Audit Quality, Earnings Management, and Cost of Equity Capital: Evidence from India

• DOI: http://doi.org/10.1111/ijau.12087
• Author: Muhammad Nurul Houqe,Kamran Ahmed,Tony Zijl
• Published date: 01 July 2017
• Date: 01 July 2017

Audit Quality, Earnings Management, and Cost of Equity Capital: Evidence

from India

Muhammad Nurul Houqe,

1

Kamran Ahmed

2

and Tony van Zijl

1

1

Victoria Business School,Victoria University of Wellington

2

La Trobe Business School,La Trobe University

This study examinesthe effect of audit quality on earnings management and cost of equity capitalof listed companies

in India. Our results show that companies employing a high-quality auditor have a lower degree of earnings

managementand lower cost of equity capital.The results also show that companiesbelonging to business groupshave

a lower degree of earningsmanagement and lower cost of equity capitalthan do stand-alone companies but that they

benefit less from employing a high-quality auditor. Our results are based on a large sample of 7,303 firm-year

observationson listed companies in India and arerobust to alternative measuresfor our main variables –audit quality,

earnings management, and cost of capital –and to tests for endogeneity and the impact of the global financial crisis

(GFC). Giventhe distinctive and unique institutional featuresof the Indian market such as the dominant role of family

business groups in the national economy, large market share of domestic audit firms, less litigious environment, and

less effective professional accounting bodies in checking audit failure, our findings make a significant contribution to

the literature on the role of audit qualityas a corporate governance monitoring mechanism as reflected in the impact

on earnings management and cost of equity capital.

Key words: Audit quality, earningsmanagement, cost of equity capital, Indian stock market,Emerging economy, Big 4

auditor

1. INTRODUCTION

The Indian economy,which used to be state-controlled, has

undergone major restructuring and reforms, including the

liberalization of the corporate sector in the early 1990s.

The restructuring of the economy sparked the growth of a

strong investment culture, reduced the dependence on

state-owned enterprises, and generated a proliferation of

groups of enterprises led by entrepreneurial families. India

is the second largest economy in Asia after China and in

recent years real GDP has grown by around 7.0 per cent.

While there are over 6,000 public listed companies, many

are affiliated with business groups owned by family

entrepreneurs. Chakrabarti, Megginson and Yadav (2008)

estimate that business groups account for 60 per cent of

the largest 500 companies in India and 65 per cent of the

total market capitalization of these companies. Business

groups are a common feature of developing economies

but the degreeof their dominance in India is unique.

In this study, we examine the effects of external audit

quality on earnings management and the cost of equity

capital for listed companies in India. We also examine

whether these effects differ between companies affiliated

to a business group (hereafter ‘group companies’)and

other companies (hereafter ‘stand-alone companies’). We

thus address the aggregate and differential effects of audit

quality on both financialreporting –earnings management

–and the capital market –cost of equity capital. We

measure audit quality by the employmentof an audit firm

affiliated witha Big 4 auditor, earnings quality by absolute

discretionary accruals, and cost of capital by the modified

PEG method. We use a large sample of 7,303 firm-year

observations on listed companies over the period 1998–

2009. Our results show that, subject to certain company-

specific controls, audit quality is inversely associated with

both earnings management and the cost of equity capital.

However, while group companies have a lower degree of

earnings management and lower cost of equity capital

compared with stand-alone companies, group companies

benefit less from employing a high-quality auditor than

do stand-alone companies. The main result confirms the

findings from studies on the effects of audit quality, but

the result of differential effects across the two types of

companies is novel. The latter finding is facilitated by the

unique institutional setting of India. Our results are robust

to the use of alternative measures for our main variables –

audit quality, earnings management and cost of equity

capital –and to testsfor impact of the global financial crisis

(GFC) and for endogeneity.

Although a number of studies have examined the effect

of audit qualityon financial reporting credibility in a range

of countries (Teoh & Wong, 1993; Becker et al.,1998;

Khurana & Raman, 2004; Weber, Willenborg & Zhang,

2008; Chen et al., 2011; Cameran et al.,2015),theresults

cannot be generalized to a country such as India, which

has a distinctive and unique securities market and

institutional setting. For example, studies of the US audit

market assume thatthe effects of audit quality on financial

reporting credibility are uniform across companies (Chen

et al., 2011). In an emerging market context, Chen et al.

(2011) examined the effect of audit quality on earnings

management and cost of capital of state-owned (SOE)

and non-state-owned companies in China (NSOE) and

found that the effect of higher audit quality was greater in

reducing earnings management and cost of equity capital

for NSOEs than for SOEs. However, China’s institutional

setting is significantly different from that of India. In

India, business groups play a major role in the economy

where the ‘promoters’(together with their relatives and

friends) are the dominant shareholders, while in China

state enterprises are the significant players.

Khanna and Rivkin (2001) define a business group as ‘a

set of firms which, though legally independent, are bound

together by a constellation of formal and informal ties

Correspondence to: Kamran Ahmed, Professor of Accounting, La Trobe

Business School, La Trobe University, Melbourne, Vic 3086, Australia.

Email: k.ahmed@latrobe.edu.au

International Journal of Auditing doi: 10.1111/ijau.12087

Int. J. Audit. 21:177–189 (2017)

©2017 John Wiley& Sons Ltd ISSN 1090-6738