Earning management remains as the main issues concern by the investors, analysts and public in all over the world. The awareness of earning management activities is become increasing after Enron case in the USA and World Com issues as well as HIH in Australia (Johl.S , Jubb.C.A and Houghton K.A., 2007). Beside, audit quality also being questionable and concern after all these scandals and theoretical research shows that quality audit plays in important role in order to avoid and mitigate earning management activities Chen K.Y et al, (2005).
Beneish M.D, 2001 had cited the definition of earning management by Schipper, 1989 as the intention of interference in the external financial reporting process with the purpose of gaining some personal benefit by adjusting reported earnings in the company. In the other hand, according to Guidelines on Audit Quality, 2009, "quality" of audit is defined as the extent to which a set of inherent characteristics of an audit fulfils requirements. This may include the significant of audit tasks, reliability of audit findings, objectivity and clarity of audit opinion, the scope and timeliness of audit performance and the most important is the efficiency and effectiveness of the audit activities and its findings.
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The main objective of this study is to examine the relationship between audit quality and earning management in the respect of cross country studies. This paper is organized as follows. The next section discusses the previous literature studies on earnings management and audit quality. This is followed by cross countries study on relation to the audit quality and earning management in different perspective such as earning management measurement in term if audit quality (size and industry expert) and interference of the investors as well as the earning management practice during IPO process. This study may include the discussion from Europe, Malaysia and Taiwan and the paper ends with a conclusion and discussions.
2.0 LITERATURER REVIEW
Many previous scholars' studies on the relationship between audit quality and earning management practice. Earning Management is the strategy done by the managers to gain an incentive by manipulating the earning in the company. The quality of the financial results is being open to discussion where the financial statement users believed that the profitability of the company's is associated with the manager's compensations. According to Hirst (1994), if the auditors expect and believe that managers have inducement to do earning management activities, result shows that high possibilities of the existing of material misstatement in the financial statements might be occurred.
Therefore, the perception on the quality of financial reporting will be judge on the auditor's responsibilities where the audit qualities are significant towards constraining the earning management activities. It is because; the prevention of misleading financial reporting is one of the main roles that should be performed by the auditors. Earning management is being practice in the companies by manipulating the earning figure either increase earnings or income decreasing accounting (Krishnan, 1999). Managers in the companies increase the reported earning before going to public in order to gain higher share price. They tend to engage in earning management activities because they are trying to establish higher marker price and increase their company's reputation (Ebrahim A., 2001). Beside that, Krishnan, 1999 also argue that the quality of audit performed will be used to determine aggressive earning management activities. Johl. et.al. (2007) describe audit quality is measured is dependent on auditor quality as the ability to detect and willingness to report material manipulation/misstatements giving rise to material uncertainties or/and going concern problems. Thus previous study suggested that Big 4 and non Big 4 audit firms has significant different in measuring the earning management which most on client with Big 4 engage lesser in earning management compared to those company with non Big 4 audit firms (Maijoor S.J and Vanstraelen.A, 2006, Johl. et.al. 2007).
2.2 Audit Quality
Measurement of audit qualities is varies among the audit firm either Big 4 or non-Big 4 companies. According to Tendeloo B.V. and Vanstraelen A. (2005) and Carlin, Finch, and Laili (2008), previous scholars basically use the dichotomous Big 4 or non-Big 4 audit variable to capture audit quality differences.
Many of the studies show that the quality audit is based on the auditor's size which it referring to the numbers of client they had and the fees they earned ( Ebrahim A. 2001 and (Maijoor S.J and Vanstraelen.A, 2006). This had been supported by Salleh Z, Stewart J and Manson S. (2006) where they found that the auditee size as measured by revenues is found to be associated with audit fees as they need to performed grater audit effort. Ebrahim A. (2000) added that most of the companies who involved in earning management are come from the non-big auditing firm's client comparing to the clients of the big auditing firms. This has been supported by Tendeloo B.V. and Vanstraelen A. (2005) and (Maijoor S.J and Vanstraelen.A, 2006) where the result shows that larger audit firms are anticipated to be likely to perform high-quality audits. With effective audit, they are able to identified the probably of material misstatement and can constraint the earning management activities. Moreover, Big firm company will performed high quality audit because they will facing high possibilities to lose in terms of clients and audit fees in case of an audit failure. Thus, larger audit firms has ability provided that a larger restriction on earnings management.
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On the other hand, one could argue that, larger audit firm depending on their international reputation and brand, hence could enhance the demand from clients to seek services and opinion from Big 4 audit firms (Tendeloo B.V. and Vanstraelen A., 2005). The high demand from the client is could be due to the incentive and the resources that the Big 4 had from where they can supply high quality audit. Thus it shows the size of audit firms also has significant impact towards the client choice and will reflect to the earning management activities (Johl. et.al. 2007).
Beside the size of audit firms, most of the client especially from the private company believed that Big 4 audit firm had auditor's expert in the scope of industry performance. This issue had been highlighted by Krishnan. G.V, (2003) where he notices that audit quality also can be measure by the auditor's industries expertise. From here we can see that, auditors who had good experience in industry will lead to perform high quality audit as well as the ability to detect any fraudulent activities by their clients. Industry experienced by the auditors will enhance ability to detect fraud (Krishnan. G.V, 2003). Audit effectiveness performed by the auditors normally associate with the audit quality where it is depending on the accuracy of auditor's free error frequency knowledge (Krishnan, 2003). He added that by gaining industrial experiences, Big firms can further enhance the credibility and quality of accounting information.
Nevertheless, based on the experienced gain in the industries, many of the Big 4 auditors will become a specialist auditor. This specialist auditors are expert in detecting any fraudulence action and able to discover any signal of financial distress in the client's financial statements. As a result, specialist auditor has ability to detect and constrain earning management activities as well due to the availabilities of the resources, industry expertise and incentive that they had (Krishnan, 2003). However, the studies conducted by Chen K.Y et al, (2005) found that not all the industry specialist auditors come from Big 4 companies.
In the respect of audit fees, there are some different between the fees charged by the Big audit firm and non-audit firm. This may due to the different numbers of clients and complexity of the audit activities (Johl. et.al. (2007). Big 4 companies charged higher fees because of their reputation and the availabilities of the specialist auditors. This is one of the reasons why the specialist auditor charge higher audit fees because of their ability to mitigate and constraint earning management activities better than non-specialist auditors (Krishnan, 2003).
3.0 CROSS COUNTRY STUDY ON AUDIT QUALITY AND EARNING MANAGEMENT
The study done by Tendeloo B.V. and Vanstraelen A., 2005 shows the relationship between earning management and audit quality in respect of evidence from the private segment market. The countries involved in this study are Belgium, Finland, France, Netherlands, Spain, Germany and the United Kingdom. The companies used in this study included This country had been choosing by Tendeloo B.V. and Vanstraelen A, 2005 is based on to the availability of financial data and audit firm data. However, the major concern in this study focuses on three countries which are UK, France and Germany. Maijoor S.J and Vanstraelen.A, (2006) reported that descriptive statistics on the magnitude of abnormal working capital accruals in France, Germany and the UK. The result suggests that the magnitude of earnings management is the highest in Germany, followed by the UK and France. This is based on the strictness of audit quality regime in that country.
The result from this study by Tendeloo B.V. and Vanstraelen A., 2005 divided into two categories which is individual earnings management measures and aggregate earnings management measure for the different industry-country groups. The result shows that industry groups with a Big 4 auditor have a lower aggregate earnings management measure compared to non-Big 4 auditors. Means that companies with Big 4 auditors less involved in earning management compare to those companies with non-Big 4 auditors. Similar result goes to the individual earning management where Tendeloo B.V. and Vanstraelen A., 2005 observe that there are a similar pattern for the earnings smoothing measures and one earnings discretion measure. This result is consistent to the previous finding by Johl. et.al. (2007), Krishnan, 2003 and Maijoor S.J and Vanstraelen.A, (2006) where most of the Big 4 auditors are associated with a significantly lower absolute value of abnormal working capital accruals compared with non-Big 4 auditors, and also with a significantly lower magnitude of income-increasing and income-decreasing earnings management compared with non-Big 4 auditors. This again will reflect the audit quality performed by Big 4 auditors and their ability to constraint earning management activities. The ranking of the most significant audit quality different in Europe countries goes to UK followed by Germany which the audit quality difference is less significant and the differences between Big 4 and non-Big 4 auditors are smaller. However, in Frances, there are no significant differences between Big 4 and non-Big 4 auditors (Maijoor S.J and Vanstraelen.A, 2006).
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Besides that, Tendeloo B.V. and Vanstraelen A., 2005 also examine on earning management measures in the perspective of audit quality, legal protection and investor orientation. All earnings management measures seem to be significantly interrelated with each other. For audit quality is significantly negatively correlated with aggregate earning management and earnings smoothing but is not significantly correlated with earnings discretion measure. This is also had been revealed by Hirst (1994) where the management ability to make discretionary accrual is limited. However, the result in reflect to the audit quality with the legal protection shows that the companies residence in countries with strong legal protection and poor investor orientation has significant to constrain earning management activities. This has been supported by (Maijoor S.J and Vanstraelen.A, 2006) where it found that the strong audit quality difference in the UK could be explained by the fact that the UK has a much stronger investor protection environment compared to France and Germany. As a result Big 4 audit firm conservatism appears to be present only in the UK, and not in France and Germany.
In contrast, the result is not significant for companies domiciled in countries with weak legal protection and a strong investor orientation. In general, Big 4 auditors do not give the impression to impose a stronger constraint on earnings discretion compared to non-Big 4 auditors, while companies in countries with a strong legal protection engage significantly less in earnings management. In the same way, companies with a Big 4 auditor has a significant constraint on earnings management if there had legal protection while this constraint is not significant for companies with a non-Big 4 auditor. On the other hand, for companies with a non-Big 4 auditor shows a significant constraint on earnings management if there are investor orientation while this constraint is not significant for companies with a Big 4 auditor. Hence, while audit quality and legal protection appear to be complement, audit quality and investor orientation seem substitutes.
Moreover, Tendeloo B.V. and Vanstraelen A., 2005 also conducted sensitivity analysis where they found that when using the aggregate earnings management measure and earnings discretion as dependent variable, audit quality differentiation is enhanced in countries with a high tax alignment. Comparing with countries with a low tax alignment, the result shows private companies with a Big 4 (non-Big 4) auditor engage significantly less (more) in earnings management activities.
From here we can see that there are significant differences in the degree of earnings management across countries (Maijoor S.J and Vanstraelen.A, 2006) where companies in the UK and France involved significantly less in earnings management compared to Germany. This could be due to a stricter audit environment in UK and France which can reduce on average the extent to which companies engage in earnings management.
A study conducted by Johl. et.al. (2007) examined that high levels of absolute abnormal accruals and earning management activities is associated with the audit opinion and audit quality. In Malaysia perspective, Johl. et.al. (2007) argued that Malaysian companies provide a setting "less transparent with low levels of public inquiry" compared to the West. This could be due to the tendency of auditors to issue a qualified audit opinion when earning management is not constrained. Hasnan. S, Abdul R, and Mahenthiran (2000) revealed that Malaysia was among the top ten countries that falls under the category of most earnings aggressive group and one of the three East Asian countries (i.e. Malaysia, Hong Kong, and Singapore) have by far the worst earnings management ratings compared to other countries.
In Malaysia, the non-Big 5 (now Big 4) audit a similar proportion of listed companies to that featured in some US studies where with respect to the market for audit services in Malaysia in 1998, most of private companies were audited by the Big 5 (now Big 4) companies (Johl. et.al. 2007). Auditor quality has significant impact toward the financial statement reporting as the auditor will qualified the report. There were three forms of qualified opinion in Malaysia - "except for"; adverse; and disclaimer opinions (Johl. et.al. 2007, p.14). These types of qualified opinion being raised depending on the material misstatement in regards to the limitation of scope of the audit; disagreement with management regarding the financial report (including inherent uncertainty not adequately disclosed); and a limitation on the scope of the audit (ISA 700), respectively (Johl. et.al. 2007, p.14).
Compared to other auditors, Big 5(now Big 4) or known as industry specialist auditors is expected to frequently issue qualified audit opinions as the level of unjustifiably high-abnormal accruals increases ceteris paribus (Johl. et.al. 2007). The finding on the audit quality presented by Johl. et.al. 2007 are being categories into three phase considering financial crisis 1997; pre-crisis, crisis and post-crisis. This is because in Malaysia, the numbers of fraudulent financial reporting cases reported increased over the period of the financial crisis in 1997-1998 (Hasnan. S. et, al, 2000). During pre-crisis, there are lower percentage of opinions issued are qualified comparing to the higher qualified opinion on post-crisis and during crisis. This type of opinion is greater than the adverse or disclaimer type opinion as per expected.
On the other hand, audit quality differences between Big 5(now Big 4) and non-Big 5(now Big 4) companies also show different audit opinion. Most of the Big 5(now Big 4) client received qualified opinions more frequently than non-Big 5 clients. However, during crisis and post financial crisis 1998, the issues highlighted on unqualified opinions are frequently being raises.
In respect to the earning management, the results prove that absolute abnormal accruals for observations receiving a qualified opinion are being higher than for those with unqualified opinions during pre-crisis (Johl. et.al. 2007). Nevertheless, the finding post and crisis periods seem to indicate that qualified opinions issued are largely associated with negative abnormal accruals indicating possible "big-bath" activity that is most probably due to financial distress or performance related.
With regards to audit quality, most of the Big 4 performed high audit quality where they details in conducting audit tasks. Malaysia companies result are similar to the previous studies which the companies who used serviced from the Big 5(now Big 4) are received qualified opinion and less contribute in earning management activities (Johl. et.al. 2007, Tendeloo B.V. and Vanstraelen A., 2005 and Krishnan, 2003). On the other hand, companies with small from or non-Big 5 will possibilities to received unqualified opinion and have higher potential to do abnormal accruals which directly contributed to earning management activities. The findings indicate a differential level of audit quality displayed by auditors contingent on auditor size.
Moreover, politically linked companies in Malaysia also have significant contribution towards the audit quality. In general, politically linked companies receive frequent qualified audit opinion and report less than non-politically linked companies. This could due to the ability of the managers of politically linked companies in avoiding a qualification due to their political influence during the auditor-client interaction/negotiation. This will led to higher possibilities of earning management activities but being able to be hidden from the public knowledge. Thus, the auditors unable to provide truth judgments and has difficulties to mitigate the earning management activities due to political influence and pressure.
Similar finding with UK, in Malaysia the auditor conservatism rationale may also be in place due to the possibility of heightened litigation risk post-crisis (Maijoor S.J and Vanstraelen.A, 2006, and Johl. et.al. 2007). Consequently, there are significantly interaction between opinion and Big 5(now Big 4) which indicates a greater level of auditor conservatism observed. This is implies a differential level of audit qualify exhibited by top-tier auditors.( Johl. et.al. 2007, p. 21).
Although many studies reported that top-tier auditors performed high audit quality, however in Malaysia, it found that some auditors appear more willing to tolerate and accept errors and discrepancies in note form disclosures than in recognized numbers on the primary financial statements (Carlin et al, 2008). Failure to comply with even the most basic elements of financial statement will demonstrating poor quality compliance by the auditors and it will encourage the potential of any unethical act by both parties either auditors as well as the their clients itself. Therefore, auditors show less sensitive on client's intention towards earning management activities (Hirst, 2004).
A study conducted by Chen K.Y et al, (2005) is discussing the relationship between audit quality and earning management in respect of IPO process. According to Chen K.Y et al, (2005), there are some significant difference between Taiwan's procedures in registering IPO process and regulation different with regards to the audited financial reporting compared to comparing to US procedures. One the differences are during the process of signing the auditor's report. In Taiwan, auditor's report need to be signed by two audit partners while only one signature required as representative of audit firms in US (Chen K.Y et al, 2005). There are several reasons that will reflect the earning management in the IPO process which includes the management of the company may increase the earning during IPO process which to ensure increase in price in order to gain greater proceed that would increase company's reputation. Besides, the other reason is IPO firms are being allowed by Accounting Principles Board (APB 20) to change accounting principles in the prospectus as long as financial statements of previous years are restated. This may offer management chances to engage in earnings management activities (Chen K.Y et al, 2005).
In the respect of audit quality and earning management, alike to prior finding, result shows that high audit quality is associated with the earning management practice in Taiwan's companies. "In Taiwan, the big five audit firms are T.N. Soong & Co. (member of Arthur Andersen), PricewaterhouseCoopers, KPMG, Deloitte and Touche, and Diwan Ernst & Young. Due to the Enron scandal and ceased operation of Andersen on August 31, 2002, T.N. Soong & Co. merged into Deloitte and Touche and became Deloitte and Touche on June 1, 2003. The clients of T.N. Soong were also transferred to Deloitte and Touche, which is different from the situation in the US, where Andersen's clients chose other big five or non-big five audit firms as successor auditors"( Chen K.Y et al, 2005, p. 5).
From here we can see that the merger of the audit firm will reflect to the client's choice of their auditors. Therefore, similar to others country, in Taiwan, Big 5 (now 4) auditor are known as high quality auditor while non-Big 4 auditors, especially for those local audit firms are frequently recognized as lower quality auditors. These have been proved where most of the clients choose Big 4 companies in the IPO process (Chen K.Y et al, 2005). This scholar suggested that during IPO process many of Taiwan's company tend to practice earning management where they are trying to increase the share price by manipulating earning figures. Increase in the price of the share is associated with the information provided by that company and it is also significant with the firm's size as well where this scholar informed that large firms employ more in income increasing earnings management in the IPO process. However, Chen K.Y et al, 2005 added that the successful of earning management practice in these companies is depends on whether the market can notice through the earnings manipulation. Moreover, companies with non-Big 4 auditors tend to engage to smooth earning activities where they will manipulate the account by greater income-increasing (decreasing) unexpected accruals. For IPO firms unexpected accruals is lower if used services from big 4 auditors and it will maybe mitigate earning discretions by management. Thus, we can conclude that the size of auditor has signification impact with lower unexpected accruals, constant with the ability of constraining earnings management and providing more accurate information by the high quality auditors.
In the other hand, by looking at the industry specialist auditors, the IPO companies in Taiwan did not well recognized the industry specialization as the important element of audit quality. It is could be due to the condition where Taiwan's audit market is smaller than US. Even though the industry specialist auditors did not well recognized, but there are significant different between industry specialists for Big 4 clients and non-Big 4 clients where only Big 4 client's do highly recognized industry specialist. It is because in the IPO process in Taiwan, this industry specialist auditor is more likely to detect and constrain earnings management.
Based on these three countries, we can see that there are similarities result show in the relationship between earning management and audit quality. In term of constraining earning management activities, the study on these three countries agreed that the Big 4 companies will be able to mitigate and reduce earning management compared to non Big 4 companies. In the respect of specialize industry auditors, most of the Big 4 promote themselves as specialize expert where they are required to perform detailed audit task in order to qualified audit report beside constraining earning management. Beside, as per discussed in Europe cases, if the countries have strong legal protection, the study suggested that the engagement in the earning management activities in lesser. On the other hand, in Taiwan, it shows that the specialize industry auditor does not play significant contribution to earning management activities as Taiwan audit environment is smaller than others countries especially UK. However, the study conducted in Malaysia shows that, the auditors also may sometimes tolerate and accept errors done by the managers in the client company. By doing this, it will encourage the earning management practice. Therefore, further study can be conducted in measuring the relationship of the audit quality and the earning management in different perspectives where may be will look at on the auditors involvement or contribution toward earning management practices.