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  • The Auditing Section
    The Influence of Audit Firm Specialization on Analysts’ F...
    research summary posted April 16, 2012 by The Auditing Section, tagged 11.0 Audit Quality and Quality Control, 11.04 Industry Experience, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Influence of Audit Firm Specialization on Analysts’ Forecast Errors
    Practical Implications:

    The results of this study suggest that industry specialist auditors help constrain management’s tendency to manipulate earnings to achieve certain earnings thresholds.  These results do appear weaker when limiting the analysis to the post-SOX period, which could reflect the significant changes to the auditing market that occurred during and after 2002, but the post-SOX analysis is subject to limited data availability.

    Citation:

    Payne, J. 2008. The Influence of Audit Firm Specialization on Analysts’ Forecast Errors. Auditing: A Journal of Practice & Theory 27 (2): 109-136.

    Keywords:
    auditor specialization; analysts’ forecast error; audit quality
    Purpose of the Study:

    The prior literature shows that analysts’ forecasts provide information to financial market participants.  Also, it shows that managers have incentives to meet or beat analysts’ forecasts because failure to do so could result in negative stock price reactions, reduced compensation, costly legal actions, or all of the above.  However, managers also have incentives to reduce reported earnings down to analysts’ forecasted amount if earnings were to exceed the forecasted amount and establishing accrual reserves would allow  management to more easily meet future earnings expectations.  Therefore, the amount of analyst forecast error (i.e., the difference between the consensus analyst forecast and actual earnings) provides a proxy for management’s use of earnings manipulation activities.

    Prior literature also shows that higher quality auditors constrain management’s earnings manipulation activities, including their use of total and discretionary accruals.  Additionally, prior literature examines and shows a decreased level of reported earnings that just meet or beat analysts’ forecasts when the companies are audited by city-specific auditor specialists, as well as reduced analyst forecast errors for quarterly periods that are subject to financial statement audit requirements versus review requirements (i.e., the 4th quarter versus quarters 1 through 3).  However, the purpose of this paper is to fill a void in the literature and examine the impact of higher audit quality, as proxied by industry specialist auditors, on managements’ use of accruals when management has specific incentives to manipulate earnings (up or down) towards a predetermined target level.

    Design/Method/ Approach:

    To isolate industry specialization, the author examines U.S. publicly traded companies who are audited by Big N firms during the period of 1989-2005.  The author measures managements earnings manipulation by modeling  the absolute value of analyst forecast error and reported earnings exceeding analysts’ forecasts by exactly 1 cent.  Differential audit quality is based on measures for auditor specialization as proxied by the auditor’s industry market share, audit firm portfolio market share, and a combined indicator of those two measures.  The author examines both measures in the pre- and post- SOX period.

    Findings:
    • The results indicate that absolute analyst forecast errors are greater for companies audited by industry specialist auditors. 
    • Companies audited by industry specialist auditors are less likely to just meet or beat analysts’ earnings forecasts.
    • There is no difference with respect to the period absolute analyst forecast errors analysis in the pre- or post-SOX period.
    • The negative association between auditor specialists and companies that just meet or beat analysts’ earnings forecasts is weaker during the post-SOX period.
    Category:
    Audit Quality & Quality Control, Corporate Matters
    Sub-category:
    Industry Experience, Earnings Targets & Management Behavior
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  • The Auditing Section
    Revenue Manipulation and Restatements by Loss Firms
    research summary posted April 16, 2012 by The Auditing Section, tagged 06.06 Earnings Management, 14.0 Corporate Matters, 14.01 Earnings Management, 14.05 Earnings Targets and Management Behavior in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Revenue Manipulation and Restatements by Loss Firms
    Practical Implications:

    This study’s results provide auditors and regulators with another potential indicator of managerial incentives to manipulate reported revenues (i.e., continued losses or negative cash flows) and how managers might achieve this result.  The authors demonstrate that this manipulation incentive applies across the general spectrum of firms and is not limited to young or internet-based businesses.

    Citation:

    Callen, J., S.W.G. Robb, D. Segal 2008. Revenue Manipulation and Restatements by Loss Firms. Auditing: A Journal of Practice & Theory 27 (2): 1-29.

    Keywords:
    revenue manipulation; earnings management; auditing; restatements
    Purpose of the Study:

    Regulating entities (such as the SEC and FASB) and auditors recognize managers have incentives to manipulate revenue accounts to achieve certain financial statement-related goals and perceptions with analysts and investors.  Although management can also manipulate earnings and financial data using expense-related accounts, accounting violation investigations by the SEC, FBI, and U.S. Attorney General’s office suggest that management is more likely to manipulate results using revenue-related items.  Survey evidence indicates management’s use of revenue items to increase earnings is more common, and studies show that firms have capital market incentives to provide positive revenue surprises.  Academic studies examining SEC enforcement actions support this perception.  Studies also indicate that individual firm characteristics could lead to a greater tendency to manipulate revenue-related line items.  For instance, studies suggest that young firms and internet-related businesses are more likely to manipulate earnings using revenue accounts.

    One reason why firms are more likely to manipulate revenue-related accounts is that firms with repeated losses or negative cash flows cannot be valued accurately using traditional valuation models such as the discounted cash flow and discounted residual earnings models.  In these cases, analysts use other models and ratios, such as the price-to-sales ratio, to value the firm.  Manipulating revenues in these situations help management project positive expectations concerning future growth and induce higher market capitalization.

    Although prior studies and enforcement actions suggest that firms, in particular young and/or internet-based firms, are more likely to manipulate revenues, the purpose of this study is to examine a broad spectrum of firms to determine whether repeated losses and anticipated future losses are an indicator of firms’ likelihood to manipulate revenues in violation of GAAP.

    Design/Method/ Approach:

    The authors use restatement data on U.S. publicly-traded firms for the years 1992-2005 to examine the relationship between revenue misstatements and past and expected future loss or negative operating cash flows.

    Findings:
    • Consistent with prior research, revenues appear relevant to the market valuation of loss and negative cash flow firms, but earnings and operating cash flows do not.
    • The authors find a positive association between the number of anticipated loss years and a firm’s accounts receivables, even after controlling for the firm’s credit policy.
    • The authors find a positive association between the number of actual and anticipated loss years and the probability of a firm manipulating revenue.
    • The authors find that the probability of revenue manipulation is positively related to the level of a firm’s accounts receivable balance.
    Category:
    Corporate Matters
    Sub-category:
    Earnings Management, Earnings Management, Earnings Targets & Management Behavior
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