Client importance and earnings quality: an analysis of the moderating effect of managerial incentives for target beating versus auditors’ incentives to avoid reputational losses and litigation

Abstract

I examine the effects of client importance on accounting quality. In particular, I analyse whether these effects are moderated by managerial incentives to engage in earnings management (like benchmark beating) or by auditors’ incentives to maintain their reputation and avoid litigation. While the managerial incentives would lead to lower earnings quality, auditors’ incentives would lead to higher earnings quality. My results are in line with client importance being associated with better quality accounting. In particular, I show that auditors’ incentives are important and moderate the relation between client importance and accounting quality.

Keywords:

• auditor independence
• client importance
• earnings management
• earnings targets
• income-increasing discretionary accruals

JEL classification:

• G32
• L21
• M12
• M41
• M42

ORCID

Bum-Jin Park http://dx.orcid/0000-0003-1372-5994

Notes

1. Following this trend, since December 2001, the Korean financial supervisory service has required all KOSPI- and KOSDAQ-listed markets to report audit fees, audit hours, the contents of service contracts and related fees on their annual reports.

2. This Act stipulates the establishment of the Public Company Accounting Oversight Board (PCAOB), with the authority to set Generally Accepted Auditing Standards (GAAS). The Act also stipulates that the CEO and CFO shall certify the financial statements and the disclosures in those statements and that the auditor shall report on the client’s internal controls and requires the pre-approval by audit committees of any non-audit services by the incumbent auditor. Further, it requires audit committees to have at least one member who is a financial expert and provides that the partners and managers related to the audits should be rotated every 5 years (Rittenberg & Schwieger, 2005).

3. Knowledge spillovers represent the information that the auditor obtains from the client during the provision of non-audit services. This information can promote audit efficiency by reducing related costs (DeFond et al., 2002).

4. Non-audit services in Korea can be delineated into three types: prohibited, conditional and approved (Korea Certified Accountant Law [KCAL] Article 21 and Enforcement decree Article 14; Korea Generally Accepted Auditing Standards [KGAAS] Article 4).

5. The cross-sectional modified Jones model (Dechow et al., 1995) is used to estimate discretionary accruals. As a result, some observations are deleted from the industries that contain fewer than 15 non-sample firms each year. According to the modified Jones model (1995), residuals (e_t) in the following equation (i) indicate discretionary accruals created by the manager.

(i)

where TA is the total accruals in year t; A_t-1 is the total assets in year t – 1; ΔREV_t is the change in sales in year t; ΔAR_t is the change in receivables in year t; PPE_t is the gross property, plant and equipment in year t.

6. As in Kothari et al. (2005), performance-adjusted discretionary accruals are denoted as residuals (e_t) in the following equation (ii). Consistent with the cross-sectional modified Jones model, some observations are deleted from the industries that contained fewer than 15 non-sample firms each year. Definitions of variables are detailed in Equation (i) of note 5. ROA indicates current income before taxes deflated by total assets in the prior fiscal year.

(ii)

7. This measure includes only non-audit service fees paid to the incumbent auditor.

8. In Korea, prestigious Big 4 auditors refer to auditors in partnerships with foreign auditors, including PricewaterhouseCoopers (Samil), Deloitte (Anjin), KPMG (Samjung) and Ernst & Young (Hanyoung).

9. The black bars in the graphs in Figure 1 indicate the firms that would have a strong incentive to achieve earnings targets.

10. There is a high probability that sample firms that have different characteristics with respect to accounts closing month or business type can generate inaccurate results.

11. The debt covenant hypothesis stipulates that the managers attempt to perform earnings management to avoid breaching a clause specified in the debt contract (DeFond & Jiambalvo, 1994; Sweeney, 1994; Watts & Zimmerman, 1986).

12. After discretionary accruals are divided into income-increasing and income-decreasing discretionary accruals, client importance is still negatively related to both of income-increasing and income-decreasing discretionary accruals.

13. This analysis cannot directly observe the means through which earnings management is implemented or the magnitude of its implementation.

Additional information

Funding

This research was supported by the Soonchunhyang University Research Fund.