Performance-matched Discretionary Accruals Research Articles

Non-Big 6 audit firms’ access to external resources through inter-organisational relationships

Small audit firms try to reduce their resource constraints in serving clients by creating inter-organisational relationships (IORs) through membership in accounting networks or in agreements with individual firms. Through these relationships, firms have access to audit manuals/methodology, personnel, and may perform joint audits and joint marketing of their audit services. We identify the existence of IORs from PCAOB Form 2 filings and test whether audit quality and fees vary cross-sectionally as a function of the specific resource obtained from the IOR. We find evidence that firms with access to audit technology through IORs charge higher audit fees and provide higher quality audits, in terms of smaller clients’ performance-matched discretionary accruals, higher auditors’ likelihood of issuing going concern opinions to financially distressed clients, and fewer audit deficiencies identified in PCAOB inspection reports. The findings highlight the importance of access to audit technology through IORs in improving small audit firms’ real and perceived audit quality.

전문성이 필요한 산업에 속한 피감사기업을 감사하는 산업전문감사인의 감사행태

[Purpose] This study aims to examine the behavior of industry specialist auditors according to industry characteristics. Specifically, this study aims to provide evidence on the audit efficiency of industry specialist auditors by analyzing whether the audit hours and audit fees of industry specialist auditors are differentiated for industries requiring industry specialization designated by the Financial Supervisory Service.
 [Methodology] We used a sample of 19,115 firms and years for Korean listed companies from 2008 to 2020. For the industries requiring specialization, we used the industry groups selected by the Financial Supervisory Service in November 2023 based on the opinions of listed companies and accounting firms.
 [Findings] The results show that, first, industry specialist auditors are associated with higher audit fees and more audit hours on average, but these fees and audit hours are significantly lower for industries designated as requiring industry specialty, which can be interpreted as an audit efficiency. Second, the above association does not appear in the analysis using hourly audit fees, explaining the process by which efficiency gains are passed on to client firms. Third, the relations does not appear in analyses of audit quality measured by the absolute value of performance－matched discretionary accruals, providing further evidence of the efficiency with which audit quality is maintained at lower levels of audit time. These results can be interpreted as indicating that industry specialist auditors perform the audit process efficiently in industries where specialization is essential, and that the benefits of reduced audit efforts are fully passed on to the clients through this efficient audit process.
 [Implications] The contribution of this study is that it provides evidence on the audit efficiency of industry specialist auditors through data that directly manifests the need for specialization while reflecting the perspectives of both audited companies as consumers and accounting firms as suppliers of industry specialization.

The Supervision Role of Independent Commissioner in Decreasing Risk From Earnings Management and Debt Policy

Purpose : This study examines the effect of earnings management and debt policy on financial distress. In addition, this study examines the role of the independent commissioner as a moderating variable in the relationship between the independent and dependent variables. Financial distress in this study employs the Altman model (1968) modified by Graham et al. (1998) which has a high prediction rate, above 60 percent, and its size has been used in various countries. Earnings management in is study employs the model of Kothari et al. (2005), known as the Performance-Matched Discretionary Accruals model. The advantage of the model is that it can measure earnings management more accurately. Using independent commissioners as a moderating variable in the association between earnings management and debt policies on financial distress is rarely used in previous studies.
 Method : This study uses a quantitative method approach. The research data is sourced from consumer goods sector companies listed on the Indonesia Stock Exchange (IDX) financial statements. Research data sourced from www.idx.co.id and www.idnfinancials.com. Based on purposive sampling, the research sample consisted of 138 observations from 46 companies from 2018 to 2020. Hypothesis testing was carried out using multiple linear regression for panel data.
 Findings : The results of this study indicate that earnings management has a negative effect on financial distress, while debt policy has a positive effect on financial distress. This study also finds that independent commissioners can attenuate the negative effect of earnings management on financial distress. Still, independent commissioners cannot have a moderating effect on the relationship between debt policy and financial distress.
 Novelty : This study places independent commissioners, which have greatly influenced a company’s management performance, as a moderating variable in testing earnings management and debt policies on financial distress, which are rarely used in previous studies.
 Keywords: Financial Difficulties; Earnings Quality; Capital Structure; Corporate Governance

Auditor tenure, investor protection and accounting quality: international evidence

PurposeThis study aims to investigate whether auditor tenure has a significant influence on accounting quality and whether investor protection moderates the effect of auditor tenure on accounting quality.Design/methodology/approachThis study uses weighted least squares regression on a sample of 77,855 firm-year observations from 36 countries during the period 2010–2016. This study uses the absolute value of performance-matched discretionary accruals to measure financial reporting quality.FindingsThis study finds that a longer auditor tenure is associated with higher accounting quality, thus supporting the knowledge effect arguments. The results on the joint effect of investor protection and auditor tenure show evidence of the substitutive effect of investor protection, where the positive impact of auditor tenure on accounting quality is weaker in a high investor-protection environment.Practical implicationsThese findings provide input for policy implications involving the auditing profession. Regulators may need to weigh the costs and benefits of mandatory audit rotation because country-level institutional factors influence auditing regulations and practices, as well as the auditors’ behaviors.Originality/valueThis study adds to the limited, albeit important, evidence on the joint effect of auditor tenure and country-level governance on accounting quality. The authors respond to the call by Brooks et al. (2017) for more evidence on the role of audits on financial reporting outcomes across various legal institutions for creating effective policies.

Financial Crisis and Earnings Management Under U.S. GAAP and IFRS

This paper examines the effects of the global financial crisis of 2008 on real and accrual-based earnings management activities of foreign companies listed in the United States as American Depositary Receipts (ADRs). The ADR firms are classified according to whether they report under U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Accrual-based earnings management is measured using the absolute value of performance-matched discretionary accruals. We also use the positive and negative values of performance-matched discretionary accruals to examine income-increasing and income-decreasing earnings management, respectively. Real earnings management proxies are measured using performance-matched measures of the abnormal levels of cash flow from operations, production costs, and discretionary expenses. In summary, our findings indicate no difference in accrual-based earnings management for ADRs reporting under IFRS and U.S. GAAP but suggest that ADRs reporting under IFRS are more likely to manage earnings using income-decreasing discretionary accruals and aggregate real earnings management than ADRs reporting under U.S. GAAP during the financial crisis.

Does Sharia Compliance Affect the Earnings Management of Companies in Muslim Majority Countries?

Purpose – Sharia compliance states that the compliant company operates not only under regulations but also to the restrictions and permission of Islam. This research aims to reveal whether Sharia compliance enhances financial reporting quality. Design/methodology/approach – The sample is constructed from 15 Muslim majority countries, 2,300 companies for the periods between 2005 and 2017 with 23,810 firm*year observations. Financial reporting quality is measured with discretionary accruals and audit aggressiveness. Discretionary accruals is the absolute of Kothari, Leone, and Wasley’s (2005) “Performance Matched Discretionary Accruals Model”. Audit aggressiveness is calculated with absolute of Gul, Wu, and Yang’s (2013) model. Findings – This research reveals the behavioral differences on financial reporting quality between Sharia-compliant and non-compliant companies. According to the analyses, Sharia compliance increases the financial reporting quality by decreasing the discretionary accruals and audit aggressiveness. The robustness tests support this result. Practical implications – Sharia compliance is not limited to the business activity, financial restrictions, and Supervisory Board for Sharia-compliant companies. It also enhances the companies’ financial reporting quality. Robustness analysis also showed that IFRS increases the financial reporting quality by reducing discretionary accruals and audit aggressiveness. Originality/value – This research contributes to the accounting literature by providing insight into the use of Islamic financial instruments. The empirical results also show that the use of IFRS and Islamic financial instruments decreases the discretionary accruals and audit aggressiveness.

Reply to 'The Reg SHO Reanalysis Project: Reconsidering Fang, Huang and Karpoff (2016) on Reg SHO and Earnings Management' by Black et al. (2019)

In a 2016 paper (Fang, Huang, and Karpoff, 2016), we report that firms exposed to an increase in the prospect of short selling during the Reg SHO pilot program have lower discretionary accruals during the pilot period. Black, Desai, Litvak, Yoo, and Yu (2019, hereafter, BDLYY) argue that this result is not replicable. We show that BDLYY’s claim is incorrect. The accruals result previously was replicated in papers by Massa, Zhang, and Zhang (2015) and Heath, Ringgenberg, Samadi, and Werner (2019), and is easily replicable using data and code that we have shared widely since 2014 – including with the BDLYY team in 2015 – and that we recently posted publicly. The accruals result also is robust to a wide range of specification changes, including those implied by the BDLYY paper, which include: various measures of performance-matched discretionary accruals and total accruals; using our original 2012 Compustat data or currently available 2019 Compustat data; including both firm and year fixed effects; including or excluding other covariates in the difference-in-differences (DiD) tests; and using unbalanced rather than balanced panels. We conjecture that BDLYY’s results are inconsistent with prior results because they rely partly on non-standard accruals measures and/or use samples that differ from those used by Fang et al. (2016), Massa et al. (2015), and Heath et al. (2019). We conclude by discussing two theoretical concerns. First, we reiterate that an observed increase in short selling during the Reg SHO period is neither necessary nor sufficient to establish that the prospect of short selling has a disciplinary effect on earnings management, as managers’ endogenous adjustments affect short sellers’ opportunities and observed short selling. Second, we discuss a concern that the Reg SHO change appears to be too small to explain a wide range of firm outcomes, as recent empirical findings suggest.

Earnings Management and Board Characteristics: Evidence from French ListedFirms

The purpose of this paper is to test the effect of the board characteristics including; its size, independence, the CEO duality and its activity on the earnings management in companies listed on the SBF 250. We use discretionary accruals (DA) as a proxy for the earnings management. To calculate DA, we use two models which are the modified Jones model (and performance-matched discretionary accruals estimated from the modified Jones model. Based on a sample of 70 French listed companies over the period of 4 years from 2008 to 2012, the study finds that the earnings management is negatively associated with the board size. This suggests that large boards are more effective in monitoring a CEO‘s action. The CEO duality is found to have a positive relationship with the earnings management suggesting that, by combining the role of the CEO and that of the chairman of the board helps increase the earnings management because the CEO may reduce the effectiveness of the board and create a conflict between the management and the board that may reduce the earnings management. Moreover, the board activity is found to have a positive relation with the earnings management suggesting that a board meeting more often helps to increase the earnings management. The present study finds no effect of the board independence on the earnings management. This result is in contradiction with previous studies that have found a significant negative relationship between these two variables. Overall, from the result of this study, we conclude that the earnings management takes place in French listed companies.

Accruals quality, financial constraints, and corporate cash holdings

PurposeThe purpose of this paper is to examine how information asymmetry driven by earnings quality affects corporate cash holdings. It also investigates the role that financial constraints play in this effect.Design/methodology/approachThe paper examines a large sample of 6,501 observations of 741 firms listed on Euronext Paris over the period 2000–2015. Earnings quality is computed using the Jones model performance-matched discretionary accruals developed by Kothari et al. (2005): the larger the absolute value of discretionary accruals, the lower the accruals quality.FindingsThe study finds that firms with poor accruals quality hold more cash and that cash holdings in firms of low reporting quality are higher under financial constraints. These results indicate that firms tend to increase their cash reserves in the presence of high information asymmetry which is notably driven by low accounting quality. The findings also suggest that information asymmetry associated with low reporting quality is greater when firms also have strong financial constraints. The study’s conclusions are consistent with the precautionary motive for cash holdings.Practical implicationsThe results would enhance practitioners’ awareness of the importance of accounting choices in the management of cash policies. It would also give researchers an incentive to further explore how these policies are influenced by the precautionary behavior of managers.Originality/valueThis paper is the first work to investigate the effect of accruals quality on corporate cash holdings in the French equity market, which typically has a poor information environment resulting in high information asymmetry. Moreover, the role of financial constraints in this effect has not yet been explored.

Corporate governance, earnings management and the value-relevance of accounting information: Evidence from Pakistan

This paper examines the effect of corporate governance and earnings management on the value relevance of accounting information. Using data collected from the annual reports of non-financial companies listed in Pakistan Stock Exchange, it is concluded that earnings and book value are value relevant. The value relevance of earnings decreases while the value relevance of book value increases for the firms engaged in the earnings management. On the contrary, good corporate governance practices have a positive impact on the value relevance of earnings as well as the book value. Firm-specific characteristics enhance the predictive power of the model by more than 14%. A robustness test was carried out for alternative measures of earnings management. For this purpose, first performance-matched discretionary accruals were calculated following Kothari et al. (2005). Second, short-term accruals (DeChow, 1994), long-term accruals (Teoh et al., 1998b) and total accruals (Whelan, 2004), are calculated to analyze the effect on the value relevance of earnings and book value. The results support our null hypothesis.

Late for a very important date: financial reporting and audit implications of late 10-K filings

Delays in financial reports often reflect issues related to period-end accounting and audit processes. We investigate the impact of filing delays in connection with auditor characteristics on the quality of financial statements in a sample of firms that filed Form 10-K after the statutory due date. We find that late filing firms are associated with lower financial reporting quality compared to timely filing firms matched by propensity scores, where financial reporting quality is measured by the absolute value of performance-matched discretionary accruals and the probability of a late filing being restated in subsequent periods. Furthermore, we demonstrate that the adverse consequences of late filings can be largely mitigated by having a Big 4 auditor. The differential audit quality stems primarily from Big 4 auditors in large offices and is more pronounced when an auditor may need to draw on additional resources in a limited period.

Who Did the Audit? Audit Quality and Disclosures of Other Audit Participants in PCAOB Filings

ABSTRACTWe empirically test whether audit quality is affected when part of an SEC issuer's audit is outsourced to auditors other than the principal auditor (“participating auditors”). We find a significantly negative market reaction and a significant decline in earnings response coefficients (ERCs) for experimental issuers disclosed for the first time as having participating auditors involved in their audits. However, we find no market reaction and no decline in ERCs for a matching sample of issuers that are not disclosed as using participating auditors, nor for issuers disclosed for the second or third time as using participating auditors. We also find actual audit quality as measured by absolute value of performance-matched discretionary accruals is lower for the experimental issuers, although we find no difference in audit fees paid by the experimental and matching issuers in a multivariate model. Our findings suggest that the PCAOB's proposed rule requiring disclosure of the use of other auditors in addition to the principal auditor would provide information useful to investors in assessing audit quality for SEC issuers.

Who Did the Audit? Investor Perceptions and Disclosures of Other Audit Participants in PCAOB Filings

We empirically test whether audit quality is affected when part of an SEC issuer’s audit is outsourced to auditors other than the principal auditor (“participating auditors”). We find a significantly negative market reaction and a significant decline in earnings response coefficients (ERCs) for experimental issuers disclosed for the first time as having participating auditors involved in their audits. However, we find no market reaction and no decline in ERCs for a matching sample of issuers that are not disclosed as using participating auditors, nor for issuers disclosed for the second or third time as using participating auditors. We also find actual audit quality as measured by absolute value of performance-matched discretionary accruals is lower for the experimental issuers, although we find no difference in audit fees paid by the experimental and matching issuers in a multivariate model. Our findings suggest that the PCAOB’s proposed rule requiring disclosure of the use of other auditors in addition to the principal auditor would provide information useful to investors in assessing audit quality for SEC issuers.

Analysis of firm size, leverage, corporate governance on earnings management practices (Indonesian evidence)

A B STRA C T The inconsistency of the results in previous studies related to the relationship of firm size and leverage on earnings management practices is still interesting. In contrast to the previous studies, this study is not merely to determine the effect of firm size, leverage, and corporate governance on earnings management practices partially but also to include the variable corporate governance (CG) is also thought to be able to moderate the effect of firm size and leverage variables on earnings management practices. Discretionary accruals as proxy for earnings management and are also measured using Performance-Matched Discretionary Accruals Model. Using Moderated Regression Analysis (MRA) and Residual Test, the result shows that firm size and corporate governance have a significant effect on earnings management, whereas the leverage was not found to have a significant effect. In addition, the results of this study indicate that corporate governance is able to moderate the relationship firm size and leverage on earnings management practices.

The Earnings Quality of High Growth Firms Before and after the Sarbanes-Oxley Act

Here we examine whether earnings quality improved after the Sarbanes-Oxley Act of 2002 (SOX) in the context of high growth and lower growth firms. Our examination is based on the notions that high growth creates unique management and reporting challenges that can contribute to lower earnings quality and that the period of increased attention to accounting and reporting issues initiated by SOX has been particularly relevant for high growth firms. Our earnings quality measures include modified Jones performance-matched discretionary accruals and absolute value book tax differences. Our results indicate that earnings quality for high growth firms improved in the period after SOX relative to lower growth firms. We also find that the relation between accounting returns and market returns weakened in the period after SOX. However, we find that the returns relations are significantly lower only for lower growth firms. We interpret these results as indicative of dual and potentially conflicting effects from improvements in financial reporting.

Late for a Very Important Date: Financial Reporting Implications of Late 10-K Filings and the Role of Auditor Reputation

Delays in Securities and Exchange Commission (SEC) filings often reflect issues related to period-end financial reporting and audit processes. We investigate the impact of filing delays in connection with auditor characteristics on the quality of audited financial statements in a sample of firms that filed Form 10-K after the statutory due date. We find that late filing firms are associated with lower financial reporting quality compared to timely filing firms matched by propensity scores, where financial reporting quality is measured by the absolute value of performance-matched discretionary accruals and the probability of a late 10-K filing being restated in subsequent periods. We also find that late filing explanations disclosed on SEC Form 12b-25, Notification of Late Filing, reveal to some extent the issues faced by such firms. Furthermore, we demonstrate that the adverse consequences of late filings can be largely mitigated by having a Big 4 auditor. The differential audit quality stems primarily from Big 4 auditors in large offices, and is more pronounced in situations in which the auditor may need to draw on additional resources in a limited period of time. Overall, our findings suggest that the issues underlying a delinquent 10-K filing have adverse consequences for accounting/audit quality, and large Big 4 offices have both more in-house capacity and greater incentives for reputation protection to respond to the risk associated with late filers.

Earnings management and board oversight: an international comparison

PurposeThis paper attempts to investigate the relationships between the board of directors' characteristics and earnings management being a proxy of earnings quality in two separate countries, France and Canada. Specifically, it aims to investigate how certain contextual features affect differently earnings management behavior, and to reveal which factors are the most prominent incentives of management discretion in both cases.Design/methodology/approachThe paper uses a performance matched discretionary accruals (PMDA) measure as a proxy for earnings management. Three separate panel‐regressions are then performed on a full sample, comprising a French sub‐sample and a Canadian sub‐sample, to detect board characteristics and institutional features' impacts on the PMDA. Regressions are based on a panel of 180 French and Canadian listed firms' data over the period 2006‐2008.FindingsEvidence shows that CEO stock ownership, independent monitoring and institutional investor's property are strong earnings management determinants in both the French and Canadian frameworks. Nevertheless, leadership structure and board size seem to be neutral. Furthermore, French firms show specific earnings management incentives which are related to high ownership concentration, low equity widespread and high contractual debt costs. Dominant minority ownership and capital market forces are the key earnings management incentives in the Canadian context. These findings are robust to alternative sensitivity tests.Research limitations/implicationsEven though the findings answer some questions, earnings management incentives are still to be decided. Future research could further highlight the impact of contractual, legal, cultural, ethical and political country‐specific factors related to financial reporting.Originality/valueThis paper investigates how an effective board of directors is able to provide a monitoring mechanism to ensure high quality of earnings. Moreover, it builds on cross‐country variations in corporate governance features and contextual‐specific factors to reveal earnings management behavior's incentives in two separate environments, namely French and Canadian ones. The underlying promise is that poor corporate governance (weak board monitoring), high ownership concentration, and intensive financial market forces create incentives that largely influence manager's willingness to report earnings that don't reflect a firm's true performance.

Value relevance of key accounting information and earnings management: high-tech versus low-tech firms

This paper examines the value-relevance of primary accounting information and the size of earnings management concurrently for high-tech versus low-tech firms. Specifically, the results reveal that earnings and changes in earnings of high-tech firms reflect lower levels of security price reactions and associations than those of low-tech firms. In addition, consistent with evidence from prior research, greater levels of earnings management, measured by modified Jones and performance-matched discretionary accruals (proxies for earnings management), exist for high-tech firms vis-à-vis low-tech firms over the sample period. More importantly, this paper also documents that the association between cumulative adjusted returns and key financial variables, including earnings, changes in earnings, sales, and changes in sales, remains weaker for high-tech firms than for low-tech firms even after levels of earnings management have been controlled for.

Performance matched discretionary accrual measures

We examine the specification and power of tests based on performance-matched discretionary accruals, and make comparisons with tests using traditional discretionary accrual measures (e.g., Jones and modified-Jones models). Performance matching on return on assets controls for the effect of performance on measured discretionary accruals. The results suggest that performance-matched discretionary accrual measures enhance the reliability of inferences from earnings management research when the hypothesis being tested does not imply that earnings management will vary with performance, or where the control firms are not expected to have engaged in earnings management.

The Relation Between Auditors' Fees for Non-Audit Services and Earnings Management

This paper examines whether auditor fees are associated with earnings management and the market reaction to the disclosure of auditor fees. Using data collected from proxy statements, we present evidence that non-audit fees are positively associated with small positive earnings surprises, the magnitude of absolute discretionary accruals, and the magnitude of income-increasing and income-decreasing discretionary accruals. In contrast, audit fees are negatively associated with these earnings management indicators. These results are robust to a variety of alternative variable definitions and model specifications. Specifically, contrary to the claims of Ashbaugh et al. (2002), the results are robust to the use of performance-matched discretionary accruals. Moreover, contrary to the claims of Francis and Ke (2002), the results for small positive earnings surprises are robust regardless of whether the comparison group is all other earnings surprises or small negative earnings surprises. Our final set of results provide evidence of a significant negative association between non-audit fees and share values on the date the fees were disclosed, although the effect is small in economic terms.