Accounting Horizons American Accounting Association Vol.25,No.2DOI:10.2308/acch-10025 2011
pp.315–335品牌推广计划
Is Enhanced Audit Quality Associated with Greater Real Earnings Management?
Wuchun Chi,Ling Lei Lisic,and Mikhail Pevzner SYNOPSIS:We examine whether firms resort to real earnings management when their
ability to manage accruals is constrained by higher quality auditors.In ttings involving
strong upward earnings management ,for firms that meet or just beat
earnings benchmarks and firms that issue asoned equities,we find that city-level
auditor industry experti and audit fees are associated with higher levels of real earnings
management.We find similar,albeit weaker,results for the Big N auditors.Our paper
suggests an unintended conquence of higher quality auditors constraining accrual
earnings management,namely,firms resorting to potentially even more costly real
earnings management.We also find that longer auditor tenure is associated with greater
real earnings management,which could suggest merits of mandating audit firm rotation.
Keywords:real earnings management;audit quality;industry experti;auditor tenure;
audit fees.
表示笑的四字成语JEL Classifications:M40;M41.
INTRODUCTION
海尔洗衣机不脱水
I n this paper,we examine the association between audit quality and real earnings management.
Prior literature suggests that higher quality auditors reduce the level of accrual earnings management (Becker et al. 1998;Johnson et al. 2002;Balsam et al. 2003). We argue that, as a conquence of constrained accrual earnings management,clients of higher quality auditors likely resort to more real activities manipulation.Thus,we expect that higher audit quality is associated with higher levels of real earnings management whenfirms have strong incentives to manage earnings.
Prior rearch suggests that accruals and real activities are two alternative ways to manage earnings (Roychowdhury 2006;Cohen et al. 2008;Zang 2007). While earlier studies focus on
Wuchun Chi is a Professor at National Chengchi University.Ling Lei Lisic is an Assistant Professor and Mikhail Pevzner is an Assistant Professor,both at George Mason University.
We thank Dana Hermanson(the Editor),two anonymous reviewers,and the workshop participants at George Mason University and Peking University for their helpful comments and suggestions.Wuchun Chi acknowledges thefinancial support from National Science Council(99-2410-H-004-061)and Mikhail Pevzner acknowledges summer rearch grants from George Mason University’s Provost and Accounting Advisory Council.All errors are our own.
Submitted:March2010
换岗暧昧故事Accepted:November2010
Published Online:June2010
Corresponding author:Ling Lei Lisic
Email:llisic@gmu.edu
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accrual earnings management (Jones 1991; Teoh et al. 1998), more recent papers suggest that firms also engage in real earnings management (Roychowdhury 2006; Kim et al. 2010; Cohen and Zarowin 2010). Real earnings management potentially impos greater long-term costs on shareholders than accrual earnings management becau it has negative conquences on future cash flows and might hurt firm value in the long run (Roychowdhury 2006; Cohen et al. 2008;Cohen and Zarowin 2010). Such long-term costs are driven by temporary price discounts or more lenient credit terms that lower margins on future sales, reductions in valuable investments in rearch and development and SG&A activities,and/or increasing investments in unneeded inventories via inventory over-production (Roychowdhury 2006; Gupta et al. 2010). Cohen and Zarowin (2009) also find evidence that firms engaging in real earnings management over-invest,which could adverly affect firms’ long-term prospects.
However,managing real activities is less costly to managers becau it is less likely to draw auditor or regulatory scrutiny (Cohen et al. 2008). Real earnings management, as long as it is properly disclod in the financial statements,cannot influence auditors’opinions or regulators’actions (Kim et al. 2010). Hence, managers could prefer real earnings management to accrual earnings manageme
nt (Roychowdhury 2006).
思考的艺术Zang (2007)documents that accrual earnings management and real earnings management function as substitutes.Thus,we expect that firms are more likely to engage in more extensive real earnings management when their ability to manage accruals is constrained.We can also derive this prediction from the theoretical work of Ewert and Wagenhofer (2005),who model shows that firms resort to real earnings management when their accounting flexibility is reduced.One way to reduce a firm’s accounting flexibility is to engage an auditor who is less agreeable to earnings management.1Prior rearch shows that higher quality auditors are more successful in constraining accrual earnings ,they constrain accounting flexibility of managers.Conquently,higher audit quality could be associated with higher levels of real earnings management among firms with incentives to manage earnings.
Recent work by Reichelt and Wang (2010) shows that auditor industry specialization is a critical indicator of audit quality.In particular,clients of such auditors have lower discretionary accruals and are less likely to just meet analyst expectations. Other studies also find that industry expert auditors are associated with lower likelihood of being involved in Securities and Exchange Commission (SEC) enforcement actions (Carcello and Nagy 2004) and lower probabilities of restatements (Roma
nus et al. 2008). Prior rearch also suggests that audit firm size (Big N versus non-Big N)is another indicator of audit quality.Studies find that the Big N auditors charge higher audit fees (Craswell et al. 1995), and they are associated with lower absolute value of discretionary accruals (Becker et al. 1998) and higher ERCs (Teoh and Wong 1993). Thus, we focus on the two auditor characteristics,namely,auditor industry experti and audit firm size,and examine their association with levels of real earnings management.
Following Reichelt and Wang (2010), we measure auditor industry experti as the audit fee market share of each auditor in each industry at both the national level and the city level.We measure audit firm size as a Big N versus non-Big N indicator. Following Roychowdhury (2006)and Cohen et al. (2008), our proxies for real earnings management are estimates of a firm’s abnormal cash flows,abnormal inventory production,abnormal discretionary expenditures,and a summary measure combining the three components.
We focus on a sample of 925firm-year obrvations from 2001to 2008that likely have strong incentives to manage earnings upward (identified ex post or ex ante ),i.e.,firms that meet/just beat one 1Other possible ways are introductions of less flexible accounting standards or more stringent governance mechanisms.
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of the earnings benchmarks(zero earnings,previous year’s earnings,and analyst forecasts)andfirms that issue asoned equity offerings.Our primaryfinding is that within that sample,city-level auditor industry experti is associated with higher levels of the overall real earnings management index and each of the components of the real earnings management ,lower levels of abnormal cash flows,higher levels of abnormal production,and lower levels of abnormal discretionary expenditures. We alsofind that the Big N auditors are associated with higher overall levels of the real earnings management index and lower levels of abnormal cashflows.When we u audit fees as an alternative measure of audit quality in additional analys,wefind similar ,higher audit fees are associated higher levels of real earnings management.Collectively,ourfindings are consistent with our prediction that higher audit quality is associated with higher levels of real earnings manage
ment forfirms that have strong incentives to manage earnings.In addition,wefind that longer auditor tenure is associated with higher levels of real earnings management at both the overall level and the individual component level amongfirms with incentives to manage earnings.2Finally,wefind that the positive association between city-level industry experti and real earnings management measures is significantly stronger in the upward earnings management sample than in the sample lacking of such ,all samples excluding the upward earnings management sample).
Our paper contributes to the literature by demonstrating thatfirms adapt to the prence of more stringent levels of auditing by engaging in real earnings management.Past auditing rearch has exclusively focud on accrual earnings management when examining the impact of audit quality on the clients’behavior.Our paper suggests that an unintended conquence of higher quality auditors constraining accrual earnings management is that clients resort to higher levels of real earnings management,which is potentially more costly to the shareholders in the long run.Furthermore,our findings regarding the positive association between auditor tenure and real earnings management shed additional insights into the long and heated debate of whether auditfirm rotation should be mandated (American Institute of Certified Public Accountants [AICPA] 1978, 1992; U.S. Hou of Reprentatives Sarbanes-Oxley Act [SOX] 2002; General Accounting Office [GAO] 2003; Cox 2006)
. Past rearch has exclusively focud on accrual earnings management when analyzing the benefits/costs of mandatory auditor rotation (Johnson et al. 2002;Myers et al. 2003; Davis et al. 2009). Our results alert regulators and rearchers that mandating audit firm rotation could potentially reduce real earnings management, a benefit that has not been documented in prior rearch.
Our paper proceeds as follows.The cond ction reviews the literature and develops our hypothes.The third ction discuss rearch design.The fourth ction describes our sample. Thefifth ction prents empirical results.The sixth ction contains additional analys.Finally, the venth ction concludes.
LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT Prior rearch suggests thatfirms manage both accruals and real activities to maximize their valuations,avoid negative contracting conquences such as violations of debt covenants,and/or
2Our results complement Cohen and Zarowin (2010), who examine firms that issue asoned equities only and, in one of the tests,find that the Big8auditors and auditor tenure are associated with the probability of clients’overall levels of real earnings management index being above the sample m
edian. However, we note that Cohen and Zarowin (2010)do not consider the impact of auditor industry experti, which, according to the results in Reichelt and Wang (2010), is a dominant audit quality measure. In addition, our paper considers a broader t of incentives for real earnings management, including but not limited to asoned equity offerings. Finally, we study individual components of real earnings management, in addition to the composite index studied in Cohen and Zarowin (2010). In addition, a contemporaneous study, Yu (2008), examines national-level auditor industry experti only andfinds a positive relation with real earnings management.We take a broader view and u multiple proxies for audit quality.Wefind that city,but not national,level industry experti is associated with greater real earnings management.
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avoid negative regulatory conquences.While earlier papers focus more on accrual management (e.
g., Jones 1991; Teoh et al. 1998), more recent papers suggest real activities manipulation for objectives similar to accrual earnings management. In particular, Roychowdhury (2006) finds that firms manage real activities to avoid missing earnings targets. Cohen and Zarowin (2010) report that firms engage in real earnings management in the year of asoned curities offerings (SEO)to avoid SEO under-pricing. Kim et al. (2010) find that firms engage in greater real activities manipulation when they are clor to debt covenant violations.
The departing assumption of our paper is that among firms with incentives to manage earnings,accruals and real earnings management are substitutes.When costs of accrual earnings management are higher,ceteris paribus ,firms are more likely to engage in real earnings management. In particular, Zang (2007) and Cohen et al. (2008) suggest that the prence of more stringent litigation and regulatory regime drives firms to real earnings management.This happens becau real earnings management does not involve direct violation of any laws or regulations,as long as the outcomes of real earnings management are properly disclod in the financial statements.This reasoning suggests that firms might switch from accrual earnings management to real earnings management when opportunities of accrual earnings management are constrained.Consistent with this argument, Ewert and Wagenhofer (2005) show analytically that whe
n accounting standards are ,when accounting flexibility is reduced,firms tend to resort to real earnings management. Cohen et al. (2008) provide initial empirical support to Ewert and Wagenhofer’s (2005) model. SOX has impod greater regulatory scrutiny on firms and,potentially, reduced their accounting flexibility. Cohen et al. (2008) find that, conquently, firms engage in less accrual earnings management,but more real earnings management post-SOX.An alternative way to reduce accounting flexibility is to engage an auditor less agreeable to accrual earnings management. Hence, we examine whether firms, conditional on incentives to manage earnings,resort to real earnings management when their auditors are of higher quality.
We focus on two auditor characteristics that proxy for higher level of audit quality: auditor industry experti and audit firm size.A wide literature suggests that auditor industry experti enhances audit quality and, thus, credibility of financial reporting. Craswell et al. (1995) find that audit specialists command higher fees. Knechel et al. (2007) find that firms audited by specialists receive higher valuations, and Dunn and Mayhew (2004) find that the firms have better disclosure quality. Balsam et al. (2003) and Krishnan (2003) find that auditor industry experti is associated with lower levels of accrual earnings management.In addition to lower accruals,Reichelt and Wang (2010)show that auditor industry specialization is associated with lower likelihood of clients just meeting analyst e
xpectations. Griffin et al. (2009) suggest that industry expert auditors have a greater propensity to issue going-concern opinions. Carcello and Nagy (2004) find that industry expert auditors are less likely to be involved in SEC enforcement actions. Romanus et al. (2008)find clients of industry expert auditors have lower probabilities of restatements.
The literature also recognizes that the Big N auditors provide higher quality audits and offer greater credibility to clients’ financial statements than the non-Big N auditors. Nichols and Smith (1983) find that the stock market reacts more favorably when a client switches to a Big N auditor than when it switches to a non-Big N auditor. Lennox (1999) suggests that the Big N auditors give more accurate signals of financial distress in their audit opinions. Craswell et al. (1995) document that the Big N auditors charge an audit fee premium over the non-Big N auditors.Studies also show that clients of the Big N auditors have lower absolute values of discretionary accruals (Becker et al.1998) and higher ERCs (Teoh and Wong 1993). Firth and Smith (1992) find that clients of the Big N auditors incur less IPO underpricing than clients of the non-Big N auditors.
Thus,bad on prior findings that industry expert auditors and the Big N auditors constrain their clients’ability to manage earnings via accruals,we expect that their clients will resort to more real earnings management given incentives to manage earnings.Hence,our prediction is:
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H1:Audit quality,as operationalized by auditor industry experti and the prence of a Big N auditfirm,is associated with higher levels of real earnings management amongfirms with incentives to manage earnings.
RESEARCH DESIGN
We focus on contexts in which the literature has shown thatfirms have strong incentives to manage earnings upward.We identify thefirms ex post asfirms that meet or just beat earnings benchmarks(zero earnings,previous year’s earnings,and analyst forecasts)and ex ante asfirms that issue asoned equity offerings. Following Roychowdhury (2006), we define firms as meeting or just beating zero earnings benchmarks if their net income scaled by total asts at the beginning of the y
ear falls into the interval [0, 0.005]. We similarly define firms as meeting or just beating previous year’s earnings benchmarks if their change in net income scaled by total asts at the beginning of the year falls into the interval between[0,0.005].3Finally,we definefirms as meeting or just beating analyst forecasts if their actual annual EPSfigures reported by I/B/E/S are larger than the most recent connsus analyst forecasts before earnings announcements by one cent or less (Roychowdhury 2006). Following Gupta et al. (2010), we define firms as issuing asoned equity offerings if Compustat reports a nonzero data item SSTK.4 To maximize the sample size, we pool allfirms that satisfy at least one of the four conditions for upward earnings ,firms meeting or just beating one of the three earnings benchmarks or issuing asoned equity offerings.
国学入门We follow Roychowdhury (2006) and Cohen et al. (2008)in defining our proxies for real earnings management. As in the two papers, we consider abnormally low levels of cash flow from operations and discretionary expens,and abnormally high levels of production costs as indicators of upward real activities manipulations.Our estimations of abnormal cashflow(Abn_CFO), abnormal production costs(Abn_Prod),and abnormal discretionary expens(Abn_Discexp) follow Cohen et al. (2008). Specifically, we calculate Abn_CFO as residuals of regression Model (A),which is estimated by year and industry identified using two-digit SIC code:
CFO it=Asts i;tÀ1=a1tð1=Asts i;tÀ1Þþa2tðSales i;t=Asts i;tÀ1Þ
þa3tðD Sales i;t=Asts i;tÀ1Þþe itðAÞwhere CFO is cashflow from operations.
五年级数学试卷We similarly calculate Abn_Prod as residuals of regression Model(B):
Prod it=Asts i;tÀ1=b1tð1=Asts i;tÀ1Þþb2tðSales i;t=Asts i;tÀ1Þ
þb3tðD Sales i;t=Asts i;tÀ1Þþb4tðD Sales i;tÀ1=Asts i;tÀ1Þþe itðBÞwhere Prod is sum of cost of goods sold and change in inventory in year t.
Finally,we calculate Abn_Discexp as residuals of regression Model(C):
Discexp it=Asts i;tÀ1=c1tð1=Asts i;tÀ1Þþc2tðSales i;tÀ1=Asts i;tÀ1Þþv itðCÞwhere Discexp is the sum of advertising expens,R&D expens,and SG&A expens.
Also,following Cohen et al.(2008),we develop a comprehensive measure of real earnings management by combining the three individual measures.Specifically,we compute REM_Index as the sum of the three standardized individual ,Àstandardized Abn_CFOþ3Widening the intervals for definingfirms as meeting or just beating zero earnings and previous year’s earnings benchmarks to[0,0.01]or[0,0.02]generates very similar results.
4Following Cohen and Zarowin (2010) and Gupta et al. (2010), we measure asoned equity offerings in year t,
<,in the same year as our real earnings management measures.Our results are robust to measuring asoned
equity offering in year tþ1to examine real earnings management in anticipation of asoned equity offerings. Is Enhanced Audit Quality Associated with Greater Real Earnings Management?319
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