Late for a very important date: financial reporting and audit implications of late 10-K filings

Delays in financial reports often reflect issues related to period-end accounting and audit processes. We investigate the impact of filing delays in connection with auditor characteristics on the quality of financial statements in a sample of firms that filed Form 10-K after the statutory due date. We find that late filing firms are associated with lower financial reporting quality compared to timely filing firms matched by propensity scores, where financial reporting quality is measured by the absolute value of performance-matched discretionary accruals and the probability of a late filing being restated in subsequent periods. Furthermore, we demonstrate that the adverse consequences of late filings can be largely mitigated by having a Big 4 auditor. The differential audit quality stems primarily from Big 4 auditors in large offices and is more pronounced when an auditor may need to draw on additional resources in a limited period.     

Auditor choice and accruals patterns of cross-listed firms

We examine the association between auditor choice and the accruals patterns of Chinese listed firms that cross-list in Hong Kong. Our evidence suggests that the clients of Big 4 auditors report lower unsigned discretionary accruals relative to the clients of non-Big 4 auditors. Further, we find that cross-listed firms with non-Big 4 auditors are more likely to understate their earnings and experience larger reversals of accruals in the future than cross-listed firms with Big 4 auditors. These findings suggest that Big 4 auditors play a meaningful role in improving earnings quality for cross-listed firms, which helps to explain why cross-listed firms have higher earnings quality than their domestic counterparts, as documented in the previous literature.     

Are Accruals during Initial Public Offerings Opportunistic?

We find evidence that initial public offering (IPO) firms, on average, have high positive issue-year earnings and abnormal accruals, followed by poor long-run earnings and negative abnormal accruals. The IPO-year abnormal, and not expected, accruals explain the cross-sectional variation in post-issue earnings and stock returns. The results are robust with respect to alternative abnormal accruals and earnings performance measures. IPO firms adopt more income-increasing depreciation policies when they deviate from similar prior performance same industry non-issuers, and they provide significantly less for uncollectible accounts receivable than their matched non-issuers. The results taken together suggest opportunistic earnings management partially explains the new issues anomaly.     

The Effect on Financial Reporting Quality of an Exemption from the SEC Reporting Requirements for Foreign Private Issuers

We test for differences in financial reporting quality between companies that are required to file periodically with the SEC and those that are exempted from filing reports with the SEC under Rule 12g3-2(b). We examine three earnings quality measures: conservatism, abnormal accruals, and the predictability of earnings. Our results, for all three measures, show different financial reporting quality for companies that file with the SEC than for companies exempt from the filing requirements. This paper provides empirical evidence of a link between filing with the SEC and financial reporting quality for foreign firms.     

The impact of audit quality on real and accrual earnings management around IPOs

We examine the relation between audit quality and the earnings management activities of IPO firms. The impact of high quality auditors on real earnings management has been researched in a number of settings e.g. SEOs. However, to date, there has been no work on the effect of high quality auditors on real activities-based manipulation around IPOs. We examine UK IPOs between 1998 and 2008 and find evidence that high quality auditors constrain the use of real activities manipulation that occurs via the management of discretionary expenses. We also find evidence, consistent with prior research, that high quality auditors constrain the manipulation of discretionary accruals. Crucially, we find IPO firms audited by high quality auditors undertake sales-based manipulation in order to manage earnings upward at the end of the IPO year. The presence of high quality auditors is not, therefore, sufficient to constrain all forms of earnings management.     

Earnings Behaviour of Financially Distressed Firms: The Role of Institutional Ownership

Using a sample of 859 U.S. bankruptcy-filing firms over the period 1986–2004, we examine the earnings behaviour of managers during the distressed period by looking at sources of abnormal accruals prior to the bankruptcy-filing year. Results show that managers of highly distressed firms shift earnings downwards prior to the bankruptcy filing. We test and provide evidence in support of two potential contributing factors. First, top-level management turnover among distressed firms leads new managers to earnings bath choices during the distressed period. Second, qualified audit opinions exert pressure on managers to follow more conservative earnings behaviour during the distressed period. Evidence is also provided that the management of distressed firms with lower (higher) institutional ownership has greater (lesser) tendency to manage earnings downwards. Results also show that higher institutional ownership mitigates the negative abnormal returns of firms with top management turnover. To the authors' knowledge, this is the first study that attempts to examine whether institutional ownership relates to market reaction in conjunction with a top management turnover or a qualified audit opinion during the distressed period. Prior studies focused on the investigation of earnings management or institutional ownership (separately) during the distressed period, but did not examine if the effect of institutional ownership on earnings behaviour also influences subsequent returns. Thus, the results of this study should be of interest to analysts, standard setters and regulatory bodies since our results show that management turnover, qualified audit opinions and firm governance mechanisms affect the quality of earnings and the level of abnormal returns.     

Does audit quality matter more for firms with high investment opportunities?

This paper examines the association of firms with high investment opportunities with high quality audits (proxied by Big 5 auditors) and whether that association results in a lower likelihood of earnings management. Firms with high investment opportunities may demand high quality audits for curbing earnings management. This is because they have more flexibility in the provision of discretionary accruals that arises from the attendant operating uncertainty which creates particular monitoring problems. Big 5 auditors will provide high quality audits that will constrain earnings management for firms with high investment opportunities because the risk of losing (and hence the likelihood of maintaining) auditor independence is higher. Results show the following. First, firms with high investment opportunities are more likely to hire Big 5 auditors than firms with low investment opportunities. Second, firms with high investment opportunities are more likely to have more discretionary accruals but this relationship is weaker when they have Big 5 auditors. These results are robust to various sensitivity tests.     

Does auditor designation by the regulatory authority improve audit quality? Evidence from Korea

In Korea, the regulatory authority designates external auditors for firms that are deemed to have strong incentives and/or great potential for opportunistic earnings management, and mandates these firms to replace their incumbent auditors with new designated auditors and to retain them for a certain period, typically one to three years. We call this regulatory regime ‘auditor designation’. This paper investigates whether the auditor designation rule in Korea is effective in deterring managers from making income-increasing earnings management. Consistent with our hypothesis, we find that the level of discretionary accruals is significantly lower for firms with designated auditors than firms with a free selection of auditors. We also find that firms with mandatory auditor changes (i.e., auditor designation) report significantly lower discretionary accruals compared to firms with voluntary auditor changes. The above findings are robust to a battery of robustness checks. Overall, our results are consistent with the notion that the auditor designation enhances audit quality and thus the credibility of financial reporting.     

Do auditors react to real earnings management?

Prior research has documented an association between audit effort and real earnings management [REM]. Specifically, audit report lags have been shown to be positively associated with REM. We investigate the auditor and firm characteristics underlying this association. Our results indicate that overall, REM is associated with longer abnormal audit report lags [ARLs]. We find, however, that this association is driven largely by non-accelerated filers. This result holds for both suspect firms (those firms just meeting earnings benchmarks) and non-suspect firms, for specialist as well as non-specialist auditors, and for profit as well as loss firms. Together our results indicate that when auditors are not constrained by the time pressure of accelerated filing, encountering REM is associated with greater audit effort. Our results may indicate, however, that with respect to accelerated filers, abnormal ARLs may be an imperfect proxy for additional effort. These results have implications for both future research and for the impact of accelerated filing deadlines on audit quality.     

Is Chapter 11 Efficient?

The efficiency of the Chapter 11 bankruptcy process is examined by estimating the impact of Chapter 11 filings on the operating performance of bankrupt firms. We control for firm‐level heterogeneity in prefiling characteristics using matching methods to select benchmark firms comparable to filing firms. We compare bankrupt firms’ operating performances with those of matched nonbankrupt firms. Our results challenge the contention that Chapter 11 is an inefficient, debtor‐friendly mechanism that rehabilitates economically nonviable firms. We demonstrate that firms that file under Chapter 11 perform no worse and, if anything, better than comparable nonfiling firms.     

Accruals Management to Achieve Earnings Benchmarks: A Comparison of Pre-managed Profit and Loss Firms

Abstract:  This study examines whether firms with profits before accruals management are more likely than firms with losses before accruals management to meet or exceed earnings benchmarks when pre-managed earnings are below those benchmarks. We extend Brown (2001) by documenting that the differential propensity to achieve earnings benchmarks by profitable and nonprofitable firms results from differential accruals management behavior. We find that firms with profits before accruals management are more likely than firms with losses before accruals management to have pre-managed earnings below both analysts' forecasts and prior period earnings and reported earnings above these benchmarks.     

Client importance and audit partner independence

We use data from Taiwan where audit partners are required to sign audit reports to examine whether audit partners compromise their independence for economically important clients. Uniquely, we include both listed and unlisted clients in audit partners’ client portfolios and separately study these clients for Big N and non-Big N auditors. We employ multiple proxies for auditor independence, including various abnormal accruals measures, the propensity of audit partners to issue modified audit opinions, and the probability that clients meet or just beat earnings targets. We fail to find evidence that Big N audit partners compromise their independence for economically important clients; however, we find such evidence for non-Big N auditors. Our results are robust to a battery of sensitivity analyses. While our inferences are limited to the Taiwanese capital market, our study may be of interest to market participants and regulators in other well developed capital markets.     

Managerial discretion in distressed firms

This study examines the earnings management behaviour of 455 distressed US firms that filed for bankruptcy during the period 1986–2001. We examine (a) possible earnings management during the years prior to bankruptcy-filing, (b) whether qualified audit opinions cause conservative earnings management behaviour, (c) whether earnings management differs between firms that discontinued operations and firms that survived thereafter, and (d) the effect of earnings management on subsequent stock returns. Our results are consistent with downwards earnings management 1 year prior to the bankruptcy-filing. Results also show that (a) firms receiving unqualified audit opinions 4 or 5 years prior to the bankruptcy-filing event manage earnings upwards in subsequent years, consistent with Rosner [2003. Earnings manipulation in failing firms. Contemporary Accounting Research 20, 361–408], (b) more conservative earnings management seems to be related to the qualified audit opinions rendered in the preceding year, (c) firms with long-term negative accruals the year of bankruptcy-filing have a greater chance to survive thereafter, and (d) more pronounced (negative) earnings management is associated with more negative (next year's) subsequent returns.     

Do REITs Manipulate Their Financial Results Around Seasoned Equity Offerings? Evidence from US Equity REITs

This study addresses two questions: Is there earnings management in the REIT industry around seasoned equity offerings (SEO)? How is earnings management affected by financial and governance factors? Discretionary accruals methods are used to measure earnings management. In addition, the difference between actual and calculated FFO is used to capture the potential FFO manipulation. We examine how these manipulation measures change in the five quarters around SEOs. Moreover, we investigate how a REIT’s earnings management decision is affected by its financial structure, operating style, external auditor and corporate governance. We find clear evidence of FFO manipulation around SEOs, but the extent of earnings management is relatively weaker. We find that REITs issuing SEOs more often are more aggressive in manipulating FFO than earnings. Moreover, there is a notable difference between these two types of financial results manipulation. A mean-reversion trend is found in discretionary accruals, but not for FFO manipulation. Manipulation in financial results is influenced by various factors. A diminished capability to generate cash flow, high leverage, volatile cash flow, frequent SEOs and slack corporate governance are all the features of REITs more likely to manipulate financial results.     

Does sharing the same network auditor in group affiliated firms affect audit quality?

We contribute to the literature on audit quality by examining whether sharing the same network auditor among group affiliated firms is related to lower or higher audit quality in China. We find that choosing the same network audit firm among group affiliated firms is associated with more sanctions by regulators regarding fraudulent financial reporting, higher abnormal accruals, larger standard deviation of abnormal accruals, higher likelihood of a downward restatement in earnings, and lower likelihood of receiving a going concern modified opinion. We further identify contexts that moderate audit quality. Higher audit quality is associated with the use of a specialist auditor and firms that operate in more homogeneous industries. Lower audit quality is associated with longer auditor tenure (more than five years), greater geographic distance between a parent company and its subsidiaries, and greater control by a parent company over its subsidiaries.     

Strategic Bankruptcies and Price Reactions to Bankruptcy Filings

This study investigates whether the stock market differentiates between firms that file bankruptcy petitions for strategic reasons and firms that file bankruptcy petitions for financial reasons. We perform both univariate and regression tests on a sample of 245 firms that filed Chapter 11 bankruptcy petitions between 1981 and 1996. After controlling for bankruptcy outcome, probability of bankruptcy, firm financial condition, and firm size, we find that, in the period around bankruptcy filing, firms that file bankruptcy petitions for financial reasons have significantly larger stock price declines than firms that file bankruptcy petitions for strategic reasons.     

Audit quality,accruals quality and the cost of equity in an emerging market: Evidence from Vietnam

This study explores the relationship between audit quality, accruals quality, and the cost of equity in the context of Vietnam. Particularly, we examine the impact of auditor size and accruals quality on the industry-adjusted earnings – price ratio. Using a sample of Vietnamese listed companies, the study shows that firms audited by a Big Four auditor are associated with a lower cost of equity than firms with a non-Big Four auditor. The results indicate that the auditors' information role is more relevant than the insurance role in a civil law context with a relatively low auditor litigation risk. In addition, the findings show that companies with better accruals quality are associated with a lower cost of equity. The study has implications for managers and regulators. The findings highlight the importance of ensuring sound auditing practices and maintaining high-quality financial reporting for corporations.     

Auditor reputation and earnings management: International evidence from the banking industry

We examine the relation between auditor reputation and earnings management in banks using a sample of banks from 29 countries. In particular, we examine the implications of two aspects of auditor reputation, auditor type and auditor industry specialization, for earnings management in banks. We find that both auditor type and auditor industry specialization moderate benchmark-beating (loss-avoidance and just-meeting-or-beating prior year’s earnings) behavior in banks. In addition, we find that once auditor type and auditor industry specialization are included in the same tests, only auditor industry specialization has a significant impact on constraining benchmark-beating behavior. In separate tests related to income-increasing abnormal loan loss provisions, we find that both auditor type and auditor expertise constrain income-increasing earnings management. Again, in joint tests, only auditor industry expertise has a significant impact on constraining income-increasing earnings management.     

Asset write-offs discretion and accruals management in Taiwan: the role of corporate governance

Using a sample of Taiwan’s public firms, this paper examines whether managers use discretionary write-offs and abnormal accruals jointly to reach earnings targets and how corporate governance mechanisms react to such opportunistic behavior. We develop a set of simultaneous equations that capture executives’ incentives to manage earnings through write-offs and accrual management. These incentives include the existence and tightness of accounting-based covenants, “big bath,” income smoothing, and changes in senior management. The empirical results show that firms with larger discretionary write-offs also have lower discretionary accruals. In addition, we find that these earnings management tools are endogenous, suggesting that discretionary write-offs and discretionary accruals are partial complements for earnings manipulation and that their magnitudes are determined jointly. These findings contrast sharply with the tenor of discussion in the U.S. literature concerning the potential for using asset write-offs and discretionary accruals to manipulate earnings, which documents that managers use their discretion over accruals to signal economic realities rather than to obfuscate. Moreover, the results reveal that the empirical association between discretionary write-offs and abnormal accruals is more pronounced in weakly governed firms, suggesting that a strong governance setting is likely to constrain management’s discretionary behavior. The above implications are robust to a number of alternative specifications and variables definitions.     

When and why do IPO firms manage earnings?

There is significant disagreement about whether, when, and why IPO firms manage earnings. We precisely identify the timing and motives behind earnings management by IPO firms. The period around an IPO is characterized by two events: the IPO itself and the lockup expiration. Both the raising of capital at the IPO and the exit by pre-IPO shareholders at lockup expiration create incentives for firms to manage earnings. To disentangle the effect of these events, we examine quarterly, rather than annual, abnormal accruals. We find no evidence of income-increasing earnings management before the IPO. However, IPO firms exhibit positive abnormal accruals in the quarter before and the quarter of the lockup expiration. Positive abnormal accruals are concentrated in less scrutinized firms and firms with high selling by pre-IPO shareholders. Moreover, we find that these accruals subsequently reverse and that such reversals contribute to long-run IPO underperformance.