Audit Quality: Earnings Management in the Context of the 1997 Asian Crisis by Shireenjit Johl* Multimedia University Christine A Jubb Monash University Keith A. Houghton Australian National University January 2003 Draft only: Please do not quote without permission Address for Correspondence: Associate Professor Christine Jubb, Department of Accounting and Finance, Faculty of Business and Economics, Monash University, Berwick. Vic. 3806. Phone +61 3 9904 7102. Fax +63 3 9904 7100, email: [email protected] Audit Quality: Earnings Management in the Context of the 1997 Asian Crisis ABSTRACT This study assumes that evidence regarding audit quality can be derived from the level of earnings management reflected in reported abnormal or discretionary accruals. Given this assumption, audit quality is examined in the context of the 1997 Asian financial crisis using data from Malaysia. Examining audit quality in its association with earnings management across differential macroeconomic periods provides insights that may be otherwise masked. The period of the crisis is partitioned between pre-crisis (1994-1996), crisis (1997-1998) and post-crisis (1999). Using a robust approach to the measurement of abnormal accruals, the association of Big 5/non-Big 5 and Industry Specialist/Industry non-specialist auditors with both the levels of, and change in levels of, abnormal accruals is investigated across and within the crisis sub-periods from 1994-1999. Audit quality is found to be associated with abnormal accruals, and differentially so across macroeconomic period with greater constraint evident post-crisis. Key Words: Audit quality, Earnings management, Auditor size, Auditor industry specialization, Asian financial crisis. 2 Audit Quality: Earnings Management in the Context of the 1997 Asian Crisis 1.0 Introduction In any capital market auditors play a vital role in the issuance of high quality financial reports. The question of whether auditors adequately play this role in enhancing credible reporting received much attention in Asia during and after the 1997 Asian Crisis, and more recently with the very public collapses of major corporations both in the United States (US) (eg Enron and WorldCom) and elsewhere (eg HIH in Australia). Against this backdrop, this study investigates audit quality by examining earnings management behaviour of auditees during periods of discernibly different macroeconomic condition – the pre and post 1997 Asian Crisis as experienced in Malaysia. During economic crisis, auditors are placed under heightened strain and public scrutiny since the likelihood of corporate failure increases. During the Asian Crisis, the World Bank questioned the quality of audits by Big 5 auditors operating in Asia . Many East Asian corporations, having received clean audit reports from Big 5 auditors, subsequently demonstrated that those opinions may not have been appropriate (Accountancy, 1998). This study hypothesises that clients of quality auditors (Big 5 and/or Industry Specialist auditors) report lower earnings management compared to clients of other auditors both across the Asian economic crisis and within identifiable sub-periods of pre- and post- crisis. Regulators, the accounting and auditing profession, standard setters, and the business community at large will benefit from better understanding the mechanisms of earnings management and differential audit quality within clear periods of economic upturn and downturn. The Malaysian economy during the period 1994-1999 provides an opportunity to examine this audit quality issue within a macroeconomic environment that exhibits distinguishable pre-crisis, crisis and post-crisis sub-periods. 2.0 Motivation 2.1 Macroeconomic risk-incentives Asare and Davidson (1995) point out the need to investigate the effect of macreconomic information on auditors’ judgement, but few studies attempt to do this. Cohen, Krishnamoorthy and Wright (2000) find that auditors generally concentrate on financial trends as opposed to non- financial trends in establishing the overall level of audit scope, whilst non-financial information is 3 generally used as corroborating evidence. In addition, they find that when financial information indicates a decline and is substantiated by non-financial information, auditors appear to extend the level of audit scope beyond the normal level. Within the existing earnings management-audit quality literature, to date no published study examines the effects of macroeconomic condition on auditor behaviour. Yet macroeconomic condition affects other commercial behaviour. For instance, Matolcsy (2001) finds no relation between changes in management cash compensation and changes in measures of corporate performance during periods of economic downturn, but a significant positive association during periods of economic growth. 2.2 Gaps within the existing audit quality differentiation-earnings management literature Examining evidence from a period in which managers are likely to engage differentially in manipulation of accounting accruals provides a robust setting for investigating whether better quality auditors ‘see through’ accounting distortions and constrain this activity. Prior results of both experimental (eg Hirst 1994; Hackenbrack and Nelson 1996; Phillips 1999) and archival (eg Becker, DeFond, Jiambalvo and Subramanyam 1998; Francis, Maydew and Sparks 1999; Francis and Krishnan 1999) studies suggest auditors are alert to aggressive earnings management and that Big 5 auditors are associated systematically with lower levels of accruals. It is important to investigate whether this apparent influence on earnings management is robust across macroeconomic condition (upturn, downturn and recovery). Additionally some of these cited studies find evidence consistent with auditors being more conservative in circumstances favouring income-increasing accounting methods. However, it is unclear whether auditors exert similar levels of audit attention in situations favouring income-decreasing methods. In a period of economic decline, some companies are likely to favour income-decreasing accruals and so this study provides evidence in relation to this important issue also. 2.3 Audit Quality Proxies Used in Prior Studies Prior studies investigating the relationship between audit quality and earnings management use auditor size as a proxy for audit quality. This study extends prior research by examining the relationship between industry specialist auditors, a finer measure of audit quality than auditor size alone (Craswell, Francis and Taylor 1995), and earnings management. The differential level of audit quality exhibited by industry specialist auditors is expected to be more pronounced during periods of economic downturn as these auditors compared to non-specialists are expected to have 4 heightened insight into the industry implications and to be more efficient in identifying errors and misstatements. 2.4 Regulatory and Environmental Factors Ball, Kothari and Robin (2000) argue that and provide evidence for differences in the demand for accounting earnings information in different institutional environments causing its properties – timeliness and conservatism - to vary internationally. They find that code-law reported income (France, Germany and Japan) is substantially less timely and less conservative than common-law reported income (Australia, Canada, UK and US). In a related study of four East Asian countries (Malaysia, Hong Kong, Singapore and Thailand), Ball, Robin and Wu (2000) show that reported earnings in these countries generally lack transparency with respect to timeliness in incorporating economic income, particularly negative economic income or “bad news”. Given Ball, Kothari and Robin’s (2000) findings, earnings management can be expected to be more pronounced in environments that have more rather than less flexibility in choice of accounting policies. It has been argued that flexibility in accounting standards leads to ambiguity in implementation (Bayless, Cochrane, Harris, Leisenring, McLaughlin and Wirtz 1996). The practice by many South East Asian countries, including Malaysia, of modifying International Accounting Standards (IASs) to suit local conditions (known as creating ‘IASC-lite’), has lead to questioning of the ‘credibility’ of those standards (Ravlic, 1999: 49). The existence of flexibility and subjectivity in accounting procedures and policy choices provides greater room for earnings management and heightens pressure for negotiation between management and the auditor on the application of appropriate Generally Accepted Accounting Principles (GAAP). Additionally the public sanctioning auditors face for alleged audit failure is virtually non-existent in South East Asia compared with the West (Favere-Marchesi 2000). Understanding whether factors found important to the level of earnings management and audit quality provided in the West translate to the East provides additional motivation for this study. The remainder of this paper is organised as follows. The next section discusses briefly the Malaysian corporate and regulatory background, followed by discussion of the relevant audit quality and earnings management literature, and then by hypotheses development. Model development, the selection and measurement of variables, sample selection and information regarding data collection follow next. Results are then reported with conclusions, implications and suggestions for future research appearing in the last section. 5 3.0 Background Malaysia