Higher Accruals Quality Research Articles

The Impact of Firm Characteristics on Earnings Management: A Study of Firms Listed in India

This study examines the impact of firm characteristics on earnings management (EM) using a sample of listed non-financial firms in India. First, we take a comprehensive perspective to estimate EM focusing on total accruals, current accruals and specific accruals. Second, we examine firm characteristics such as size, leverage, performance, growth opportunities and industry membership that are potentially related to accruals EM. We find that: 1) Large firms and firms with high performance have higher accruals quality. 2) Firms with higher growth opportunities have lower accruals quality. 3) Firms with high leverage use accruals EM to avoid violation of debt covenants. These findings indicate that investors and regulators should take into account both: the abnormal accruals over a period of time and the variability of abnormal accruals to analyse the quality of financial reporting of large firms, firms with high performance and highly levered firms.

Auditor Materiality Threshold and Audit Quality—Evidence from the Revised ISA 700 in the United Kingdom

SYNOPSIS Using a broad sample of U.K. firms that are required to disclose auditor materiality thresholds under the International Standards on Auditing (United Kingdom and Ireland) 700, we examine whether the auditor materiality threshold is associated with audit quality. We document that a lower materiality threshold is associated with higher audit quality, as measured by lower absolute discretionary accruals, higher accruals quality, and a lower propensity to just meet or beat analysts’ earnings expectations. We also find some evidence that the negative association between the materiality threshold and audit quality is attenuated when the audit committee is more effective and when the auditor is more economically dependent on the client, and the negative association is more pronounced when management has a stronger incentive to manage earnings. Overall, our study extends the limited studies on large-sample archival evidence on the implications of audit materiality thresholds on audit outcomes. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M40; M41; M42.

Lead independent directors and accruals quality

AbstractWe investigate the association between firms having a lead independent director (LID) who serves on the audit committee and accruals quality using a sample of 32,346 observations during 2001–2018 period. Our results suggest that firms with an LID who serves on the audit committee are associated with higher accruals quality. The results suggest that these firms are associated with an increase in accruals quality equal to 6.60% of the accruals quality metric's median value. We also find that as board size increases, the positive influence of an LID on accruals quality weakens—but only for firms with an LID who does not serve on the audit committee. Supplemental analyses indicate that our inferences still hold when using a changes model, when examining a firm's initial adoption or elimination of the LID position, and when using an entropy balancing approach.

Geographic location of audit committee chairs and accruals quality: evidence from China

Using a large sample of Chinese firms, we examine if the geographic proximity of audit committee chairs (ACCs) to firms is associated with accruals-based financial reporting quality. We define an ACC who is in the same province/municipality as the firm headquarters as “local” and an ACC who is not as “nonlocal”. We find that a local ACC is associated with higher accruals quality, evidenced by a decrease in the absolute value of discretionary accruals. The improvement in financial reporting quality may lie in the fact that the firms with local ACCs more likely appoint Top10 auditors and/or hold more audit committee meetings. Furthermore, we find that local ACCs are associated with better accruals quality in firms with more opaque information environments and higher uncertainties in future prospects, and that the relation between local ACCs and better accruals quality is weakened in firms with powerful CEOs. Our findings suggest that the informational benefit derived from the geographic proximity of local ACCs outweighs the resultant agency effect on financial reporting.

Auditor University Education: Does it Matter?

We examine the implications of auditor education for audit quality and audit pricing. We exploit a novel institutional setting in the UK, where auditors major in many different degrees at university and signing auditors are identifiable. Using hand-collected data for a large sample of signing auditors, we establish two main findings. First, auditors whose degrees have a quantitative orientation are associated with higher accruals quality and higher audit fees than those with more qualitative degrees. Second, auditors with degrees directly relevant to accounting are also associated with higher accruals quality and increased audit fees relative to auditors with unrelated university degrees in qualitative subjects. Overall, our study provides evidence that heterogeneity in auditor education is associated with divergent audit outcomes.

Accruals quality and analyst forecast accuracy: evidence from the property-casualty insurance industry

This paper examines the association between property-casualty insurer accruals quality and analysts' earnings forecasts (i.e., accuracy and dispersion of forecasts). Using insurer-specific accruals, loss reserves, we calculate accruals quality which can be decomposed into its innate and discretionary components. Our results provide evidence that higher accruals quality - as measured by lower standard deviation of loss reserve errors - is positively associated with analysts' forecast accuracy. In other words, our results suggest that analysts provide less accurate forecasts for firms with higher reserve error volatility. Also, we show that lower accruals quality is associated with higher forecast dispersion indicating more disagreement among analysts. Our results hold consistent with decomposed components of accruals, innate and discretionary, and conclude that both managerial discretion and basic operations of firms affect insurers analysts' earnings forecasts.

The Effect of Information Asymmetry on the Method of Payment and Post-M&A Involuntary Delisting

Purpose - This paper shows an unexplored area related to involuntary delisting. Specifically, this research investigates the effect of target firm information asymmetry on the likelihood that the acquirer or newly merged firm will be forcibly delisted post-merger. Design/methodology/approach - The research uses a sample gathered on local US mergers and acquisitions from the Thomson Reuters Securities Data Company (SDC) Platinum Mergers and Acquisitions database. It applies the logistic regression with industry and year effects and corrects the error term using clustering at the industry level. The research also matches the forced delisted firms to control firms based on industry, acquisition completion year, and firm size and then employs a matched sample analysis. Findings - Findings show that M&As between firms where the target firm is opaque and burdened with high information asymmetry issues are likely to be paid for using majority stock and that M&As involving such opaque targets also have a higher likelihood of getting delisted post-merger. Research implications or Originality - Our results are relevant given the very nature of M&As which involve two players: the acquirer and target who both may have different incentives. Acquirers especially have the tendency to suffer losses and even get delisted if they over-pay for or get merged to a poor target which conceals its poor performance evidenced by higher accruals quality.

The Effect of Information Asymmetry on the Method of Payment and Post-M&A Involuntary Delisting

Purpose - This paper shows an unexplored area related to involuntary delisting. Specifically, this research investigates the effect of target firm information asymmetry on the likelihood that the acquirer or newly merged firm will be forcibly delisted post-merger. Design/methodology/approach - The research uses a sample gathered on local US mergers and acquisitions from the Thomson Reuters Securities Data Company (SDC) Platinum Mergers and Acquisitions database. It applies the logistic regression with industry and year effects and corrects the error term using clustering at the industry level. The research also matches the forced delisted firms to control firms based on industry, acquisition completion year, and firm size and then employs a matched sample analysis. Findings - Findings show that M&As between firms where the target firm is opaque and burdened with high information asymmetry issues are likely to be paid for using majority stock and that M&As involving such opaque targets also have a higher likelihood of getting delisted post-merger. Research implications or Originality - Our results are relevant given the very nature of M&As which involve two players: the acquirer and target who both may have different incentives. Acquirers especially have the tendency to suffer losses and even get delisted if they over-pay for or get merged to a poor target which conceals its poor performance evidenced by higher accruals quality.

Auditor Education: Does it Matter?

We examine the implications of auditor education for audit quality and audit pricing. We exploit a novel institutional setting in the UK, where auditors major in many different degrees at university and signing auditors are identifiable. Using hand-collected data for a large sample of signing auditors, we establish two main findings. First, auditors whose degrees have a quantitative orientation are associated with higher accruals quality and higher audit fees than those with more qualitative degrees. Second, auditors with degrees directly relevant to accounting are also associated with higher accruals quality and increased audit fees relative to auditors with unrelated university degrees in qualitative subjects. Overall, our study provides evidence that heterogeneity in auditor education is associated with divergent audit outcomes.

Accounting information quality and guaranteed loans: evidence from Japanese SMEs

We empirically investigate the effects of accounting information quality, as measured by accruals quality, on the use of government guaranteed loans, which we regard as a form of transaction lending. We find that higher accruals quality is associated with higher usage rates of government guaranteed loans, but not with those of nonguaranteed loans, which we consider to constitute relationship lending within the Japanese context. We also find that higher accruals quality is not related to the interest rate for guaranteed loans, but rather is associated with a lower interest rate for nonguaranteed loans. These results indicate that the relevant accounting information is effectively used in screening processes for small- and medium-sized enterprises (SMEs), but that effectiveness varies, depending on the particular lending technology employed.

Do Managers Make Voluntary Accounting Changes in Response to a Material Weakness in Internal Control?

SUMMARY This study examines whether managers make voluntary changes in accounting principle in response to a material weakness (MW). We find that managers are more likely to report voluntary changes in the same year as and year following a MW disclosure, a result largely driven by companies with a greater number of MWs. Although MW companies with new CFOs are more likely to make voluntary changes in the same year, restatements and new auditors, CFOs, CEOs, and directors are not the primary drivers of these results. Managers of MW companies justify voluntary changes as improving accounting information, conforming internal policies, and providing administrative benefits. MW companies that report voluntary changes in the same year and justify the changes as improving accounting are more likely to remediate at least one MW in the following year. Further, entity-level MW companies with voluntary changes in the same year are associated with higher accruals quality than other entity-level MW companies, and a similar result holds for companies with more MWs. These results suggest that MW companies likely report voluntary changes as part of a strategy to improve financial reporting processes and policies. Our study informs both internal control policymakers and accounting standards setters. Data Availability: All data are publicly available from sources identified in the study.

Did CEO’s Equity-Based Compensation Benefit Firms at All? – Evidence From the Regime Before Adoption of Statement of Financial Accounting Standards 123(R)

Previous studies documented empirical evidence that stock- and option-based compensation exacerbates the agency problem, which is opposite to the goal of awarding such kind of compensations to executives. If the stock- and option-based compensation is so bad, why did companies previously adopt such kind of compensation method. I use data from 1992-2005, a period before the adoption of FAS 123 (R), to examine whether the stock-based and option-based compensation benefits firms at all. I find that the firms, whose CEOs received higher values of stock- and option- compensations, have higher accruals quality and more predictable reported earnings, as well as enjoy lower implied costs of equity capital.These findings are robust to various sensitivity tests. The results indicate that such compensation method at least provided certain benefits to the firms.

The economic effects of IFRS adoption in Korea

This paper examines whether Korea’s mandatory adoption of International Financial Reporting Standards (IFRS) is associated with higher earnings quality. Based on Korean listed companies, we compare earnings quality and market assessment in the pre-IFRS period (2007–2010) with those in the post-IFRS period (2011–2014). We find significant IFRS adoption effects by documenting smaller absolute values in discretionary accruals and real earnings management, higher accrual quality, stronger earnings persistence, and less frequent negative earnings. Thus, we provide evidence of improved earnings quality with Korea’s mandatory IFRS adoption. Additionally, we document an increase in the value relevance of earnings, more accurate analysts’ earnings forecasts, and higher audit fees and hours. These results show that investors and analysts view improvements in the information environment, and auditors’ respond to the complex environment by demanding higher audit fees and making additional efforts after mandatory IFRS adoption.

Audit Quality And Accrual Quality: Do Big 4 Auditors Indeed Enhance Accrual Quality Of ‘Powerful’ Clients?

External auditors are considered ‘watchdogs’ which closely monitor corporate financial reporting process and provide guidelines for investors and financial institutions. However, recent accounting scandals in Korea indicate that external auditors may cater their audit reports to their clients’ needs. Based on a sample of listed companies on the Korea Stock Exchange from 2001 to 2010, this study finds the evidence consistent with such conjecture. First, large business conglomerates in Korea (so called ‘chaebols’) audited by Big 4 have lower accrual quality than the others, indicating that Big 4 auditors may not serve as watchdogs to enhance accrual quality of ‘powerful’ clients. However, powerful clients who pay greater non-audit service fees to Big 4 auditors have higher accrual quality than the others. This result suggests that non-audit services provided by Big 4 may not necessarily harm the quality of accounting information, contrary to the traditional view in the literature.

Dividends and earnings quality: Evidence from China

This paper investigates the association between dividend payouts and earnings quality for Chinese listed firms. The results show that dividend payouts are associated with more persistent earnings, higher accrual quality, and greater earnings informativeness, confirming the hypothesis on information content of dividends for Chinese firms. Further analyses show that the relationship between dividends and earnings could change with factors influencing the incentives to pay dividends. We find that the positive impact of dividend payouts on earnings quality is reduced for firms conducting equity refinancing. We also find evidence that the state ownership can reduce the information-conveying role of dividends.

Do Managers Make Voluntary Accounting Changes in Response to a Material Weakness in Internal Control?

This study examines whether managers make voluntary changes in accounting principle in response to a material weakness (MW). We find that managers are more likely to report voluntary changes in the same year as and year following a MW disclosure, a result largely driven by companies with a greater number of MWs. Auditor, CFO, CEO, and director turnover and restatements are not the primary driver of these results, although MW companies with new CFOs are more likely to make voluntary changes in the same year. Managers of MW companies justify voluntary changes as improving accounting information, conforming internal policies, and providing administrative benefits. MW companies that report voluntary changes in the same year and justify the changes as improving accounting are more likely to remediate at least one MW in the following year. Further, entity level MW companies with voluntary changes in the same year are associated with higher accruals quality than other entity level MW companies, and a similar result holds for companies with more MWs. These results suggest that MW companies likely report voluntary changes as part of a strategy to improve financial reporting processes and policies. Our study informs both internal control policymakers and accounting standards setters.

RATINGS: IT'S ACCRUAL WORLD

AbstractLoss reserves are a discretionary tool for managing insurer earnings, with more accurate and/or less volatile reserve errors resulting in higher accruals quality. We investigate whether accruals quality is related to insurer financial strength ratings. Specifically, we use insurer loss reserve errors as a measure of the quality of accruals and examine whether overall accruals quality, as well as a decomposition into innate and discretionary accruals quality, is related to insurer financial strength ratings. We find that firms with lower‐quality (noisier) accruals receive lower financial strength ratings from A.M. Best. This result holds for both innate and discretionary accruals. Overall, we provide the first evidence that the quality of accounting information is a significant factor in ratings of insurance firms.

The effect of audit adjustments on earnings quality: Evidence from China

We examine how adjustments to earnings during year-end audits affect measures of earnings quality. There are four key findings. First, audit adjustments cause earnings to become smoother and more persistent. Second, the adjustments result in higher accrual quality. Third, audit adjustments have a larger negative effect on signed accruals than absolute accruals. Fourth, the adjustments do not reduce the discontinuity in the earnings distribution around zero. These findings are of interest to researchers who use earnings properties as proxies for earnings quality and audit quality. However, we caution that our findings for China may not generalize to other countries.

Mandatory Audit Firm Rotation and Audit Quality

Recently, regulators and policy makers who witnessed the global financial crisis during 20072009 began considering a variety of ways to enhance auditor independence and financial reporting quality, ultimately aiming at investor protection. Since the enactment of the SarbanesOxley Act of 2002 (SOX), the Mandatory Audit Firm Rotation (MAFR) requirement has once again received significant attention from regulators and policy makers around the world, including the European Union (EU) and the U.S. Public Companies Accounting Oversight Board (PCAOB). In this paper, we investigate whether MAFR enhances audit quality in Korea. We find that under MAFR, newly rotated auditors are more likely to issue first-time going-concern audit opinions to financially distressed firms during their initial (first-year) financial statement audit compared with under the Voluntary Audit Firm Change (VAFC). Moreover, firms audited by mandatorily rotated new auditors have less discretionary accruals and higher accrual quality than those audited by voluntarily switched new auditors during the initial audit engagement. These results of earnings quality are more pronounced for firms that received a first-time going-concern audit opinion during the initial financial statement audit under MAFR. Taken together, the findings suggest that MAFR produces better audit quality than the VAFC. Further, our study provides implications for regulators and policy makers of countries considering the adoption of MAFR.

High-Quality Rank and File Employees and Financial Reporting Outcomes

We examine whether high-quality rank and file (i.e., non-executive) employees are associated with improved financial reporting outcomes. We argue that high-quality rank and file employees provide better information for executives to use when making reporting choices, and that these employees are better able to identify and uncover intentional financial misreporting, perhaps before it even develops into a larger misreporting event. We use the average education level of the workforce in MSA(s) where the firm operates as a proxy for the quality of the firm’s rank and file employees, and find that firms with a higher-quality workforce produce financial statements with higher accruals quality, fewer internal control system violations, and fewer restatements, suggesting that these employees improve their firm’s mandatory disclosures. We also find that firms with higher-quality rank and file employees issue management forecasts that are more frequent, timely, accurate, precise, and less biased, suggesting that the benefits of high-quality rank and file employees also extend to firms’ voluntary disclosures. In additional analyses, we find that when financial reporting violations do occur, the quality of the firm’s workforce is positively associated with the likelihood that an employee blows the whistle to a regulator. Overall, our findings suggest that high-quality rank and file employees are positively associated with financial reporting quality.