Empirical Research, Audit Quality And Real Earnings Management Relations

Earnings management is quite a common phenomenon in China's listed companies which will undoubtedly affect the objectivity and fairness of financial information. What's more, it will affect the decision-making process of financial information. Certified Accountants and auditors play important role to ensure the authenticity legitimacy and fairness of financial information. Audit opinion is the result of audit quality on the theory, the audit quality should have a close relationship with the solvency,profitability and asset management levels of entities and auditing opinion should be able to effectively control the earnings management. At the same time, variables on earning management should be able to properly reflect the constrain effect of auditing opinion.Prior research suggests that accruals and real activities are two alternative ways to manage earnings. While earlier studies focus on accruals earnings management, more recent papers suggest that firms also engage in real earnings management. Real earnings management potentially imposes greater long term costs on shareholders than accruals earnings management because it has negative consequences on future cash flows and might hurt firm value in the long run. 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 research and development and SG&A activities, and/or increasing investments in un-needed inventories via inventory over-production. However, managing real activities is less costly to the managers because it is less likely to draw auditor or regulatory scrutiny. Real earnings management, as long as it is properly disclosed in the financial statements, cannot influence auditors'opinions or regulators' actions.Because firms choose between accruals and real earnings management, we expect that they are more likely to engage in more extensive real earnings management when their ability to manage accruals is constrained. We derive this expectation from the theoretical work of Ewert and Wagenhofer (2005) whose 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.1 Prior research shows that higher quality auditors are more successful in constraining accrual earnings management, i.e. they constrain accounting flexibility of managers. Consequently, higher audit quality could be associated with higher levels of real earnings management. Prior research suggests that auditor industry expertise and tenure are both associated with proxies of higher audit quality. Studies find that industry expert auditors are associated with lower levels of accruals earnings management, lower likelihood to be involved in the SEC enforcement actions, and lower probabilities of restatements. Although the theoretical link between auditor tenure and earnings quality is somewhat controversial, empirically, most studies find that longer auditor tenure is associated with lower levels of accruals earnings management, lower probabilities of client restatements, and lower incidence of client financial fraud. Thus, we focus on these two auditor characteristics (namely auditor industry expertise and tenure) and examine their association with levels of real earnings management.