Impact of Audit Quality On Earnings Mana PDF
Impact of Audit Quality On Earnings Mana PDF
Impact of Audit Quality On Earnings Mana PDF
Abstract
The aim of the research presented in this paper is to provide empirical evidence on
the impact of Audit Quality on Discretionary Accruals, as a measure of Earnings
Management, in Iranian listed firms. Multiple regression analysis is used in the study in
estimating the relationship between the Audit Quality and firm’s Discretionary Accruals.
Using three different measures of Audit Quality (i.e. Auditor size, Auditor industry
Specialization and Auditor Independence) and based on a sample of 90 non-financial
Iranian listed firms from 2004 to 2009, the results reveal that Discretionary Accruals are
negatively related to Auditor size and Auditor industry Specialization. Our findings also
support our hypothesis of the negative association between auditor independence and
Discretionary Accruals. Overall, this study provides evidence that firms which are audited
by high quality auditors are more likely to have less Discretionary accruals, a finding that is
consistent with prior research.
1. Introduction
The agency problems associated with the separation of ownership and control create the demand for
external audit. Initially, the agency problems arise from the asymmetric information in the Principal-
agent contracts. Asymmetric information refers to a situation where one party to a transaction has more
information than the other party. Analytical models have demonstrated that the existence of
information asymmetry between firm management and firm shareholders is a necessary condition for
the practice of earnings management (Trueman and Titman, 1988; Dye, 1988). When information
asymmetry exists, shareholders have insufficient resources, incentives, or access to relevant
information to monitor manager's actions, earnings management can also occur (Schipper, 1989;
Warfield, Wild, and Wild, 1995).
International Research Journal of Finance and Economics - Issue 66 (2011) 78
Many studies have been done in the area of corporate governance and Audit quality all of
which know the two mechanisms as effective factors to restrain excessive opportunistic behavior
amongst corporate management. Prior research on the relationship between Audit quality and earnings
management has been done in the developed countries, however, a few studies have been done to
examine this relationship in the emerging countries, which is the motivate for the present study.
Therefore, the study is intended to find an acceptable answer to the question that whether the audit
firm's independence, industry specialization and size, as criteria of audit quality, can limit the applying
of earnings management in Iranian firms.
The remainder of this study is organized as follows. The background and hypotheses
development are discussed in Section 2. The research sample and design are discussed in Section 3,
and the results of testing the hypotheses are discussed in Section 4. Section 5 contains the summary
and conclusion that includes identified limitations and suggestions for further research.
in the early years of the audit assignment. The linkage is based on the assumption that industry-
specialist auditors have the industry expertise that results in better understanding of the client’s
business. Hence, H2 is as follows:
H2: There is a significantly negative association between Auditor industry specialization and
the occurrence of earnings management.
Where:
ARi,t = firm i’s change in accounts receivable in year t.
In turn, Discretionary accruals (DAi,t) for firm i in year t are:
DAi,t= TAi,t/Ai,t-1 – NDAi,t
j= 1
S A L E ijk
M S ik = I J
∑ ∑
k ik
i=1 j= 1
S A L E ijk
Where:
SALEijk = total sales of client firm j in industry k audit by auditor i.
i=1, 2,..., I = an index for audit firms.
j=1, 2,..., J = an index for client firms.
k=1, 2,..., K = an index for client industry.
Ik = the number of audit firms i in industry k.
Jik = the number of clients served by audit firm i in industry k.
When auditor j’s market share is greater than 20 percent in Industry k, the auditor j is treated as
an industry specialist.
3.2.2.3. Auditor Independence
There is no agreement on how to measure the Auditor independence. Prior studies have used a number
of variables: fee ratio (non-audit fee over total fee), total fees, and separate audit and non-audit fees. In
this study, because the data related to non-audit fees are unavailable, the natural log of audit fees are
used as the opposite criterion of audit independence. Large (small) values of audit fees imply poor
(good) Auditor independence.
3.2.3. Control Variables
We control for variables that have been identified in prior literature as likely to affect the reporting of
discretionary accruals such as firm size, operating cash flows, growth prospects and leverage.
Large firms are less likely to engage in earnings management due to more scrutiny from
financial analysts and investors (Zhou and Elder, 2001). Becker et al (1998) and Reynolds and Francis
(2001) report cash flow from operations influences corporate management actions in managing
earnings. In addition, researchers such as Skinner and Sloan (2002) and, Matsumoto (2002) suggest
that firms with higher growth prospects are more likely to manage earnings. Finally, Leverage is
included as prior studies show that firms with a higher likelihood of violating debt agreements are
81 International Research Journal of Finance and Economics - Issue 66 (2011)
more likely to have an incentive to engage in earnings management to increase earnings (Healy and
Palepu, 1990; Sweeney, 1994).
3.3. Regression Model
A linear-multiple regression analysis was used to test the association between the dependent variable of
Discretionary accruals and the independent variables of Audit Quality. The following model is
estimated:
DAi,t= β0+ β1 AudSIZEi,t + β2 SPECi,t + β3 AudINDi,t + β4OCFi,t+ β5 GWTHi,t+ β6SIZEi,t+ β7LEVi,t+εi,t εi,t
Where, for sample firm i at the end of year t:
DA= Discretionary Accruals estimated using Modified-Jones Model.
AudSIZE = dummy variable, 1 if the firm is audited by a Big 4 auditor, 0 otherwise.
SPEC= dummy variable, 1 if MS > 20 percent, and 0 otherwise.
AudIND = auditor independence defined as log of firm’s total audit fees.
OCF= operating cash flows divided by total assets at fiscal year-end.
GWTH = growth prospect defined as the market value of equity divided by book value of equity.
SIZE = firm size defined as natural log of firm’s total assets.
LEV = ratio of total debt to total assets.
εεi,t = the error term.
As shown in this table, the Adjusted R2 of 52.68 percent gives confidence in the explanatory
power of the model. The coefficient of AudSIZE in the Model is negative, as expected, and is
significant at the 0.01 level. This result indicates a significant negative relationship between auditor
size and Discretionary Accruals; the analysis thus supports H1.
The SPEC coefficient in the Model is also negative, as predicted, and statistically significant at
the 0.05 level, which indicates a significant negative relationship between industry specialist auditors
and Discretionary Accruals; hence H2 is also supported.
As shown in Table II, The coefficient for AudIND is negative, as expected, and is significant
(at the 0.05 level). This result supports our hypothesis of the negative association between auditor
independence and Discretionary Accruals.
The control variables, GWTH, and LEV are positively and significantly associated with
Discretionary accruals that was expected and is in line with prior research. We also find that the larger
the firms, the lower the Discretionary Accruals, suggesting that Large firms due to more scrutiny from
financial analysts and investors are less likely to engage in earnings management. On the other hand,
the coefficient of OCF is not statistically significant at the 0.05 level; this indicates that OCF has no
significant effect on DA.
Table II: Multiple regression results
Collinearity Statistics
Explanatory variable Expected Sign Coefficients t-statics
VIF
Intercept ? 0.2654* 2.044 -
AudSIZE - -1.0414** -4.3315 1.015
SPEC - -0.7579* -2.0226 1.288
AudIND - -0.5643* -2.1684 1.421
OCF ? -0.4121 -1.0124 1.394
GWTH + 0.5311* 2.1216 1.047
SIZE - -0.3224** -3.3745 1.007
LEV + 0.7541* 1.9821 1.346
Adjusted R2 52.68 F-value 14.256
Durbin Watson 2.148 P-value of F-test 0.000
Notes: * statistically significant at the <5 percent level, one-tailed test;** statistically significant at the <1 percent level,
one-tailed test; AudSIZE- dummy variable, 1 if the firm is audited by a Big 4 auditor, 0 otherwise; SPEC- dummy
variable, 1 if MS > 20 percent, and 0 otherwise; AudIND-auditor independence defined as log of firm’s total audit
fees; OCF-operating cash flows divided by total assets at fiscal year-end; GWTH-growth prospect defined as the
market value of equity divided by book value of equity; SIZE-firm size defined as log of firm’s total assets; LEV -
ratio of total debt to total assets.
5. Conclusion
A vast literature investigates the implications of Audit quality since the seminal work of DeAngelo
(1981). Most of these studies investigate these implications in the developed countries, very little is
empirically known about such implications in emerging or transition economies such Iran. The study
investigates the impact of audit quality on earnings management of listed firms in Iran, as one of
emerging or transition economies.
Based on a sample of 540 firm-year observations from the TSE for fiscal years 2004 to 2009,
and using three measures of Audit quality (AudSize, SPEC, and AudIND), the study finds that Auditor
size is negatively associated with the earnings management measured by DA, thus indicating that firms
which use big 4 auditors will engage in less earnings management than firms with non-big 4. Our
results are consistent with those of Zhou and Elder (2003) and Chen et al (2005) that suggest, the big-5
auditors are associated with reduced management discretion over earnings. We also find that firms
audited by industry specialist auditors engage in less earnings management. This is consistent with the
findings of Zhou and Elder (2003) and Rusmin (2010) that auditor industry specialists can be used to
constrain earnings management.The results from testing the association between the Auditor
independence and earnings management suggest that the more an audit firm enjoys from independence,
83 International Research Journal of Finance and Economics - Issue 66 (2011)
the more the quality of auditing will enhance, which is by itself considered as one of the obstacles for
applying earnings management in firms.
Like any other research, the present research has also some limitations which seem necessary to
be mentioned. First of all, the sample only covers six years of Iranian data and an external validity
problem exists that the results may not be so generalizable to cover different periods of time and
different locations. Secondly, in the study, the effect of inflation and other economical conditions on
the figures related to financial statements and the calculation of discretionary accruals were ignored.
Future research should include other factors that may affect the occurrence of earnings management in
the firms such as corporate governance mechanisms.
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