The impact of audit quality on real earnings management in the UK context

• DOI: https://doi.org/10.1108/IJAIM-10-2020-0156
• Published date: 19 March 2021
• Date: 19 March 2021
• Pages: 368-391
• Subject Matter: Accounting & finance,Accounting/accountancy,Accounting methods/systems
• Author: Syed Numan Chowdhury,Yasser Eliwa

The impact of audit quality on real

earnings management in the

UK context

Syed Numan Chowdhury

School of Business and Entrepreneurship, Independent University,

Bangladesh (IUB), Dhaka, Bangladesh, and

Yasser Eliwa

School of Business and Economics, Loughborough University, Loughborough, UK

and Faculty of Commerce, Cairo University, Cairo, Egypt

Abstract

Purpose –The purpose of this paper is to examine whether audit quality influence real earnings

management activities using a sample of UK listed firms that have strong incentives to manage earnings

upward through meeting past year’s earningsas a benchmark in the post-adoption period of International

FinancialReporting Standards (IFRS).

Design/methodology/approach –The authors use a sample of 4,774 firm-year observations of UK

listed firms during the period 2005–2018.Univariate and multivariate analyses have been conducted to test

the associationafter controlling for firm characteristics and institutionalvariables.

Findings –The study reportsthat the presence of Big 4 auditors is significantly andpositively related with

greater levels of sales and discretionary expenses manipulation. Though the authors do not find any

conclusive evidenceon production costs manipulation, the aggregated measure of real earnings management

shows a significantpositive association with the presenceof Big 4 auditors.

Practical implications –The study implies that managers who have incentives to manage earnings

upward around the UK firms take advantageof the accounting flexibility in defining policies while reducing

information asymmetry among the investors to signal better future performance. The approach to detect

earningsmanipulation as described in the auditing standards fails to limit the managerial use of real activities

due to limited scope and unclear guidance.Thus, due to the significant impact on public policies, the results

should, therefore,be of interest to the regulators and standard setters.

Originality/value –To the best of the authors’knowledge, this is the first study that examines the

association betweenaudit quality and real earnings management for the UK all-purposeoperational firms in

sampled datathat just meet past year’s earnings as a benchmark in the post-IFRS period.

Keywords IFRS, Real earnings management, Audit quality, Earnings benchmark

Paper type Research paper

1. Introduction

The purpose of this paper is to contribute to the accounting literature by investigating the

relationship between audit quality and real earnings management. Whilst the extant

literature has mostly investigated the impact of audit quality on accruals earnings

management (Becker et al., 1998;Francis and Wang, 2008;Chen et al.,2011;Persakis and

Iatridis, 2016;Houqe et al.,2017;Alzoubi, 2018), a limited number of studies provide

The authors are thankful for the constructive and stimulating comments received from the editor,

Professor Maggie (Chunhui) Liu, and the two anonymous reviewers.

IJAIM

29,3

368

Received2 October 2020

Revised28 December 2020

Accepted22 January 2021

InternationalJournal of

Accounting& Information

Management

Vol.29 No. 3, 2021

pp. 368-391

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-10-2020-0156

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/1834-7649.htm

evidence on real earnings management (Chi et al.,2011;Alhadab and Clacher, 2018;Choi

et al.,2018). Even though the findings are consistent in prior studies that the presence of a

Big 4 auditor restricts accruals earnings management, it is unclear whether real earnings

management is also constrained by the Big 4 auditors. In this study, we examine whether

the Big 4 auditors influence the managerial use of real activities when the UK firms have

strong incentives to manage earnings upward (i.e. firms that just meet or beat an earnings

benchmark) post the implementationof International Financial Reporting Standards (IFRS).

The UK setting inspires this study in two ways. First,the mandatory adoption of IFRS in

2005 is considered as a major regulatory changein the UK capital market. The cost-benefit

analysis of IFRS adoption has been a prevalent area of empirical studies (Jeanjean and

Stolowy, 2008;Khlif and Souissi, 2010;Doukakis, 2014;De George et al., 2016;Oz and

Yelkenci, 2018). Previous work suggeststhat the implementation of IFRS has decreased the

level of reporting discretion and created managerial opportunities to explore real earnings

management. The disclosure requirementpromotes greater flexibility of accounting choices

due to unclear guidance and subjective estimates, leading to an increase in the managerial

use of real activities (Byard et al.,2010;Capkun et al., 2016;Li, 2019). Second,the UK capital

market presents an interestingsetting to evaluate upward earnings management using real

activities for firms that meet or beat earnings benchmarks. Prior studies (Ball et al.,2000;

Brown and Ngo Higgins, 2001;Beaver et al.,2003)find that the UK firms are subject to less

regulatory scrutiny compare to other common law countries, such as the USA, in which

managers are more likely to achieve target earnings through manipulating accruals or real

activities to avoid reporting a loss or a decline in profit(Zalata and Roberts, 2017).

Athanasakou et al. (2009) find insignificant use of accruals in the UK firms that have

incentives to manage earningsupward, indicating a possibility of managerial dependencein

using real activities than to incur the cost of using discretionary accounting choices. Zhao

et al. (2012) report that firms meeting benchmarks to manage earnings upward achieve

better future performance compare to those that miss the targets. This supports the

signalling argument that managersuse real activities to signal better future performance to

the capital market without impairing firms’value or future growth potentials (Bartov et al.,

2002;Jiang, 2008;Taylorand Xu, 2010).

The extant literature provides inconsistent evidence in evaluating the impact of audit

quality on real earnings management.For instance, Alhadab and Clacher (2018) examine the

UK initial public offering (IPO) firms during the period 1998–2008, comprising financial

information from both the UK generallyaccepted accounting principles and IFRS eras. They

report that real earnings management activities are partially constrained where

discretionary expenses manipulation decreases, and sales manipulation increases in the

presence of a Big 4 auditor. Sitanggang et al. (2019) find opposing evidence on the UK

manufacturing firms, suggesting that managerial use of discretionary expenses increases,

whereas sales manipulation decreases in the presence of enhanced audit quality. Further,

Choi et al. (2018) document the jointeffect of the Big 4 auditors and a country’s legal regime

on real earnings management in a cross-countryanalysis. Using data from 22 countries, the

study reports that strongerlegal regimes are positively, and the presence of Big 4 auditors is

negatively related with real earnings management. This suggests that firms’real earnings

management activities in a strong legal regime are constrained by Big 4 auditors. Whilst

extant studies provide mixed evidence, very little research has explored the association

between audit quality and real earnings management, especially for firms that have strong

incentives to manage earnings upward. To the best of authors’knowledge, there is only one

study by Chi et al. (2011) that examines the impact of audit quality on accruals and real

earnings management in a setting involving the US firms with incentives to meet earnings

Impact of audit

quality

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