Earnings Management to Avoid Losses and Earnings Decreases and the Auditor’s Response －Some Empirical Evidence on the Private Firms－
Asian Tax Journal Vol. 15 No. 6 (2014), pp. 9-53
Abstract
This study examines how the earnings management behavior in private firms affects auditpricing. Specifically, we investigate whether the auditors receive their fees from their clients whenthe client firms report the small positive earnings or the small earnings increases as identified inBurgstahler and Dichev (B&D, 1997). B&D documents that firms manage their reported earningsto avoid the losses or the earnings decreases, thus increasing the incidence of producing the smallpositive earnings and the small earnings increases. Choi and Kwak (2010) find that firms with thesmall positive earnings or the small earnings increases in private firms have significantly higherdiscretionary accruals than other firms. The purpose of this study is to examine the earnings management perspective of B&D targetingthe non－listed firms in the audit market in Korea. We explore whether the auditors penalize theprivate firms reporting the small earnings and the small earnings increases, thus increasing auditfees as the audit risk. In response to the increased audit risk, auditors probably are doing morework, which also to increase audit fees. The external auditor plays a crucial role in promotingfinancial reporting quality, because auditors lend credibility to accounting information byproviding independent verification of manager－prepared financial statements (e.g., Simunic andStein 1987). In other words, the external audit potentially reduces agency costs between firms(managers) and external parties. For empirical analyses, we employ B&D’s methodology. Thisstudy uses the total 24,565 firm－year observations for the period from 2005 to 2008. Our empirical results present the evidence that when the firms reporting small positive earningsand small earnings increases show significantly lower audit fees respectively, than firms notfalling into the regions, after controlling for other correlated variables. It suggests that auditors notperceive that firms report the small positive earnings in order to avoid losses and the smallearnings increases to avoid earnings decreases. In sum, we conclude that the earnings management regions identified in the cross－sectionaldiscontinuity of earnings distribution around zero presented by B&D have positive impact on audit pricing private firms compared to the firms not falling into the regions. Thus, auditor impose areward rather than give a penalty in terms of the audit pricing. Our evidence is consistent withBradshaw et al. (2001)’s claim that the current audit process is ineffective at warning investorsabout many subtle cases of earnings management. Therefore, our findings provide a crucial insightto various stakeholders of non－listed firms in Korea, such as creditors, credit rating agencies,regulators, government etc., in the sense that the earnings management behaviors of non－listedfirms identified by B&D are priced in the audit market.
Keywords
- Private firms
- Small positive earnings to avoid losses
- Small earnings increase to avoid earnings decrease
- Auditor’s perception
- Audit fee
- Auditor size
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