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    Client Importance and Earnings Management: The Moderating...
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 04.03 Non-Audit Services, 13.0 Governance, 13.05 Board/Audit Committee Oversight 
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    Title:
    Client Importance and Earnings Management: The Moderating Role of Audit Committees
    Practical Implications:

    The results of this study have implications to both New Zealand and the United States. Regulators in New Zealand should assess these results as possible indications that the profession’s self-regulated status may need to be revised in light of the existence of lower financial reporting quality for clients that have weak audit committee oversight and are economically important clients to the auditor. Additionally, these results provide evidence to contribute to the ongoing debate in the United States regarding the merits and the intended and unintended consequences of independent auditor oversight through regulatory bodies such as the PCAOB.

    For more information on this study, please contact Vineeta D. Sharma.
     

    Citation:

    Sharma, V., D.S. Divesh, and U. Ananthanarayanan. 2011. Client importance and earnings management: the moderating role of audit committees. Auditing: A Journal of Practice and Theory 30 (1): 125-156.

    Keywords:
    audit committee; auditor independence; accruals; corporate governance; fees, earnings management; non-audit
    Purpose of the Study:

    As a result of declining investor confidence in the quality of financial information due to financial scandals, many countries have implemented corporate governance reforms that specifically identify the audit committee as the primary mechanism for the oversight of auditor independence and financial statement quality. This study investigates how the association between the economic importance of a client to the auditor and earnings management is moderated by the audit committee. Client importance is a potential threat to auditor independence and thus is a potential threat to audit quality. The authors suggest that the possibility exists that auditors may view the audit wealth provided from a client as more important than maintaining independence which is determinant of the audit quality; therefore, the authors examine if there is a positive correlation between client importance and earnings management. Certain circumstances, such as management ownership, leverage, high growth, and firm size, could potentially promote an environment that is conducive to earnings management independent of the external audit. In consideration of these circumstances, the auditors studied whether the association between client importance and earnings management was effected by these firm environmental factors. The audit committee’s response and efforts to mitigate these factors were also examined, specifically in light of the best practices recommendations. 

    Design/Method/ Approach:

    The authors conducted this study by gathering empirical evidence from firms listed on the New Zealand Stock Exchange in the fiscal years 2004 and 2005. The NZSE was chosen as a proper natural laboratory because there is no ban or limit on non-audit services, no mandate on the roles and composition of the audit committee exists, the audit profession is self-regulated, it is a less litigious environment, and it is geographically and economically small.

    Findings:
    • A positive correlation was observed between client importance and the observed proxies for earnings management, which included both performance-adjusted discretionary total and current accruals. This implies that as client importance, as related to the wealth production to the external auditors, increases the possibility of the existence of earnings management in the financial statements also increases.
    • The association became more pronounced for income-increasing accruals that potentially diminish the quality of earnings and are of greater concern to regulators; however, this was moderated by the audit committee.
    • The association between client importance and earnings management is conditional on other firm characteristics such as inside ownership, growth, leverage, and firm size. These factors could create potential agency conflicts but are moderated by the audit committee.
    • Accounting expertise on the audit committee and committees composed completely of outside directors explain the moderating effects of the audit committee.
    • The association with earnings management became more pronounced when the audit committee did not meet the best practices outlined by the NZSEC. These practice suggestions from the NZSEC are merely recommendations, not requirements, as the auditing profession is self- regulated in New Zealand.
       
    Category:
    Governance, Independence & Ethics
    Sub-category:
    Board/Audit Committee Oversight, Impact of Fees on Decisions by Auditors & Management, Non-audit Services