Audit quality and the trade-off between real and accrual earnings management in the oil and gas industry: the GCC evidence

Abstract

PurposeThis paper examines the impact of audit quality on the managerial preferences between real and accrual earnings management (REM and AEM, respectively) in oil and gas firms operating in the Gulf Cooperation Council (GCC) member countries.Design/methodology/approachThe study relies on the modified Jones model’s (Dechow et al., 1995) to capture AEM and employs Roychowdhury (2006) approach to examine the use of REM through abnormal cash flows, abnormal production and abnormal discretionary expenditures. Audit quality is measured by auditor-industry specialization. The analyses are based on a sample of 30 oil and gas firms from 2008 to 2019.FindingsThe findings highlight that sample companies may substitute between earnings management strategies and tend to shift from AEM to REM when audited by an industry expert. Further analysis points out that the trade-off decision of the pooled sample stems from both upstream and downstream sectors.Research limitations/implicationsThis study is subject to two main limitations. First, the narrowed scope of audit quality related factors due to the scarcity of corporate governance reports of companies. Second, the sample size is reduced.Practical implicationsThe regulators and users of financial statements should be aware that REM strategy is used by oil and gas firms even when scrutinized by a high quality auditor, calling for extra caution when auditing or analyzing the financial information.Originality/valueThe current research is the first, unveiling the association between audit quality and the trade-off between AEM and REM in a less inspected sector and a unique institutional setting.