Audit Quality, Institutional Environment And Corporate Earnings Management

Earnings management is an old and vital topic in corporate finance, which has three basic forms: accrual-based earnings management, real-activities earnings management and classification shifting. Corporates’ earnings management lessen the reliability of financial statements, mislead the decisions made by stakeholders such as investors, creditors and government, and harm the efficiency of capital market. Current empirical research mainly study earnings management from the view of accrual-based earnings management and real-activities earnings management. No research has ever studied earnings management from the whole view of three forms. Besides, current research rarely focus on the relationship between classification shifting and other two forms. This paper studies how audit quality affects three forms of earnings management and whether it also affects corporates’ choice among three forms of earnings management.As basic environment where capital market works, institutional environment has a significant influence on the effect of audit supervision. This paper studies whether audit quality’ effects on three forms of earnings management differ with institutional environment, so as to reveal the important role institutional environment plays in the function of capital market intermediary organization.Using the data of A-share listed companies from 2007 to 2013 as sample, this paper finds that higher audit quality reduces accrual-based earnings management but raise the extent of classification shifting, while it has no significant effect on real-activities earnings management. Overall, higher audit quality reduces companies’ whole level of earnings management. Furthermore, we find such effects only exist significantly in companies under better institutional environment. Such results suggest several things:first is that higher audit quality mainly reduces accrual-based earnings management and auditors should be more concerned about classification shifting; second is the substitution between accrual-based earnings management and classification shifting; third is that the effects of higher audit quality rely on a good institutional environment.