One of the key objectives of external audit function is to identify the quality of financial reporting and quality of financial reports drops down when managers try to manage the bottom line - the earning figure. When managers discover that auditors would not be able to identify the degree of earnings management, they try to use this figure to cater their purpose. Therefore a naïve assumption is that probability of earnings management is negatively related with quality of audit. However in this world of complex financial reporting, agency relationship and accounting standards, there are many reasons and many ways for the managers to manage the company earnings. Therefore it needs strong evidence to claim that audit quality has a negative relationship with earnings management.
Tendeloo and Vanstraelen (2008) researched on European private companies, with an assumption that private (non-listed) companies engage more in managing earnings than public companies, and found that the quality of audit constrains earnings management. Researching on FTSE 100 and AIM companies would let us know whether audit quality can do the same thing to public companies.
The main objective of this research is to find out the influence of audit quality on earnings management. The research will also explore -
Establishing single and composite measurement of audit quality;
Establishing simplest indicator of earnings management;
The research will investigate historical information to find out whether auditors opinion reflects management of earnings.
The main difficulty in such research is to use the appropriate measurement of audit quality and also earnings management. Both the variables are of subjective nature and lacks appropriate proxies. Tandeloo and Vanstraelen (2008) assumed the big four audit firms conduct high quality audit. For earnings management measure they used composite discretionary accruals. However, the variables lack quality to strongly defend their findings as there are many ways to manage earnings and many auditors other than big fours conduct quality audits. Ahmed Ebrahim (2001) found a relationship of audit tenure and also client importance with earnings management. While audit tenure is a quantitative variable, client importance is completely a subjective one. The prevalence of too many subjective issues is therefore the key constraint of research on audit quality and earnings management.
This research will investigate the relationship between audit quality and earnings management assuming that audit quality is the independent variable. We also would incorporate audit tenure, audit fees and client importance as independent variable. On the other hand, as measurement of earnings management, we used a simpler method - ratio of total accruals and total assets. We assumed that the more the ratio size is the more there is chance of accrual management. We used this measurement just to keep the research output simple and understandable to wide group of accountants and non-accounting managers.
We also used auditors' opinions in this research to find out whether magnitude of earnings management is reflected by the opinions.
We have chosen twenty FTSE 100 and twenty AIM listed companies for the research purpose. Most of the FTSE 100 companies are the clients of big four auditors. However, AIM companies are clients of auditors other than big fours. We will report our research findings both in two categories and aggregately.
At the end of this research we expect the following outputs
Research Output
Explored Variables
Data
Research Techniques
A relationship between Auditor's Size and Earnings Management
Rank of Auditors and Net Accruals: Average Assets
All 40 Companies (20 of FTSE 100 and 20 of FTSE AIM 100)
Descriptive Statistics and Simple Regression Analysis
Relationship between Audit Tenure and Earning Management
Average Tenure of Audit Activities and Net Accruals: Average Assets
Selective
Simple Regression Analysis
Relationship between Audit Fees and Earning Management
Audit Fees and Net Accruals: Average Assets
Selective
Simple Regression Analysis
Relationship Between Client Significance and Earnings Management
Client significance as 1(FTSE AIM) and 2 (FTSE 100) against Net Accruals :Net Reported Earning
All 40 Companies (20 of FTSE 100 and 20 of FTSE AIM 100)
Descriptive Statistics and Regression Analysis
Influence of Auditor Ranks, Audit Fees, Audit Tenure and Client Significance on Earnings Management
All Explored earlier
Selective
Multiple Regression Analysis
Top Predictor or Earnings Management
Auditor Ranks, Audit Tenure and Client Significance
Findings of Earlier Analysis
Comparison of Degrees of Relationships of Variables Explored
Relationship of Auditors' Opinion with Earnings Management
Rank of Auditors Opinion and Net Accruals: Average Assets
Auditors' Statements (Selective)
Descriptive Statistics and Regression Analysis
The research report starts with an insightful discussion on theoretical perspective of audit quality and earnings management. The literature review section consists of traditional theories about auditing, audit quality and earnings management. In the third chapter we'll introduce contemporary theories and practical perspective of auditing and management of earnings where research objectives and hypothesis will be explored critically. In the fourth chapter we will explore the research methodologies. Finally research findings will be presented in fifth chapter followed by a thorough analysis. Following is a brief outline of the paper -
Chapter
Title
Objective
One
Introduction
An introduction to the research idea/topic
Two
General Literature Review
An understanding of all theoretical perspectives of auditing and earnings management
Three
Relevant Literature Review
A detailed presentation of the research topic and understanding of relevant contemporary theoretical and practical issues
Four
Methodology
An introduction to methods of this research and data to be used
Five
Findings
Summary of statistical analysis
Six
Discussion on Research Findings
Implications of research findings and presentation research outputs
Seven
Conclusion
Discussion on limitations of this research and further scope of research
Eight
