Absolute Discretionary Accruals Research Articles

Does Audit Quality Influence the Relation between Earnings Management and Internal Control Weakness in the Post –SOX Period

Material weaknesses in the internal control system of a company create more opportunities for managers to engage in opportunistic earnings management. In this study the authors investigate the relation between earnings management and disclosed material weaknesses in the internal controls, both under SOX 302 and SOX 404, and examine whether audit quality, measured as being audited by a Big Four auditor, has an effect on that relation. The results suggest that material weakness firms have more absolute discretionary accruals and greater income-decreasing discretionary accruals. So evidence is provided that material weakness firms engage in more earnings management, however not in opportunistic income-increasing earnings management. When audit quality is high, measured as being audited by a Big Four auditor, the disclosed material weaknesses are lower just as total and absolute discretionary accruals are. It is also interesting in our findings that when material weakness firms are audited by a Big Four auditor a positive relationship seems to exist with discretionary accruals, suggesting that when a firm is audited by a Big Four auditor, material weaknesses in the internal controls will lead to opportunistic earnings management.

Measuring quality of reported earnings’ response to corporate governance reforms in Russia

Purpose – An important objective of corporate governance reforms is to increase transparency. The purpose of this paper is to investigate whether this objective of corporate governance reforms of 2002 was achieved in Russia.Design/methodology/approach – This paper utilizes the data collected from UBS Brunswick's “Russian Equity Guides” published during 1999‐2004, and companies’ annual reports. The modified accrual model of Jones presented by Dechow et al. is used to ascertain the quality of reported earnings of 91 Russian listed companies during the pre‐ and post‐ reform periods.Findings – This research paper shows that the quality of earnings – measured as the inverse of absolute discretionary accruals – is not affected by the 2002 reforms in Russia. Therefore, one of the most important objectives of bringing transparency in the Russian corporate sector was not successfully achieved. Instead, this paper finds that adoption of international financial reporting standards (IAS/USGAAP) by Russian listed comp...

The Monitoring Effectiveness of Co-Opted Audit Committees

We investigate the relation between audit committee co-option and financial reporting quality, where audit committee co-option is measured as the proportion of audit committee members who joined the board after the appointment of the current Chief Executive Officer (CEO). Because CEOs are often actively involved in the director nomination and selection process, we expect that higher levels of audit committee co-option will be associated with less effective monitoring, as evidenced by more financial statement misstatements and greater absolute discretionary accruals. Consistent with our expectations, we find a positive relation between audit committee co-option and misstatements as well as between audit committee co-option and absolute discretionary accruals. Consistent with prior work which documents the importance of accounting expertise on the audit committee, subsequent tests reveal that the adverse implications of audit committee co-option are mitigated when the audit committee chair is an accounting expert. Our findings should be of interest to regulators, investors, and other stakeholders because we provide new evidence about how potential CEO influence on director nominations and audit committee appointments impacts the effectiveness of monitoring by the audit committee.

Does Appointing a Former CFO as CEO Influence a Firm's Financial Reporting, Disclosure and Tax Policies?

We study CEO successions to investigate the factors that lead a firm to select an individual with CFO experience for their CEO and whether appointing a former CFO leads to systematic changes in financial reporting, disclosure, and tax policies relative to other CEO appointments. Consistent with the “fit/refit” model, we find that the selection of a former CFO is associated with several changes in firm characteristics leading up to the appointment, including increases in analyst coverage, analyst forecast dispersion, and absolute discretionary accruals. We also document improvements in the firms’ reporting and disclosure quality after the appointment of a CEO with CFO experience relative to appointments of other CEOs. Our study provides insight into the circumstances under which CFO experience is valued in the top leadership position of the firm and the reasons underlying the documented effect of individual CEOs on a firm’s accounting policies.

Does XBRL Adoption Constrain Managerial Opportunism in Financial Reporting? Evidence from Mandated U.S. Filers

In this study, we examine whether XBRL disclosure (i.e., interactive data submissions) reduces the magnitude of accounting accruals for firms during SEC mandated years. Using mandated XBRL filers, we first compare the magnitude of absolute discretionary accruals in the XBRL-adoption quarters with that in the non-XBRL-adoption quarters. This comparison shows that absolute discretionary accruals decreases significantly from the pre-XBRL-adoption period to the post-XBRL-adoption adoption period. This finding is in line with the view that the XBRL adoption constrains managerial opportunism in financial reporting in general and opportunistic accrual management in particular. Our analyses further reveal that the use of standardized official XBRL elements significantly reduces levels of discretionary accruals in the post-adoption period, while the use of customized extension elements does not. This result is consistent with the view that the former discourages opportunistic accruals management more effectively than the latter by improving transparency and comparability in financial reporting.

Collateral Damage: Audit Quality and Office Growth

This study provides evidence on how local office growth affects audit quality. We predict that significant recent growth will temporarily stress office resources, leading to a negative relation between office-level growth and audit quality. To test this prediction, we examine a sample of 17,062 firm-year observations from 2005-2010. Results indicate a consistent negative relation between changes in volume of audit work and audit quality. Specifically, clients of offices that experience increases in workload over the prior year have greater absolute discretionary accruals as well as an increased likelihood of restatement. Our tests also indicate that the effect of office growth is transient and vanishes after one year. We find limited evidence that the size of the auditor’s national network of offices partially mitigates the negative effects of office growth on audit quality. We further show that proxies for audit quality are negatively related to office-level growth from new and existing clients. These findings are robust to controls for client and auditor characteristics as well as alternative specifications of growth. Taken together, evidence indicates that while larger offices provide higher audit quality, the benefits of office size are not realized immediately and rapid growth temporarily impairs audit quality. These results are informative to regulators concerned with audit quality and to practitioners charged with adjusting to office growth.

Abnormal Audit Fee and Audit Quality

SUMMARYThis study tests the hypotheses that below-normal audit fees signal important nuances in the balance of bargaining power between the auditor and the client, and that such power may ultimately influence audit quality. We find that audit quality, proxied by absolute discretionary accruals and meeting or beating analysts' earnings forecasts, declines as negative abnormal audit fees increase in magnitude, with the effect amplified as proxies for client bargaining power increase. We find that this effect is dampened in years following the Sarbanes-Oxley Act (SOX), suggesting that SOX was effective in enhancing auditor independence.

The Effect of Nonaudit Fees and Family Owned Businesses on Earnings Management in the Indian Industry

This paper extends the findings of Frankel, Johnson, and Nelson (2002) by providing empirical evidence on the relation between nonaudit fees and earnings management for a sample of Indian firms. In addition, we investigate whether there is a greater incidence of earnings management in family owned firms versus non family owned firms. Our tests are motivated by concerns about decreasing auditor independence due to a greater economic bond between the firm and the auditor in the presence of nonaudit fees. These concerns are reflected by the SEC, who issued auditor independence rules in November 2000 that required firms to file proxy statements on or after February 5, 2001 that disclose the amount of total audit fees paid along with a breakdown between audit fees and nonaudit fees. We find a positive association between nonaudit fees and the magnitude of absolute discretionary accruals. We also find a positive association between family owned firms and the magnitude of discretionary accruals.

The effect of audit committee characteristics on earnings management: Evidence from the United Kingdom

This study examines the impact of audit committee (AC) characteristics on earnings management (EM), of FTSE 350 companies, for the fiscal years 2006 and 2007. Characteristics such as number of members and meetings; independence; directors’ remuneration; outside directorships; various types of financial expertise; AC members’ ownership; regulated sector; and the listing on FTSE 100 are investigated. No significant association was found between absolute discretionary accruals and these characteristics, apart from in the regulated industry. The results for signed discretionary accruals show that some characteristics have an effect on either upward or downward EM. This reveals the importance of distinguishing between AC effectiveness on constraining upward and downward EM. This article explores some qualitative AC characteristics, which have not previously been examined. In addition, it is probably the first to examine the effect of several AC characteristics on EM in the UK context. The findings of this study provide useful insights for regulators in order to improve and reconsider the current regulations on AC mechanisms. The findings of generally ineffectual ACs in the United Kingdom, along with many similar findings from other countries (see Xie et al, 2003 and Baxter and Cotter, 2009), raise concerns about the current situation of the regulation and the composition of ACs. External auditors are warned against relying on the form rather than substance of ACs.

Auditor-client compatibility and corporate governance effectiveness: an empirical analysis

This paper examines a new facet of the auditor-client relationship, the extent to which the auditor’s portfolio of audited clients’ industries matches its client’s portfolio of business segments which I refer to as the auditor-client compatibility. The paper examines how compatibility affects audit quality and consequently the auditor’s governance effectiveness. Using a sample of clients of big auditing firms, I empirically examine the effect of compatibility on earnings quality proxied by absolute discretionary accruals as a manifestation of audit quality and in turn corporate governance effectiveness. I document a negative relation between compatibility and discretionary accruals suggesting that compatibility contributes to effective governance. This result holds for several robustness checks. The study introduces a new measure of industry specialisation; compatibility. It also highlights how the multi-segment nature of companies has auditing and governance implications, a dimension that has been relatively ignored in the auditing and corporate governance literatures.

Does Regulator Selection of Auditors Improve Audit Quality? Evidence from Auditor Designation in Korea

Although the hiring and firing of auditors by clients is believed to create a fundamental conflict of interest, there is little research on the issue except for experimental evidence in Mayhew and Pike (2004). To provide evidence on the issue, in this paper we exploit the setting in Korea, known as auditor designation, wherein regulators selectively and episodically selected auditors for certain client firms. We fail to find that audit quality proxied by absolute discretionary accruals, audit hours, modified opinions, and the tendency to meet or beat benchmarks, is higher for designated auditors. Our results therefore question whether hiring and firing of auditors by clients is a threat to auditor independence.

How Would the Mandatory Adoption of IFRS Affect the Earnings Quality of U.S. Firms? Evidence from Cross-Listed Firms in the U.S.

SYNOPSISWe examine the impact of IFRS adoption on the earnings quality of foreign firms cross-listed in the U.S. from countries that have already adopted IFRS on a mandatory basis. We use the cross-listed firms as surrogates for the U.S. firms so we can observe the effect of IFRS adoption in the U.S. We examine five measures of earnings quality related to discretionary accruals, target beating, earnings persistence, timely loss recognition, and the earnings response coefficient (ERC). To isolate the effect of IFRS adoption, we use a matched sample design where each cross-listed firm is matched to a U.S. firm. We find the difference in earnings quality from the pre- to post-IFRS period is not different for the cross-listed and matched firms when earnings quality is measured by absolute discretionary accruals, timely loss recognition, or a long-window ERC. However, for the incidence of small positive earnings and earnings persistence, we find significant difference-in-differences, indicating that IFRS adoption led to an improvement in earnings quality for cross-listed firms relative to the matched firms. Our results are slightly surprising since U.S. GAAP is generally viewed as high-quality standards with little room for improvement.

Auditor mergers, audit quality and audit fees: Evidence from the PricewaterhouseCoopers merger in the UK

Focusing on the merger of Price Waterhouse and Coopers & Lybrand in 1998, we document increased audit quality (measured by earnings quality of the clients) for the merged firm and other big-X auditors (The big-X auditors are Ernst & Young, Deloitte, KPMG and Arthur Anderson.) during the post-merger period because: (1) controlling for economic conditions, clients of big-X auditors have lower levels of absolute discretionary accruals and (2) the value relevance of earnings has significantly increased. Furthermore, we find evidence that in the post-merger period, there is a significant increase in audit fees for PricewaterhouseCoopers and other big-X client firms, which suggests that the effect of collectively enhanced market power of big-X auditors (which tends to increase audit fees) dominates the effect of cost savings from the merger (which tends to lower audit fees). The results have implications for regulators and policy makers.

Earnings Quality, Corporate Governance and Firm Performance

Quality of earnings as reflected by the lower absolute discretionary accruals in the accounting disclosures of firms identifies whether firms manage their earnings disclosure in order to meet market expectations. Literature evidence suggests that corporate governance initiatives of firms have improved the earnings quality of firms. This research identifies the relationship between earnings quality and firm performance in order to test the ability of market to infer managed earnings. In addition corporate governance initiatives taken by the firms and its influence on earnings quality is examined to improve governance and reporting practices of firms towards true firm valuation by the market. Further across the industry comparison of earnings quality and firm performance and their influence by governance initiatives examine industry specific practices in India.

Big 4 auditor affiliation and accruals quality in Bangladesh

PurposeBangladesh is an emerging economy and international audit firms operate there through affiliated local audit firms. The Bangladesh audit market can be characterized as an intensely competitive small audit market with relatively poor demand for high‐audit quality. In addition, Bangladesh has a relatively small and under developed but growing capital market that is characterized by poor corporate regulation and weak investor protection. The purpose of this paper is to examine the association between Big 4 affiliated auditors and accruals quality in Bangladesh.Design/methodology/approachFollowing prior literature, this paper uses both absolute discretionary accruals and signed discretionary accruals as proxies of accruals quality. The sample is 382 firm‐year observations and covers fiscal years 2000‐2003.FindingsIt was found that the association between Big 4 affiliates and accruals quality in Bangladesh depends on measures of accruals quality and accruals models used. Overall, Big 4 affiliates do not have a positive impact on accruals quality of their clients in Bangladesh.Originality/valueThis paper contributes to the literature on audit quality and accruals quality. The results potentially suggest that Big 4 affiliates do not have any positive impact on accruals quality of clients in an intensely competitive audit market where the demand for quality audit is poor and monitoring is lax and raise potential implications for policy makers and market participants in Bangladesh.

The role of auditors in detecting creative accounting: Singaporean and Australian evidence

This study examines the association between the magnitude of earnings management and two characteristics of auditor value - auditor independence and auditor quality. As earnings management, auditor independence and auditor quality are unobservable the study uses absolute discretionary accruals, the ratio of non-audit to total fees and auditor industry specialisation as respective proxies. This study finds no empirical evidence that non-audit services are associated with firms’ discretionary accruals. This result suggests that the provision of non-audit services by the incumbent auditor does not compromise independence. This study presents evidence of a negative association between auditor specialization and the earnings management indicator. This finding infers that the magnitude of earnings management amongst firms engaging the services of a specialist is significantly lower than firms purchasing audit services from a non-specialist auditor

Impact of IFRS in New Zealand on Accounts and Earnings Quality

The impact of the adoption of International Financial Reporting Standards (IFRS) on the accounts and the quality of earnings of New Zealand firms is examined. Our analysis of IFRS adjustments for the last period under pre‐IFRS NZ Generally Accepted Accounting Principles (GAAP) reveals that total assets, total liabilities and net profit were significantly higher under IFRS than under pre‐IFRS GAAP. Profit and equity under IFRS were increased by adjustments for goodwill and other intangibles and investment property, and decreased by adjustments for employee benefits and share‐based payments. Using data for 2002–2009, we find that absolute discretionary accruals were significantly higher under IFRS than under pre‐IFRS NZ GAAP, suggesting lower earnings quality under IFRS than under pre‐IFRS NZ GAAP. However, we find no significant differences in signed discretionary accruals and the ability of earnings to predict one‐year‐ahead cash flows between pre‐IFRS NZ GAAP and IFRS. These results are consistent across alternative measures of accruals quality, sample selection and whether firms elected to adopt IFRS in 2005 rather than comply with them in 2007.

The Role of International Financial Reporting Standards in Accounting Quality: Evidence from the European Union

AbstractPrevious studies on the effect of International Financial Reporting Standards (IFRS) on accounting quality often have difficulties to control for confounding factors on accounting quality. As a result, the observed changes in accounting quality could not be attributed mainly to IFRS. We use a unique research setting to address this issue by comparing the accounting quality of publicly listed companies in 15 member states of the European Union (EU) before and after the full adoption of IFRS in 2005. We use five indicators as proxies for accounting quality. We find that the majority of accounting quality indicators improved after IFRS adoption in the EU. That is, there is less of managing earnings toward a target, a lower magnitude of absolute discretionary accruals, and higher accruals quality. But our results also show that firms engage in more earnings smoothing and recognize large losses in a less timely manner in post‐IFRS periods. In addition, we examine the effects of institutional variables on financial reporting quality. Our contribution to the literature is that we show the improved accounting quality is attributable to IFRS, rather than changes in managerial incentives, institutional features of capital markets, and general business environment, etc.

Do Abnormally High Audit Fees Impair Audit Quality?

SUMMARY: This study examines whether and how audit quality proxied by the magnitude of absolute discretionary accruals is associated with abnormal audit fees, that is, the difference between actual audit fee and the expected, normal level of audit fee. The results of various regressions reveal that the association between the two is asymmetric, depending on the sign of the abnormal audit fee. For observations with negative abnormal audit fees, there is no significant association between audit quality and abnormal audit fee. In contrast, abnormal audit fees are negatively associated with audit quality for observations with positive abnormal audit fees. Our findings suggest that auditors’ incentives to deter biased financial reporting differ systematically, depending on whether their clients pay more than or less than the normal level of audit fee. Our results are robust to a variety of sensitivity checks.

CFO Gender and Accruals Quality

SYNOPSIS: The authors examine the association between chief financial officer (hereafter, CFO) gender and the quality of accruals. Based on findings in prior research on gender differences in a variety of decision settings—risk-taking attitudes, financial judgments, and regulatory compliances—they hypothesize that firms with female CFOs will have higher quality of accruals. The empirical findings, based on a sample of 1,559 (1,222) firms in 2005 (2004), support this hypothesis. The study shows that companies with female CFOs have lower performance-matched absolute discretionary accruals and lower absolute accrual estimation errors, after controlling for other factors that prior research has shown to be associated with accruals.