The joint determination of audit fees, non-audit fees, and abnormal accruals

Prior research has estimated piece-meal the determinants of audit fees, non-audit fees and abnormal accruals. Intuition, informal analysis, and a variety of theories suggest that audit fees, non-audit fees, and abnormal accruals are jointly determined. We address this endogeneity issue by modeling the confluence of audit fees, fees for non-audit services and abnormal accruals in a system of simultaneous equations. Our joint estimation provides a starting point to look simultaneously at several competing theories. Using audit and non-audit fee data from the UK for 1994–2000, we find evidence consistent with knowledge spillovers (or economies of scope) from auditing to non-audit services and from non-audit services to auditing. While knowledge spillovers from non-audit services to auditing have been found in prior research [e.g. see Simunic, 1984], the presence of knowledge spillovers from auditing to non-audit services is a new result. Contrary to recent results in Ferguson et al. (2000) and Frankel et al. (2002), we do not find support for the assertion that fees for non-audit services increase abnormal accruals. In fact, contrary to the results in Ashbaugh et al. (2003) and Chung and Kallapur (2003), we find that non-audit fees decrease abnormal accruals, which we attribute to the productive effects of non-audit services. We also find evidence that audit fees increase abnormal accruals, consistent with behavioral theories of unconscious influence or bias in the auditor-client relation. The findings are robust to tests with US data. JEL Classification C30 · M40 · M41 · M49     

The Usefulness of Measures of Consistency of Discretionary Components of Accruals in the Detection of Earnings Management

Abstract:  Prior research has shown the prevalence of measurement error in models used to estimate aggregate discretionary accruals. In these models, the incremental information content of the various components of accruals is ignored. Limited prior research and data gathered from firms under Securities and Exchange Commission (SEC) litigation indicate that managers use either one or more than one component of accruals simultaneously, in a consistent way to manipulate bottom-line earnings in a given direction. I propose two measures that capture the consistency between the discretionary components of accruals and test their significance in earnings management (EM) detection in firms that have artificially added accrual manipulation and firms that were targeted by the SEC for accrual manipulation. There is evidence that this information is incrementally useful in detecting EM. This finding paves the way for improvements in the discretionary accruals measure by including consistency information from the components of aggregate accruals.     

Toward an Archival Measure of the Likelihood of Auditor–Client Management Negotiation: An Exploration of the Audit Lag Measures Conjecture*

Salterio (2012) hypothesized that adaptations of an audit efficiency measure, audit report lag (the length of time between the financial statement year‐end date and the auditor's report date), could provide measures of underlying auditor–client management (ACM) negotiation likelihood. Salterio argued that these measures would enable archival researchers to examine issues that heretofore were the exclusive domain of experimental and field researchers. Using an audit report lag measure and a measure of abnormal audit report lag lags (the residual based on audit report lag determinants model), we show that a larger lag is associated with higher audit fees after controlling for other known determinants of audit fees. We also show that larger lags are associated with higher levels of discretionary accruals—that is, lower accrual quality. Based on our findings, we suggest that there is support for Salterio's hypothesis that audit report lags and abnormal audit report provide valid archival proxies for the differences in year‐end ACM negotiation likelihood. We suggest that this proxy will allow researchers to study issues related to published accounting numbers in light of whether negotiations are likely to have occurred in addition to providing regulators and others the means to determine what clients of audit firms are more likely to have different types of ACM relationships.     

Inventory policy, accruals quality and information risk

This paper provides evidence consistent with firms with Last-in-first-out (LIFO) inventory policy being priced by the market as having lower information risk than First-in-first-out (FIFO) firms. Furthermore, the paper shows that this pricing differential is sustained after controlling for accruals quality, suggesting that the inventory policy signals some information risk characteristics that are not captured by accruals quality measure. We investigate the relation between inventory policy and accruals quality and find that accruals quality is systematically worse for FIFO firms than for LIFO firms after controlling for correlated omitted variables and known firm attributes. These findings complement the currently established relationship between the cost of capital, market pricing and accruals quality by focusing on the need for understanding the incremental effects of individual accounting policies.     

The value relevance of cash flows, current accruals, and non-current accruals in the UK

Cash flow statements have a longstanding history as mandated financial statement disclosures, having replaced funds flow statements. The usefulness of such disclosures with respect to one of the main purposes of financial statements—providing information relevant to the assessment of future cash flows and their uncertainty, and the market value of firms—is still subject to debate. This study investigates whether various partitions of earnings involving combinations of a cash flow measure of performance and measures of current accruals and non-current accruals improve the ability to explain market values in the UK relative to using earnings alone. Using a valuation model-based methodology, and employing a UK sample of non-financial firms for the years 1993 to 2007, our results suggest strong support for the assertion that cash flows can have incremental value relevance relative to either earnings or funds flows. By implication, cash flows can have separate value relevance from total and, in particular, current accruals. There is slightly less consistent evidence that current and non-current accruals can have separate value relevance but, nonetheless, the results are still strongly in favour in this respect. Generally, the main source of increase in explanatory power for market values is the separate inclusion of our cash flow measure in the estimated regressions. As a consequence, we conclude that the statement of cash flows in the UK provides information useful to UK investors in valuing firms. Further, requiring a cash flow statement, as opposed to a funds flow statement, improves the information content of financial statements in the UK.     

EARNINGS MANAGEMENT INDUCED BY COGNITIVE REFERENCE POINTS

Previous studies (Carslaw, 1988; Thomas, 1989; Niskanen & Keloharju, 2000) have shown that companies' managers tend to round-up the first digits of reported earnings (i.e. for companies reporting profits). According to Carslaw (1988), this type of behaviour is inspired by the existence of the so-called ‘$1·99’ phenomenon where a price of $1·99 is perceived as being abnormally lower than one of $2·00. In the current study, we try to determine whether managers of UK-listed companies also engage in this type of ‘earnings rounding-up behaviour’. Analogous to the earlier studies, our study compares observed and expected frequencies for the second-from-the-left digit in reported earnings. Our results suggest that managers of UK-listed companies tend to round-up reported pre-tax income, in a way that increases the first digit by one, when they are faced with a nine in the second-from-the-left position for this particular earnings measure. The major contribution of the current study is that it introduces discretionary accruals in this line of research. Discretionary accruals were estimated using both the Jones model (1991) and the modified Jones model as proposed by Dechow et al. (1995). Our results clearly suggest that discretionary accruals are used in order to round-up reported earnings figures. Moreover, discretionary accruals enabled us to increase the power of the tests used in previous studies.     

Earnings quality,bankruptcy risk and future cash flows

Prior research suggests that the quality of accruals may be compromised where the magnitude of accruals is abnormally high, due to the presence of errors in the accruals‐estimation process (Dechow and Dichev, 2002; Richardson, 2003). A consequence of this is that abnormal accruals may not map into realised future cash flows to the extent that would normally be expected of accruals data. Indeed, the association may be insignificant if abnormal accruals consist primarily of estimation noise. Our study investigates whether abnormal accruals for UK firms provide incremental insight into future cash flows. In particular, our paper may be viewed as a development of Subramanyam (1996). We find a significant positive association between abnormal accruals and one‐year‐ahead operating cash flows. This provides a rationale for the pricing of abnormal accruals by the market (Subramanyam, 1996; Xie, 2001) and suggests that abnormal accruals are not merely the products of noise in the accruals‐estimation process. However, our results are conditional upon the probability of one‐year‐ahead bankruptcy risk (Charitou et al., 2004). We also find that abnormal accruals possess small but significant explanatory power for future cash flows even when controlling for the disaggregation of accruals into individual items (Barth et al., 2001).     

The Usefulness of Long-Term Accruals

Though empirical evidence strongly supports the role of short-term operating accruals in improving operating cash flows as a measure of performance, there is little support or consensus with respect to the effect of long-term accruals. We provide evidence that long-term accruals do reduce timing and matching problems in cash flows. In return-earnings regressions, long-term accruals are found to improve earnings as a measure of firm performance, although not to the same extent as short-term accruals. Further, our analysis highlights differences in economic and statistical properties between short-term and long-term accruals and demonstrates how these differences impede the ability of long-term accruals to improve earnings as a performance measure in a return-earnings context. The incremental explanatory power of long-term accruals is shown to be hampered by the lack of present-value considerations in the existing accounting model, timeliness problems, and measurement error in the indirect method of computing cash flows and accruals.     

Accruals,Investment, and Future Performance

It is well documented that accounting measures of investment, such as working capital and capital expenditures, negatively predict future stock returns. The earnings fixation hypothesis suggests that investors overestimate and overvalue the persistence of the accrual component of earnings. Another stream of the literature argues that since accruals capture growth, the accruals anomaly can be explained by the investment anomaly, which finds that firms that grow their assets tend to have lower future returns. As empirical proxies for accruals and investment are either positively correlated or interchangeably used, it is difficult to distinguish between the competing hypotheses in empirical tests. This study contributes to the debate by identifying two special economic settings in which the two explanations offer diverging predictions. First, investment in research and development (R&D) represents an investment expenditure that reduces earnings but is not subject to accrual accounting. Thus, the earnings fixation hypothesis predicts a positive relation between increases in R&D investments and future returns, whereas the investment anomaly predicts a negative relation. Second, firms operating with negative working capital have working capital accruals that are negatively correlated with other forms of investment and growth. Therefore, while the earnings fixation hypothesis still predicts a negative relation between accruals and future returns in this setting, the investment explanation predicts a positive relation. For both sets of tests, the empirical evidence supports the earnings fixation hypothesis for the accruals anomaly and is inconsistent with the notion that the investment anomaly subsumes earnings fixation in explaining future stock returns.     

Earnings management and abnormal returns: Evidence from the 1970–1972 Price Control Regulations

We examine the association between abnormal returns and earnings management in the context of price control regulations to test the construct validity of the earnings management model. Abnormal returns are used as a market–based measure, and discretionary accruals are employed to measure earnings management. Our results support the hypotheses that (1) price control regulations affect firms' security prices negatively, (2) firms make income–decreasing discretionary accruals to increase the likelihood of price increase approval, and (3) firms that are affected most negatively by the regulations manage earnings more aggressively. We conclude that the earnings management model we use in this study is capable of predicting opportunistic discretionary accruals.     

Interfirm differences in earnings variability: an analysis of fundamentals,cash flows and accruals

Prior research shows that the time‐series variability of corporate earnings affects forecasting accuracy and corporate risk, yet little is known about the determinants of earnings variability. This study analyses interfirm differences in earnings variability. Large‐sample evidence shows how the ratio of accrual variability to cash‐flow variability varies across a cross‐section of firms and how these components and the correlation between contemporaneous cash flows and accruals are related to key economic fundamentals.     

Ownership,two-tier board structure,and the informativeness of earnings – Evidence from China

This study extends previous research by empirically examining how ownership, two-tier board structure, and auditor affect the informativeness of earnings for companies listed in China. We measure the informativeness of earnings by the earnings–returns relation, discretionary accruals, and audit opinion. The results show that ownership concentration, the presence of foreign shareholders, the percentage of tradable shares, the type of dominant shareholder, the supervisory board, and independent directors affect the earnings response coefficients and discretionary accruals. We also find that the type of dominant shareholder, the size of the supervisory board, and the percentage of independent directors have an impact on the frequency of modified audit opinions. Our research has implications for China’s regulators who are striving to improve accounting information, transparency, and corporate governance.     

Do abnormal accruals affect the life expectancy of audit engagements?

We examine the cross-sectional determinants of audit engagement length, paying particular attention to abnormal accruals as a potential driver. We are interested in how the potentially incongruent incentives of managers and auditors can cause frictions, and in turn affect the audit engagement’s life expectancy. We estimate a hazard model in the form of a multi-period logit model, allowing us to estimate (the inverse of) the life expectancy of audit engagements. We find that audit engagement life expectancy at any age decreases when firms make relatively large positive or large negative abnormal accruals. One interpretation of these results is that large positive (negative) abnormal accruals make the auditor (client) more likely to terminate the engagement. Conversely, smaller abnormal accruals reflect a compromise which extends the life of the engagement. Our results are robust to several alternative specifications and controls. However, because there is no complete theoretical model that explains audit engagement length, our results should be interpreted with caution.     

The Influence of Remuneration Structures on Financial Reporting Quality: Evidence from Australia

This cross‐sectional study investigates the influence of remuneration structures on financial reporting quality, based on a sample of companies listed on the Australian Securities Exchange (ASX). Compliance with Remuneration Principle eight issued by ASX (providing recommendations on formation, operation and disclosure of remuneration committees) is expected to improve financial reporting quality represented by a decreased level of earnings management. This study expands the corporate governance literature by examining an under‐researched mechanism to address the agency problem. Earnings management, as a consequence of the agency problem, is measured using the level of absolute discretionary accruals. In this study, we use the modified Jones model to measure the level of discretionary accruals and the existence of reduced earnings management. The study is conducted using a random sample of 214 firm‐year observations selected from the ASX listed companies. Our findings show a higher level of compliance with the principle on remuneration is associated with lower levels of earnings management. The findings support the efficient functioning of the ASX‐proposed remuneration structure in reducing earnings manipulations.     

Regulatory incentives and financial reporting quality in public healthcare organisations

English National Health Service Foundation Trusts are subject to a regulatory regime in which the level of monitoring and intervention is determined by performance against two key performance metrics: a ‘financial risk rating’, based on a number of performance metrics, such as the reported surplus margin and return on assets, and a ‘prudential borrowing limit’. In this paper, we investigate the variation in financial reporting quality, proxied by discretionary accruals, with the incentives introduced by this regime. We find: first, that discretionary accruals are managed to report small surpluses; second, that, consistent with the avoidance of regulatory intervention in both the short and medium term, discretionary accruals are more positive when pre-managed performance is below intervention triggering thresholds and more negative when well above threshold; third, that, despite a move away from financial breakeven as the primary performance objective, there remains an aversion to small loss reporting. We further find that the level of discretionary accruals is driven by two metrics of strategic significance: the surplus margin (a measure of retained earnings) and the prudential borrowing limit (a measure of borrowing capacity).     

Accrual mispricing,value-at-risk,and expected stock returns

We investigate the extent to which a parsimonious measure of maximum likely loss that captures the tail risk of returns—known as value-at-risk (VaR)—explains the relationship between accruals and the cross-sectional dispersion of expected stock returns. We construct portfolios based on Sloan’s (Account Rev 71(3):289–315, 1996) total accruals (TA) measure and individual asset-level VaR, which reflects the dynamic behavior of the asset distribution. We document that VaR is in congruence with portfolio-level accruals and that there is a significant positive relationship between VaR and the cross-section of portfolio returns. Allowing a double-sort involving VaR and TA further suggests that the spread between low- and high-TA portfolios is significantly attenuated after controlling for VaR. We also conduct a firm-level cross-sectional regression analysis and demonstrate that the TA- and VaR-based characteristics—but not the factor-mimicking portfolios—are compensated with higher expected returns, and that VaR neither subsumes nor is subsumed by TA. Finally, our cross-sectional decomposition analysis suggests that the firm-level VaR captures at least 7% of the accrual premium even in the presence of size and book-to-market. These findings lend support for the mispricing explanation of the accrual anomaly.

     

Accruals and the Conditional Equity Premium

Accruals correlate closely with the determinants of the conditional equity premium at both the firm and the aggregate levels. The common component of firm‐level accruals, which cannot be diversified away by aggregation, explains the positive relation between aggregate accruals and future stock market returns. The residual component, which accounts for most variation in firm‐level accruals, is responsible for the negative cross‐sectional relation between firm‐level accruals and future stock returns. Consistent with the risk‐based explanation, aggregate accruals, as a proxy for the conditional equity premium, forecast changes in aggregate economic activity. Moreover, we document a similar comovement of earnings with the conditional equity premium at both the firm and the aggregate levels, which helps explain the negative relation between changes in aggregate earnings and contemporaneous market returns.     

Accruals quality and the incentive contracting role of earnings

This paper investigates the association between accruals quality and the usefulness of accounting earnings in incentive contracting. Accruals quality, which measures the precision with which accruals predict future cash flows, has two potential opposing effects on the noise in earnings as a measure of managerial performance. Specifically, higher quality accruals should decrease the deviations of earnings from future cash flows and increase the sensitivity of earnings to cash flows that are not attributable to managerial actions. My evidence indicates that better accruals quality is associated with a higher weight on earnings in compensation contracts, which suggests that accruals quality overall reduces the noise in earnings. I also find that the positive association between accruals quality and the weight on earnings is mainly driven by innate accruals quality rather than discretionary accruals quality. Therefore, accrual errors resulting from the volatility of the operating environment are a primary source of noise in earnings considered by compensation committees.     

Accounting Choices: Variation in Managerial Opportunism

This study focuses on variation in managers' accounting choices given motivations to use accounting accruals opportunistically. Prior research identifies a number of motivations arising from accounting–based contracts that encourage opportunistic reporting by managers. However, prior research implicitly assumes all managers respond identically to the same contractual motivations. This study identifies variation in managers' responses to contractual motivations involving accruals that is related to managers' stewardship of corporate assets. Evidence shows that modeling how managers use corporate assets enhances the explanation of their accounting choices given motivations to (a) use accruals opportunistically, and (b) to smooth income via accruals. Managers with high ratings on judicious use of corporate assets are less responsive to motivations to use accruals opportunistically, and to smooth income via accruals, than managers with low ratings. This evidence suggests that not all managers are equally opportunistic, and that modeling this factor helps explain cross–sectional differences in managers' accounting choices.     

The Differential Persistence of Accruals and Cash Flows for Future Operating Income versus Future Profitability

Prior research provides evidence that a higher proportion of accrued relative to cash earnings is associated with lower earnings performance in the subsequent fiscal year. The result has been widely interpreted as indicative of higher levels of operating accruals relative to cash flows foreshadowing a subsequent earnings reversal, and thus signaling earnings management. We note, however, that earnings performance in prior studies is typically defined as one-year-ahead operating income divided by one-year-ahead invested capital, or a measure of profitability. We find that accruals are more highly associated than cash flows with invested capital in the denominator of the profitability measure. In contrast, accruals and cash flows have no differential relation to one-year-ahead operating income. The evidence is not consistent with accruals having a reversal effect on earnings. This suggests that the lower persistence of accruals versus cash flows may not be due to earnings management but may rather be due to the effect of growth on future profitability.