Understanding earnings quality - MIT Sloan School of Management

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5.4.3 Studies of other auditor characteristics Auditor effort: Direct studies of the effects of auditor effort are generally not possible because effort is unobservable, but experimental settings and surveys provide some evidence on auditor effort. Phillips (1999) suggests that auditors increase their effort when the risk of misstatements is high; accordingly, the presence of auditing can deter financial reporting irregularities (e.g., Schneider and Wilner, 1990). Hirst (1994) finds that auditing judgments reflect earnings management incentives from management buyout and bonus plans, which suggests that an auditor’s ability to detect errors varies with his effort to understand incentives. Nelson, Elliot, and Tarpley (2002) survey 253 auditors from one of the Big-five audit firms who identify 515 experiences of attempted earnings management. The surveyed auditors suggest that they do adjust for attempted earnings management, especially when attempted earnings management increases current-year earnings. Using a unique archival dataset, Caramanis and Lennox (2008) document a significant negative relation between audit hours worked, as a proxy for auditor effort, and discretionary accruals for a sample of audits from Greece. 60 Industry expertise: Krishnan (2003) finds that the magnitude of discretionary accruals is lower for clients of auditors with industry expertise. Litigation risk: In an experiment, Barron, Pratt, and Stice (2001) find that auditors are more likely to adjust errors that overstate earnings than errors that understate earnings, and they are more likely to correct errors when litigation against the auditor of a competitor to the client firm for a similar misstatement resulted in a loss to the auditor. They conclude that auditors are more likely to correct 60 However, an “in-basket” task experiment that asked managers to make discretionary accrual decisions and that varied the manager’s perceptions of internal and external auditor aggressiveness based on fabricated correspondence included in the experimental materials found no support for the hypothesis that internal and external auditors act as a deterrent to aggressive financial reporting (Uecker, Brief, and Kinney, 1981). 105
errors when litigation risk is high. Using archival data, Heninger (2001) finds that shareholder lawsuits against auditors increase with discretionary accruals. Auditor tenure: Johnson, Khurana, and Reynolds (2002) find no evidence that long auditor tenure is associated with low earnings quality, measured by the magnitude of discretionary accruals and the persistence of accruals. Chen et al. (2008) show that audit partner tenure is negatively associated with the magnitude of discretionary accruals in a sample of Taiwanese companies. Revolving-door auditors: Menon and Williams (2004) report that hiring former auditing partners as officers, which they suggest might compromise auditor independence, is associated with two proxies for lower EQ: higher discretionary accruals and a higher likelihood of meeting analyst forecasts. However, using a longer sample period, Geiger, Lennox, and North (2008) find no evidence that such appointments are associated with lower financial reporting quality, as measured by discretionary accruals and the likelihood that the firm is the subject of an SEC enforcement action. 5.4.4 Summary We began this section by discussing the theoretical foundation for the prediction that auditor effort/effectiveness can mitigate accounting misstatements. Auditor effort/effectiveness, however, is unobservable. Evidence from experiments and surveys suggest that greater effectiveness, specifically related to recognizing audit risk and adjusting the audit process, 61 decreases observed earnings management. The most direct empirical proxies for effort/effectiveness such as hours spent auditing and auditor industry expertise, also are negatively associated with earnings management. However, one must use caution when interpreting the evidence that uses indirect proxies for auditor effort/effectiveness such as fees and audit firm size. To mitigate misstatements, auditors must both 61 Uecker, Brief, and Kinney (1981), however, conclude that the perceived aggressiveness of the auditor (both internal and external) does not deter earnings management behavior by management based on a field experiment that employed business managers. 106
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*Title Page/Author Identifier Page/
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Street equity valuation model as ea
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earnings quality proxy is the indep
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of fundamental earnings will be a f
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contributions of the fundamental co
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accruals, in total or individually,
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While we identify these contradicti
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Proxies for asymmetric timeliness b
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sample. Hence, sample specific char
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unintentional misstatements, which
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Empirical studies have examined mul
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there are (in theory) predictable a
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is primarily driven by the firm’s
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methodology. Studies could make uni
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The discussion of earnings persiste
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and documents that β2 < β1, which
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1993). 12 The studies find conflict
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Xie (2001) uses the Jones model (di
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sophisticated investors do understa
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measurement. Nwaeze, Yang, and Yin
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and better reflects revenue manipul
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All of the accruals models can be e
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Second, investors seem to recognize
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fact improve predictability relativ
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lower book values of assets (higher
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than code law countries. The differ
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explain the kink. Durtschi and East
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Hung, M., 2000. Accounting standard
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Kothari, S., Leone, A., Wasley, C.,
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Malmquist, D., 1990. Efficient cont
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Phillips, F., 1999. Auditor attenti
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Tucker, J., Zarowin, P., 2006. Does
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Figure 1. Summary of the investigat
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Figure 3: Key links between determi
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Table 1. Categories of “Earnings
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Exhibit 1: Summary of earnings qual
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Exhibit 2: Summary of widely used m
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