The Relationship between Earnings Management and Audit Quality

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The Relationship between Earnings Management and Audit Quality  - page 1
The Relationship between Earnings Management and Audit Quality: Evidence from Iran Saied Jabbarzadeh Kangarluei 1 *, Seyed Sadegh Ghazavi, Yagub Behnamoon, Mohammad Amin Ojaghi 2 1 Department of Accounting, Islamic Azad University, Urmia Branch, Iran. *Corresponding Author, E-mail: Dr_jabbarzadeh@yahoo.com. 2 M.A. Student in Accounting at Science and Research Branch-Islamic Azad University-Urmia Abstract This paper examines the relationship between earnings management and audit quality in Tehran Stock Exchange (TSE). In other words, this study sought to answer the question is whether audited firms with high-quality showed lower earnings management?. For this purpose a sample of 85 member companies of TSE were selected and examined in the period 2003 to 2010. In this paper, for measuring of earnings management variable has used modified Jones model (1991) and for audit quality has used auditor tenure and size variables. To test of hypothesis has used multiple regression models and Pearson and Spearman correlation coefficients. Results indicate that there is a weak and positive correlation between earnings management and audit quality. Also, to enter control variables such as operating cash flow, Loss and Income Index and firm size increases the correlation between earnings management and audit quality. Key words: Earnings Management, Auditor Tenure, Auditor Size and Audit Quality. 1
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The Relationship between Earnings Management and Audit Quality  - page 2
1. Introduction Investor confidence is fundamental to the efficient operation of the world’s financial markets and contributes to economic growth and stability worldwide. Investors need to know that the financial information on which they base capital allocation decisions is credible and reliable. Audits, and audit opinions on financial reports, are crucial to achieving this (IFAC, 2004). The purposes of the financial statement are to facilitate users to comprehend the business operation and support the credit policy decision makings. The information asymmetry between managers and potential investors provides managers with incentives to influence investor estimates of firm value by managing reported earnings (Richardson, 2000; Jain et al., 2005). The accounting choice for the earnings manipulation is to influence and deceive the decision makings of interested parties (Huang and Lin, 2007). Auditors supply higher audit quality when they constrain managers´ flexibility to report discretionary accruals, because the higher levels of discretionary accruals lead to lower quality accounting numbers (Becker, DeFond , Jiambalvo and Subramanyam, 1998; Dechow, Sloan and Sweeney, 1996; Francis and Krishnan, 1999; Lee and Mande, 2003). However previous studies show that auditors may tend to let managers engage in higher levels of discretionary accruals in order to keep clients and only supply high audit quality when there are incentives to encourage then to do so (Francis and Krishnan, 1999; Francis, Maydew and Sparks, 1999; Francis and Wang, 2008). In this paper we examine relationship between earnings management and audit quality in Iranian firms. The structure of the research is as follows: Section 2 presents the literature review. Section 3 discusses the research hypotheses. Section 4 describes the data and methods, Section 5 discusses the empirical findings, and Section 6 presents the conclusions. 2. Literature Review Audit quality is perceived as the probability of detecting and reporting material misstatements, financial errors or lower quality accounting numbers (DeAngelo, 1981). The audit provides assurance to the owners and management of companies and to investors and stakeholders. Audit, along with financial reporting, corporate governance and regulation, supports confidence in capital markets. Following the collapse of Enron and other high profile corporate scandals, the responsibility and quality of audit came under intense scrutiny on an international scale. Government, regulators and other stakeholders asked many hard questions about audit and the auditing profession. The very public debate that ensued on the role and quality of audit brought the auditing profession 2
The Relationship between Earnings Management and Audit Quality  - page 3
centre stage and resulted in significant changes in how auditors are regulated and the way in which auditors communicate and interact with regulators and other stakeholders. As commerce and financing have developed into truly international operations, so too, has the auditing profession become international. No single market can operate successfully in isolation from the global economy. Audit is a cornerstone of confidence in capital markets and making audit services of the highest quality is of crucial importance for all participants in the capital markets and especially important to the auditing profession. On the other hand, accounting standards allow for managerial discretion in the application of accounting methods used to report firm performance. When this discretion is used with the intent to manipulate reported results, it is called earnings management (Riahi-Belkaoui, 2004; Nigrini, 2005). The managers purposely select preferred accounting policy or arranged transactions to accomplish the business anticipations. Healy and Wahlen (1999) advocated the management applying the flexibility of financial report, designated accounting, and intended deals to modify the earnings of the financial statement. They try to misrepresent the perception of the operation performance for the interested parties. Or they design to influence the financial reporting figures to satisfy the manipulator self-benefits. DeAngelo (1981) introduces a two-dimensional definition of audit quality that set the standard for addressing the critical issue. The material misstatement of the client’s accounting system must be detected and reported. The audit quality is imperative to reporting integrity and earnings quality. Especially nowadays, the credibility of the external financial reporting process has been severely challenged by high-profile audit failures, material misstatements, and restatements of financial reports. The audit quality indicates as the capacity of external audits to detect material misstatements and improprieties (Kane and Velury, 2005) .In addition, audit quality conveys the company value. When the manager has confidence about the business and financial report, they expect to explicitly exhibit the true value of the company through the audit quality. They have incentive to hire high audit quality auditor to certify their report (Titman and Trueman, 1986). Abundant research indicates higher audit quality mitigates the earnings management (Becker et al., 1998; Francis et al., 1999; Bauwhede et al., 2003; Zhou and Elder, 2004; Chen et al., 2005; Van Tendeloo and Vanstraelen, 2008; Francis and Yu, 2009; Lin and Huang, 2010 ; Jordan et al., 2010). CPAs would like to avoid the litigation, they judge the adequacy of the accounting principles by the clients’ litigation risks (Becker et al., 1998). They apply the Big-Six (now Big-Four) and non-Big-Six (now non-Big-Four) as the audit quality proxy variable and assume the non-Big-Six clients would adopt more earnings accrual items than the Big-Six ones. They find the discretionary accrual items of the non-Big-Six CPA firms (low audit quality) audited companies are all larger than the Big-Six CPA firms (high audit quality) audited companies. The low audit 3
The Relationship between Earnings Management and Audit Quality  - page 4
quality CPA firms allow more earnings management to favor their client. The presumption of the CPA firm selection would affect the clients earnings management is supported (Becker et al., 1998). Francis et al. (1999) suggest that the audited reports by Big-Six CPA firms were considered as high audit quality and observed the effect from the audit quality difference to the earnings management. The results indicate that the audited clients by the Big-Six CPA firms had fewer earnings management than the non-Big-Six CPA firms. Therefore, the high audit quality enables to reduce the earnings management. Zhou and Elder (2004) conducted 2,453 observations of the seasoned equity offerings (SEOs) from 1991 to 1999. They explored the relationship among the SEOs, audit quality, industry experts, and earnings management. The earnings management and audit quality are measured by the CPA firm sizes and discretionary accrual items. The study results indicate that the Big-Five presenting lower earnings management at the prior one year, current, and post one year periods of SEOs. Summarizing the above, the audit quality enables to reduce the earnings management of SEOs. Chen et al. (2005) examine 367 initial public offer (IPO) companies from 1999 to 2002 to explore the IPO audit quality (Big-Five vs. non-Big-Five) and earnings management (by discretionary accruals items measurement). They find the Big-Five audited IPO companies revealed less earnings management in IPO year. To solve the problems derived from the information asymmetry between the financial report preparers and users, the authority requires the SMEs to obtain CPAs audited financial reports. The professional, creditworthy, and independent CPAs perform audit assurance to strengthen the financial report reliability. Nevertheless, audit quality affects the reliability of the audit report as well as earnings management. Therefore, the study assumes that the high audit quality can reduce earnings management. In this study it was anticipated that SMEs leaping the zero earnings thresholds of the earnings management goal and preferring the low audit quality CPAs for financing audit services (Chiang et al., 2011). Considering the above discussion, this study because of the need for richness of the accounting literature in this field, reviews relationship between earnings management and audit quality of companies accepted in Tehran Stock Exchange. 3. Research Hypotheses Main hypothesis There is a significant relationship between earnings management and audit quality in TSE. Sub hypothesis 1. There is a significant relationship between earnings management and auditor size in TSE. 4
The Relationship between Earnings Management and Audit Quality  - page 5
2. There is a significant relationship between earnings management and auditor tenure in TSE. 4. Research Method 4.1. Sample & Statistical Population The statistical population in this study includes the accepted companies in Tehran Stock Exchange in the period of 2003 to 2010. Existence of some heterogeneousness among the accepted companies in Tehran Stock Exchange led to consider some special conditions for selection of studied companies as follows: Companies selected must be accepted in Tehran Stock Exchange since the year 2000. Companies should not be changed the financial period in the study period. Security transaction is done continuous in Tehran Stock Exchange and never occurred trading stops in stocks mentioned more than a month. With regard to the above conditions, 85 firms were selected as the statistical sample. 4.2. Data Collection Tools and Data Analysis Method In this paper, for measuring of research variables are applied the following models: Measurement of Earnings Management A generally used approach in earnings management literature is the Jones model. Conceptually, total accruals (TACC) are decomposed into non-discretionary (NDACC) and discretionary accruals (DACC). The difference between total accruals and non-discretionary accruals is the discretionary component. In other words, discretionary accruals are the prediction error in the Jones (1991) accruals model. Jones uses a two-step approach. First, a cross-sectional regression is performed for total accruals (TACC). Total accruals (TACC) are measured as the change in non-cash working capital plus depreciation and amortization. Jones then regress total accruals on the change in sales and property, plant and equipment. (1) Where in above equation TA (total assets), REV (changes in revenue), REC (changes in receivables) and PPE is property, plant and equipment. REV & PPE be controlled for the non-discretionary part of total accruals since those items are associated with changes in operating activity and level of depreciation. 5 TACC / TA 1 = β 0 j (1/ TA 1 ) + β 1 j ( REV − ∆ REC ) / TA 1 + β 2 j ( PPE / TA 1 ) + ε it it it it it it it it it
The Relationship between Earnings Management and Audit Quality  - page 6
The second step is to use these industry-year parameter estimates from the previous equation (1) to divide the total accruals into a discretionary part (DACC) and a non-discretionary part (NDACC). Non-discretionary accruals (NDACC) are the predicted part of total accruals and discretionary accruals (DACC) are the residual resulting from this regression. NDACC = β 0 j (1/ TA it 1 ) + β 1 j ( REV it − ∆ REC it ) / TA it 1 + β 2 j ( PPE it / TA it 1 ) it DACC = TACC / TA 1 β 0 j (1/ TA 1 ) + β 1 j ( REV − ∆ REC ) / TA 1 + β 2 j ( PPE / TA 1 ) it it it it it it it it it β 0 , β 1 and β 2 are the industry-year parameter estimated in regression (1). Measurement of Audit Quality To measure audit quality following variables are used: Auditor Size: Such that in regression models No 1 & 2 if auditing institution is audit organization, dummy variable of 1 is used, otherwise number 0 is used. Auditor Tenure: So that in regression methods no 1 & 2, if auditor tenure is 5 years or more, dummy variable of 1 is used, otherwise number 0 is used. Measurement of Control variables 1. Operating Cash Flow (CFO) According to Becker & et al. (1998) there is considerable different about operating cash flows in 5 firms that have been audited by 5 big auditor and 5 firms that have not been audited by 5 Big auditor. Therefore, operating cash flow is calculated as follow and it is added to research as a control variable. 2. Losses and Income Index Burgstahler and Dichev (1997) have done researches that show firms avoid income and losses reduce reporting attempt to earnings management. For this reason income and losses indicators has been considered as control variables to be shown due to lack of stimulating managers to reduce profit and loss reports. 3. Company Size: Large companies are being investigated accurately by an increasing a lot of financial analysts and investors, Therefore may be these companies less willing to earnings management (Chen & et al., 2005) for this reason companies selling log as control variable has been added to research for the impact of firm size on earnings management. 6
The Relationship between Earnings Management and Audit Quality  - page 7
5. Analysis Descriptive statistics for total companies (484 firm-year observations) have been represented in Table 1. Findings show that SIZE variable among variables has had the lowest variation coefficient (Std. Dev. Divided by Mean) but earnings management variable was of the most variation coefficient in study period. This means that investigated companies have had instability earnings management in during research period, whereas independent and control variables have approximately been stable. This subject indicates that earnings management in TSE is a function from different factors and it’s necessary to investigate in future studies. Table 1. Descriptive Statistics Statistics Mean Variables Earning Management Auditor Size Auditor Tenure Operating Cash Flows Loss index Income index Size -0.002 0.51 0.31 0.09 0.07 0.69 5.49 0.132 0.49 0.58 0.49 0.37 0.42 0.71 Std. Dev. Variation Coefficient (CV) -66.02 0.96 1.87 5.44 5.28 0.60 0.12 Observations 484 484 484 484 484 484 484 Test of first sub hypothesis H 0 : There is not a significant relationship between earnings management and audit size in TSE. H 1 : There is a significant relationship between earnings management and audit size in TSE. In testing of first sub hypothesis, goal is the investigation of the relationship between quantitative variable of earnings management and nominal variable of auditor size. When a variable has a nominal scale and other variable with a ratio scale, index that can be used to measure the correlation intensity is correlation ratio index or η2 squared. According to table 2. Correlation ratio index (η2 squared) is 0.175, which indicates a weak correlation between earnings management and auditor size. 7
The Relationship between Earnings Management and Audit Quality  - page 8
This correlation with respect to p-value is significant, so this hypothesis is accepted. Table 2. Correlation Ratio Index (η2 squared), Pearson and Spearman Correlation Coefficient Statistics Approximate Prob. Value (P) Variables η 2 Coefficient Pearson Correlation Coefficient Spearman Correlation Coefficient 0.000 0.000 0.175 0.175 0.188 Test of first sub hypothesis H 0 : There is not a significant relationship between earnings management and auditor tenure in TSE. H 1 : There is a significant relationship between earnings management and auditor tenure in TSE. As regards, in testing of above hypothesis, the relationship between a quantitative variable of earnings management and a nominal variable of auditor tenure is studied. Similar to the first sub hypothesis, index that can be used to measure the correlation intensity is correlation ratio index or η2 squared. According to table 3. Correlation ratio index (η2 squared) is 0.217, which indicates a weak correlation between earnings management and auditor tenure. This correlation with respect to p-value is significant, so this hypothesis is accepted. Table 3. Correlation Ratio Index (η2 squared), Pearson and Spearman Correlation Coefficient Statistics Approximate Prob. Value (P) Variables η 2 Coefficient Pearson Correlation Coefficient Spearman Correlation Coefficient 0.000 0.000 0.217 0.217 0.222 8
The Relationship between Earnings Management and Audit Quality  - page 9
The regression model between EM & AQ in Table 4 shows that relation between these variables is positive and significant. Determination coefficient shows that approximately 7% of changes EM can be explained by AQ in during the research period. In general, regression model is significant with respect to F- statistic and Durbin-Watson statistic shows that the model hasn’t autocorrelation problem. Table 4. Regression Model between of Earnings Management (EM) and Audit Quality (AQ) with out control variables t-Statistic Variables Coefficient Std. Error Prob. C AQ R-squared 0.075 -0.001 0.035 0.005 0.005 -0.2 6.14 0.609 0.000 Adjusted R-squared 0.069 Durbin-Watson Stat 1.78 Prob. (F-Statistic) 0.000 The results of general regression model with control variables in Table 5 show that relation between EM and AQ is positive and significant and relation between EM with CFO, Loss index and SIZE is positive but no significant statistically. Value of determination coefficient shows that approximately 8% of changes EM can be explained by AQ and control variables in during the study period. In general, regression model is significant with respect to F-statistic and Durbin-Watson statistic shows that the model hasn’t autocorrelation problem. Table 5. Regression Model between of Earnings Management (EM) and Audit Quality (AQ) with control variables t-Statistic Variables Coefficient Std. Error Prob. C AQ CFO Loss Size R-squared 0.082 -0.012 0.035 0.018 0.001 0.004 0.024 0.006 0.021 0.006 0.007 -0.5 5.83 0.85 0.16 0.57 0.536 0.000 0.124 0.866 0.595 Adjusted R-squared 0.075 Durbin-Watson Stat 1.87 Prob. (F-Statistic) 0.000 9
The Relationship between Earnings Management and Audit Quality  - page 10
6. Conclusion The purpose of this paper is examining the relationship between earnings management and audit quality in companies listed in Tehran Stock Exchange. Overall, research findings show that there is significant relationship between earnings management and quality audit. According to the first sub-hypothesis testing and correlation ratio index (η2 squared) show weak and positive correlation between earnings management and auditor size. In other words, the managers of firms have motivation for minimizing the difference between estimated earnings and reported earnings and also they use discretionary accruals and other accounting practices, precautions to manipulate reported earnings in order to minimizing these differences. In second sub-hypothesis test similar to the first sub-hypothesis, is used the correlation ratio index and results show weak and positive relation between earnings management and auditor tenure. As can be seen correlation intensity between earnings management and auditor tenure is more than correlation intensity between the earnings management auditor sizes. The results of this research are against with research results Dey Angelo (1993), Chen et al (2005), , and Tendello and Vanstraelen (2008). References 1. Bauwhede V. H., Willekens, M. & Gaeremynck, A. (2003). "Audit Firm Size, Public Ownership, and Firms’ Discretionary Accruals Management", Int. J. Account., 38 (1): 1-22. 2. Becker, C. L., Defond, M. L., Jiambalvo, J. J. & Subramanyam, K. R. (1998). "The Effect of Audit Quality on Earnings Management", Contemp. Account. Res, 15 (1): 1-24. 3. Burgstahler, D. & Dichev, I. (1997). "Earnings Management to Avoid Earnings Decreases and Losses", Journal of Accounting and Economics, 24(1): 99-126. 4. Chen, K. Y., Lin, K. & Zhou, J. (2005). "Audit Quality and Earnings Management for Taiwan IPO Firms", Manag. Audit. J., 20 (1): 86-104. 5. Chiang, S. L., Huang, L. H. & Chin Hsiao, H. (2011). "Study of Earnings Management and Audit Quality", African Journal of Business Management, 5(7), 2686-2699. 6. Dechow, P. M., Skinner, D. J. (2000). "Earnings Management: Reconciling the Views of Accounting Academics, Practitioners, and Regulators". Account. Horiz, 14 (2): 235-250. 10
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