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Auditor industry specialization and real earnings management

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Abstract

This study examines whether audit partners’ industry specialization could reduce real activity earnings management (RM). We argue that partners with industry specialization can reduce RM because they can better assess their clients’ business risk, and will more protect their reputation than other auditors. However, the extent to which auditors can constrain RM depends on whether the type of RM can affect accruals and internal controls. Focusing on two types of RM, we find that individual audit partners’ industry expertise is negatively associated with overproduction, but do not find evidence that audit partners’ industry specialization reduces firms’ abnormal reduction of discretionary expenditures. Cross-sectional analysis shows that the effect of audit partners’ industry expertise on overproduction is stronger when the firm has better corporate governance and has at least one director with auditor-related experience on the board. These suggest that strong governance and director expertise act as a complement mechanism that facilitates auditors’ communication with corporate managers. Overall, the findings suggest that auditors with industry expertise care about their reputation in detecting accruals and thus put more efforts in constraining overproduction, but not in cutting discretionary expenses.

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Notes

  1. Following Zang (2012), we do not examine abnormal cash flows from operations because real activities manipulation affects this in different directions and the net effect is ambiguous. Specifically, Roychowdhury (2006) points out that price discount, channel stuffing and overproduction will decrease cash flows from operations, while cutting discretionary expenditures increases cash flows from operations.

  2. The traditional model of cost behavior relates costs to changes in demands (Noreen and Soderstrum, 1994). When demand increases (decreases), managers increase (decrease) committed resources to the extent necessary to accommodate additional sales. However, many studies find that managers retain unutilized resources more than what sales demand needs. Self-interested managers may make decisions that maximize their personal utility but are not optimal from the perspective of a firm’s stockholders (Jensen and Meckling, 1976).

  3. Chi et al. (2011) find a positive association between city-level auditor industry expertise (based on a US sample) and real earnings management, concluding that firms resort to higher levels of RM when higher quality auditors constrain accrual earnings management. Our study documents that audit partners’ industry specialization (based on a sample of Taiwanese firms) exert a significant influence incremental to audit firms’ industry expertise in deterring client firms’ RM.

  4. We enquire audit partners from Big4 and they all reach consensus that auditors are concerned about client’s abnormal operating decisions to meet or beat their earnings benchmarks. The results are in line with Kim and Park (2014). For example, one audit partner said, “I know that we are not directly responsible for overproduction. However, the regulators or investors may blame us for not paying attention to the overproduction later on if the client encounters any financial constraints. Overproduction definitely can increase audit risk” Another partner said that” overproduction is linked to the probability of inventory write-downs in the future. It can directly reduce a firm’s value and financial health, which in turn can affect our audit risks.”

  5. We enquire audit partners from Big4 and they all reach consensus that auditors are concerned about client’s abnormal operating decisions to meet or beat their earnings benchmarks. The results are in line with Kim and Park (2014).

  6. For example, suppose a company with total fixed costs of $2,100,000 expects current demand to be 10,000 units, but the company produces 30,000 units of products. Under the sales level of 10,000 units, the company will report cost of goods sold of $700,000 ($2,100,000/30,000*10,000), with $1,400,000 fixed costs being absorbed in the inventory. As a result, the company could report an income of $1,400,000 higher than what would have been reported had the production level been kept at 10,000 units.

  7. Analytical procedures generally involve comparison of current-year account balances to balances of prior periods, evaluation of the financial relationships among accounts, and comparison of current-period account balances and financial relationships with similar information for the industry in which the company operates (SAS 56, AU 329).

  8. As mentioned previously, audit reports in Taiwan are required to be signed by two audit partners. We identify the partner whose signature appears first as the lead audit partner. We focus on lead partners in the analysis because the lead partner typically directs the total effort, interpret the audit evidence and determines the audit report (Chin and Chi 2009). In addition, the lead partner exhibits more hands-on experience during the audit engagement than the concurring partner (Chin and Chi 2009).

  9. We do not control for the office-level specialists because the city offices in Taiwan are mainly located in five cities (Taipei, Hsinchu, Taichung, Tainan, and Kaoshiung) which are not far from each other in the relatively small geographical Taiwan. Besides, the signing auditors are primarily concentrated in the Taipei office.

  10. During our sample period, there were big five during 2000–2002, and big four during 2003–2009. All our results remain qualitatively similar if we conduct all tests using the sample audited by Big N alone.

  11. We also use factor analysis to extract principle components from these six variables and replace GOV with the factor score. The results are qualitatively similar.

  12. This measure is based on the following formula: − 4.803− 3.6 (net income/total assets)  +  5.4 (total debt/ total assets) − 0.1 (current assets/ current liabilities).

  13. In Taiwan, the Securities and Futures Investors Protection center, set up under the Securities Investors and Futures Traders Protection Act, effective on January 1, 2003, is responsible to claim compensation from companies whose investors seek compensation for their losses. For all the cases being accepted by the center, we find that the center files a lawsuit to the auditors for more than 60% of cases. The audit partners in Big4 have claimed that deterioration of the client’s performance can lead to a high probability of litigation against auditors. As investors usually expect an insurance role from the auditors, they are likely to sue auditors for alleged financial losses for which auditors are not directly responsible. The assertion is in line with prior studies (Menon and Williams 1994; Mansi et al. 2004). It is difficult for the Investor Protection Center to identify accrual earnings management that violate GAAP from those that result from RM. Therefore, the RM can increase the auditors’ litigation risks and we cannot see much of substitute between accrual-based earnings management and RM.

  14. In Taiwan, modified opinions include qualified opinion, disclaimer and adverse opinion before 1999. After 1999, the Statement on Auditing Standard No. 33 requires that unqualified audit opinions with explanatory paragraph should be separated from the qualified opinion. Following Lennox (2005), we define unfavorable modified audit opinions as including (1) qualified opinion, (2) disclaimer, (3) adverse opinion, and (4) unqualified opinion with explanatory paragraph for “unfavorable” emphases of matters, such as substantial doubts about going-concern, contractual uncertainties, litigation, income/asset overestimation, unrecorded liabilities, and correction of accounting errors relating to previous years. Clean audit opinions include standard unqualified opinion and modified opinion with “harmless” explanatory paragraph, such as changes in accounting principles and the sharing of audit opinion with another audit firm.

  15. This measure is based on the following formula: − 4.803− 3.6 (net income/total assets) + 5.4 (total debt/total assets)− 0.1 (current assets/ current liabilities).

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Funding

Audrey Wen-Hsin Hsu is appreciated for the research funding by MOST (Ministry of Science and Technology) 110C8389-1 (110-2410H002-063 MY2).

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  1. National Taiwan University, No.1 Sec 4, Roosevelt Road, Taipei, 10617, Taiwan

    Audrey Wen-Hsin Hsu & Chih-Hsien Liao

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Hsu, A.WH., Liao, CH. Auditor industry specialization and real earnings management. Rev Quant Finan Acc 60, 607–641 (2023). https://doi.org/10.1007/s11156-022-01106-3

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