Managers’ Response to Extended Audit Report: Evidence from the United Kingdom
Job market paper
I investigate how audit regulation affects managers’ disclosing and earnings management behaviors. Using the United Kingdom setting, where International Standard on Auditing (ISA) 700 required listed firms to provide tailor-made audit reports starting from June 2013, I show that managers respond to the new standard by providing more risk-related disclosure in the notes of financial statements. I find that the increase of risk-related disclosure in the notes of financial statements after the passage of ISA 700 is more profound if the auditors identified and revealed new risk of material misstatement (RMM). My results also show that, after ISA 700 passage, managers are more involved in greater real earnings management activities, but the effect is mitigated if auditors identify real earnings management-related risks in RMM. Collectively, these results suggest that the change of audit regulation affects both managers’ disclosure and operational decisions.
Revising for third-round review in European Accounting Review
We examine the effects of mandatory IFRS adoption on accounting-based prediction models for CDS spreads for a sample of 292 firms in 16 IFRS-adopting countries. We do this by estimating accounting-based prediction models for CDS spreads separately for financial and non-financial firms before and after mandatory IFRS adoption. We find that mean and median absolute percentage prediction errors are larger for both financial and non-financial firms after mandatory IFRS adoption. We also estimate accounting-based prediction models for CDS spreads separately for financial and non-financial US firms before and after mandatory IFRS adoption to obtain prediction errors serve that as a benchmark. Although US firms also exhibit an increase in mean and median absolute percentage prediction errors over the same period, findings from regressions using a difference-in-difference design indicate that the increase is significantly greater for firms in countries that adopted IFRS mandatorily. We also find that in the post-adoption period, prediction errors are larger for firms in countries with decreases in the rule of law, as well as low levels of strength of financial reporting standards, property rights, and access to credit.
Auditor’s Expertise and the Trade-off between Accrual-based and Real Earnings Management with Cédric Lesage
We explore the behavior of earnings management method facing higher audit quality. We predict that, on one hand, increased audit quality constrains the use of accrual earnings management (AEM) by impose more scrutinizing pressure, which leads to higher real earnings management (REM). However, we argue that the strength of this substitution effect depends on the level of expertise of the auditor, to such an extent that it can even switch to a complementary effect for less expert auditors. We test these hypotheses on a sample of listed non-financial US firms over the years 2000 – 2014. Our analyses show: 1) a negative association between AEM and auditor’s level of expertise; 2) a positive association between REM and auditor’s level of expertise; 3) the substitution effect is stronger for expert auditors; 4) a complementary effect appears for some REM for non-expert auditors. This study contributes the prior literature by providing a deeper understanding of the complex relation between AEM and REM beyond the observed main substitution effect.
Audit quality, Real Earnings Management and Investment Efficiency with François Larmande
We revisit the conventional wisdom that higher audit quality improves earnings quality. We analyze a model in which an entrepreneur must raise external financing and issues an interim accounting report which signals future prospects. Accounting information is thus used for investment efficiency. The entrepreneur can engage in both accounting and real earnings management to manipulate this report. An auditor is hired to certify the interim accounting report truly reflects the current economic performance (that is, free of accounting earnings management). We assume a complete contracting framework in which the entrepreneur reward can be based on the long-term performance of the firm. The main result of the paper is that when unmanaged current economic performance is a good proxy for long-term performance, audit quality (defined as the effort made by the auditor to detect an accounting misstatement) has an inverted U shape relationship with investment efficiency (defined as the expected value of the firm before taking into account audit fees). In other words, audit quality – above a given threshold – decreases accounting quality because of the substitution between accounting and real earnings management. The paper helps to deepen our understanding of the link between audit quality and accounting quality.