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Journal ArticleDOI

The Effect of Audit Quality on Earnings Management

TL;DR: In this article, the authors examined the relation between audit quality and earnings management and found that clients of non-Big Six auditors report discretionary accruals that increase income relatively more than the discretionary accumruals reported by clients of big six auditors.
Abstract: This study examines the relation between audit quality and earnings management. Consistent with prior research, we treat audit quality as a dichotomous variable and assume that Big Six auditors are of higher quality than non-Big Six auditors. Earnings management is captured by discretionary accruals that are estimated using a cross-sectional version of the Jones 1991 model. Prior literature suggests that auditors are more likely to object to management's accounting choices that increase earnings (as opposed to decrease earnings) and that auditors are more likely to be sued when they are associated with financial statements that overstate earnings (as compared to understate earnings). Therefore, we hypothesize that clients of non-Big Six auditors report discretionary accruals that increase income relatively more than the discretionary accruals reported by clients of Big Six auditors. This hypothesis is supported by evidence from a sample of 10,379 Big Six and 2,179 non-Big Six firm years. Specifically, clients of non-Big Six auditors report discretionary accruals that are, on average, 1.5-2.1 percent of total assets higher than the discretionary accruals reported by clients of Big Six auditors. Also, consistent with earnings management, we find that the mean and median of the absolute value of discretionary accruals are greater for firms with non-Big Six auditors. This result also indicates that lower audit quality is associated with more “accounting flexibility”.
Citations
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Journal ArticleDOI
April Klein1
TL;DR: In this paper, the authors examined whether audit committee and board characteristics are related to earnings management by the firm and found a negative relation between audit committee independence and abnormal accruals.

3,298 citations

Journal ArticleDOI
TL;DR: This paper pointed out that the "quality" of earnings is a function of the firm's fundamental performance and suggested that the contribution of a firms fundamental performance to its earnings quality is suggested as one area for future work.
Abstract: Researchers have used various measures as indications of "earnings quality" including persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness, and external indicators such as restatements and SEC enforcement releases. For each measure, we discuss causes of variation in the measure as well as consequences. We reach no single conclusion on what earnings quality is because "quality" is contingent on the decision context. We also point out that the "quality" of earnings is a function of the firm's fundamental performance. The contribution of a firm's fundamental performance to its earnings quality is suggested as one area for future work.

2,633 citations


Cites background from "The Effect of Audit Quality on Earn..."

  • ...With few exceptions,75 studies suggest that firms with Big-X auditors76 have significantly lower discretionary accruals than firms with non-Big-X auditors (Becker et al., 1998; DeFond and Subramanyam, 1998; Francis et al., 1999; Kim et al., 2003)....

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  • ...With few exceptions, studies suggest that firms with Big-X auditors have significantly lower discretionary accruals than firms with non-Big-X auditors (Becker et al., 1998; DeFond and Subramanyam, 1998; Francis et al., 1999; Kim et al., 2003)....

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Journal ArticleDOI
TL;DR: In this paper, the authors point out that the quality of earnings is a function of the firm's fundamental performance and suggest that the contribution of a firms fundamental performance to its earnings quality is suggested as one area for future work.

2,140 citations

Journal ArticleDOI
TL;DR: In this article, the authors define higher audit quality as greater assurance of high financial reporting quality, and they provide a framework for systematically evaluating their unique strengths and weaknesses, including the role of auditor and client competency in driving audit quality.
Abstract: We define higher audit quality as greater assurance of high financial reporting quality. Researchers use many proxies for audit quality, with little guidance on choosing among them. We provide a framework for systematically evaluating their unique strengths and weaknesses. Because it is inextricably intertwined with financial reporting quality, audit quality also depends on firms’ innate characteristics and financial reporting systems. Our review of the models commonly used to disentangle these constructs suggests the need for better conceptual guidance. Finally, we urge more research on the role of auditor and client competency in driving audit quality.

1,553 citations


Cites methods from "The Effect of Audit Quality on Earn..."

  • ...The most frequently used measures are based on the Jones (1991) discretionary accruals (DAC) model (e.g. Becker et al., 1998; Francis et al., 1999)....

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Journal ArticleDOI
TL;DR: In this paper, the authors investigate if the use of a Big 6 auditor is increasing the propensity of a firm's endogenous propensity to generate accruals and find that high-accrual firms have greater scope for aggressive and/or opportunistic strategies.
Abstract: This study investigates if the use of a Big 6 auditor is increasing in the firm's endogenous propensity to generate accruals. High‐accrual firms have greater scope for aggressive and/or opportunist...

1,429 citations


Cites background from "The Effect of Audit Quality on Earn..."

  • ...4 Becker et al. (1998) also report lower discretionary accruals for Big-6-audited companies, though their analysis is based on a smaller sample from the period 1989–1992, and a more limited analysis of time periods, industry sectors, firm size, and alternative specifications of discretionary accruals models....

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References
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Journal ArticleDOI
TL;DR: In this article, the authors draw on recent progress in the theory of property rights, agency, and finance to develop a theory of ownership structure for the firm, which casts new light on and has implications for a variety of issues in the professional and popular literature.

49,666 citations

Journal ArticleDOI
TL;DR: In this article, the authors test whether firms that would benefit from import relief attempt to decrease earnings through earnings management during import relief investigations by the United States International Trade Commission (ITC).
Abstract: This study tests whether firms that would benefit from import relief (eg, tariff increases and quota reductions) attempt to decrease earnings through earnings management during import relief investigations by the United States International Trade Commission (ITC) The import relief determination made by the ITC is based on several factors that are specified in the federal trade acts, including the profitability of the industry Explicit use of accounting numbers in import relief regulation provides incentives for managers to manage earnings in order to increase the likelihood of obtaining import relief and/or increase the amount of relief granted While studies of earnings management typically examine situations in which all contracting parties have incentives to "perfectly" monitor (adjust) accounting numbers for such manipulation, import relief investigations provide a specific motive for earnings management that is not

7,362 citations


"The Effect of Audit Quality on Earn..." refers background or result in this paper

  • ...With respect to studies that examine discretionary accruals (e.g., Healy 1985; DeAngelo 1986; Jones 1991; DeFond and Jiambalvo 1994; Dechow, Sloan, and Sweeney 1995; Subramanyam 1996), our results suggest that tests may be more powerful if they control for cross-sectional variation in audit quality....

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  • ...En ce qui a trait aux 6tudes portant sur les 616ments discretionnaires (par exemple, Healy, 1985 ; DeAngelo, 1986 ; Jones, 1991 ; DeEond et Jiambalvo, 1994 ; Dechow, Sloan et Sweeney, 1995 ; et Subramanyam, 1996), les resultats obtenus ici donnent a penser que la puissance des tests pourrait etre superieure s'ils permettaient de controler la variation transversale dans la quality de la verification....

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Posted Content
TL;DR: In this paper, the authors evaluate alternative models for detecting earnings management by comparing the specification and power of commonly used test statistics across the measures of discretionary accruals generated by each model.
Abstract: This paper evaluates alternative models for detecting earnings management. The paper restricts itself to models that assume the construct being managed is discretionary accruals, since such models are commonly used in the extant accounting literature. Existing models range from simple models in which discretionary accruals are measured as total accruals, to more sophisticated models that separate total accruals into a discretionary and a non-discretionary component. Prior to this paper, there had been no systematic evidence bearing on the relative performance of these alternative models at detecting earnings management. This paper evaluates the relative performance of the competing models by comparing the specification and power of commonly used test statistics across the measures of discretionary accruals generated by each model. The specification of the test statistics is evaluated by examining the frequency with which they generate type I errors for a random sample of firm-years and for samples of firm-years with extreme financial performance. We focus on samples with extreme financial performance because the stimuli investigated in previous research are frequently correlated with financial performance. The first sample of firms are targeted by the Securities and Exchange Commission for allegedly overstating annual earnings and the second sample is created by artificially introducing earnings management into a random sample of firms.

6,217 citations


"The Effect of Audit Quality on Earn..." refers methods in this paper

  • ...Comparability across cash fiow deciles is desirable because the model in Jones (1991), which we use to estimate discretionary accruals, may be sensitive to extreme measures of cash fiows (Dechow et al. 1995)....

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Journal ArticleDOI
TL;DR: In this paper, the authors present some empirical results of a study predicting corporate failure as evidenced by the event of bankruptcy, and the methodology is one of maximum likelihood estimation of the so-called conditional logit model, in which the data set used in this study is from the seventies (1970-76).
Abstract: This paper presents some empirical results of a study predicting corporate failure as evidenced by the event of bankruptcy. There have been a fair number of previous studies in this field of research; the more notable published contributions are Beaver [1966; 1968a; 1968b], Altman [1968; 1973], Altman and Lorris [1976], Altman and McGough [1974], Altman, Haldeman, and Narayanan [1977], Deakin [1972], Libby [1975], Blum [1974], Edmister [1972], Wilcox [1973], Moyer [1977], and Lev [1971]. Two unpublished papers by White and Turnbull [1975a; 1975b] and a paper by Santomero and Vinso [1977] are of particular interest as they appear to be the first studies which logically and systematically develop probabilistic estimates of failure. The present study is similar to the latter studies, in that the methodology is one of maximum likelihood estimation of the so-called conditional logit model. The data set used in this study is from the seventies (1970-76). I know of only three corporate failure research studies which have examined data from this period. One is a limited study by Altman and McGough [1974] in which only failed firms were drawn from the period 1970-73 and only one type of classification error (misclassification of failed firms) was analyzed. Moyer [1977] considered the period 1965-75, but the sample of bankrupt firms was unusually small (twenty-seven firms). The

5,244 citations


"The Effect of Audit Quality on Earn..." refers background in this paper

  • ...However, high leverage is also associated with financial distress (Beneish and Press 1995; Ohlson 1980)....

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Journal ArticleDOI
TL;DR: In this paper, the authors argue that audit quality is not independent of audit firm size, even when auditors initially possess identical technological capabilities, and when incumbent auditors earn client-specific quasi-rents, auditors with a greater number of clients have more to lose by failing to report a discovered breach in a particular client's records.

4,969 citations


"The Effect of Audit Quality on Earn..." refers background or result in this paper

  • ..., and theory suggests that audit firm size is a proxy for audit quality (DeAngelo 1981; Dopuch and Simunic 1982)....

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  • ...Theoretical support for such a quality differentiation is provided in DeAngelo 1981, who demonstrates analytically that larger audit firms have greater incentives to detect and reveal management misreporting. Because Big Six firms are larger than their competitors, it follows from DeAngelo's analysis that they are of higher quality. Several empirical studies have documented evidence consistent with DeAngelo's analysis. Teoh and Wong (1993) document higher earnings response coefficients for clients of Big Six auditors as compared to clients of non-Big Six auditors. Several studies have also documented an audit fee premium attributed to Big Six auditors (e.g., Craswell, Francis, and Taylor 1995). In addition, St. Pierre and Anderson (1984) find a lower incidence of litigation among Big Six auditors compared with non-Big Six auditors. DeFond and Jiambalvo (1991) consider errors and irregularities as a form of earnings management and hypothesize that clients of Big Six firms are less likely to have errors or irregularities....

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  • ...Theoretical support for such a quality differentiation is provided in DeAngelo 1981, who demonstrates analytically that larger audit firms have greater incentives to detect and reveal management misreporting. Because Big Six firms are larger than their competitors, it follows from DeAngelo's analysis that they are of higher quality. Several empirical studies have documented evidence consistent with DeAngelo's analysis. Teoh and Wong (1993) document higher earnings response coefficients for clients of Big Six auditors as compared to clients of non-Big Six auditors....

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  • ...Theoretical support for such a quality differentiation is provided in DeAngelo 1981, who demonstrates analytically that larger audit firms have greater incentives to detect and reveal management misreporting. Because Big Six firms are larger than their competitors, it follows from DeAngelo's analysis that they are of higher quality. Several empirical studies have documented evidence consistent with DeAngelo's analysis. Teoh and Wong (1993) document higher earnings response coefficients for clients of Big Six auditors as compared to clients of non-Big Six auditors. Several studies have also documented an audit fee premium attributed to Big Six auditors (e.g., Craswell, Francis, and Taylor 1995). In addition, St. Pierre and Anderson (1984) find a lower incidence of litigation among Big Six auditors compared with non-Big Six auditors. DeFond and Jiambalvo (1991) consider errors and irregularities as a form of earnings management and hypothesize that clients of Big Six firms are less likely to have errors or irregularities. Results support the hypothesis only when fraudulent firms are excluded from their sample. DeFond and Jiambalvo (1993) show that auditor-client disagreements result from incentives to manage earnings and are more likely to occur when firms have Big Six auditors....

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  • ...Theoretical support for such a quality differentiation is provided in DeAngelo 1981, who demonstrates analytically that larger audit firms have greater incentives to detect and reveal management misreporting. Because Big Six firms are larger than their competitors, it follows from DeAngelo's analysis that they are of higher quality. Several empirical studies have documented evidence consistent with DeAngelo's analysis. Teoh and Wong (1993) document higher earnings response coefficients for clients of Big Six auditors as compared to clients of non-Big Six auditors. Several studies have also documented an audit fee premium attributed to Big Six auditors (e.g., Craswell, Francis, and Taylor 1995). In addition, St. Pierre and Anderson (1984) find a lower incidence of litigation among Big Six auditors compared with non-Big Six auditors....

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