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In this chapter we will review theories close to the purpose of this research. Key objective of this research is to find out the influence of audit on earnings management. We will also develop the research hypothesis in this chapter.
3.1 Audit Quality in FTSE 100 and AIM Companies
Measuring audit quality is not an easy task. All public limited companies (FTSE companies) are required to have their financial statements audited. The statutory auditor provides stakeholders of the company the assurance regarding the accuracy of the financial statements, the absence of fraud in financial statements and the going concern status.
There is a good chance that agency conflicts may be strong in public firms compared to private firms. This is because ownership and control are highly separated which increases the demand for financial statements for monitoring managers and a high quality audit.
Now the question is how to measure that an audit is of high quality. As part of this research we pointed out the following factors which might be indicator of audit quality -
Size of the audit firm: It is assumed that the big four audit firms conduct high quality audit;
Audit tenure: It is assumed that the more the time spent in auditing the more the quality of the audit would be;
Client significance: Irrespective of other issues when the client company is a significant entity, auditors provide more effort to maintain audit quality;
Audit Fee: Though audit fee has a positive relationship with size of the audit firm, a weak link can be made that high audit fee may make the auditor give up some quality in favour of client management.
In perspective of audit market, audit quality is dependent on (1) the probability that material misstatements and signals of financial distress are discovered and (2) the probability that the auditor will report these misstatements and signals (DeAngelo, 1981).
The procedural capability of auditors or the likelihood that the auditor will find out material misstatements and going concern breaches is often assumed to be invariable across different auditors; audit quality is therefore a function of auditor independence. The auditors would not compromise their independence when there are provisions of litigation and disciplinary actions.
It provides incentives to the auditor to constrain earnings management or issue a qualified opinion when necessary. Other than the sanctions, even controversial actions or disciplinary sanctions damage the auditor's reputation. From this perspective, it is assumed that larger audit firms are less likely to perform low quality audits because they will lose in terms of clients and audit fees in case of an audit failure. Auditor independence is therefore a goodwill capital (DeAngelo, 1981). However, when the risk of audit failure detection and litigation is low, lawsuit and reputation costs of offering a low quality audit are expected to be decreased which lowers the incentives of big audit firms to supply a high quality audit.
According to documentation of various empirical studies (e.g. Maijoor and Vanstraelen, 2006; Francis and Wang, 2008), Big 4 audit firms are less inclined to supply public client firms with high quality audits in countries investor protection is weaker, lower level of enforcement and lower risk of legal action. In private companies, lawsuit and goodwill costs are likely much lower, despite the presence of stronger investor protection or legal enforcement as financial statements of private firms are not scrutinized as much by investors, financial analysts or regulating authorities of stock exchanges (Chaney et al., 2004; Vander Bauwhede and Willekens, 2004).
3.2 Earnings Management in FTSE 100 and Aim Companies
Many studies have investigated earnings quality and its determinants among public firms (see Beatty and Harris, 1998; Beatty et al., 2002; Coppens and Peek, 2005; Burgstahler et al., 2006). Public companies are widely held having little managerial ownership, shareholders have very little insider access to corporate information and shareholders cannot take active role in management. Moreover, their financial statements are widely distributed to the public and are more likely to be influenced by shareholder objectives and managerial performance issues.
The main users of public firms' financial statements are equity investors. To protect the interests of these equity investors, all FTSE companies are required to have their financial statements audited.
Earnings management in public firms deprives the users of financial statements of obtaining reliable information. The responsibility of the statutory auditor is protecting the stakeholders' interests. Them main interest of this research is to find out at what extent audit quality constrains on earnings management in public firms.
3.2.1 Proxy of Earnings Management for FTSE and AIM Companies
According to our discussion in earlier sections, discretionary accruals are very strong measure of earnings management. However for the purpose of simplicity we used a simpler method - ratio of total accruals and total assets. The more the ratio size is the more there is chance of accrual management. This measurement is used to keep the research output simple and understandable to wide group of accountants and non-accounting managers.
Reported earnings number of a firm is typically a focus of the analysts and the media. Aspects other than these in financial statements may be overlooked, despite these items provide valuable information about the quality of firms' reported earnings.
In determining earnings quality, accounting analysis generally relies on subjective input. It's needed to incorporate opinions regarding the scale of accounting accruals: the macro-micro business environment, control, insider trading, opinions of auditors, and fees and management incentives to manipulate financial statement results. Accounting analysis is not a standalone methodology for determining the investment merits of a security. This accounting analysis fits into a larger structure of analysis, which includes strategic examination, financial ratio analysis and valuation analysis.
3.2.2 Earnings Management and Audit Quality
Few prior studies have looked at the relation between earnings management and audit quality. These studies also examined the impact of auditor quality on management incentives to manipulate the reported earnings. Hirst (1994) used an experimental design to verify the effect of auditors' belief that managers may have incentives to manage reported earnings on their expectation of material misstatements in financial statements (Ebrahim, 2001). According to Defond (1993) firms that changed the auditor after a client-auditor disagreement are leveraged highly and more likely to have debt covenant violation. These firms also are more likely to have a decline in reported earnings. The findings also show that in the presence of questionable accounting procedures, this would result in smoothed earnings numbers or flat growth in earnings. However we found very few studies on audit quality and earnings management of FTSE and specially AIM companies.
3.2 Hypothesis Development
In this section we will present the research topics in relevance with the research hypothesis.
3.2.1 Size of the Audit Firm and Earnings Management
It is assumed that big audit firms with many partners have strong structure, method and policy to conduct better quality audit. This is why these audit firms have gone large. Also big auditors are influential and focus client retention based on quality of audit. As a result our first hypothesis is as following -
H1: The size/rank of the audit firm reduces the probability of earning management, i.e., net total accruals/average asset would have a negative relationship with the size of the auditors.
3.2.2 Audit Tenure and Earnings Management
If auditing function takes longer time, the auditors can verify more transactions and there the audit can find out more material information. Thus longer audit tenure can de-motivate both the discretionary and non-discretionary accruals. Therefore our second hypothesis is as following -
H2: Longer audit tenure reduces the probability of both the discretionary and non-discretionary earnings management.
3.2.3 Client Significance and Earnings Management
As we discussed earlier, significance of the client company may encourage the auditors to conduct high quality audit irrespective of the size of the audit firm or audit tenure. Therefore our third hypothesis is as following -
H3: Size and significance of the client may limit the probability of earnings management.
3.2.4 Audit Fees and Earnings Management
Though theoretically there is no direct link between audit fees and earnings management, evidence were found that audit fee can constrain the earnings management or increase the probability of earnings management. Our research hypothesis is -
H4: High audit fee may encourage the auditors to retain its client for long time and work alongside management and allow earnings to be managed. The opposing issue is that lower audit fee may reduce the audit quality and there increases the audit quality.
3.2.5 Auditor's Opinion as Signal of Earnings Management
As we have discussed earlier that auditor expresses his/her opinion on the financial statements. Such opinion should be presented fairly in accordance with relevant reporting framework and states whether the financial statements are prepared in accordance with statutory requirements. Normally, higher magnitude of earnings management should be reflected in auditor's opinion. Therefore our final hypothesis as following -
H5: Auditor's opinion reflects the possibility of earnings management. For example, larger Net Accruals/Average Asset would be reflected in auditor's opinion.