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    Audit Quality and the Trade-Off between Accretive Stock...
    research summary posted June 21, 2013 by Jennifer M Mueller-Phillips, last edited June 21, 2013, tagged 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality, 14.0 Corporate Matters, 14.01 Earnings Management, 14.05 Earnings Targets and Management Behavior 
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    Title:
    Audit Quality and the Trade-Off between Accretive Stock Repurchases and Accrual-Based Earnings Management
    Practical Implications:

    This study provides evidence that is important to corporate governance decisions. The results suggest that hiring a high quality auditor to constrain accruals earnings management may result in management’s use of real earnings management as a substitute. Real earnings management involves potentially costly deviations from “business as usual.” Consequently, it may be important to consider other corporate governance measures aimed at constraining real earnings management concurrently with the decision to hire a high quality auditor. 

    Citation:

    Burnett, B., B. Cripe, G. Martin, and B. McAllister. 2012. Audit Quality and the Trade-Off between Accretive Stock Repurchases and Accrual-Based Earnings Management. The Accounting Review 87 (6): 1861-1884.

    Keywords:
    Real earnings management; stock repurchases; audit quality; audit industry specialization
    Purpose of the Study:

    When managers decide to manipulate earnings they must make a choice about how they will achieve their goal. The two broad methods for manipulating earnings are the manipulation of accounting choices and estimates (i.e. accrual earnings management) and the manipulation of real business practices (i.e. real earnings management). The authors of this study argue that either method could be considered questionable because the intent of earnings management is to mislead investors or influence accounting-based contractual arrangements. The choice between the two methods is of interest because governance activities that are taken to constrain one type of earnings management behavior may result in another.

    This study investigates whether audit quality affects management’s choice between accrual earnings management and accretive stock repurchases when firms manage earnings per share (EPS) to meet or beat analysts’ forecasts. The use of accretive stock repurchases to manage EPS is a type of real earnings management that involves the firm repurchasing shares in order to boost EPS figures. The authors believe that, because this form of real earnings management can be done quickly and with little disclosure, it is a good comparison to accrual management in this scenario. The authors make and test the following hypotheses (stated in null form):

    H1: High audit quality is unrelated to the use of accretive stock repurchases to meet or beat consensus analysts’ forecasts.

    H2: High audit quality is unrelated to the trade-off between the use of accretive stock repurchases and accrual-based earnings management to meet or beat consensus analysts’ forecasts.

    Design/Method/ Approach:

    The authors use data on publicly-traded companies that meet or beat analysts’ earnings forecasts but would have missed these forecasts if they had not managed their earnings. Using this subset of firms, the authors compare companies that hired an industry specialist auditor to those that had a non-specialist auditor. The sample period includes data from years 1989-2009.

    Findings:

    The authors document (1) a positive and significant relationship between having a high quality auditor and employing accretive stock repurchases in order to meet or beat EPS estimates, and (2) a negative and significant relationship between having a high quality auditor and employing accrual-based earnings management in order to meet or beat EPS estimates. The authors claim that these results suggest the use of accruals-based earnings management is constrained by high quality auditors and, as a result, when managers are faced with a high quality audit they employ accretive stock repurchases instead of accrual-based earnings management to meet or beat analysts’ EPS forecasts.

    Category:
    Audit Quality & Quality Control, Corporate Matters
    Sub-category:
    Earnings Management, Earnings Targets & Management Behavior
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