The effect of audit quality on earnings management (a study of financial institutions in nigeria)

THE EFFECT OF AUDIT QUALITY ON EARNINGS MANAGEMENT

(A STUDY OF FINANCIAL INSTITUTIONS IN NIGERIA)

Chapter One

INTRODUCTION

1.1 Background of the Study

In 2009, Nigeria was shaken by the insolvency of five deposit money banks and subsequent takeover by the central Bank of Nigeria. The above case and other similar cases in the past were reported without any warming from the auditors of those institutions.

At the core of these scandals was usually the phenomenon of earnings management. Earnings management has been a great and consistent concern among practitioners and regulators. Earnings management masks the true financial results and position of businesses and obscures the facts that stakeholders ought to know. Reported earnings are considered by shareholders to be value relevant and useful in estimating future returns and thus earnings and share returns are expected to be related. A weak earnings - return association can be linked with low information content of reported earnings. This low earnings quality is due to management manipulation activities. Confidence brought about by the above cases resulted in legislative novelties which underlined two basic features; strengthening of the corporate governance rules and improvement of audit quality

1.2 Statement of the Problem

Opportunistic earnings management practice produces less reliable accounting earnings that do not reflect a firm’s financial performance. Earnings management is likely to reduce the quality of reported earnings and its usefulness for investment decisions, thus reducing investors’ confidence in the financial reports.

High quality audit is perceived to be monitoring system that may help to align the interest of managers and shareholders and reduce the potential for opportunistic managers behaviour. Frankel et al. (2002) shows that monitoring offered by independent and high quality audit reduces management’s ability to manage earnings.

1.3 Objectives of the Study

The general objective of this study is to investigate the effect of audit quality on earnings management practice in Nigeria.

The specific objectives of this study include to;

  i.  Examine the extent to which Auditor size affects Earnings management.

  ii.  Find out the extent to which provision of Non-audit Services affect earnings management.

  iii.  Establish whether Auditor Industry Specialisation has any effect on earnings management

  iv.  Make appropriate recommendations necessary to improve the external audit functions in Nigeria.

Chapter Two

Review of Related Literature

Earnings management is a form of earnings manipulation that is likely to reduce the reliability of earnings. Schipper (1989), defines earnings management as: “a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain”. Earnings management occurs when managers use judgment in financial reporting and in structuring transaction to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.

2.1 Review of Empirical Studies

Krishnan (2003), examines the association between auditor industry expertise, measured in terms of both auditor market share in an industry and an industry’s share in the auditor’s portfolio of client industries, and a client’s level of absolute discretionary accruals, a common proxy for earnings management. They use a large sample of Big 6 auditors. Client of non specialist auditors report absolute discretionary accruals that are on average 1.2 percent of total assets higher than the discretionary accrual reported by clients of specialist auditors. Adeyemi and Olowookere (2012), examine the relationship between Non-Audit Service and auditor independence. A well-structured questionnaire was used to collect data. Respondents were sampled from five sectors: Banking, Brewry, Chemical and Paints, Conglomerates, and Health. The non-parametric statistical tests used in this study include the Kruskal-Wallis Test and the Mann-Whitney U Tests to draw inferential conclusions regarding the data collected since the data was collected from the different categories of respondents. The findings indicate that the provision of non-audit services significantly affects investors’ perceptions of auditor independence, and there is high correlation between auditors’ Independence and Non-Audit Services in Nigeria.

2.2 The Agency theory

The Agency theory is based on the relationship between the principal (owners) and the agent (managers). The separation of ownership from management in modern corporations provides the context for the function of the agency theory. Modern organisations have widely dispersed ownership, in the form of shareholders, who are not normally involved in the management of their companies.

In these instances an agent is appointed to manage the daily operations of the company. This distinction between ownership and control creates the potential for conflicts of interests between agents and principals which result in costs associated with resolving these conflicts (Jensen and Meekling, 1976 and Eisenhardt, 1989)

Auditors act as agents to principals when performing an audit and this relationship therefore brings with it similar concerns with regards to trust and confidence as the director - shareholder relationship, prompting questions about who is auditing the auditor.

Chapter Three

Methodology

3.1 Research design

The time serial ex-post-facto and analytical research designs will be used to investigate the relationship between Audit Quality and Earnings Management.

3.2 Population of the Study

The population of this study is made up of companies listed on the floor of the Nigerian stock exchange which currently stands at 200 companies.

3.3 Sample Size

A sample of 21 audited financial reports of quoted Deposit Money Banks for the period ended 2014 would be used.

3.4 Data and Variable Description

This study will be based on secondary data. A sample of annual observations on time series covering the period from 1990 to 2014 will be employed. Most series will be collected from the Central Bank of Nigeria statistical bulletin (various editions).

3.5 Model Specification:

Linear regression model will be designed and tested for the purpose of achieving the objectives stated earlier in the study. The computation of the earnings management used in this study will be based on modified Jones model by Dechow et al (1995). This model is as follows;

LnDACC= a +a1LnSIZE +a2LnNAS+ a3LnAIS +t

Where:

DACC = Total Discretionary Accruals

SIZE = Auditor Size

NAS = Non-Audit Services.

AIS = Auditor Industry Specialisation.

t = Random Error Term

a = Constant

a1, a2, a3, are the coefficient of the regression equation

3.6 Model Estimation:

The long run impact analysis will be estimated using the Ordinary Least Square (OLS) estimation technique

Chapter Four

Expected OutCome:

(i). There is a significant negative relationship between Auditor Size (represented by the BIG4 audit firms) and earnings management.

(ii). There is a significant positive relationship between the Provision of Non-audit Services and Earnings management.

(iii). There is a significant negative relationship between Auditor Industry Specialisation and Earnings management.

References

Adeyemi S. B, Olowookere J. K (2012), Non-audit services and auditor independence-Investors perspective in Nigeria. Business and management review Vol 2(5) pp 89-97.

Dechow, P. M.R. G. Sloan and AP Sweeney (1995). Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research, 13(Spring), 1-36.

Eisenhardt, K. M. (1989). Agency Theory: An Assessment and Review. Academy of Management Review, Vol. 14, No. 1: pp. 57–74.

Frankel, R. M., Johnson and K. Nelson. (2002). The relation between auditors’ fees for non - audit services and earnings quality. The Accounting Review 70: 145-177.

Jensen, M. C and W. Meckling. (1976). Theory of the firm: managerial behaviour, agency costs and ownership structure. Journal of Financial Economics 3(4):305-360.

Jones, J. (1995). Earnings Management During Import Relief Investigations. Journal of Accounting Research, Vol. 29, No. 2: pp. 193-223.

Krishnan G. V. (2003), Does Big 6 Auditor Industry Expertise Constrain Earning Management? Accounting Horizons Supplement 2003 pp 1-16

Schipper, K. (1989). Commentary on Earnings Management. Accounting Horizons, Vol.3: pp.91-102.