This paper studies the relation between audit and earnings quality. It examines whether firms audited by a Big 4 member engage in higher earnings management activities as proxied by the magnitude of discretionary and absolute accruals, as well as an income smoothing measure. The author predicts that large auditors have higher competencies and incentives to deliver a higher quality audit. Therefore, their clients are expected to reveal less sophisticated earnings management and thus higher earnings quality. The results do not support this relation.
Since standardsetters have been concerned about managers’ use of discretion to manage earnings in their financial reports, an increasing amount of empirical research was conducted to address this issue, additionally to regulation. While independent auditors (aim to) assure that these statements are in accordance with legal compliance, the actual audit quality can be grasped as the contingency that the auditor exposes and discloses an anomaly in their clients’ financial reports. Whereas numerous audit scandals threaten the trustworthiness of well-known large auditors, there is various research revealing that Big N audited firms are supposed to disclose financial reports of higher quality.
Supplementing misguiding accrual accounting practices in this regard, this study also addresses another proxy for earnings management: income smoothing. Burgstahler and Dichev (1997) explain corporate income smoothing with the fact that managers avoid revealing earning decreases and losses to diminish costs arising from transactions with stakeholders. Similarly, Degeorge, Patel and Zeckhauser (1999) show that managers smooth earnings to meet analysts’ forecasts.
On the other hand there are various contrary studies. DeFond and Jimbalvo (1993) found that auditor-client disagreements resulting from earnings management, are more present in Big 4 audited firms. They explain this with the properties of the “common” Big 4 clients. For the reason of the ambiguous results, it is interesting to study the effects and compare them with prior evidence to answer the question whether Big 4 auditors deliver “higher” quality in terms of a “better” financial reporting. The terms are operationalized using a dis-cretionary accruals and income smoothing measure and analyzed for (non-)Big 4 audited UK-firms in the period 2005-2011.
Table of Contents
1. Introduction
2. Prior Research and Hypothesis Development
2.1. Audit quality
2.2. Earnings Quality
3. Research Question and Design
3.1. Audit Quality
3.2. Discretionary Accruals
3.3. Income Smoothing
4. Sample and Data
4.1. Sample Composition
4.2. Descriptive Statistics
4.3. Correlations
5. Distributional Properties
5.1. Linearity and Normality
5.2. Heteroskedasticity
6. Empirical Results
6.1. Discretionary Accruals
6.2. Income Smoothing
7. Discussion
8. Conclusion
A. Appendix
B. Description of the formulas
I. Modified Jones Model
II. Income smoothing model
Research Objectives and Core Themes
The research investigates the relationship between audit quality—proxied by whether a firm is audited by a Big 4 member—and earnings quality, measured through discretionary accruals and income smoothing activities. The primary research question addresses whether clients of high-quality auditors exhibit superior financial reporting compared to those audited by smaller firms, specifically testing if such clients engage in less aggressive earnings management.
- Analysis of audit quality and its influence on earnings management practices.
- Application of the Modified Jones Model to estimate discretionary accruals.
- Evaluation of income smoothing as a proxy for earnings management.
- Empirical assessment using quantitative archival data from UK-firms (2005-2011).
- Comparison of financial reporting outcomes between Big 4 and non-Big 4 audited firms.
Excerpt from the Book
1. Introduction
Since a long time that standardsetters have been concerned about managers’ use of discretion to manage earnings in their financial reports, an increasing amount of empirical research was conducted to address this issue, additionally to regulation. While independent auditors (aim to) assure that these statements are in accordance with legal compliance, the actual audit quality can be grasped as the contingency that the auditor exposes and discloses an anomaly in their clients’ financial reports. Whereas numerous audit scandals threat the trustworthiness of well-known large auditors, there is various research revealing that Big N audited firms are supposed to disclose financial reports of higher quality.
Supplementing misguiding accrual accounting practices in this regard, this study also addresses another proxy for earnings management: income smoothing. Burgstahler and Dichev (1997) explain corporate income smoothing with the fact that managers avoid revealing earning decreases and losses to diminish costs arising from transactions with stakeholders. Similarly, Degeorge, Patel and Zeckhauser (1999) show that managers smooth earnings to meet analysts’ forecasts.
On the other hand there are various contrary studies. DeFond and Jimbalvo (1993) found that auditor-client disagreements resulting from earnings management, are more present in Big 4 audited firms. They explain this with the properties of the “common” Big 4 clients.
For the reason of the ambiguous results, it is interesting to study the effects and compare them with prior evidence to answer the question whether Big 4 auditors deliver “higher” quality in terms of a “better” financial reporting. The terms are operationalized using a discretionary accruals and income smoothing measure and analyzed for (non-)Big 4 audited UK-firms in the period 2005-2011.
Summary of Chapters
1. Introduction: Presents the research problem regarding audit quality and earnings management, outlines the study's scope, and defines the research question based on existing literature.
2. Prior Research and Hypothesis Development: Reviews theoretical perspectives on audit and earnings quality, establishing the foundation for testing the influence of Big 4 auditors on financial reporting.
3. Research Question and Design: Details the operationalization of audit quality, discretionary accruals, and income smoothing, and presents the regression models used for empirical testing.
4. Sample and Data: Describes the data source (Worldscope), the selection criteria for the 6,081 final observations, and provides an overview of the sample's descriptive statistics and bivariate correlations.
5. Distributional Properties: Examines the linearity, normality, and heteroskedasticity of the regression residuals to ensure the robustness and validity of the applied models.
6. Empirical Results: Reports the statistical findings from the OLS regressions and t-tests, revealing that the data does not support the postulated hypotheses regarding Big 4 influence.
7. Discussion: Interprets the insignificant results in the context of existing literature, addressing potential statistical weaknesses and institutional factors like the UK audit regime.
8. Conclusion: Summarizes the study’s contributions to external stakeholders and suggests future research directions, such as focusing on specific balance sheet items prone to discretionary activities.
Keywords
Earnings management, Audit quality, Big 4, Discretionary accruals, Income smoothing, Financial reporting, Modified Jones Model, UK-firms, Quantitative research, Earnings quality, Accrual accounting, Audit scandals, Regression analysis, Agency costs, Institutional differences.
Frequently Asked Questions
What is the core focus of this research?
The research examines the impact of audit quality—specifically the distinction between Big 4 and non-Big 4 auditors—on the earnings quality of firms.
What are the primary thematic areas covered?
The main themes include earnings management detection, the role of audit firms in corporate governance, the use of accrual models, and the investigation of income smoothing practices.
What is the central research question?
The study asks whether firms audited by higher-quality (Big 4) auditors produce better financial reporting by engaging in less aggressive earnings management.
Which scientific methods are applied in this study?
The paper uses empirical quantitative research, specifically OLS regression models and two-sample t-tests, utilizing the Modified Jones Model to analyze archival data.
What does the main body of the work address?
The main body systematically develops hypotheses, selects and describes the data, assesses the statistical properties of the model, and performs empirical tests to evaluate the hypotheses.
Which keywords characterize this paper?
Key terms include earnings management, audit quality, discretionary accruals, income smoothing, financial reporting, and Big 4 auditors.
Did the study confirm the expected positive relation between Big 4 auditors and higher earnings quality?
No, the empirical results did not support the hypothesis that Big 4 auditors lead to higher earnings quality; in some instances, the results were even contradictory to the theory.
Why does the author suggest that the UK's regulatory environment might influence these results?
The author notes that institutional differences and the strictness of the UK audit quality regime may render national differences in earnings management more dominant than the impact of the auditor itself.
- Quote paper
- Anonym (Author), 2017, Evidence on the Relation between Audit and Earnings Quality. Do Clients of Higher Quality Auditors Provide Better Financial Reporting?, Munich, GRIN Verlag, https://www.grin.com/document/368367
