Impact of Audit Quality on Earnings Management: Evidence from Iran

Transcription

1 International Research Journal of Finance and Economics ISSN Issue 66 (2011) EuroJournals Publishing, Inc Impact of Audit Quality on Earnings Management: Evidence from Iran Mahdi Safari Gerayli Ph. D. Student, Department of Accounting, Bandargaz Branch Islamic Azad University, Bandargaz, Iran E mail: safari@bandargaziau.ir Abolfazl Momeni Yanesari M.A. in Accounting, Behshahr Payame Noor University, Behshahr, Iran E mail: momenipnu@yahoo.com Ali Reza Ma'atoofi Ph. D. Student, Department of Management Gorgan Branch, Islamic Azad University, Gorgan, Iran alirezamaetoofi@gmail.com Tel: ; Fax: Abstract The aim of the research presented in this paper is to provide empirical evidence on the impact of Audit Quality on Discretionary Accruals, as a measure of Earnings Management, in Iranian listed firms. Multiple regression analysis is used in the study in estimating the relationship between the Audit Quality and firm s Discretionary Accruals. Using three different measures of Audit Quality (i.e. Auditor size, Auditor industry Specialization and Auditor Independence) and based on a sample of 90 non-financial Iranian listed firms from 2004 to 2009, the results reveal that Discretionary Accruals are negatively related to Auditor size and Auditor industry Specialization. Our findings also support our hypothesis of the negative association between auditor independence and Discretionary Accruals. Overall, this study provides evidence that firms which are audited by high quality auditors are more likely to have less Discretionary accruals, a finding that is consistent with prior research. Keywords: Audit Quality, Earnings Management, Discretionary Accruals 1. Introduction The agency problems associated with the separation of ownership and control create the demand for external audit. Initially, the agency problems arise from the asymmetric information in the Principalagent contracts. Asymmetric information refers to a situation where one party to a transaction has more information than the other party. Analytical models have demonstrated that the existence of information asymmetry between firm management and firm shareholders is a necessary condition for the practice of earnings management (Trueman and Titman, 1988; Dye, 1988). When information asymmetry exists, shareholders have insufficient resources, incentives, or access to relevant information to monitor manager's actions, earnings management can also occur (Schipper, 1989; Warfield, Wild, and Wild, 1995).

2 International Research Journal of Finance and Economics - Issue 66 (2011) 78 Many studies have been done in the area of corporate governance and Audit quality all of which know the two mechanisms as effective factors to restrain excessive opportunistic behavior amongst corporate management. Prior research on the relationship between Audit quality and earnings management has been done in the developed countries, however, a few studies have been done to examine this relationship in the emerging countries, which is the motivate for the present study. Therefore, the study is intended to find an acceptable answer to the question that whether the audit firm's independence, industry specialization and size, as criteria of audit quality, can limit the applying of earnings management in Iranian firms. The remainder of this study is organized as follows. The background and hypotheses development are discussed in Section 2. The research sample and design are discussed in Section 3, and the results of testing the hypotheses are discussed in Section 4. Section 5 contains the summary and conclusion that includes identified limitations and suggestions for further research. 2. Background and Hypothesis Development The role of auditing in ensuring the quality of reported earnings and constraining client earnings management has come under considerable scrutiny due to recent corporate accounting scandals. Audit quality differences result in variation in credibility offered by the auditors, and in the earnings quality of their audit clients. The current paper concentrates on discussing and analyzing the effect of audit quality on earnings management. Hence, several hypotheses are developed that identify and link some specific aspects of audit quality to earnings management Auditor Size and Earnings Management DeAngelo (1981) argues that Big4 auditors provide better quality audits than non-big4 auditors, which is supported by extensive subsequent empirical research. Teoh and Wong (1993) find higher ERCs for clients audited by Big4 firms compared to those audited by non-big4 firms. Becker et al (1998), Francis et al (1999) and Krishnan (2003) demonstrate that Big4 auditors are better at constraining client earnings management compared to non-big4 auditors; they find that clients of non-big4 auditors have higher levels of discretionary accruals. In addition, Zhou and Elder (2003) and Chen et al (2005) find that Big 4 auditors associate with less earnings management in the firms. Hence, the following hypothesis is proposed: H 1 : There is a significantly negative association between auditor size and the occurrence of earnings management Auditor Industry Specialization and Earnings Management In addition to auditor size, auditors industry specialization is considered to be another proxy for audit quality. Several prior studies show that client firms with industry specialists are associated with higher quality of financial reporting (e.g. Balsam et al, 2003; Krishnan, 2003). Therefore, the use of an auditor with industry specialization will help curb earnings management. These findings are consistent with the theory that auditors specialize in various industries to achieve product differentiation and provide higher quality audits (Simunic and Stein, 1987; Dunn and Mayhew, 2004). Higher quality of audits by industry specialists is also attributed to the fact that they invest heavily in technologies, physical facilities, personnel, and organizational control systems that enable them to detect irregularities and misrepresentations more easily (Simunic and Stein, 1987). Their ability to provide higher quality audits comes from their experience in serving other clients in the same industry and learning and sharing best practices across the industry (Dunn and Mayhew, 2004). Similarly, PricewaterhouseCoopers (2002) argue that audit quality depends on numerous factors including an auditor s knowledge and understanding of the company being audited and the industry in which it operates. Furthermore, Zhou and Elder (2003) and Rusmin (2010) argue that the discretionary accruals of industry specialist auditor clients are lower than discretionary accruals of nonindustry specialist clients. These arguments thus suggest that auditors with industry expertise are more likely to detect misrepresentations and irregularities than auditors without industry expertise, especially

3 79 International Research Journal of Finance and Economics - Issue 66 (2011) in the early years of the audit assignment. The linkage is based on the assumption that industryspecialist auditors have the industry expertise that results in better understanding of the client s business. Hence, H 2 is as follows: H 2 : There is a significantly negative association between Auditor industry specialization and the occurrence of earnings management Auditor Independence and Earnings Management Prior studies contend that high fees paid by a company to its external auditor increase the economic bond between the auditor and the client and thus the fees may impair the auditor s independence (e.g. Frankel et al, 2002; Li & Lin, 2005). The impaired independence results in poor audit quality and allows for greater earnings management (resulting in lower earnings quality). This discussion leads to the development of H 3 : H 3 : There is a significantly negative association between Auditor independence and the occurrence of earnings management. 3. Sample selection and Measurement of Variables 3.1. Sample Selection We select all publicly- listed companies in Tehran Stock Exchange (TSE) over the entire duration of the estimation time period ( ) as initial samples. Of these initial 735 firm- year observations, firms that are either missing financial variables or that have insufficient data are eliminated. Financial institutions, banking, finance and investment firms are also eliminated, since their accounting and reporting environments differ from those in other industries. This gives a final sample of 540 firm-year observations from the fiscal years 2004 to Measurement of Variables Dependent Variable In order to analyze the effect of Audit quality on the earnings management, discretionary accruals was used to measure earnings management (EM) as the dependent variable. The practice of using discretionary accruals to proxy for EM is consistent with the extant EM literature (for example, Johnston and Rock, 2005; Cahan et al, 1997; Hall and Stammerjohan, 1997). While there are many ways to estimate discretionary accruals, this study employs the Modified-Jones Model (Dechow et al, 1995). The Modified-Jones Model has been shown to outperform other discretionary accrual models in detecting EM (Dechow et al, 1995) and is frequently used in the accounting literature (DeFond and Subramanyam, 1998; Guidry et al, 1999). Prior to estimating discretionary accruals, total accruals (TAC) are calculated as: TAC i,t = CA i,t - CASH i,t - CL i,t + STDEBT i,t DPN i,t Where: TAC i,t = total accruals for firm i in time period t; CA i,t = change current assets for firm i from time period t 1 to t; CASH i,t = change cash balance for firm i from time period t 1 to t; CL i,t = change current liabilities for firm i from time period t 1 to t; STDEBT i,t = change in short-term debt for firm i from time period t 1 to t ;and DPN i,t = depreciation & amortization expense for firm i from time period t 1 to t. To estimate Discretionary accruals (DA i,t ) for firm i in year t, we perform the following crosssectional regression for each firms in each year: TA i,t /A i,t-1 = α 1 (CFO/A i,t-1 ) + α 2 ( REV i,t /A i,t-1 ) + α 3 (PPE i,t /A i,t-1 ) + ε i,t (1) Where: REV i,t = firm i s change in revenues in year t, PPE i,t = firm i s gross value of property, plant, and equipment in year t, and we have deflated by firm i s total assets in year t-1(a i,t-1 ). We then use the firm-specific parameter estimates from (1) to estimate firm-specific Discretionary accruals (DA i,t ) for firm i in year t as a percent of lagged total assets; that is, NDA i,t = α 1 (1/A i,t-1 )+ α 2 ( REV i,t AR i,t )/A i,t-1 + α 3 (PPE i,t /A i,t-1 )

4 International Research Journal of Finance and Economics - Issue 66 (2011) 80 Where: AR i,t = firm i s change in accounts receivable in year t. In turn, Discretionary accruals (DA i,t ) for firm i in year t are: DA i,t = TA i,t /A i,t-1 NDA i,t Independent Variables With regards to the independent variables, because there is no agreed-upon metric for the audit quality construct, it was measured using three different measures as follows: Auditor Size Regarding the significance of auditor size, DeAngelo (1981) and Datar et al (1991) claim that large and more prestigious public accounting firms concerned about protecting their investment in reputation capital have more incentive than do other auditors to supply a high-quality audit. Further, Craswell et al (1995), and Francis and Reynolds (2000) find that the large audit firms have brand-name reputation, charge higher audit fees, and/or behave qualitatively differently from smaller audit firms. Overall, these studies generally suggest that audit quality is likely to be positively related to audit firm size. We set Auditor size equal to 1 if the company audited by Big 4 audit firm, otherwise, Auditor Industry Specialization A dichotomous variable was used to denote if the auditor was an industry specialist or not. Following Dunn et al (2000), an auditing firm was classified as industry specialist (SPL_20) if its market share was greater than or equal to 20% of total market share of its specific industry. Similar to prior studies (Velury et al., 2003; Dunn et al, 2000; Craswell et al, 1995), auditor industry market share was defined as the proportion of industry revenue audited by an individual accounting firm relative to the total industry revenue for all companies in that industry audited by all public accounting firms. J i k S A L E j = 1 i j k M S i k = I k J i k S A L E i = 1 j = 1 i j k Where: SALE ijk = total sales of client firm j in industry k audit by auditor i. i=1, 2,..., I = an index for audit firms. j=1, 2,..., J = an index for client firms. k=1, 2,..., K = an index for client industry. Ik = the number of audit firms i in industry k. Jik = the number of clients served by audit firm i in industry k. When auditor j s market share is greater than 20 percent in Industry k, the auditor j is treated as an industry specialist Auditor Independence There is no agreement on how to measure the Auditor independence. Prior studies have used a number of variables: fee ratio (non-audit fee over total fee), total fees, and separate audit and non-audit fees. In this study, because the data related to non-audit fees are unavailable, the natural log of audit fees are used as the opposite criterion of audit independence. Large (small) values of audit fees imply poor (good) Auditor independence Control Variables We control for variables that have been identified in prior literature as likely to affect the reporting of discretionary accruals such as firm size, operating cash flows, growth prospects and leverage. Large firms are less likely to engage in earnings management due to more scrutiny from financial analysts and investors (Zhou and Elder, 2001). Becker et al (1998) and Reynolds and Francis (2001) report cash flow from operations influences corporate management actions in managing earnings. In addition, researchers such as Skinner and Sloan (2002) and, Matsumoto (2002) suggest that firms with higher growth prospects are more likely to manage earnings. Finally, Leverage is included as prior studies show that firms with a higher likelihood of violating debt agreements are

5 81 International Research Journal of Finance and Economics - Issue 66 (2011) more likely to have an incentive to engage in earnings management to increase earnings (Healy and Palepu, 1990; Sweeney, 1994) Regression Model A linear-multiple regression analysis was used to test the association between the dependent variable of Discretionary accruals and the independent variables of Audit Quality. The following model is estimated: DAi,t= β0+ β1 AudSIZEi,t + β2 SPECi,t + β3 AudINDi,t + β4ocfi,t+ β5 GWTHi,t+ β6sizei,t+ β7levi,t+ε i, t ε i, t Where, for sample firm i at the end of year t: DA= Discretionary Accruals estimated using Modified-Jones Model. AudSIZE = dummy variable, 1 if the firm is audited by a Big 4 auditor, 0 otherwise. SPEC= dummy variable, 1 if MS > 20 percent, and 0 otherwise. AudIND = auditor independence defined as log of firm s total audit fees. OCF= operating cash flows divided by total assets at fiscal year-end. GWTH = growth prospect defined as the market value of equity divided by book value of equity. SIZE = firm size defined as natural log of firm s total assets. LEV = ratio of total debt to total assets. εε i, t = the error term. 4. Results and Discussion 4.1. Descriptive Statistics Table I presents a summary of descriptive statistics of the dependent and independent variables used in the study. The mean (median) value for discretionary accruals (DA) is (0.896) percent of the sample are audited by the Big 4 auditors. The mean (median) audit fee is IRR m (IRR m) and it ranges from IRR71m to IRR m.On average, 63 percent of the firms are audited by industry specialists. as shown in Table I the mean (median) value of ratio of total debt to total assets is (0.735); this result suggests that about 71 percent of total assets of Iranian listed firms are financed by debt, this is consequently suggests that Iranian listed firms operate with high level of financial leverage Regression Results Table II presents the results of testing the Association between Audit quality measured by three different proxies namely: Auditor Size, Industry specialist auditors and Auditor independence with earnings management measured by Discretionary Accruals. To investigate the existence of multicollinearity, the variance inflation factors (VIFs) for each of the independent variables are computed. As reported in column 5 of Table II, VIFs for the explanatory variables are always below 2.0, suggesting that multicollinearity is not likely to be a major factor driving our results. Table I: Descriptive statistics for all variables Variables N Mean Median Minimum Maximum Std. Deviation DA AudSIZE SPEC Audit Fee( s) AudIND OCF GWTH SIZE LEV Notes: DA-Discretionary Accruals estimated using Modified-Jones Model; AudSIZE-dummy variable, 1 if the firm is audited by a Big 4 auditor, 0 otherwise; SPEC-dummy variable, 1 if MS > 20 percent, and 0 otherwise; AUDFEEtotal audit fees (in IRR million); AudIND-auditor independence defined as natural log of firm s total audit fees; OCF-operating cash flows divided by total assets at fiscal year-end; GWTH-growth prospect defined as the market value of equity divided by book value of equity; SIZE-firm size defined as natural log of firm s total assets; LEVratio of total debt to total assets.

6 International Research Journal of Finance and Economics - Issue 66 (2011) 82 As shown in this table, the Adjusted R 2 of percent gives confidence in the explanatory power of the model. The coefficient of AudSIZE in the Model is negative, as expected, and is significant at the 0.01 level. This result indicates a significant negative relationship between auditor size and Discretionary Accruals; the analysis thus supports H 1. The SPEC coefficient in the Model is also negative, as predicted, and statistically significant at the 0.05 level, which indicates a significant negative relationship between industry specialist auditors and Discretionary Accruals; hence H 2 is also supported. As shown in Table II, The coefficient for AudIND is negative, as expected, and is significant (at the 0.05 level). This result supports our hypothesis of the negative association between auditor independence and Discretionary Accruals. The control variables, GWTH, and LEV are positively and significantly associated with Discretionary accruals that was expected and is in line with prior research. We also find that the larger the firms, the lower the Discretionary Accruals, suggesting that Large firms due to more scrutiny from financial analysts and investors are less likely to engage in earnings management. On the other hand, the coefficient of OCF is not statistically significant at the 0.05 level; this indicates that OCF has no significant effect on DA. Table II: Multiple regression results Explanatory variable Expected Sign Coefficients t-statics Collinearity Statistics VIF Intercept? * AudSIZE ** SPEC * AudIND * OCF? GWTH * SIZE ** LEV * Adjusted R F-value Durbin Watson P-value of F-test Notes: * statistically significant at the <5 percent level, one-tailed test;** statistically significant at the <1 percent level, one-tailed test; AudSIZE- dummy variable, 1 if the firm is audited by a Big 4 auditor, 0 otherwise; SPEC- dummy variable, 1 if MS > 20 percent, and 0 otherwise; AudIND-auditor independence defined as log of firm s total audit fees; OCF-operating cash flows divided by total assets at fiscal year-end; GWTH-growth prospect defined as the market value of equity divided by book value of equity; SIZE-firm size defined as log of firm s total assets; LEV - ratio of total debt to total assets. 5. Conclusion A vast literature investigates the implications of Audit quality since the seminal work of DeAngelo (1981). Most of these studies investigate these implications in the developed countries, very little is empirically known about such implications in emerging or transition economies such Iran. The study investigates the impact of audit quality on earnings management of listed firms in Iran, as one of emerging or transition economies. Based on a sample of 540 firm-year observations from the TSE for fiscal years 2004 to 2009, and using three measures of Audit quality (AudSize, SPEC, and AudIND), the study finds that Auditor size is negatively associated with the earnings management measured by DA, thus indicating that firms which use big 4 auditors will engage in less earnings management than firms with non-big 4. Our results are consistent with those of Zhou and Elder (2003) and Chen et al (2005) that suggest, the big-5 auditors are associated with reduced management discretion over earnings. We also find that firms audited by industry specialist auditors engage in less earnings management. This is consistent with the findings of Zhou and Elder (2003) and Rusmin (2010) that auditor industry specialists can be used to constrain earnings management.the results from testing the association between the Auditor independence and earnings management suggest that the more an audit firm enjoys from independence,

7 83 International Research Journal of Finance and Economics - Issue 66 (2011) the more the quality of auditing will enhance, which is by itself considered as one of the obstacles for applying earnings management in firms. Like any other research, the present research has also some limitations which seem necessary to be mentioned. First of all, the sample only covers six years of Iranian data and an external validity problem exists that the results may not be so generalizable to cover different periods of time and different locations. Secondly, in the study, the effect of inflation and other economical conditions on the figures related to financial statements and the calculation of discretionary accruals were ignored. Future research should include other factors that may affect the occurrence of earnings management in the firms such as corporate governance mechanisms. References [1] Balsam, S., G.V., Krishnan and J.S., Yang, Auditor industry specialization and earnings quality, Auditing: a Journal of Practice & Theory, Vol. 22, No. 2, pp [2] Becker, C.L., M.L., DeFond, J., Jiambalvo and K.R., Subramanyam, The effect of audit quality on earnings management, Contemporary Accounting Research, Vol. 15, No. 1, pp [3] Cahan, S., B., Chavis and R., Elmendorf, Earnings management of chemical firms in response to political costs from environmental legislation, Journal of Accounting, Auditing & Finance, Vol. 12 No. 1, pp [4] Chen, K.Y., K., Lin and J., Zhou, Audit quality and earnings management for Taiwan IPO firms, Managerial Auditing Journal, Vol. 20, No. 1, pp [5] Craswell, A., J., Francis, and S., Taylor, Auditor brand name reputations and industry specializations, Journal of Accounting and Economics, Vol. 20, No. 3, pp [6] Datar, S.M., G.A., Feltham, and J.S., Hughs, The role of audits and audit quality in valuing new issues, Journal of Accounting and Economics, Vol. 14, No. 1, pp [7] DeAngelo, L.E., Auditor size and audit quality, Journal of Accounting and Economics, Vol. 3, No. 3, pp [8] Dechow, P., R., Sloan and A., Sweeney, Detecting earnings management, The Accounting Review, Vol. 70, No. 2, pp [9] DeFond, M. and K., Subramanyam, Auditor changes and discretionary accruals, Journal of Accounting and Economics, Vol. 25, pp [10] Dunn, K. A., and B.W., Mayhew, Audit firm industry specialization and client disclosure quality, Review of Accounting Studies, Vol. 9, PP [11] Dunn, K., B., Mayhew and S., Morsefield, Disclosure quality and auditor choice, Working paper, CUNY-Baruch. [12] Dye, R., Earnings management in an overlapping generations model, Journal of Accounting Research, Vol. 26, Autumn, pp [13] Francis, J., and J.K., Reynolds, Does size matter? The influence of large clients on office-level auditor reporting decisions, Journal of Accounting and Economics, Vol. 30 (December), PP [14] Francis, J.R., E.L., Maydew and H.C., Sparks, The role of big 6 auditors in the credible reporting of accruals, Auditing: a Journal of Practice & Theory, Vol. 18, No. 2, pp [15] Frankel, R. M., M. F., Johnson and K.K., Nelson, The relation between auditors fees for nonaudit services and earnings management, The Accounting Review, Vol. 35, No. 1, pp [16] Guidry, F., A., Leone and S., Rock, Earnings-based bonus plans and earnings management by business unit managers, Journal of Accounting and Economics, Vol. 26, pp [17] Hall, S. and W., Stammerjohan, Damage awards and earnings management in the oil industry, The Accounting Review, Vol. 72, No. 1, pp

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