Audit quality determinants and their effect on earnings management during the global financial crisis

Abstract

The early twenty first century witnessed several accounting scandals that culminated in the collapse of many renown large organizations such as Enron and the bankruptcy filing of WorldCom. These scandals cast doubts on the quality of auditing. As part of the efforts of restoring quality of auditing and earnings reporting, several standards, guidelines, and codes have been imposed by International and Malaysian regulatory bodies. However, those regulatory authorities view audit quality as subjective, multi-dimensional, vast and a complex issue (Financial Reporting Council, 2007; International Auditing and Assurance Standard board, 2011; Canadian Public Accountability Board, 2012), which makes it difficult to define and measure. In order to untangle this multi-dimensional and complex issue, this study conducted a systematic review, maps the audit quality literature and came up with an audit quality framework (AQF). AQF is a comprehensive framework with the inclusion of the International Standard on Quality Control 1 (ISQC 1). The AQF is further enhanced by inculcating qualities from an Islamic perspective. The AQF reveals that the outcome of a quality audit should be reflected in the financial reporting quality, which is proxied by diminished earnings management practices. There is strong evidence that earnings management practices during the abnormal time (financial crisis) differed in terms of magnitude and direction (Mohd-Saleh and Ahmed, 2005; Johl et al., 2007; Iatridis and Dimitras, 2013). Hence, whether earnings management practices in the context of Malaysian listed companies really differ during the recent financial crisis needs to be tested before determining whether audit quality determinants are able to alleviate it. Therefore, this study examines earnings management practices during the recent financial crisis and makes a comparison with the pre-crisis period. In addition, this study investigates the effect of different determinants of audit quality on earnings management practices. The hypotheses of this study were developed and examined based on the related literature, both agency and big bath theories. Data were collected from literature, databases, related regulations and standards (audit quality framework), annual reports (audit quality determinants), and the Bloomberg database (earnings management components). The AQF suggests that audit quality determinants can be categorized into two major dimensions of attributes (i.e. proficiency and morality). The proficiency attributes dimension is related to the ability of the auditor to detect the misstatement, whilst the morality attributes dimension is the willingness of the auditor to report the detected misstatement. The Islamic perspective shows that the two main categories of the AQF (proficiency, morality) are not new and are referred to in the Holy Qur’?n as strength and trustworthiness. Furthermore, Islam emphasizes more on the latter. As for the empirical findings of paired-sample T-tests analysis for 1,189 firm-years, it is revealed that there is a significant decrease of positive earnings management and a significant increase in downwards earnings management during the recent global financial crisis (2009; 2008) compared to before crisis period (2006; 2005). These findings confirm that Malaysian managers apply the big bath strategy during the crisis period. However, the magnitude of earnings management of the Malaysian companies in the recent financial crisis was distinctly lower than those of prior studies (Johl et al., 2007; Iatridis and Dimitras, 2013). Considering this difference, the study tests whether audit quality determinants, as used by prior studies, similarly deterred earnings management practices in the recent crisis in Malaysia. The findings of the regression analysis for the 245 Malaysian listed companies revealed that five out of ten audit quality determinants (i.e. audit firm type, auditor industry specialist, board of directors’ size, board of directors’ independence, and audit committee independence) play a significant role in restricting earnings management practices. Therefore, the study shows that, by analysing the empirical findings and referring back to the AQF, audit quality determinants related to competent monitoring by expert auditors (proficiency attributes) and independent board of directors and audit committee (morality attributes) deter earnings management practices during the recent financial crisis. However, other audit quality determinants seem ineffective under these circumstances.