Income-increasing Discretionary Accruals Research Articles

The Effect of Tenure, Specialization, Conservatism, and Fees on the Relationship between Going-Concern Opinions and Client Bankruptcy

ABSTRACT This paper uses the relationship between a going-concern modified audit opinion and client bankruptcy as an audit quality indicator to investigate factors that could affect audit quality. The setting is important because, although stakeholders often view bankruptcies without a preceding going-concern opinion as evidence of impaired auditor independence, there could be various reasons behind them. Using a matched sample of bankrupt and nonbankrupt clients, this paper finds that the relationship is less positive when auditors are nonspecialists, allow more income-increasing discretionary accruals, or receive higher audit fees. These results suggest that auditors provide lower audit quality when they lack sufficient industry knowledge, are less conservative, or are more reliant on audit fees. Data Availability: Data are publicly available from the sources identified in the paper.

When Executives Pledge Integrity: The Effect of the Accountant’s Oath on Firms’ Financial Reporting

ABSTRACT We study the effect of executives’ pledges of integrity on firms’ financial reporting outcomes by exploiting a 2016 regulation that requires holders of Dutch professional accounting degrees to pledge an integrity oath. We identify chief executive officers (CEOs) and chief financial officers (CFOs) required to take the integrity oath and find that firms reduce income-increasing discretionary accruals after executives took the oath. These firms also reduce discretionary expenditures, indicating that oath-taking executives reduce overall earnings management and do not merely substitute accruals-based with real-activities earnings management. These effects are concentrated in firms where the CFO took the oath. Overall, our results indicate that integrity oaths for executives improve firms’ financial reporting quality. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M40; M41.

Auditor choice in reverse mergers: Evidence from China

Using data from 123 reverse mergers (RMs) in China, this study investigates the determinants and economic consequences of auditor choice in RMs. We find that the choice of a new auditor instead of the incumbent auditor is not related to auditor competence but to the relative bargaining power of RM firms and publicly listed firms (shell firms), and that the probability of choosing new auditors is higher when RM firms have more bargaining power relative to shell firms. We also find that hiring new auditors in the RM is associated with a higher valuation of injected assets and higher pre-listing income-increasing discretionary accruals in RM firms. Furthermore, post-merger firms exhibit drops in accounting performance and firm value and are more likely to restate their financial reports within 3 years of listing when new auditors are appointed in RMs. Finally, the cross-sectional test shows that this effect mainly exists in the context of RMs where the newly appointed auditor is a non-Big 10 auditor and a non-specialist auditor. Overall, our results emphasize the role of RM firms and shell firms in auditor choice for RMs and highlight the implications of such a joint decision on investor protection.

The impact of audit quality on earnings management and cost of equity capital: evidence from a developing market

PurposeThis study aims to examine the effects of audit quality on earnings management and cost of equity capital (COE) considering the impact of two owner types: government ownership and foreign ownership.Design/methodology/approachThe study uses a panel data set of 236 Vietnamese firms covering the period 2007 to 2017. Because the two main dependent variables of the COE capital and the absolute value of discretionary accruals receive fractional values between zero and one, the paper uses the generalised linear model (GLM) with a logit link and the binomial family in regression analyses. The paper uses numerous audit quality measures, including hiring Big 4 auditors or the industry-leading Big 4 auditor, changing from non-Big 4 auditors to Big 4 auditors or the industry-leading Big 4 auditor, and the length of Big 4 auditor tenure. Big 4 companies include KPMG, Deloitte, EY and PwC, whereas the non-big 4 are the other audit companies.FindingsThe study finds a negative relationship between audit quality and both the COE capital and income-increasing discretionary accruals. The effects of audit quality on discretionary accruals and the COE capital depend on the ownership levels of two important shareholders: the government and foreign investors. Foreign ownership is negatively associated with discretionary accruals; however, the effect is more pronounced in the sub-sample of state-owned enterprises (SOEs), the firms where the government owns 50% or more equity, than in the sub-sample of Non-SOEs.Originality/valueTo the best of the knowledge, no prior similar study exists that used the GLM with a logit link and the binomial family regression. Global investors may be interested in understanding how unique institutional settings and capital markets of each country impact the financial reporting quality and cost of capital. Further, policymakers of developing markets may have incentives to improve the quality of financial reporting and reduce the cost of capital which should result in attracting more foreign investments.

Challenges are thrown in Corporate Governance during COVID 19

The challenging issues in corporate governance and company performance were explored in the international conference that took place in Lisbon on October 26th, 2017, entitled “Corporate governance and company performance: Exploring the challenging issues” (the joint organization was composed by ISEG Lisbon, publishing house “Virtus Interpress”, ADVANCE/CSG Research Center and Virtus Global Center for Corporate Governance). The main purpose of the conference was to provide the platform at international level for academics to analyse recent trends and upcoming challenges in corporate governance and company performance, major challenges and new horizons in further research. Keynote speakers addressed valuable suggestions and examples of how researchers focused on the board of directors can learn from research approaches of behavioural scientists regarding individual and group behaviour. Scholars participated in the conference concluded that insights from various disciplines should be combined for performing more precise and accurate research on corporate boards. Moreover, scholars identified main challenges currently facing the boards, namely the exponential rise in the number of risks and the difficulties of developing relevant strategies. A relevant discussion was raised concerning as to whether discretionary accruals fit methodological needs of researchers focused on corporate governance and on the financial information disclosed. In the line with recent practices in corporate governance in Europe, scholars suggested that female directors were associated with fewer income-increasing discretionary accruals.

Effects of the Big 4 national and city-level industry expertise on audit quality in the United Kingdom

In this study, we examine for the first time in the UK, the effects of the Big 4 audit firms’ national (firm-level) and city-office (office-level) industry specialization on audit quality. Based on public firms listed on the London Stock Exchange (LSE), we find that clients of the Big 4 joint national and city-level auditor industry specialists have smaller magnitude of discretionary accruals, lower income-increasing discretionary accruals, and lesser accrual estimation error, indicating higher audit quality. In addition, we also find that when the Big 4 auditors are both national and city-specific industry leaders, their clients are more likely to be issued a modified audit opinion as well as a going concern audit report. The findings imply that industry expertise of the national and city-based professionals of the Big 4 firms have now been captured and distributed more broadly throughout the firm and within their offices. In addition, the outcome of this study provides additional evidence that the more recent UK evidence of a fee premium exclusively attached to the Big 4 joint specialists reflects their differentiated service and higher quality audit relative to their non-specialist counterparts.

The Moderating Effect of Audit Quality on the Links Between Stock Market Segmentations, Surplus Free Cash Flow, and Income-increasing Discretionary Accruals

The objective of this paper is to examine the impacts of stock market segmentations (SMS) and surplus free cash flow (SFCF) on income-increasing discretionary accruals. The study also provides the initial evidence regarding the influence of audit quality (AQ) as a moderating variable on those relationships. A sample of non-financial firms was taken from the list of Amman Stock Exchange over the period 2013-2019. Using Huber-White’s sandwich estimator for pooled OLS regression, the current research presents empirical evidence harmonious with the prediction in all hypotheses. Further, the findings document that a Big 4 auditor weakens the SMS-DAC and SFCF-DAC associations, which suggests that the role of Big 4 audit firms is effective in mitigating management’s opportunistic behaviour. However, the reported results provide beneficial information to investors, regulators, external auditors, policymakers, shareholders, and other countries with similar institutional environment.

Habitual Earnings Surprises, Earnings (Expectations) Management, and Market Valuation

This study examines characteristics, managerial behavior, and market valuation of U.S. firms that habitually surprise the market. Results show that compared to firms that habitually miss analysts’ forecasts by a small margin, all other habitual groups apply income-increasing discretionary accruals. In addition, firms that habitually beat analysts’ forecasts by big margins also resort to income-increasing real earnings management, and firms that habitually meet/marginally beat analysts’ forecasts apply downward analysts’ forecast management. Valuation tests reveal that none of the other habitual firms fare better than firms that habitually miss analysts’ forecasts by a small margin. In particular, firms that habitually meet/marginally beat analysts’ forecasts by using income-increasing accruals earnings management and downward analysts’ forecast management experience a significant value reduction measured in Tobin’s Q.

Surplus Free Cash Flow, Stock Market Segmentations and Earnings Management: The Moderating Role of Independent Audit Committee

Management engages in earnings manipulation for different reasons. This article argues that low-growth firms with high free cash flow will opt for income-increasing earnings management in order to obscure the low profits derived from their investments in negative net present value (NPV) projects. On the other hand, we argue that the listed companies might be interested in being listed in the first market due to its privileges and to preserve the competitiveness, through managing their earnings upwardly, so that they can satisfy the condition of achieving a particular earnings limit. This article should advance the body of earnings management literature in the Jordanian context by examining the effect of the moderating role of an independent audit committee (IAC) in the association between surplus free cash flow (SFCF) and income-increasing discretionary accruals (DAC). Further, this is the initial empirical attempt to investigate the moderation effect of IAC between stock market segmentations (SMS) and positive DAC. The results of this current study offer original and beneficial information for the Jordanian government and other countries with a similar institutional environment because the study promotes the application of applying IAC as an efficient tool to constrain management behaviour towards manipulation of the accruals. On top of that, this research offers information concerning the prevailing situation of earnings management practices and corporate governance in Jordan, in which shareholders, local and international investors, policymakers, regulators and academic researchers are interested. Finally, panel data analyses and various statistical techniques are employed to derive conclusions.

Accretive Share Repurchases Versus Accrual/Real Earnings Management: Complements or Substitutes?

This paper seeks to address whether managers use accretive repurchases in conjunction with or to the exclusion of other earnings management tools. Prior literature has shown that managers use accretive repurchases to meet or beat analyst forecasts of earnings per share (EPS). However, whether such planned and aggressive repurchasing of common shares outstanding is used as a complement or substitute for traditional tools of earnings management remains unexplored. I find a complementary relationship between accretive repurchases and income-increasing discretionary accruals, a complementary relationship between accretive repurchases and abnormal discretionary expense cuts, and a substitutional relationship between accretive repurchases and abnormal operating cash flow reductions. In addition, I find that the likelihood to use income-increasing discretionary accruals in conjunction with accretive repurchases is significantly driven by the number and dollar amount of stock and stock options awarded to the firm’s CEO in the previous year. I also find that firms with a CFO who is co-opted by the firm’s CEO are more likely to use accretive repurchases than firms in which the CFO is not co-opted by the CEO. This suggests that a CEO likely influences the CFO to make capital allocation decisions that benefit the CEO, but may not be in the best long run interests of the firm. Finally, I find that transient investors strongly predict whether a firm uses accretive repurchases, suggesting that managers use this tool to avoid price pressures imposed by not hitting quarterly forecasts of EPS.

Short-horizon incentives and stock price inflation

Do managerial incentive horizons have capital market consequences? We find that they do when short-sale constraints are more binding. Firms experience significant stock price inflation when their CEOs have short horizon incentives. The short-horizon CEOs sell more shares at inflated prices and generate greater abnormal trading profits. The stock price inflation is partly explained by greater earnings surprises and more positive investor reaction to the surprises. To inflate stock prices, short-horizon firms are more likely to employ income-increasing discretionary accruals. Consistent with theoretical predictions, all these effects are attenuated or statistically insignificant when short-sale constraints are less binding.

Moving to Less Contaminated Audit Offices and the Likelihood of Misstatement

This study investigates whether companies improve their financial reporting quality after changing to a less contaminated audit office using the contamination score from Swanquist and Whited 2015. We use the likelihood of misstatement as our proxy for financial reporting quality and find a significantly lower likelihood of misstatements after a company moves to a less contaminated audit office. We find that this effect exists in both the short-term and long-term and is influenced by the magnitude of the contamination score difference between the predecessor audit office and the successor audit office. Additional analyses indicate that both, a lower likelihood of missed internal control weaknesses and reduced income-increasing discretionary accruals, are possible explanations for the lower likelihood of misstatements. The results suggest that companies successfully improve their financial reporting quality after moving to less contaminated audit offices even in the presence of issues related to short-term auditor tenure.

Corporate governance and company performance: Exploring the challenging issues

The challenging issues in corporate governance and company performance were explored in the international conference that took place in Lisbon on October 26th, 2017, entitled “Corporate governance and company performance: Exploring the challenging issues” (the joint organization was composed by ISEG Lisbon, publishing house “Virtus Interpress”, ADVANCE/CSG Research Center and Virtus Global Center for Corporate Governance). The main purpose of the conference was to provide the platform at international level for academics to analyse recent trends and upcoming challenges in corporate governance and company performance, major challenges and new horizons in further research. Keynote speakers addressed valuable suggestions and examples of how researchers focused on the board of directors can learn from research approaches of behavioural scientists regarding individual and group behaviour. Scholars participated in the conference concluded that insights from various disciplines should be combined for performing more precise and accurate research on corporate boards. Moreover, scholars identified main challenges currently facing the boards, namely the exponential rise in the number of risks and the difficulties of developing relevant strategies. A relevant discussion was raised concerning as to whether discretionary accruals fit methodological needs of researchers focused on corporate governance and on the financial information disclosed. In the line with recent practices in corporate governance in Europe, scholars suggested that female directors were associated with fewer income-increasing discretionary accruals.

Earnings management and managerial ownership in private firms

PurposeThe purpose of this paper is to investigate two related questions. First, is earnings management behaviour in private firms related to managerial ownership and if so, what form does the relationship take. Second, is there evidence of opportunistic earnings management behaviour in private firms.Design/methodology/approachThis study uses univariate and multivariate (regression) methodologies to examine the association between managerial ownership and earnings management in private firms. The study employs a data set of 1,223 large private UK firms.FindingsEvidence is presented indicating opportunistic earnings management behaviour in private firms. Specifically, firms with low managerial ownership appear to engage in more earnings management when faced with poor performance. Further, when firms report income-increasing discretionary accruals, the magnitude of abnormal accruals varies non-linearly with managerial ownership.Research limitations/implicationsThis study is limited by availability of data on sample firm ownership. This study uses cross-sectional data due to these limitations. Further research could investigate the relationships between earnings management and classes of shareholders other than managers in private firms.Practical implicationsPolicy implications of this work suggest that non-managing shareholders in private firms face considerable agency costs, in particular where managerial ownership is very low or very high.Originality/valuePervasiveness of earnings management in private firms compared to public firms is well documented in the literature. There is limited extant research on the relationship between ownership structure and earnings management in private firms. The novel aspect of this study is to present findings on the association between this behaviour, managerial ownership and firm performance in private firms.

Audit Quality and Specialist Tenure

ABSTRACTWe argue that the association between auditor industry specialization and audit quality depends on how long the auditor has been a specialist. We measure audit quality using absolute discretionary accruals, income-increasing discretionary accruals, and book-tax differences. Our results, based on a sample of Big 4 audit clients from 2003–2015, indicate that auditors who have only recently gained the specialist designation produce a level of audit quality that does not surpass that produced by non-specialist auditors, and is generally lower than the audit quality produced by seasoned specialists. We estimate that the seasoning process takes two to three years. In contrast to prior research that finds no effect of specialization after propensity score matching, we find that seasoned specialists generally produce higher-quality audits than other auditors even after matching. This suggests that the audit quality effect associated with seasoned industry specialist auditors is not due to differences in client characteristics.JEL Classifications: M42.Data Availability: Data used in this study are available from public sources identified in the text.

Why Shouldn't Higher IQ Audit Partners Deliver Better Audits?: A Discussion of Kallunki, Kallunki, Niemi and Nilsson

Kallunki, Kallunki, Niemi, and Nilsson (2018, hereafter KKNN) obtain a comprehensive dataset of cognitive abilities (i.e., intelligence quotient or IQ) for 407 male audit partners in Sweden. They find negative associations between partner IQ and the propensity to make errors in the issuance of going concern opinions and income-increasing discretionary accruals, as well as a positive association between partner IQ and audit fees. KKNN argue that this evidence is consistent with smarter auditors delivering higher quality audits. While the evidence in KKNN may not appear too surprising, I discuss how it advances our understanding of whether individual engagement partner characteristics matter from an audit quality standpoint. This discussion highlights the factors that could strengthen or moderate the relation between partner IQ and audit quality. IQ likely can affect audit quality through several channels, such as a more effective application of prior knowledge, a higher ability to learn, and reduced incentives to shirk. I highlight particularities of KKNN’s setting and show that their evidence probably cannot be directly generalized to publicly traded corporations outside of Sweden. Finally, I provide suggestions for future research.

PENGARUH REAKSI PASAR ATAS PENGUMUMAN INFORMASI LABA PERUSAHAAN BERKAITAN DENGAN MANAJEMEN LABA PADA PERUSAHAAN MANUFAKTUR DI BURSA EFEK INDONESIA

<p>Financial report is an important factor for inventors to make investment decision in capital market. Publicly financial report which has relevant information will be reacted by market player. Many investors and other users of financial report do not pay attention to the process of publishing financial report, so it pushes the emergence of dysfunctional behaviours like earning management practices.<br />The research aims to analyze the difference of market reaction between:1) earning management companies and non-earning management companies; 2) income-decreasing discretionary accruals companies and income-increasing discretionary accruals companies.Population of this research is 130 manufactured companies listed in JSX during 2009-2010. Using convenience sampling method, 49 companies were taken to become final samples for each period. The result with two independent samples test Kruskal Walles χ (sign 5%) shows that there was no difference of market reaction between earning management companies and non-earning management companies (χ 0,58989 dan 0,03137), and neither was there between income-decreasing discretionary accruals companies and income-increasing discretionary accruals companies (χ 0,735 dan 2,82767).<br />Keywords : Earning Management, Market Reaction.</p>

Differences in responses to accounting-based and market-based benchmarks – Evidence from Nasdaq

We study how managers of Nasdaq-listed firms respond to the threat of delisting due to quantitative listing deficiencies. We find that managers' responses vary by deficiency type, specifically, whether the deficiency is accounting-based (related to shareholders' equity) or market-based (related to market value or bid price). Firms with accounting-based deficiencies exhibit income-increasing discretionary accruals. In contrast, firms with market-based deficiencies do not. We also find that shareholders' equity-deficient firms respond with equity issuances and bid price-deficient firms initiate reverse stock splits. These findings suggest that firms trade off among methods to meet benchmarks based on costs and constraints. In additional analyses, we find some evidence that firms' delisting avoidance strategies succeed in delaying or avoiding regulatory delistings.

The impact of CEOs’ accounting backgrounds on earnings management and conservatism

Purpose Existing literature in experimental accounting research suggests that accounting professionals and people with accounting backgrounds tend to have a lower level of moral reasoning and ethical development. Motivated by these findings, this paper aims to examine whether chief executive officers (CEOs) with accounting backgrounds have an impact on firms’ earnings management behavior and the level of accounting conservatism. Design/methodology/approach The authors classify CEOs into those with and without accounting backgrounds using BoardEx data. Using discretionary accruals from several different models, they do not find that CEOs with accounting backgrounds are more likely to engage in income-increasing accruals. However, the authors find that CEOs with accounting backgrounds exhibit lower levels of conservatism, proxied by C-scores and T-scores (Basu, 1997). This finding suggests that CEOs with accounting backgrounds recognize bad news more quickly than good news, consistent with the accounting principle of “anticipating all losses but anticipating no gains”. Findings The authors show that firms whose CEOs have accounting backgrounds exhibit lower levels of accounting conservatism. However, these firms do not exhibit higher levels of income-increasing discretionary accruals. This study documents the impact of CEOs’ educational backgrounds on firms’ accounting choices and confirms prior findings in experimental accounting research using large sample archival data. Originality/value This paper is the first study that investigates the impact of CEOs’ accounting backgrounds on firms’ financial reporting policy. The findings may have some policy implications. If accounting backgrounds of CEOs can make a significant difference on firms’ behavior, it is reasonable to make CEOs accountable for the quality of financial reporting. This paper is one of the first to empirically test inferences drawn by experimental accounting research. There has been a gap between archival and experimental accounting studies. The authors propose that interesting research questions can be addressed by filling in such a gap.

Short-Horizon CEO Incentives and Abnormal Stock Returns, Insider Trading, and Earnings Management

Firms with short-horizon CEO incentives experience stock price inflation followed by reversal. Short-horizon CEOs exploit the price inflation by selling relatively more stock and making greater abnormal profits than long-horizon CEOs do. The stock price inflation is partly explained by greater earnings surprises and more positive investor reaction to the surprises. To sustain the inflated price, short-horizon firms are more likely to employ income-increasing discretionary accruals. The findings are consistent with recent theories linking short-horizon incentives to stock price inflation, suggest CEOs have some success in doing so, and shed light on the role earnings management plays in the process.