The Effect of Audit Quality on Earnings Management

Abstract

This paper examines the relation between economic incentives to manage earnings and discretionary accruals and the modifying effects of audit quality on this relation. We hypothesize that incentives to smooth earnings and incentives created by debt agreements motivate managers to strategically bias earnings. However, we expect that earnings manipulation is tempered by the quality of the firm's external auditor. The findings indicate that companies with non-Big Six auditors (a proxy for lower audit quality) report discretionary accruals that significantly increase income compared to companies with Big Six auditors. We also find that managers respond to debt contracting and income-smoothing incentives by strategically reporting discretionary accruals. In addition, companies with incentives to smooth earnings upwards (downwards) report significantly greater income-increasing (decreasing) discretionary accruals when they have non-Big Six auditors. However, we do not find that audit quality affects earnings management that occurs in response to high leverage.