Is Enhanced Audit Quality Associated with Greater Real Earnings Management?

ABSTRACT

We examine whether firms resort to real earnings management when their ability to manage accruals is constrained by higher quality auditors. In settings involving strong upward earnings management incentives, i.e., for firms that meet or just beat earnings benchmarks and firms that issue seasoned equities, we find that city-level auditor industry expertise 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 consequence 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 expertise, auditor tenure, audit fees

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.

Source : Wuchun Chi, Ling Lei Lisic, Mikhail Pevzner (2011) Is Enhanced Audit Quality Associated with Greater Real Earnings Management?. Accounting Horizons: June 2011, Vol. 25, No. 2, pp. 315-335.