The impact of regulations on audit effort and earnings quality

Abstract

The main purpose of this study is to examine the impact of the establishment of the Audit Oversight Board (AOB) on audit effort and earnings management. Specifically, it is argued that the monitoring role of the AOB leads to auditors being more rigorous in conducting audits so as to achieve high compliance with auditing standards. Thus, auditors have to put in more effort, which requires them to increase audit fees to compensate the increase in hours spent on an engagement. This study hypothesizes that an increase in audit effort should mitigate earnings management due to consequent higher detection. Besides the impact of the AOB, this study also examines the effect of the introduction of provisions 317A and 320A of the Capital Markets and Services Act (CMSA), the intention of which is to ensure the independent board of directors and audit committee are more effective in discharging their monitoring roles. It is also hypothesized that the level of earnings management should be reduced as a result of the more effective monitoring by independent boards of directors and audit committees. The data for the study is obtained from secondary data (annual reports). The final data samplecomprises2, 124 observations collected from the annual reports of 708 firms for three years from 2009–2011, which covers the periods before and after the establishment of the AOB. The results indicate that there is an increase in audit effort from pre- to post-AOB. This suggests that the monitoring role of the AOB makes auditors more proper in carrying out the audit process and in collating supporting documentation. However, the regression analyses do not support the hypotheses except in relation to the role of board independence in reducing earnings management after the new regime was enforced. This study contributes to the corporate governance literature by examining the effect on financial reporting quality after the changes in rules and legislation, especially in respect of the audit regulatory system with the establishment of the AOB. This study is important as it provides some support for the argument that the failure of monitoring bodies to act diligently on behalf of the principal to reduce agency conflict could be solved by strict enforcement. Moreover, this study is conducted in Malaysia, which is a unique environment that offers a different perspective on the development of the AOB monitoring system and its role in the auditing process.