Network Intelligence Studies

Volume II, Issue 1 (3), 2014

Andra GAJEVSZKY
The Bucharest University of Economic Studies
The Institute of Doctoral Studies, Faculty of Accounting
Bucharest, Romania

THE IMPACT OF Empirical

AUDITOR`S OPINION ON study
EARNINGS MANAGEMENT:
EVIDENCE FROM ROMANIA

Keywords
Audit
Financial reporting
Earnings management
Romania

JEL Classification
G10, M41, M42

Abstract

The aim of this research is to analyze the relation between modified audit opinion and
discretionary accruals in the case of Romanian listed entities. In order to investigate the
influence of auditor`s opinion on earnings management, a multiple regression was designed.
The final sample, after eliminating the financial institutions due to homogeneity
considerations, consists of 60 companies listed on the Bucharest Stock Exchange in 2012.
The most significant findings of this research are that the probability to manage earnings to
the decrease is related to the issuance of a qualified audit report and the presence of a Big 4
audit firm. Thus, both audit opinion and auditor size are negatively related to discretionary
accruals in the case of the Romanian listed companies.

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Introduction future periods by reducing income in a

The external auditor plays a vital year with good performance, thus reducing
role in the corporate governance mosaic income volatility (Leuz et al., 2003).
through its influence on promoting the The Agency Theory, which
quality of financial reporting. From this creates two diverse interest groups -
optic, the audit opinion acts as a guardian owners and managers- is considered the
of the management`s behaviour, especially most prevailing source of conflicts of
when there is an increased tendency of interest. Due to the fact that management
earnings manipulation. is invested with almost full powers within
The aim of this research is to the organization, management may be
analyze the relation between modified inclined to take advantage of the trust and
audit opinion and discretionary accruals in lack of adequate knowledge of the owners
the case of listed Romanian entities. Since and report them unreal performance.
corporate governance serves as a vital According to Barth and Taylor
mechanism for assuring the quality of (2010), as far as earnings management is
financial reporting, this study reaches its an undesirable practice from the point of
aim by capturing the influence of external view of equity holders, then it is clearly a
auditor on managerial behaviour in which matter of agency, generating a conflict of
concerns earnings manipulation at the interest between owners - who are against
level of Romanian listed entities. the use of it - and management,
Moreover, emerging economies are manipulating income in order to increase
constantly confronted with a lower level of personal wealth.
financial reporting quality and weaker Dechow and Skinner (2000) set
corporate governance mechanisms, fact off income management concept analysis
that leads to an increased need for further from the role of accruals for the reason that
improvements. accruals are forms of income manipulation
Earnings management has been difficult to distinguish from appropriate
defined as the alteration of firms` reported practices inherent in accrual accounting.
economic performance by insiders to Sill, in order for management to
either mislead some stakeholders or to successfully report over-aggressive or
influence contractual outcomes (Healey fraudulent earnings, auditors must not
and Wahlen, 1999). Starting from the succeed to discover how and where
definition supported by Healy and Wahlen, income is being manipulated. Yet, how
Roychowdhury (2006) states that the managers can successfully deflect
manipulation of accounts as a result of auditors’ attention from earnings
normal operational practices arises from manipulations remains an important
management’s motivation to influence unanswered question for researchers
investors to believe that the organization's (Peecher et al., 2007; Bell et al., 2005).
financial targets have been met in the The reminder of this paper is
normal course of business. organized as it follows: Section 2 presents
Due to the information the relevant literature review in the
asymmetry which exists between the academic area which captures the
company`s insiders and outsiders, influence of the auditor`s opinion on
individuals within an organization can rely earnings management, Section 3 describes
on their control in financial reporting and the research`s design, while Section 4
their access to financial information within presents the results. Finally, Section 5
the company to overstate the income or to emphasizes the limitations of this research
mask obtaining unfavourable results. From and Section 6 draws the conclusions.
this optic, management may use different
methods such as creating reserves for

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Literature review likely to issue modified audit reports for

In the academic arena, there is a asset realisation reservations and for going
consensus relying on the statement that concern issues than auditors of low accrual
auditing is an important means of firms, even after controlling for client-
mitigating agency conflict between specific and market risk variables.
managers and outside shareholders. From Moreover, the authors conclude that these
this optic, auditing is a monitoring device findings apply only for the Big 6 (at that
for the shareholders, thus, auditors would time) auditors, fact consistent with the
report detected material misstatements in incentives of the ``audit giants`` for acting
audited financial statements. conservatively.
Due to the fact that the major The connection between the
observable outcome of an audit process is auditor`s tenure at the same entity and
represented by the audit report, in the earnings management practices was
literature various proxies have been used examined by Gul et al. (2009). They found
in order to assess audit quality. Francis et out that there is a reduced association
al. (1999) suggest that Big 4 auditors are between audit tenure at the same entity and
able to constrain opportunistic and earnings quality at firms audited by
aggressive reporting because their clients specialists in the industry. Gul et al.
have higher total accruals, but lower explain this fact through the greater
discretionary accruals. This approach is likelihood that auditors with expertise in
focused on earnings management, on clients’ activity identify irregularities and
managerial behaviour which interfere with disingenuous representations and perform
the financial reporting process. According a qualitative audit, even though the level of
to Lawrence et al. (2011), an extensive client-specific awareness is lower, as a
stream of literature focuses on the client`s result of a short-term collaboration.
financial statements, in which Rusmin (2010) argue that the
discretionary accruals are often used as a discretionary accruals of industry specialist
proxy for audit quality as they reflect the auditor clients are lower than discretionary
auditor`s constraint over management`s accruals of non- industry specialist clients.
reporting decisions. This finding suggests that auditors with
A wide stream of researches have industry expertise are more likely to detect
documented that the influence of audit on misrepresentations and irregularities than
earnings management is noteworthy in the auditors without industry expertise,
sense that high quality auditors limit particularly in the early years of the audit
earnings management practices, in contrast assignment. The association leans on the
to lower quality external auditors (Chung assumption that industry- specialist
et al, 2005, Othman and Zeghal, 2006). auditors have the industry expertise that
Chung et al (2005) indicate that external results in enhanced perception of the
supervision constraints management not to client’s business.
use certain techniques to increase the The study conducted by Gerayli
results, fact explained by the need of the et al. (2011) on a sample of 540 firm-year
high quality external auditors to preserve observations from the Teheran Stock
their reputation and to avoid litigation. Exchange for fiscal years 2004 to 2009
Francis and Krishnan (1999) indicated that auditor size is negatively
examined the relationship between the associated with the earnings management
issuance of modified audit reports and the measured by discretionary accruals, hence
reported level of accruals for a sample of indicating that companies audited by Big 4
United States publicly listed companies. audit firms will engage in less earnings
Their results indicate that auditors of firms management than firms audited by non-
reporting high levels of accruals are more Big 4. Their results are consistent with

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Volume II, Issue 1 (3), 2014

those of Chen et al (2005) which suggest For example, Bartov et al. (2000)
that the Big-5 auditors are associated with documented that the association between
reduced management discretion over audit opinion and abnormal accruals is
earnings. negative. This result inclines to be
In the same study, Gerayli et al. associated with severely distressed firms
(2011) found that firms audited by (with going concern opinions), rather than
industry specialist auditors engage in less with firms engaging in extreme earnings
earnings management, finding consistent management.
with the results of Rusmin (2010) that However, Johl et al. (2007)
auditor industry specialists represent an examined auditor reporting behaviour in
approach to constrain earnings the presence of aggressive earnings
management. Moreover, the results from management in the Malaysian context.
testing the association between the auditor They found that Big 5 auditors emerge to
independence and earnings management issue modified audit reports more
imply that the more independent an audit frequently than their Non-Big 5
firm is, the more the quality of auditing counterparts in the presence of high levels
will enhance, fact considered being as one of abnormal accruals.
of the impediment for applying earnings The quality of auditors, reputation
management in companies. of audit firms and industry expertise of
Under the aspect of auditors` external auditor are not the only factors
independence, Luippold et al. (2013) that have an influence on earnings
demonstrate that ``simply diverting management. For example, Caramanis and
auditors to clean accounts can deter them Lennox (2008) investigated the influence
from finding managed earnings, resulting of the effort to conduct an audit, measured
in a reduction of both audit and financial in numbers of audit hours, on the possible
reporting quality``. Their study also use of earnings management techniques.
indicates that more sceptical auditors are The research results indicated that there is
more likely to discover managed earnings, a greater likelihood that management is
in contrast to less sceptical auditors. Thus, using techniques to increase earnings
given auditors’ scepticism (Nelson, 2009; (manipulate earnings) when the number of
Hurtt et al., 2013), the discovery of errors audit hours is lower.
may alarm auditors and in fact determine
them to search more extensively for errors Research design
in other areas of the audit. This section states the research`s
Another relevant research in this hypotheses, presents the sample selection
area is the one conducted by Butler et al. criterion and introduces the empirical
(2004). They examined whether certain model.
modified audit opinions (scope limitations, The research hypotheses are
deviations from the Generally Accepted constructed in accordance with the aim of
Accounting Principles (GAAP)) are this research, namely to analyze the
associated with discretionary accruals. relation between modified audit opinion
Their results indicate that in the case of and earnings management in the case of
entities with going concern opinions there Romanian listed entities. The study relies
is an association between modified audit on the expectation that there will be a
opinions and abnormal accruals, due to the significant negative association between
fact that these entities have large negative auditor size and the occurrence of earnings
accruals as a consequence of severe management. Thus, the following research
financial distress. hypotheses were developed:
The results of Butler et al. (2004) Hypothesis 1: There is a significant
are consistent with those of prior literature. negative association between auditor size

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Volume II, Issue 1 (3), 2014

and the occurrence of earnings Empirical Model

management. The empirical model is
Hypothesis 2: There is a significant represented by the multiple regression
negative association between audit which aims to determine the factors that
opinion and earnings management. influence the discretionary accruals. The
Hypothesis 3: There is a significant logistic model is presented above:
negative association between audit
opinion of Big 4 audit firm and earnings , = + , + , +
management. , + , + , ,
Where:
Sample Selection  DISCACC: discretionary accruals;
The aim of this research is to  AO: audit opinion (dummy
investigate the relation between modified variable), equals 1 if audit opinion
audit opinion and abnormal accruals is qualified, 0 otherwise;
(discretionary accruals) in the case of  AS: auditor size (dummy variable),
Romanian listed entities. equals 1 if external auditor is Big
The sample consists of companies 4, 0 otherwise;
listed on the Bucharest Stock Exchange  SZ: firm size, natural logarithm of
which publish their individual financial total assets;
statements in accordance to the
 LEV: financial leverage, measured
International Financial Reporting
as total liabilities divided to total
Standards (IFRS). Thus, a few restrictions
assets,
are required for this study, as it follows:
 : error term;
 Companies present their financial
 : The company and t: the year.
statements for the year 2012
according to the International
Dependent variable. The dependent
Financial Reporting Standards –
variable of the regression model is
IFRS 1;
represented by the discretionary accruals,
 Companies operating in the
namely the part of total accruals which is
financial sector are eliminated from
more susceptible to manipulation by
the study due to homogeneity
managers. In prior studies, discretionary
considerations - these financial
accruals are frequently used as a proxy for
institutions have specific
earnings management (for example, Jones,
regulations considering their
1991).
activity.
Discretionary accruals represent
After implementing the above-
the difference between total accruals and
mentioned restrictions, the final sample
non-discretionary accruals; total accruals
consists of 60 companies listed on the
are determined as difference between
Bucharest Stock Exchange, compiling both
operating income and cash flows from
Tiers I and II. In order to conduct this
operations. In the Jones` modified model,
study, the variables included in the below
non-discretionary accruals are the
presented model were collected from the
predicted (or expected) portion of total
individual financial statements of the 60
accruals. Moreover, in the same model, the
analyzed companies for the year 2012.
total accruals are regressed on changes in
After analyzing the financial statements
revenue, gross property, plant and
from the annual reports, the financial
equipment, and return on assets (Kothari et
elements were set up in the database and
al., 2005).
analyzed with the Analyse-it statistical
instrument.

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Volume II, Issue 1 (3), 2014

Following Kothari et al. (2005), calculated as total liabilities

the next model is being used in order to divided to total assets.
determine the total accruals:
, = + , + ,
+ , + , , all the variables are Results
divided by , , This section presents the output of
Where: both univariate and multivariate tests
 ACCR : total accruals for sample which were conducted. The univariate
firm i for year t; analysis presents the descriptive statistics
 TA: total assets for sample firm i for the dependent and independent
for year t-1; variables engaged in this study, the
correlation between variables, as well as
 ∆REV: changes in net revenues for
the results of the Mann-Whitney test. The
sample firm i for year t;
multivariate tests bring into light the
 GPPE: gross property, plant and
multiple regression`s output.
equipment for sample firm i for
year t;
Univariate analysis
 ROA : return on assets for sample Descriptive statistics. The descriptive
firm i for year t, determined by statistics for the dependent variable of this
dividing the company`s annual study, namely discretionary accruals, and
earnings (net income) by its total the non-categorical independent variables
assets; is presented in Table 1.
 ε: unexpected portion of total [INSERT TABLE 1]
accruals for sample firm i for year The results presented in Table 1
t. indicate that on average the discretionary
 The discretionary accruals are accruals are negative, implying that the
represented by the residuals εit average of the detected earnings
from this equation. management is to the decrease. Moreover,
as it can be noticed in Table 1, a third of
Independent variables. AO (audit companies (31.66%) are audited by a Big 4
opinion) is the independent variable of audit firm.
interest (the categorical independent [INSERT TABLE 2]
variable), being defined as a dummy The results presented in Table 2
variable which equals 1 if audit opinion is indicate that out of the 60 companies, only
qualified and 0 otherwise; 21 entities present a qualified audit
The non-categorical independent opinion. This fact signify that only 35% of
variables are represented by auditor size, the companies have a qualified audit
firm size and financial leverage: opinion, while the majority, namely 65%,
 AS (auditor size) is defined as a have a favourable audit output for the year
dummy variable which equals 1 if 2012. Due to the fact that the number of
external auditor is Big 4 audit firm entities which have a qualified audit
and 0 otherwise; opinion is reduced, this opinion will not be
 SZ (firm size) is an independent analyzed through its types.
variable associated to firms` [INSERT TABLE 3]
characteristics and is defined as As it can be noticed in Table 3,
natural logarithm of total assets; Big 4 clients have on average higher total
 LEV (financial leverage) is an accruals compared to the companies
independent variable associated to audited by a non-Big 4 audit firm.
firms` characteristics and it is Moreover, the discretionary accruals are
on average lower in the case of Big 4

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clients. As stated by Francis et al. (1999), Thus, discretionary accruals are negatively
Big 4 auditors are able to constrain related to the qualified audit opinion,
opportunistic and aggressive reporting supporting Hypothesis 2. When analyzing
because their clients have higher total the coefficient for audit size, the results
accruals, but lower discretionary accruals. indicate a negative coefficient (-0.0526)
[INSERT TABLE 4] which suggests that discretionary accruals
Table 4 presents the descriptive are negatively related to the Big 4 audit
statistics for companies with qualified firms, fact which supports Hypothesis 1.
audit opinion. On average, companies with Therefore, a negative Big 4 coefficient
qualified audit opinion present negative would suggest that Big 4 auditors do not
discretionary accruals (-0.0262), meaning allow their clients to manage earnings
that the average of the detected earnings (Johl et al., 2007).
management is to the decrease. Out of the Mann-Whitney test results. The
21 companies with qualified audit opinion, results of the Mann-Whitney Test for the
8 companies were audited by a Big 4 variable audit opinion (see Table 6)
auditor (approximately 38%). indicate that there is a statistically
[INSERT TABLE 5] significant difference in the discretionary
Table 5 presents the descriptive accruals between companies with qualified
statistics for companies with unqualified audit opinion and those with unqualified
audit opinion. The results indicate that on opinion. Thus, firms with qualified audit
average the discretionary accruals are report will be more susceptible to manage
positive (0.0141), leading to the the discretionary accruals to the decrease
affirmation that the average of the earnings than those with unqualified audit opinion,
management detected for the companies fact which supports Hypothesis 2.
with unqualified audit opinion (clean [INSERT TABLE 6]
opinion) is to the increase. Out of the 39 When analyzing the Z-Statistics,
companies with clean audit opinion, 11 the results indicate that there is not a
companies were audited by a Big 4 audit significant statistical difference between
firm (approximately 28%). the means of the two categories (calculated
The next step is represented by Z is less than critical Z) results which
the analysis of correlation between emphasize that, on average, companies
variables. In order to determine the level of with qualified audit opinion do not present
correlation, the Pearson`s Correlation higher discretionary accruals.
Matrix was integrated, as it can be seen in [INSERT TABLE 7]
Figure 1. Table 7 presents the results of the
[INSERT FIGURE 1] Mann-Whitney Test for the variables audit
The largest association (0.5691) is opinion and auditor size. When analyzing
between auditor size and firm size, fact the U-statistics, the results indicate that
consistent with findings in prior literature there is a statistically significant difference
which state that there is a strong in the discretionary accruals between
correlation between auditor size and the companies with qualified audit opinion
company`s size. Except for this large having a Big 4 audit firm and those with
correlation, the coefficients of correlation qualified opinion corresponding to a non-
are small, not exceeding the value of Big 4 auditor. Thus, firms with qualified
0.1799 (correlation between audit opinion audit report having a Big 4 audit firm will
and financial leverage). be more susceptible to manage the
The coefficient of association discretionary accruals to the decrease than
between audit opinion and discretionary those audited by non-Big 4 external
accruals is -0.1393, signalling a negative auditors, fact which supports Hypothesis 3.
association between these two variables.

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Moreover, when analyzing the Z- Limitations of this research

Statistics, the results indicate that there is This study presents a series of drawbacks.
not a significant statistical difference First of all, the sample population is rather
between the means of the two categories small, only 60 companies having been
(calculated Z is less than critical Z) results investigated. However, the sample is
which emphasize that, on average, homogeneous (the restrictive criterion
companies with qualified audit opinion established in the sample selection process
having a Big 4 audit firm do not present took into consideration the heterogeneity
higher discretionary accruals. aspect, so that the sample would not be
affected by heterogeneous characteristics).
Multivariate analysis Second of all, the number of companies
This section presents the multiple which present a modified audit report is
regression output, as it can be seen in rather small, only 21 firms (35%) having a
Figure 2. qualified audit opinion. Under this aspect,
[INSERT FIGURE 2] the results might not be very
When analyzing the coefficients representative. Moreover, due to the
corresponding to the regression`s reduced number of qualified audit reports,
variables, the results indicate that the a distinction between the categories of
coefficient corresponding to the audit modified audit opinion has not been
opinion variable is negative, however, it is conducted.
not statistically significant, partially
supporting Hypothesis 2. The results are Conclusions and further research
consistent with those of Butler et al. Since the external auditor influences the
(2004), who found that firms which perceived quality of financial reporting,
received going concern opinions had the audit opinion acts as a guardian of the
negative accounting accruals. management`s behaviour, especially when
Thus, firms with qualified audit there is an increased tendency of earnings
reports tend to have lower discretionary manipulation.
accruals, the phenomenon of income This research aimed to analyze
decreasing accruals signalling a the relation between modified audit
conservative application of the opinion and earnings management in the
International Financial Reporting case of Romanian listed entities. In order
Standards (IFRS) by managers. to investigate the influence of auditor`s
The coefficient for auditor size is opinion on earnings management, a
negative; still, it is not statistically multiple regression was designed. The
significant. This negative coefficient dependent variable of the regression which
indicate that discretionary accruals are measures the earnings management
negatively related to auditor size – Big 4 phenomenon is represented by
and non-Big 4- indicating that clients of discretionary accruals, being defined as the
Big 4 audit firms have lower discretionary part of total accruals that is more likely to
accruals, consistent with Hypothesis 1. manipulation by managers. The
As for the control variables, the independent variables, namely audit
coefficient of firm size is positive and not opinion, audit firm size, firm size and
significantly different from zero, reflecting financial leverage, constitute the
that larger firms tend to have higher explanatory variables of the regression
accruals. Financial leverage has a positive which aims to properly capture the impact
coefficient, not significantly different from of auditor`s opinion on reducing earnings
zero, indicating that discretionary accruals management in order to improve the
are positively related to financial leverage. quality of financial reporting process.

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The most significant findings of [1] Barth, M. and Taylor, D. (2010). In Defense of
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[3] Bell, T. B., Peecher, M. E., and Solomon, I.
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LIST OF TABLES

Table 1
Descriptive Statistics for the Dependent and Non-categorical Independent Variables
DISCACC AS SZ LEV
Number of Observations 60 60 60 60
Mean 6.01371E-18 0.3166 19.0308 0.2951

Median -0.0072 18.8508 0.2099

Standard Deviation 0.1391 0.4691 1.509 0.2765
Range 1.106 7.8574 1.4418
Minimum -0.2425 16.5072 0.0078
Maximum 0.8635 24.3646 1.4496

Table 2
Descriptive Statistics for the Categorical Independent Variable
Audit Opinion Frequency Percent
Qualified 21 0.35
Unqualified 39 0.65
TOTAL 60 100

Table 3
Companies` Accruals related to the Audit Firm
Companies` Audit Firm N Total Accruals – Mean Discretionary Accruals- Mean
Big 4 19 2107094700 -43469158.95

Non-Big 4 41 -77181.9 20144244.39

TOTAL 60

Table 4
Descriptive Statistics for Companies with Qualified Audit Opinion
Mean Median MIN MAX Range
DISCACC -0.0262 -0.0455 -0.1607 0.1573 0.3181
AS 0.3157
SZ 18.7778 18.4947 16.8176 22.3216 5.504
LEV 0.3623 0.274 0.0221 1.4496 1.4274

Table 5
Descriptive Statistics for Companies with Unqualified Audit Opinion
Mean Median MIN MAX Range
DISCACC 0.0141 -0.00003 -0.2425 0.8635 1.106
AS 0.3166

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SZ 19.1671 19.043 16.5072 24.3646 7.8574

LEV 0.2589 0.2045 0.0078 0.9823 0.9744

Table 6
Mann-Whitney Test Results- Audit Opinion
N1 N2 U-Statistics Z-Statistics
DISCACC/AO 21 39 551 -1.31

Table 7
Mann-Whitney Test Results- Audit Opinion and Auditor Size
N1 N2 U-Statistics Z-Statistics
Qualified Audit Opinion
Big 4 / Non-Big 4 8 13 86 -0.17
Unqualified Audit Opinion
Big 4 / Non-Big 4 11 28 221 0.03

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LIST OF FIGURES

Figure 1
Variables` Correlation Matrix

DISCACC AO AS SZ LEV
DISCACC 1
AO -0.1393 1
AS -0.0526 0.1014 1
SZ 0.0005 -0.1241 0.5691 1
LEV 0.0098 0.1799 -0.0102 -0.0416 1

Figure 2
Regression Output

Coefficients Standard Error t Stat P-value

Intercept -0.0033 0.2875 -0.0116 0.9908
AO -0.0405 0.0404 -1.0029 0.3203
AS -0.0129 0.0492 -0.2614 0.7948
SZ 0.0009 0.0153 0.0562 0.9554
LEV 0.0176 0.0682 0.2583 0.7972

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