Abnormal Working Capital Accruals Research Articles

The impact of director blockholders on abnormal accruals and inventory

AbstractThis paper empirically analyzes the impact that director blockholders have on earnings management. We argue that having a blockholder serve on the board of directors will improve a firm's corporate governance due to having both the ability and incentive to correct problems in a firm. We provide evidence that the presence of blockholders on the board of directors lowers the amount of abnormal working capital accruals caused by CEO incentives. We show that this is primarily done by reducing abnormal increases in inventory. This finding is most robust among busy boards, providing evidence that director blockholders can provide strong corporate governance in the absence of an attentive board of directors. Our findings suggest that director blockholders can provide an important role for firms and may prevent managers from taking value‐destroying actions.

The Anticipation of Mandatory Audit Firm Rotation and Audit Quality

ABSTRACTResearchers and regulators regularly debate whether mandatory audit firm rotation affects audit quality. Theoretically, rotation might improve auditor independence but impair competence. In 2014, the European Commission mandated audit firm rotation for public-interest entities, starting from 2020 for nonfinancial firms. However, any auditor change in the transition period could already be interpreted in light of the upcoming mandatory rotation regime, consistent with anecdotal evidence on such interpretations. These changes provide a unique setting because auditors have strong incentives to build a reputation for high-quality audits when choosing to participate in the market for rotations during the transition period. Using a balanced panel of 287 German firms and data from 2014 through 2019, we hypothesize and find lower discretionary accruals, abnormal working capital accruals, and total accruals in the first year after rotation. This effect is restricted to smaller public companies.Data Availability: The data are from public sources and are available from the third author upon written request.JEL Classifications: M42; M48.

The Impact of Abnormal Audit Fees on Audit Quality: A Study of ASEAN Countries

This study investigates the impact of abnormal audit fees on audit quality. An abnormal audit fee is the difference between the actual fee paid by the auditee to the external auditor and the normal fee. If the actual audit fee is above the normal audit fee, it is called a positive abnormal audit fee (premium) and if the actual audit fee is below the normal audit fee, it is called a negative abnormal audit fee (discount). The samples for this study were 3,694 selected companies from Indonesia, Malaysia, Singapore, the Philippines, and Thailand. Data were analyzed using regression analysis and it was found that positive abnormal audit fees could decrease the audit quality. This is because of the economic arrangement between the auditors and the clients as the auditor will be more tolerant towards the earnings management carried out by the client. On the other hand, negative abnormal audit fees have an insignificant relationship with the audit quality, which means if auditors are paid below the normal fees, they have no incentive to compromise the audit quality. Because audit fees can affect audit quality, regulators need to make policies so that audit fees paid to the external auditors should not be more than the normal fees.
 Keywords: audit quality, audit fees, negative abnormal audit fees, positive abnormal audit fees, abnormal working capital accruals

Accruals Management to Avoid The Current Ratio Falling Below One: An Empirical Analysis Among Nonprofits

This study examines the distribution of the current ratio among large Belgian nonprofit organizations (NPOs). A current ratio falling below one signals (potential) liquidity problems among different types of stakeholders. Consistent with managerial intervention to avoid the current ratio falling below one, we observe significantly more (fewer) observations meeting or just exceeding (falling below) the threshold of one than would normally be expected. This discontinuity around one disappears when considering the distribution of the “pre-managed” current ratio (i.e., the current ratio corrected for abnormal working capital accruals). The latter observation is consistent with managerial intervention in the financial reporting process to avoid the current ratio falling below one. The aforementioned findings are supported by a multivariate regression model revealing significantly higher abnormal working capital accruals for observations having a current ratio equaling or exceeding one, but a pre-managed current ratio falling below one.

Early Adopters of Mandatory Auditor Rotation and Audit Quality

Researchers and regulators have continuously debated whether mandatory audit firm rotation impacts audit quality. Theoretically, rotation might improve auditor independence but impair auditor competence. In 2014, the European Commission mandated audit firm rotation for public-interest entities, starting from 2020 for non-financial firms. However, in the transition period, any auditor change could already be interpreted in light of the upcoming mandatory regime, consistent with anecdotal evidence on such interpretations. These changes provide a unique setting because auditors have strong incentives to build a reputation for high-quality audits when choosing to participate in the market for rotations in the transition period. Using a balanced panel of 287 German firms and data from 2014 to 2019, we hypothesize and find lower discretionary accruals, abnormal working capital accruals, and total accruals in the first year after rotation. This effect is restricted to smaller public companies and does not persist in the following years.

Earnings Management in Chapter 11 Bankruptcy

We study the impact of earnings management prior to bankruptcy filing on the passage of firms through Chapter 11. Using data on public US firms, we construct three measures of earnings management: a real activities manipulation measure (abnormal operating cash flows) and two accounting manipulation measures (discretionary accruals and abnormal working capital accruals). We find that, controlling for the impact of factors known to influence earnings management and firm survival in bankruptcy, earnings management prior to bankruptcy significantly reduces the likelihood of Chapter 11 plan confirmation and emergence from Chapter 11. The results are driven primarily by extreme values of earnings management, characterized by one or two standard deviations above or below the mean. The findings are consistent with creditors reacting positively to unduly conservative earnings reports and negatively to overly optimistic earnings reports. We also find that the presence of a Big 4 auditor is associated with a higher incidence of confirmation and switching to a Big 4 auditor before filing increases the incidence of emergence.

Does the Length of the Cooling-Off Period Impact Audit Quality?

Several countries have implemented a policy of mandatory partner rotation (MPR) in response to concerns around auditor independence. Integrated within MPR requirements, minimum cooling-off periods regulate audit quality at the time of a rotation-back. Within the context of a proposed extension to the minimum cooling-off period, we examine the association between the length of the cooling-off period and audit quality. We use Australian data as the partner can be identified and there is variation in cooling-off periods since the inception of MPR. We consider the merits of an extended cooling-off period by measuring audit quality both at the time of a rotation-back and at the expiration of a cooling-off period. Consistent with prior literature, we measure audit quality as abnormal working capital accruals and the auditor’s propensity to issue a going-concern opinion for financially distressed firms. For rotation-back observations, we find no evidence of an association between the length of the cooling-off period and audit quality. For cooling-off period observations, we find some evidence of larger abnormal working capital accruals and a lower propensity to issue a going-concern opinion, consistent with a deterioration in audit quality associated with longer cooling-off periods. We provide preliminary evidence that extending the cooling-off period does not enhance audit quality when a partner rotates-back on to a client and uncover an unintended consequence of the effect of this policy during the cooling-off period.

Entrance requirements to the audit profession within the EU and audit quality

This paper examines the relation between the stringency of entrance requirements to the audit profession within the EU and audit quality. Regulators and standard setters generally believe that such entrance requirements have beneficial effects by increasing audit quality. Whether this is indeed the case, however, is an empirical question given that regulations governing the entry to the audit profession are not the product of competitive market forces. We argue that a higher educational degree and longer traineeship period will result in higher audit quality. We also hypothesize that a professional oath will be positively associated with audit quality. Based on a sample of 3,782 firms from 20 different EU member states, we assess the relation between these requirements and abnormal working capital accruals. Our findings indicate that the requirement of a master's degree compared with a bachelor's degree is significantly associated with better accruals quality of audited financial statements. Second, we find that abnormal working capital accruals are lower in countries that require a traineeship period of at least 3 years. Finally, we find mixed evidence for the effect of a professional oath as part of the entrance requirements on audit quality.

Multiple Audit Mechanism and Audit Quality: Some Preliminary Evidence

Purpose: This study focuses on the distinctive Egyptian setting, where firms could use multiple audit mechanism voluntarily or mandatory under certain circumstances. We investigate the effects on audit quality and cost of debt. Design/methodology/approach: A sample of 1699 firm-year observations of Egyptian listed firms for the 2009-2019 period is used. Abnormal accruals are employed as proxies of audit quality through abnormal working capital accruals and modified-Jones models. The multiple regression method is used to estimate the research model after controlling for firm and ownership specific factors that hypothetically influence the levels of both audit quality and cost of debt. Findings: Results suggest that joint audits are not associated with both proxies of audit quality. In contrast, the dual audit is positively associated with abnormal accruals leading to conclude that dual audits are not providing a high level of audit quality. But this result holds only in companies with income decreasing discretionary accruals. These results are in line with litigation and reputational risk fears offering motivations for auditors to favour conservative accounting alternatives (i.e., income decreasing discretionary accruals). This implies that firms opting to employ dual audits have a higher level of earnings conservatism. Our evidence also indicates that the choice of multiple audit mechanisms especially joint audits is related to significant increases in the cost of debt, implying a higher perceived level of risk. Further, dual audits decrease the cost of debt only in companies with high earnings management. Originality/value: This study adds to the literature on whether the preference of income-increasing or income decreasing discretionary accruals is related to multiple audit mechanism and consequently affected cost of debt. Together, our results support the view that voluntary joint audits are not related to audit quality in Egypt compared to mandatory dual audits, which consequently affect the pricing of debt. Our results have important implications for policymakers, audit firms and investors. .

Earnings Management, Chapter 11 Emergence and Firm Value

We study the impact of earnings management prior to bankruptcy filing on the passage of firms through Chapter 11. Using data on 261 U.S. public firms, we construct three measures of earnings management, two of which are accounting (accrual) manipulation measures (discretionary accruals and abnormal working capital accruals) and one a real activities manipulation measure (abnormal operating cash flows). Our key findings are that earnings management prior to bankruptcy reduces the likelihood of plan confirmation and emergence from Chapter 11. The findings are consistent with creditors rewarding conservative earnings reporting and punishing overly optimistic earnings reports. We find clear evidence that upward management of earnings destroys economic value by making the survival of the firm less likely, an effect that has not previously been uncovered by the literature. We also find that auditor choice (Big 4 vs. non-Big 4) directly affects the probability for plan confirmation as well as the likelihood of emergence from bankruptcy.

Mandatory management forecasts, forecast revisions, and abnormal accruals

Purpose Current systems of regulation in Japan require that listed firms disclose earnings forecasts for the coming fiscal year. The Japanese Business Federation is contesting this requirement, requesting that mandatory forecast disclosures be abolished. The purpose of this paper is to investigate the relationships between accruals and initial management earnings forecast errors (MFERR), and between accruals and forecast revisions. Further, the study offers a preliminary discussion of the economic costs of mandatory earnings forecasting, with a specific focus on firms operating under conditions of uncertainty or facing difficulty in analyzing economic information. Design/methodology/approach To investigate the relationship between accruals and management forecast errors (revisions), multiple regression models were designed using data covering the period between 2003 and 2013, pertaining to listed Japanese firms. A model developed by Dechow and Dichev (2002) was applied to estimate normal and abnormal accruals. Findings The author found a positive relationship between accruals and initial MFERR, and a negative relationship between accruals and forecast revisions. Further, the relationship between accruals and management forecast errors (revisions) is more pronounced among firms operating in uncertain business environments or facing difficulty in analyzing economic information. Originality/value The study provides an important analysis of abnormal working capital accruals in relation to both initial MFERR and forecast revisions. While total accruals or working capital accruals have been documented in prior studies in this regard, abnormal accruals have not. Furthermore, this study offers a preliminary discussion of the economic costs associated with earnings forecasting under conditions of mandatory disclosure. The economic impact of forecasting has not previously been addressed under either mandatory or voluntary conditions.

Mandatory Audit Firm Rotation and Audit Quality

In a setting where mandatory audit firm rotation has been effective for more than 20 years (i.e. Italy), we analyse changes in audit quality during the auditor engagement period. In our research setting, auditors are appointed for a three-year period and their term can be renewed twice up to a maximum of nine years. Since the auditor has incentives to be re-appointed at the end of the first and the second three-year periods, we expect audit quality to be lower in the first two three-year periods compared to the third (i.e. the last) term. Assuming that a better audit quality is associated with a higher level of accounting conservatism, and using abnormal working capital accruals as a proxy for the latter, we find that the auditor becomes more conservative in the last three-year period, i.e. the one preceding the mandatory rotation. These results are confirmed using Basu's [1997. The conservatism principle and the asymmetric timeliness of earnings. Journal of Accounting and Economics, 24(1), 3–37] timely loss recognition model. In an additional analysis, we use earnings response coefficients as a proxy for investor perception of audit quality, and we observe results consistent with an increase in audit quality perception in the last engagement period.

The effects of board and auditor independence on earnings quality: evidence from Italy

Most regulations and corporate governance codes emphasize the adjective independent next to the words auditor and director because auditor and director independence is expected to result in better protection for shareholders and other stakeholders. In this study we use (1) the extent to which the auditor provides non-audit services (NAS) to clients as a possible factor influencing auditor independence and (2) the proportion of outside independent directors to the total number of directors as a proxy of board of directors’ independence (BODI). The two fundamental questions are the following: (1) Does the provision of NAS by auditors to audit clients impair auditor independence, thus reducing the quality of earnings? (2) Does BODI play a role in improving earnings quality? An empirical analysis is conducted on a sample of Italian listed companies during the period 2007–2010. Our evidence does not show an influence of BODI on our proxies of earnings management. Regarding the issue of auditor independence, the provision of NAS appears to be positively associated with the absolute abnormal working capital accruals, which is an indicator of a lower quality of earnings. We also show that board characteristics are not determinants in the choice of purchasing NAS and that the new Italian regulation on mandatory disclosure of audit and NAS fees appears to have had some influence on the behavior of companies in the 2007–2010 period in the form of a reduction in the relative magnitude of NAS compared to audit fees.

Corporate Governance Characteristics and Earnings Management: Empirical Evidence from Chinese Listed Firms

The purpose of this paper is to investigate the efficiency of corporate governance characteristics in reducing earnings management among the listed firms of Shanghai and Shenzhen stock exchange, China. We took abnormal working capital accruals as a proxy for earning management. In this paper, we used modified Jones Model in order to calculate discretionary accruals (DAC). The sample comprises of 1009 firms over the period of 4 years from 2002 to 2006. The study essentially shows that the corporate governance characteristics play a vital role in reducing the earning management. We found a significantly positive association between earning management and different corporate governance characteristics such as CEO duality, board meetings, females directors and concentrated ownership. We lacked evidences to find relationship between board size, director’s shareholdings and proportion of independent directors with DAC as well as between the presence of audit committee and DAC. These studies will broaden the scope of the relationship between earning management and corporate governance characteristics. Very few studies have been conducted in this area especially for the Chinese listed firms with empirical evidences given. A variety of corporate governance variables are used especially board sex ratio in this analysis.

Audit Firm Rotation and Earnings Management in Brazil

The main reason for requiring rotation of independent auditors is to preserve independence and ethics in the relationship between the audited company and its external auditing firm and consequently to reduce accounting fraud and errors. To investigate whether this procedure was effective in the Brazilian capital market, we analyzed data on Brazilian public companies between 1997 and 2007. We applied the abnormal working capital accruals (AWCA) method to analyze the effects on earnings management of changing the auditor, focusing on the reason for the change (obligatory or spontaneous), classification of the auditing firm among the Big Four (PwC, DTT, E&Y and KPMG) and length of the relationship with the audited company. The findings indicate there is no significant effect on earnings management of changing the auditing firm. A factor in this respect may be that all of the Big Four have internal policies to rotate the staff assigned to specific audited companies.

Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan*

We examine the effectiveness of mandatory audit-partner rotation in promoting audit quality using audit data in Taiwan where a five-year audit-partner rotation became de facto mandatory in 2004. Using both absolute and signed abnormal accruals and abnormal working capital accruals as proxies for audit quality, we find some evidence that audit quality of companies subject to mandatory audit-partner rotation in 2004 is higher than audit quality of companies not subject to rotation in 2004. However, audit quality of companies subject to mandatory rotation in 2004 is lower than audit quality of these same companies in 2003 under the old audit partners. Furthermore, audit quality of companies subject to mandatory rotation in 2004 is indistinguishable from audit quality of companies whose audit partners were voluntarily rotated before 2003. Therefore, the effect of mandatory audit-partner rotation on audit quality, in terms of auditors constraining management's extreme income-increasing or extreme income-decreasing accruals, is mixed. In contrast, using earnings response coefficients as a proxy for investor perceptions of audit quality, we consistently find that investors perceive mandatory audit-partner rotation as enhancing audit quality, suggesting that mandatory audit-partner rotation enhances auditor independence in appearance.

Earnings management or forecast guidance to meet analyst expectations?

We examine whether UK firms engage in earnings management or forecast guidance to ensure that their reported earnings meet analyst earnings expectations. We explore two earnings management mechanisms: (a) positive abnormal working capital accruals; and (b) classification shifting of core expenses to non‐recurring items. We find no evidence of a positive association between income‐increasing, abnormal working capital accruals and the probability of meeting analyst forecasts. Instead we find evidence consistent with a subset of larger firms shifting small core expenses to other non‐recurring items to just hit analyst expectations with core earnings. We also find that the probability of meeting analyst expectations increases with downward‐guided forecasts. Overall our results suggest that UK firms are more likely to engage in earnings forecast guidance or, for a subset of larger firms, in classification shifting rather than in accruals management to avoid negative earnings surprises.

The Influence of Takeover Protection on Earnings Management

Abstract: We examine the relationship between takeover protection and earnings management. Existing theories suggest two contradictory effects of takeover protection on opportunistic earnings management: entrenchment theory suggests an exacerbating effect, whereas both alignment theory and quiet life theory posit a mitigating effect. We find that takeover protection is associated with lower levels of abnormal working capital accruals, lower levels of performance‐adjusted abnormal accruals and timelier recognition of losses. Further tests show that takeover protection is associated with lower firm value, which contradicts alignment theory but supports quiet life theory. The results suggest that takeover protection allows managers to enjoy the quiet life and thus mitigates earnings management.

Board, audit committee, culture and earnings management: Malaysian evidence

PurposeAims to investigate the extent of the effectiveness of monitoring functions of board of directors, audit committee and concentrated ownership in reducing earnings management among 97 firms listed on the Main Board of Bursa Malaysia over the period 2002‐2003.Design/methodology/approachThe current study employs the cross‐sectional modified version of Jones, where abnormal working capital accruals are used as proxy for earnings management.FindingsThe study reveals that earnings management is positively related to the size of the board of directors. This supports the view that larger boards appear to be ineffective in their oversight duties relative to smaller boards. A possible explanation for the insignificant relationship between other corporate governance mechanisms (independence of board and audit committee) and earnings management is that the board of directors is seen as ineffective in discharging their monitoring duties due to management dominance over board matters. The apparent reason for this phenomenon is attributed to the board of directors' relative lack of knowledge in company's affairs. The study also found that ethnicity (race) has no effect in mitigating earnings management, possibly due to the more individualistic behaviour of the Bumiputra directors. The modernisation of Malaysia and also the increase in Bumiputra ownership of national wealth may have caused the Malays to be more individualistic, similar to their Chinese counterpart.Originality/valueSince, there are relatively few studies conducted in this area specifically among Malaysian firms, this study will broaden the scope by providing empirical evidence of the relationship between various corporate governance characteristics, cultural factors and earnings management.

Audit Partner Tenure and Audit Quality

Rotation of audit partners is one of the main policy initiatives that has been implemented in many jurisdictions around the world to deal with concerns about audit quality. The basis of any requirement limiting the tenure of audit partners is that there is a reduction in audit quality associated with long periods of tenure. Using data from Australia, where the audit partner can be identified and for a period where partner rotation was not mandatory, we examine the association between audit quality and long audit partner tenure. The three measures of audit quality examined are the auditor's propensity to issue a going-concern audit opinion for distressed companies, the direction and amount of abnormal working capital accruals, and just beating (missing) earnings benchmarks. For long tenure observations we find a lower propensity to issue a going-concern opinion and some evidence of just beating (missing) earnings benchmarks, consistent with deterioration in audit quality associated with long audit partner tenure. There is no evidence of an association of long audit tenure with abnormal working capital accruals.