The Impact of Audit Quality on Earnings Management: Evidence from Listed Companies in Sri Lanka

Abstract

Earnings Management (EM) is related to the manipulation of reported income through accounting practices and decisions. With the occurrence of numerous financial collapses and failures, the reliability of the audit function has been challenged, as auditors play a critical role in expressing an opinion on the financial statements. This study investigates the impact of Audit Quality on EM in Sri Lankan listed companies. This study employs Modified Jones model to examine earnings management practices through Discretionary Accruals (DA). The selected proxies of audit quality which are Length of Audit Tenure, Audit Firm Size and Auditor Independence are the independent variables. The data is collected from annual reports for the financial periods 2015 - 2020 and audit reports for the financial period 2012 - 2020 of listed companies on the Colombo Stock Exchange (CSE). This study employed descriptive statistics, correlation analysis, and multivariate analysis to analyze the data. Based on the quantitative analysis, the results demonstrated that the association between audit firm size and earnings management in Sri Lankan listed companies is negative and significant. It was found that the level of EM between companies using Big 4 auditors and those using non-Big 4 auditors is much lower. This study revealed that auditor independence and EM have a significant negative association. It was suggested that independent auditors have a greater ability to regulate and identify EM activities through company management. Further, this study exposed that there is an insignificant association between the length of audit tenure and earnings management. These findings are useful to shareholders in appointing or reappointing auditors. Furthermore, this study enables stakeholders, including regulatory bodies, to examine the presence of EM practices in listed companies of CSE.