Poor Accruals Quality Research Articles

Can Critical Audit Matters Be a Signal of Poor Accruals Quality?

SUMMARY We investigate the relationship between critical audit matters (CAMs) and accruals quality. We find that companies with a higher number of CAMs in their audit reports are associated with poorer accruals quality, and this association appears to be driven by recurring rather than nonrecurring CAMs. An examination of specific CAM topics shows that revenue CAMs are associated with lower revenue-related accruals quality, and tax CAMs are associated with poorer tax-related accruals quality, suggesting that CAMs are indicators of poor accruals quality. A cross-sectional analysis shows that the CAM signal about poor accruals quality is attenuated for companies when the information environment is richer, suggesting that a rich information environment restrains the use of discretion in accruals estimation such that CAMs no longer indicate poor accruals quality. Overall, our findings suggest that CAMs can provide a relevant signal of financial reporting quality in certain circumstances. JEL Classifications: M41; M42; M48.

Political contributions and the auditor–client relationship

AbstractWe investigate the impact of audit client political contributions on various audit attributes. We find that, despite having poorer accruals quality, clients with higher political contributions have fewer restatements, receive no more going concern qualified opinions and receive fewer reported material weaknesses. Additionally, we find that auditors earn higher fees from and have longer tenure with their politically connected clients. Our evidence is indirect, but the totality of our results is most consistent with an economic bond between auditors and their politically connected clients, whereby clients are allowed more accounting discretion and receive fewer adverse audit outcomes, and the auditor charges a persistent risk premium. We conclude that client political connections likely influence audit outcomes because of either reduced scrutiny from regulators or direct influence on auditors. We extend a growing body of research on the consequences of corporate political connections.

Takeover Threats, Job Security Concerns, and Earnings Management

ABSTRACT Using the staggered adoption of takeover laws, this study examines implications of takeover threats on earnings management around the world. I find that the enactment of takeover legislation leads to increased earnings management (abnormally high accruals, target beating, and poor accruals quality). Results are driven by underperforming managers with higher turnover risk in countries with high increases in turnover sensitivity to performance, indicating job security concerns as the channel through which takeover laws increase earnings management. Furthermore, results are strongest in countries with weak investor protection, where existing governance mechanisms are weaker and earnings management is more prevalent. Moreover, regulation provisions that most directly increase takeover threats experience greater earnings management responses. Additionally, I show that accounting restatements and fraud scandals become more frequent following takeover legislation. Overall, I provide evidence that takeover reforms, although enhancing discipline of underperforming managers, inadvertently incentivize accounting manipulation due to heightened job security concerns. JEL Classifications: G34; G38; K22; M41; M43.

Do Critical Audit Matters Indicate Poor Accruals Quality?

Do Critical Audit Matters Indicate Poor Accruals Quality?

Economic policy uncertainty and financial statement comparability

We examine the implications of economic policy uncertainty (EPU) for financial statement comparability. We posit that the increased difficulty of estimating future cash flows and the increased opportunity for earnings management with increased EPU reduce the quality of earnings and its comparability. Consistent with this reasoning, we find a negative relation between earnings comparability and lagged EPU. Further, the association between EPU and comparability is more negative for firms that have poorer accruals quality and higher earnings volatility. We do not find that accounting policy choice is systematically related to the association between EPU and comparability. These results suggest that cross-sectional differences in accounting estimates rather than accounting policies influence the relation between EPU and comparability.

The Effect of Accruals Quality on Split Bond Ratings

This study examines whether good accruals quality is associated with less disagreement among credit rating agencies. Distinct from prior studies that focus on equity analysts, I examine how the quality of financial information influences rating agencies in determining bond ratings. Precise accounting information reduces the information risk of the users of the financial statements such as the credit rating agencies, and thereby affects the frequency and magnitude of split bond ratings by credit rating agencies. Specifically, this paper examines whether the quality of accounting information, proxied by accruals quality, reduces disagreement about bond ratings (i.e., split bond ratings) among the three rating agencies in Korea. I test the hypothesis which predicts that poor accruals quality raises information uncertainty about a firm’s financial condition for creditors, thereby increasing split bond ratings among rating agencies. Using 1,867 observations for public bonds in Korea, I show that better accruals quality is associated with lower frequency and magnitude of split bond ratings by credit rating agencies. This finding persists after controlling for other firm-specific factors that affect split ratings, and is robust to a battery of sensitivity analyses.

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.

Foreign Institutional Ownership and the Choice between Public and Private Debt

ABSTRACTThe objective of this study is to examine the role of foreign institutional investors (FIIs) in firms' choice of debt. Using a large sample of firms from 40 countries, we find that FIIs are positively associated with the propensity of firms to access the public debt market and the subsequent issuance of new public debt. In contrast, we find no relationship between domestic institutional ownership and public debt. Our results are robust to various specifications, including a 2SLS regression model, a change model, a Heckman two-stage model and propensity score matching model, and a quasi-natural experiment using the exogenous relaxation of foreign equity restrictiveness. Cross-sectional tests further show that findings are stronger for firms with poorer accruals quality, with higher levels of information asymmetry, and firms domiciled in countries with weaker creditor protection. Collectively, our findings suggest that FIIs play a vital role in facilitating firms' public debt financing.

Earnings quality, investment decisions, and financial constraint

Purpose – The purpose of this study was to investigate the relationship between accruals quality, financial constraint, and investment decisions and if earnings quality affects investment-cash flow sensitivities. Design/methodology/approach – An analysis was conducted of a sample with 10,318 observations of 958 non-financial companies from seven different countries, covering 1992 to 2009. Then, the investment determinants were estimated using the Generalized Method of Moments (GMM). Findings – Poor accruals quality was positively associated with investment rates for firms with overinvestment and negatively related to investment rates for firms with underinvestment. Additionally, the results indicate that accruals quality affects investment-cash flow sensitivities for firms in a situation of financial constraint; that is, poor accounting information quality can exacerbate the dependence of investment on free cash flow. Originality/value – The results show that poor accruals quality could exacerbate the problems caused by the conflict of interest between decision-makers and shareholders or other stakeholders.

An Empirical Research on the Funds Managers’ Skill and Accrual Quality Risk Premium: The Evidence from China

This paper explores the impact of accrual quality information on fund investment decisions, and examines whether fund managers can use the stock’s accrual quality information to obtain excess returns, and the difference in fund manager’s skill to influence the extent of the fund’s excess returns. This paper uses the annual observations of 2851 Chinese funds, from 2005 to 2016 to analyze the fund manager’s stock investment decision. The results show that in China capital market, there is a risk premium for accrual quality, and fund managers can obtain excess returns through selecting stocks with poor accrual quality. And fund managers with better skill, can obtain more excess returns.

Information risk, stock returns, and asset pricing: Evidence from China

PurposeThis study aims to investigate information risk in relation to stock returns of a firm and whether information risk is priced in China.Design/methodology/approachThe authors used accruals quality (AQ) as their measure of information risk and performed Fama-Macbeth regressions to investigate association of AQ with future realized stock returns. Moreover, two-stage cross-sectional regression analysis was performed, both at firm level and at portfolio level, to test if the AQ factor is priced in China in addition to existing factors in the Fama French three-factor model.FindingsThe authors found poor AQ being associated with higher future realized stock returns. Moreover, they found evidence of market pricing of AQ in addition to existing factors in the Fama French three-factor model. Further, subsample analysis revealed that investors value AQ more in non-state owned enterprises than in state owned enterprises.Research limitations/implicationsThe study sample comprises A-shares only and the generalization of the findings is limited by the peculiar institutional and economic setup in China.Originality/valueThis study contributes to market-based accounting literature by providing further insight into how and if investors value information risk, and it seeks to fill gap in empirical literature by providing evidence from the Chinese capital market.

Takeover Threats, Job Security Concerns, and Earnings Management

Exploiting the staggered adoption of country-level takeover laws that increased takeover threats, this paper examines whether the resulting increase in CEOs’ job security concerns leads to greater earnings management. Using a difference-in-difference design, I find that the enactment of laws designed to promote takeover activity is associated with greater earnings management activities (abnormally high accruals, target beating, and poor accruals quality). Furthermore, these activities contribute to increased opacity, as liquidity declines significantly (increased bid-ask spread, percentage of zero-return days, and price impact of trades) following takeover regulation. Impact on earnings management is most pronounced for managers facing the greatest risk of termination at the time of takeover law implementation – those who had been leading firms with poor performance, displaying higher inherent turnover risk, working in a merger intense industry, or working in a country-industry with heavy product market competition. However, strong institutions that can limit CEOs’ ability to manipulate accounting information mitigate the earnings management effects of takeover laws. Overall, my results suggest that reforms aimed at enhancing the monitoring role of governance have unintended consequences because these reforms increase CEOs’ job security concerns and thereby lead to greater earnings management and a more opaque information environment.

Accrual quality, skill, and the cross-section of mutual fund returns

We use returns of actively managed mutual funds to document the link between accrual quality (AQ) and systematic (priced) risk. Despite compelling theoretical arguments, prior research finds no evidence that poor AQ commands a risk premium in the cross-section of realized stock returns. We argue that the previously obtained premium estimates are biased downward because, for a large portion of poor AQ stocks, higher expected returns are offset by the news of deteriorating fundamentals. We suggest that skilled mutual fund managers should be able to either avoid investing in stocks with deteriorating fundamentals or assign them lower portfolio weights. As a consequence, returns on their portfolios should better reflect the expected AQ risk premium. Our empirical evidence is consistent with these predictions.

Accounting Quality and Access to Credit Lines

We examine the relationship between accounting quality and the firms’ use of credit lines for short-term liquidity management. Based on the corporate finance literature on liquidity management, we argue that firms who meet their liquidity needs through cash holdings and not credit lines are likely to do so because of their inability to access the credit market. In particular, we argue that poor accruals quality is likely to make it difficult for firms to access credit lines. We find that firms with poor accruals quality use less credit line to meet their liquidity needs. We also find that firms with poor accruals quality have higher credit line spreads. We also use Richardson et al. (2005) model that compares the accruals persistence with that of cash flows and find that firms that have more credit lines have higher persistence of current operating asset accruals, net non-current operating asset accruals and net financial asset accruals. Overall, the findings suggest that high accruals quality facilitates firms’ access to the debt markets.

Institutional investors and opportunistic seasoned equity offerings in the Korean stock market

ABSTRACTThis study examines the impact of institutional monitoring on opportunistic seasoned equity offerings (SEOs) in the Korean stock market. With a firm’s accrual quality as a measurement for the degree of information asymmetry between managers and investors, we hypothesize that the managers of firms with poor accrual quality are likely to engage in opportunistic SEOs, but such opportunistic activity is weak in firms strongly monitored by institutional investors. The empirical findings indicate that opportunistic SEOs tend to be deterred by institutional monitoring.

Information risk, stock returns, and the cost of capital in China

Purpose – The purpose of this paper is to investigate information risk in relation to cost of capital and, also, whether information risk is a priced risk factor in China. Design/methodology/approach – The authors used accruals quality (AQ) as the measure of information risk and employed multiple regression analysis and Fama-Macbeth regressions to investigate association of AQ with cost of capital and future realized stock returns, respectively. Moreover, two-stage cross-sectional regression analysis is performed, both at firm and at portfolio levels, to test if an AQ factor is a priced risk factor in China. Findings – The authors found poor AQ being associated with higher cost of equity but this relationship is not significant in subsample of state-owned enterprises (SOEs). The results do not support any association between AQ and cost of debt in China. Further, the authors found poor AQ being positively associated with future realized stock returns and the authors also found evidence of market pricing of an AQ factor in addition to existing factors in Fama-French three-factor model in firm level analysis. However, subsample analysis revealed that AQ is not priced in case of SOEs. Research limitations/implications – The study sample is comprised of A-Shares only and the generalization of the findings is limited by the peculiar institutional setup and other unique characteristics of Chinese capital market. Originality/value – This study contributes to literature by providing novel findings on the relationship between information risk and cost of capital in Chinese context and it provides further insight into how and if investors value information risk.

The Effects of Accruals Quality on Audit Hours and Audit Fees

We investigate whether auditors take into account accruals quality, a proxy for the cash flow risk associated with earnings, by adjusting audit hours and audit fees. Accruals quality tells investors about the mapping of accounting earnings into cash flows. Poor accruals quality weakens this mapping and thus increases this cash flow risk. We find a negative relationship between accruals quality and audit hours/fees, indicating that auditors increase their audit efforts by modifying audit procedures and substantive tests and charge higher fees for the increased cash flow risk. In addition, we find that both innate accruals quality and discretionary accruals quality are negatively related to audit hours and fees but that innate accruals quality is more likely to influence audit hours and fees than discretionary accruals quality. The results indicate that auditors incorporate the cash flow risk associated with accruals quality but that their response varies according to the source of accruals quality.

Accrual Quality and Opportunistic Seasoned Equity Offering in the Korean Stock Market

We examine accrual quality (AQ) and its relationship with opportunistic seasoned equity offering (SEO) in the emerging Korean stock market. According to our empirical results, SEO firms with lower AQ tend to show higher abnormal returns around SEO announcement and significantly lower long-term performance after SEO. These results are more evident for SEO firms in which influence of institutional investors is weak. These findings suggest that poor AQ may be an important predictor of incentive for opportunistic SEOs and that the incentive may strengthen when institutional investors’ monitoring role weakens.

Earnings Management around Large Equity Increases: Do Audit Firm Size and Non-Audit Services Matter?

We investigate how audit firm size and large auditor-provided non-audit services (NAS) affect accruals quality around large equity issues and acquisitions for Norwegian public companies from 1999-2013. We find poorer accruals quality around large equity increases. Big 4 audit firms mitigate adverse accruals quality but only if the provision of NAS is moderate or low. In contrast, non-Big 4 audit firms are associated with lower accruals quality around large equity increases, but this effect is moderated if the provision of NAS is high. The findings are consistent with joint provision of audit and NAS as an effective learning mechanism to mitigate earnings management for smaller audit firms and a lesser willingness of larger audit firms to protect earnings when the provision of NAS is high. The evidence contrasts with the notion of large audit firms as universally superior audit quality suppliers and establishes new evidence on how knowledge spillovers from NAS may improve audit quality.

Political Contributions and the Auditor-Client Relationship

We investigate the impact of audit client political contributions on various audit attributes. We find that, despite having poorer accruals quality, clients with higher political contributions have fewer restatements, receive no more going concern qualified opinions, and receive fewer reported material weaknesses. Additionally, we find that auditors earn higher fees from and have longer tenure with their politically connected clients. Our evidence is indirect, but the totality of our results is most consistent with an economic bond between auditors and their politically connected clients, whereby clients are allowed more accounting discretion and receive fewer adverse audit outcomes, and the auditor charges a persistent risk premium. Our evidence extends prior research concluding that political connections afford firms influence over governments, lenders, and regulators.