The Effect of Audit Quality on Earnings Management*

Abstract

This study examines the relation between audit quality and earnings management. Consistent with prior research, we treat audit quality as a dichotomous variable and assume that Big Six auditors are of higher quality than non‐Big Six auditors. Earnings management is captured by discretionary accruals that are estimated using a cross‐sectional version of the Jones 1991 model. Prior literature suggests that auditors are more likely to object to management's accounting choices that increase earnings (as opposed to decrease earnings) and that auditors are more likely to be sued when they are associated with financial statements that overstate earnings (as compared to understate earnings). Therefore, we hypothesize that clients of non‐Big Six auditors report discretionary accruals that increase income relatively more than the discretionary accruals reported by clients of Big Six auditors. This hypothesis is supported by evidence from a sample of 10,379 Big Six and 2,179 non‐Big Six firm years. Specifically, clients of non‐Big Six auditors report discretionary accruals that are, on average, 1.5‐2.1 percent of total assets higher than the discretionary accruals reported by clients of Big Six auditors. Also, consistent with earnings management, we find that the mean and median of the absolute value of discretionary accruals are greater for firms with non‐Big Six auditors. This result also indicates that lower audit quality is associated with more “accounting flexibility”.

Audit Quality: The Role of Board Structure in Family Firms

“…Because of their large clienteles and established international reputations, the Big 4 audit firms are expected to lose less (more) as a result of maintaining (losing) their independence in comparison to smaller audit firms (DeAngelo, 1981;Cano-Rodríquez, 2010). The validity of the Big 4 vs. non-Big 4 dichotomy as a proxy for audit quality is also supported by previous empirical findings (e.g., Becker et al, 1998;Van Tendeloo & Vanstraelen, 2008;Cano-Rodríquez, 2010). …”

Female directors and earnings management: Evidence from UK companies

“…In addition, mangers can practice their discretion either on long-or short-term discretionary accruals to mainpluate earnings. However, Becker et al (1998) argue that managers have greater discretion over current accruals than long-term ones. In this paper, we use the modified of Jones model (Dechow et al 1995) 2 to estimate current discretionary accruals.…”

The role of corporate governance in accounting discretion under IFRS: Goodwill impairment in Australia

“…Nelson et al (2003) report results suggesting that auditors are less likely to waive earnings management attempts that increase current-year income, and more likely to waive attempts they view as immaterial. Becker et al (1998) and Francis et al (1999) document that clients of non-Big Six auditors report higher absolute discretionary accruals than do Big Six auditors.…”

“…For example, research finds that Big 4 auditors (Becker et al, 1998;Blokdijk et al, 2006;Dechow et al, 1996;Francis et al, 1999;Francis and Wang, 2008), independent directors on the board (Beasley, 1996;Cheng and Courtenay, 2006;Dechow et al, 1996;Peasnell et al, 2005), independent directors of the audit committee (Klein, 2002), financial expertise of audit committee members (Abbott et al, 2004;DeZoort and Salterio, 2001;Kalbers and Fogarty, 1993;Myers, 2001;Scarbrough et al, 1998;Raghunandan et al, 2001), separation between the CEO and the board chair (Dechow et al, 1996) and frequent meetings of the audit committee (McMullen and Raghunandan, 1996;Xie et al, 2003) are all associated positively with financial reporting quality.…”