Abstract
The purpose of this paper is to examine the role of external auditors in potentially approving or limiting a firm’s earnings management practices in institutional settings which do not provide incentives for auditors to deliver high audit quality. We use signed discretionary and performance-adjusted discretionary accruals as proxies for earnings management, and audit firm size (Big 4 vs. Non-Big 4) and audit opinion type (Qualified vs. Unqualified) as measures for audit quality. Using a sample of 183 firms listed on the Karachi Stock Exchange, Pakistan for the five-year period from 2009 to 2013, we find that there is statistically no significant difference between earnings management activities of firms audited by Big 4 and non-Big 4 auditors. Audit opinion is not being issued in response to the earnings management activities being employed by firms. Further consistent with the entrenchment hypothesis, we find that earnings management is pervasive in family controlled firms and Big 4 auditors do not moderate the relation between family firm dominance and earnings management. A small audit market coupled with non-existent litigation risk, strong economic bonding of auditors with their clients, lower investor protection, poor enforcement mechanisms and dominance of firms by influential family groups lead auditors to behave opportunistically, which undermines their independence and objectivity.
Highlights
Auditing and financial reporting scandals like Enron and WorldCom have brought audit quality and governance mechanisms into the spotlight
Both models have the same dependent variable, Audit Opinion, Audit opinion (AO), whereas the independent variables are different with discretionary accruals, Discretionary accruals (DA), and performance-adjusted discretionary accruals, PADA, estimated using modified Jones model developed by P
Takingthe results of both Hypothesis 1 and 2, we find that the size of audit firm does not affect the level of earnings management and the audit opinion is not issued in relation to the management’s opportunistic behavior
Summary
Auditing and financial reporting scandals like Enron and WorldCom have brought audit quality and governance mechanisms into the spotlight. Earnings management practices have a detrimental impact on investor confidence, capital market development and transparency of financial reporting. Pakistan is a common law country, having adopted International Financial Reporting Standards (IFRS) after their promulgation on 1 January 2005. Ashraf and Ghani (2005) argue that Pakistan exhibits characteristics of code law countries, having less developed equity market, reliance on banks and financial institutions for debt financing, poor investor protection laws for minority shareholders, and concentrated ownership dominated by family business groups. Empirical studies of international comparison among countries have demonstrated that Pakistan is among the countries with the highest levels of earnings management practices (Leuz et al 2003), despite adoption of International Accounting Standards (IAS) from the outset
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Free) 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a call
