditing setting (Ponemon 1993). Finally, prior psychology research shows that individuals who have different ethical ideologies tend to differ in their judgments regarding ethical dilemma (e.g., Forsyth 1980, 1981). Individuals holding different types of ideology are expected to reason differently about ethical issues and to often reach different conclusions about the morality of particular actions (Barnett et al. 1994). Although Forsyth's (1980) ethical ideology taxonomy has been shown to be a powerful tool in describing individuals’ moral judgments in various fields (e.g., Barnett et al. 1994; Hunt and Vitell 2006; Redfern and Crawford 2004), its application to auditing is not common.

According to Forsyth (1980), taxonomy of ethical ideology is based on two fundamental ethical dimensions: relativism and idealism. Relativism refers to the extent to which an individual rejects the possibility of formulating and relying on universal moral rules at all times (i.e., the tendency to disregard universal moral rules when making moral judgments). The relativism orientation is more consistent with teleological moral philosophy, which suggests that a moral action be judged based on its consequences. In contrast, idealism refers

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to the extent to which an individual believes that desirable consequences will necessarily follow from appropriate actions (i.e., the tendency to avoid harming others when making moral judgments). The idealism orientation is consistent with deontological moral philosophy, which rejects the use of an action’s consequences as a basis for moral evaluation. When these two dimensions are dichotomized and crossed, they yield a 2 (low vs. high relativism)  2 (low vs. high idealism) classification of ideology. Table 2 presents this taxonomy.

[Insert Table 2 here]

Given the limited evidence documented in the auditing studies that adopt the ethical ideology framework, predicting the association between managers’ and auditors’ moral attitudes and their reporting decisions under a strategic setting is not as straightforward as it might seem. Therefore, I develop my hypotheses based on the moral judgment literature to examine whether existing psychological evidence can explain different players’

honest reporting in my experiment. First, as depicted in Table 2, absolutists and exceptionists have low ethical relativism. According to Forsyth’s (1980) definitions, the absolutists tend to emphasize absolute universal moral principles and allow no exceptions, regardless of the consequences. In contrast, the exceptionists share the same appreciation for absolutes moral principles but believe that following principles will sometimes cause one to act in ways that may harm innocent people, and in such instances exceptions are allowable. Forsyth (1980) further reports that absolutists rate others most severely in their assessments of morally questionable actions whereas exceptionists tend to be the most forgiving of immoral actions. These definitions and experimental findings imply that absolutists and exceptionists represent two extremes of individuals’ moral judgment, with absolutists preferring absolute honest reporting and exceptionists allowing misreporting.

Second, Table 2 indicates that situationists and subjectivists have high ethical relativism. Although these two types of individuals eschew universal moral principles, Forsyth (1980) indicates that situationists desire to achieve positive consequences for everyone concerned (i.e., high idealism) in arriving at moral judgments, while subjectivists believe that negative consequences cannot always be avoided (i.e., low idealism). Consistent with these definitions, Elias (2002) experimentally shows that subjects with high idealism view earnings management as more immoral than subjects with low idealism, whereas subjects with high relativism are more likely to accept earnings management than subjects with low relativism. These findings suggest that situationists prefer more honest reporting than subjectivists.

Based on these discussions, I posit the following two moral judgment hypotheses:

HYPOTHESIS 4A: The frequency of the manager’s misreporting is influenced by his ethical ideology types in that Absolutists < Situationists < Subjectivists < Exceptionists.

HYPOTHESIS 4B: The frequency of the auditor’s misreporting is influenced by his ethical ideology types in that Absolutists < Situationists < Subjectivists < Exceptionists.