M.S.F.Quehen (383424)
The Impact of Audit Quality on Earnings Management
A Case Study on Japan
Manon S.F. Quehen
383424
Bachelor Thesis
Under the supervision of Agapi-Thaleia Fytraki
International Bachelor of Business Economics
Erasmus School of Economics, Erasmus University Rotterdam
June 2016
Abstract
Earnings management has been one of the most debated topics of all the time in the world of accountancy as well as business. In parallel, the role of the auditor is a raising concern. Furthermore, this inappropriate behavior is observed across the world and Japan is not an exception. This paper aims at assessing the impact of audit quality on earnings management in Japan. In order to measure these terms quantitatively, audit firm size is used as a proxy for audit quality and discretionary accruals is chosen as a proxy of earnings management. The result from this research shows that for Japanese firms, the audit firm size increases the level of discretionary accruals hence auditors are not efficient in preventing earnings management. However, for Japanese corporate groupings (keiretsu), auditors from Big 4 audit firms seem to be able to constrain the level of discretionary accruals, thus preventing earnings management.
Table of Contents
Abstract 2
List of tables 4
Introduction 5
Definition of key terms 8
A. Earnings management 8
B. Earnings management in Japan 9
C. Audit quality 10
D. Audit quality in Japan 11
Literature Review 13
Hypotheses Development 16
Sample selection 19
Research model 23
Empirical results 27
A. Descriptive statistics 27
B. Results 30
C. Additional tests 37
Discussion 41
A. Conclusion 41
B. Limitations 43
C. Future research 43
References 45
List of tables
TABLE 1: Sample descriptive statistics 27
TABLE 2: Regression results models H1 30
TABLE 3: Regression results models H2 32
TABLE 4: Regression results models H3 and H4 35
TABLE 5: Weighted Least Square test for H1 37
TABLE 6: Weighted Least Square test for H3 and H4 39
Introduction
Earnings management has been one of the most debated topics of all the time in the world of accountancy as well as business. The best-known accounting scandal is the case of Enron in 2001. Its damage was severe enough to drive one of the largest companies in the United States into bankruptcy. Moreover, this inappropriate practice has been observed all over the world: In 2003, Royal Ahold was accused for its accounting scandals and was referred as “Europe’s Enron” (The Economist, 2003). Concerning East Asia, Toshiba, a Japanese electronics company was accused in 2015 for an overstatement of profits lasting for several years, which amounted to $1.9 billion (The Walls Street Journals, 2015).
A large body of research tackles the earnings management problem with aim of preventing it (Ayers et al., 2006; Darrough et al., 1998; Herrmann et al., 2003). Since the enforcement of Sarbanes-Oxley Act in 2003 which focused on the importance of auditors and their quality of audit (Balsam et al., 2003), the amount of research on the relationship between audit quality and earnings management has increased (Francis, 2004). However, the results of the research stay diverged since audit markets are country-specific due to the difference in legal practices (Francis et al., 2013). Therefore, the results of previous research cannot be enough to draw a conclusion for every single country, which gives opportunity to further consultation. This paper will particularly focus on Japanese firms in order to assess the impact of audit quality on earnings management, taking into consideration the Japanese business structure, named keiretsu, which is the Japanese corporate groupings[1] (Douthett Jr & Jung, 2001). The research question of the paper is thus:
“What is the impact of audit quality on earnings management for Japanese firms?”
The paper is related to existing research since it assesses the impact of audit quality on earnings management. More specifically, earnings management is represented by discretionary accruals, which is considered to be the “direct” measure proxy of earnings management (Balsam et al., 2003). Concerning audit quality, there are two most common proxies: audit firm size and auditor industry expertise (Balsam et al., 2003; Chen et al., 2011; DeAngelo, 1981; Jeong & Rho, 2004; Krishnan, 2003). Audit firm size indicates whether auditing company of the clients (firm) is from Big 4 audit firms (Deloitte, EY, KPMG, and PwC) or from other country-specific smaller auditing companies. Proponents for this proxy claims that large audit firms have more incentive to provide high quality audit since the damage of losing reputation is bigger than small audit firms (Francis, 2004). Concerning Japan, about 80 percent of the audit market is dominated by the Big 4 auditing companies (Yazawa, 2011). The second proxy, auditor industry expertise is whether the auditor being in charge of the work has enough comprehensive understanding of the industry he is working on (Balsam et al., 2003; Krishnan, 2003). Some existing research claim this measurement to be more credible than audit firm size since the auditor with a more comprehensive understanding is more effective in his auditing practice (Balsam et al., 2003; Krishnan, 2003). However, this paper applies audit firm size as a proxy for audit quality since audit firm size and earnings management are considered to be mutually-dependent (DeAngelo, 1981).
This paper adds value to existing research since in addition to conducting research on Japanese companies related to audit quality and earnings management, it assesses the impact of the presence of Japanese cross share-holdings system, keiretsu. Furthermore, the linkage between the level of discretionary accruals and keiretsu firms are stated in existing papers (Douthett Jr & Jung, 2001). Due to the presence of efficient internal monitoring within keiretsu groupings and higher intention to deliver the financial information with certified quality, keiretsu firms are said to be more eager to detect earnings management compared to non-keiretsu firms (Douthett Jr & Jung, 2001). Thus, this paper also aims at answering the question:
“What is the impact of audit quality on earnings management for Japanese corporate group, keiretsu?”
Definition of key terms
A. Earnings management
Earnings management occurs when managers have sufficient incentives and opportunities to manipulate earning in aim of providing financial reports that look more appealing than the reality (Chen, Chen, Lobo, & Wang, 2011). Ayers, Jiang, and Yeung (2006) claims there is a positive association between earnings management and beating earnings benchmarks, which indicates that managers have an incentive to manage earnings in order to meet the earnings target. Furthermore, earnings management is positively related with analysts’ forecast benchmark (Ayers et al., 2006). Therefore, firms try to beat not only the earnings benchmark settled by themselves but also expectations from other market players.
According to the fraud triangle model developed by Donald Cressey, earnings management (or fraud in broader term) occurs if and only if three conditions, pressure, opportunity, and rationalization are met (Wells, 2001). Pressure indicates that the individual/firm has to perceive pressure that leads them to commit earnings management (Hogan, Rezaee, Riley Jr, & Velury, 2008). Opportunity designates the individual/firm has to find an opportunity that enables them to take the action. And rationalization is the procedure of rationalizing the unethical act the individual/firm is about to conduct. An example that depicts these concepts is the Kanebo accounting scandal in 2004. Kanebo has experienced financial difficulties since the disruption of Japanese bubble economy in the late 1990s (Konishi, 2010). Therefore, the top-managers of Kanebo were under the pressure of boosting earnings of the company (pressure). Furthermore, since ChuoAoyama, the auditor of Kanebo did not object the earnings manipulation of Kanebo, top-managers were able to publish “cooked” financial reports (opportunity) (Konishi, 2010). And the rationalization of these inappropriate acts might have been that top-managers convinced themselves that the whole actions are for the sake of the firm (rationalization). Hence, deleting and detecting the opportunity in this triangle is one of the solutions in preventing earnings management and auditing and its quality plays a crucial role in it (Hogan et al., 2008).
B. Earnings management in Japan
The Japanese accounting system is a combination of the American system and the German system (Darrough, Pourjalali, & Saudagaran, 1998a). However, it also possesses some unique characteristics compared to other countries, which might have different impacts on earnings management.
In Japan, the tax regulation authority specifies the method to be used for tax consideration for recording expenses and allowances. Furthermore, the requirements and allowances for reserves are strict. Therefore even though the managers have incentives to manipulate reported earnings, the cost of manipulation is higher in Japan compared to the United States (Darrough et al., 1998).
Another distinctive aspect is the presence of corporate industrial groupings (keiretsu). Keiretsu firms can be divided into the horizontal keiretsu group and the vertical keiretsu group. Horizontal keiretsu is when the entire group is sharing the same main bank whereas vertical keiretsu is the group of large trading companies including smaller companies (Douthett Jr & Jung, 2001). Currently the six biggest horizontal keiretsu are Mitubishi, Sumitomo, Mitsui, Fuyo, Sanwa, and Dai-Ichi Kangyo group. An example of vertical keiretsu is Toyota Motor Corporation.
Under keiretsu, firms and banks within the same group hold a strongly-tied relationships among each other and there is mutual share-holdings within the group (Darrough et al., 1998; Douthett Jr & Jung, 2001). Hence, the collapse of one firm within the group can strongly damage other members in the same group. In other words, one firm’s failure becomes the whole group’s failure (Herrmann, Inoue, & Thomas, 2003). This implies that firms within the corporate groupings are more eager to protect the firm and the entire group, which leads to the tighter internal control and thus less earnings management (Douthett Jr & Jung, 2001).
C. Audit quality
The role of auditing in general is to ensure the financial statements provided by firms are free from misstatement and the role of the external auditor is to decrease the misrepresentation of financial reports (Prawitt, Smith, & Wood, 2009). In order to decrease this misrepresentation, the quality of audit becomes crucial. According to DeAngelo (1981), the quality of audit service is determined based on two criteria: (1) Whether the auditor is capable of detecting anomalies in the financial reports and; (2) whether he will report in case the anomalies are detected. Hence, providing auditing by itself cannot be sufficient as depicted by the example of numerous accounting scandals such as Enron and the focus has to be on the audit quality (Balsam, Krishnan, & Yang, 2003).
Francis (2004) argues an audit is considered to be of low quality when audit failure occurs. In other words, auditing is said to be of high quality when the auditor manages to certify the credibility to the financial reports he inspects (Teoh & Wong, 1993). However, giving an explicit definition of audit failure is difficult. An audit is said to be a failure under several circumstances: (1) when the auditor/auditing firm is sued, which is called litigation; 2) the auditing firm is investigated by legal institutions such as the SEC (Securities and Exchange Commission); 3) earnings restatements; or 4) business failures (Francis, 2004).
Following numerous accounting scandals by large firms in early 2000s, the audit sector has received harsh criticism due to the inability to prevent them (EY, 2012). Still, Francis (2004) claims that the actual audit failure is rare. Moreover, according to his analysis on existing research, the actual proven audit failure rate in the United States is near zero percent and the litigation rate against auditing firm is around 28 percent (Francis, 2004).
Even though audit failure is not a common phenomenon, high quality of audit is an effective way to discover earnings management (Balsam et al., 2003; Krishnan, 2003a; Krishnan, 2003b). Misstatement of financial reports leads to earnings management and deteriorates the quality of financial information of the company. Misstatement of financial reports affect different business players. Firstly, it brings significant damage to current investors and prevents prospective investors from investing. Furthermore, firms certified with high audit quality provide larger stock returns and reports less earnings management (Krishnan, 2003). In addition, it also decreases the information risk for investors (Chen et al., 2011). Thus, from the investors’ perspective, the quality of auditing is important. Secondly, in case audit firm services low quality auditing, their reputation can be heavily deteriorated (Skinner & Srinivasan, 2012). Therefore, delivering high quality service is primordial for auditing firms. Lastly, in case earnings management comes out, firms incur a large amount of losses and can receive severe sanctions or even in worst case, face bankruptcy, which naturally concerns the firm. In preventing this, firms require to have sufficient and various internal control such as internal auditing and enforcing transparency of information by hiring an external auditor (EY, 2012; Prawitt et al., 2009).
D. Audit quality in Japan
Audit quality has also been in concern in Japan due to several drastic accounting scandals such as Kanebo in 2004 and Livedoor in 2006 (Konishi, 2010). Despite the fact that all listed companies in Japan are required to have an external auditor (Skinner & Srinivasan, 2012), the Kanebo scandal has lead the Japanese regulations authority to settle Japanese Sarbanes-Oxley Act as in the United States, aiming at enforcing audit quality and audit system in Japan (Konishi, 2010).
Currently, Japanese audit standards are consistent with International Standards on Auditing (Yazawa, 2011). Nevertheless, the Japanese audit market possesses some originality. Compared to the United States, Japanese audit market is highly concentrated (Yazawa, 2011) since about 80 percent of the Japanese companies are audited by the Japanese Big 4 firms (Ernst & Young ShinNihon, KPMG AZSA, Deloitte Touche Tohmatsu, and PricewaterhouseCoopers Aarata), which are all affiliated with the international Big 4 firms (Yazawa, 2011). Furthermore, the litigation from audit failure is at almost zero level (Skinner & Srinivasan, 2012). Hence, the primary reason for which auditors provide services with proper quality in Japan is due to the reputation incentive (Skinner & Srinivasan, 2012). This fact is proven from the research conducted by Skinner et al. (2012), on Kanebo accounting scandals. He claims the decrease in audit quality drastically affects a firm’s reputation (Skinner & Srinivasan, 2012). Therefore, there are different factors taken to be into account in assessing the impact of audit quality on earnings management.
Literature Review
The relevant literature to motivate this research are selected based on the top twenty academic journal rankings provided by Alan Lowe et al (2006).