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The Effect of Audit Quality on Earnings Management

Posted: 4 Dec 1997  

Connie L. Becker

affiliation not provided to SSRN

Mark L. DeFond

University of Southern California - Leventhal School of Accounting

James J. Jiambalvo

University of Washington - Michael G. Foster School of Business

K.R. Subramanyam

University of Southern California - Leventhal School of Accounting

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Abstract

This study examines the relation between audit quality and earnings management. Consistent with prior research, we treat audit quality as a dichotomous variable and assume that Big Six auditors are of higher quality than non-Big Six auditors. Earnings management is captured by discretionary accruals that are estimated using a cross-sectional version of the Jones (1991) model. Prior literature suggests that auditors are more likely to object to management's accounting choices that increase earnings (as opposed to decrease earnings) and that auditors are more likely to be sued when they are associated with financial statements that overstate earnings (as compared to understate earnings). Therefore, we hypothesize that clients of non-Big Six auditors report discretionary accruals that increase income relatively more than the discretionary accruals reported by clients of Big Six auditors. This hypothesis is supported by evidence from a sample of 10, 379 Big Six and 2, 179 non-Big Six firm-years. Specifically, clients of non-Big Six auditors report discretionary accruals that are, on average, 1.5 to 2.1 percent of total assets higher than the discretionary accruals reported by clients of Big Six auditors. Also, consistent with earnings management, we find that the mean and median of the absolute value of discretionary accruals are greater for firms with non-Big Six auditors. This also indicates that lower audit quality is associated with more "accounting flexibility."

JEL Classification: M49, M43, M41

Suggested Citation

Becker, Connie L. and DeFond, Mark L. and Jiambalvo, James J. and Subramanyam, K.R., The Effect of Audit Quality on Earnings Management. Contemporary Accounting Research, Vol 15, No 1, Spring 1998. Available at SSRN: https://ssrn.com/abstract=44835

Connie Lynn Becker (Contact Author)

affiliation not provided to SSRN

No Address Available

Mark DeFond

University of Southern California - Leventhal School of Accounting ( email )

Accounting Building, Room 206
Los Angeles, CA 90089-0441
United States
213-740-5016 (Phone)
213-747-2815 (Fax)

James J. Jiambalvo

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States
206-543-9132 (Phone)
206-685-9392 (Fax)

K.R. Subramanyam

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States
213-740-5017 (Phone)
213-747-2815 (Fax)

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