Abnormal Audit Fees and Earnings Management －Focused on Privately Held Firms－
Asian Tax Journal Vol. 14 No. 3 (2013), pp. 73-121
Abstract
The aim of this paper is to investigate the role of auditing in small private firms. Specifically, this paper investigates the effects of abnormal audit fees on audit quality. We test the effect of audit quality on earnings management. Audit quality is defined as the joint probability that an existing material error is detected and reported by an audit auditor (DeAngelo 1981). The literature suggests that higher audit quality constrains earnings management. The previous studies suggest that higher quality auditors reduce the level of accrual-based earnings management (Becker et al. 1998). Additionally, prior studies suggest that accruals and real activities are two alternative ways to manage earnings (Graham et al. 2005; Roychowdhury 2006). While earlier studies focus on accrual earnings management (Jones 1991; Teoh et al. 1998 etc), more recent papers suggest that firms also engage in real earnings management (Roychowdhury 2006; Cohen and Zarowin 2010; Zang 2012). And then prior research implies that audit quality is affected by audit fees (Park and Choi 2009). In the meanwhile, a number of empirical studies have investigated the role that auditors, and audit quality more specifically, have in this context. However, the evidence so far is by no means straight forward. While most studies on the interaction between agency costs and audit quality investigate large listed firms, Ball and Shivakumar (2005) point out that important differences exist between non-listed (private) and listed firms and that the findings documented for listed firms in the accounting literature do not necessarily extend to private firms. But Lennox (2005) suggests that the monitoring value of auditing may be higher in non-listed firms. Prior studies primarily investigate whether earnings management is related to factors that could impair auditor independence and also its studies have regarded the audit fees as the proxy of the audit quality but prior studies have not examined the relationship between the unusually high or low audit fees and accrual-based earnings management (hereafter AM) or real earnings management (RM) of unlisted firms. This research decomposes actual audit fees into two parts, normal audit fees and abnormal audit fees, and pays attention to the case where abnormal audit fees are excessively high or low. Earnings management is captured by AM (Kothari et al. 2005) and RM (Roychowdhury 2006) as a proxy for unobservable audit quality that can be estimated using a performance－matched AM and RM (Kothari et al. 2005). We expected greater audit quality (i.e., abnormal audit fees) to reduce the extent to which managers report aggressively by high earnings. To test this prediction, we utilize audit fees data from 50,669 firms through year observations between 2004 and 2008 period. The samples are all private firms, December year－end firms, and firms do not belong to banking industry. The data on audit fees are collected from the KICPA database. Other firm－specific financial data is collected from KISVALUE database. The results show that the level of AM or RM of unlisted firms are lower than expected when abnormal audit fees are much higher. Conversely, this implies that excessively low audit fees would deteriorate audit quality, so the results of abnormal audit fees are a strong evidences for audit quality. The contribution of our research is to demonstrate that firms adapt to the presence of more stringent levels of auditing by engaging in accrual-based earnings management and real earnings management. Past auditing research has exclusively focused on accrual earnings management by listed firms when examining the impact of audit quality on the clients’ behavior. Our paper suggests that an unintended consequence of higher quality auditors constraining the levels of AM as well as RM by non-listed firms. Up to now, researches on non-listed firms have not been conducted. Specifically, empirical study on the effect of audit quality by non-listed firms is rare due to data availability. In these points, we expect that this paper can be useful implications for scholars, practitioners, accounting standard setters, and regulators. When it comes to academic field, it is possible to apply this paper for related researches in the future.
Keywords
- Private firms
- Abnormal audit fees
- Audit quality
- Accrual－based earnings management
- Discretionary accruals
- Real earnings management
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