Audit quality and earnings management : empirical evidence from China's stock market

Abstract

Motivated by the special features of earnings management in Chinese listed firms and the characteristics in the Chinese audit market, I study the association between audit quality and earnings management in China. I measure audit quality as auditor size, auditor location, auditors' attitudes towards important clients, and auditors' affiliation with the Big 5. There are two earnings management measures: discretionary accruals derived from a performance-matched modified Jones model, and abnormal non-core earnings computed as non-core earnings adjusted by the industry median. The first major finding is that the top 10 domestic auditors are of higher quality than other domestic auditors in deterring opportunistic earnings management. Second, the results support the use of auditor location to proxy for audit quality in China. Local clients report higher abnormal non-core earnings than non-local clients. Third, economic dependence dominates reputation protection incentive in China, so that important clients are given more flexibility in aggressive financial reporting than unimportant clients. Finally, a comparison between the top 10 domestic auditors and the Big 5 suggests that the joint ventures of the Big 5 are more effective than the domestic top 10 in limiting managers' income-increasing choices through non-core earnings. Tests confined to a rights offering sample corroborate the above findings.