The Effect of Accrual-based and Real Earnings Management by Non-listed Small Firms on Auditor Choices －Focused on Initial External Audited Firms－
Asian Tax Journal Vol. 14 No. 3 (2013), pp. 29-72
Abstract
This paper examines the effect of prior earnings management on choice of external auditor. Using non-listed small companies which received external auditing for the first time, we investigate whether firms with high level of earnings management before external auditing are more likely to prefer audit firms with low quality or not. Most prior studies focus on listed large companies to test the effect of external auditing (Francis et al. 1999). However, business environment and human resources to prepare financial statement for external auditing in non-listed companies are quite different from listed companies. We expect that for non-listed small firms, firms that have high level of earnings management right before external auditing tends to hire non-big audit firms. To test this prediction, we adopt two proxies for earnings management: performance-adjusted discretionary accruals (Dechow et al. 1995) and real manipulation using abnormal operating cash flow from sales, abnormal product cost and abnormal discretionary expenditures (Roychowdhury 2006). In addition, we re-estimate performance-adjusted real manipulation to control firm's performance following Cohen and Zarowin(2010)'s method. This procedure provides more solid results in our analyses. Using 4,163 firm-year observations from 2001 and 2008 in non-listed small companies which are external audited for the first time, we find that the level of earnings management in prior year significantly influences the choice of auditor. Specifically, firms with high level of earnings management measured by real manipulation are more likely to select low quality of audit firms. When it comes to real manipulation measures, firms with high abnormal product cost tend to avoid high quality of audit firms. These results still hold after controlling for various variables that can affect the choice of auditor. However, for performance-adjusted discretionary accruals, firms with high level of earnings management are not affected to the selection of audit firms. This finding suggests that non-listed small firms are more likely to use real manipulation rather than discretionary accruals as a method of earnings management. The findings in this study have contributions as follow. The results of this paper suggest that the level of earnings management before taking external auditing is one of important factors in selection of auditor. This opportunistic behavior may affect credibility of accounting information and thus a firm's long-term performance. Therefore, when a regulation body sets the rule to monitor audited firms, specifically, mandatory audit for non-listed small firms, screening quality and credibility of accounting information produced from non-listed firms becomes a important process. This is very useful and provides a lot of important implications to regulators, investors and creditors who are interested in non-listed companies. Academics can also apply the discussion in this paper for related researches.
Keywords
- non－listed small firms
- initial audit
- selection of external auditor
- audit quality
- discretionary accruals
- real earnings management
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