JURNAL AKUNTANSI & BISNIS. Vol. 5, No. 2, Agustus 2005: 82 -90 THE EFFECT OF AUDIT QUALITY TO THE EARNINGS MANAGEMENT . AROUND THE INDONESIAN MONETARY CRISIS PRIHAT ASSDL Accounting Department Economics Faculty University of Merdeka, Malang ABSTRACT This study investigates the effect of audit quality on the earnings management behaviour of auditee during different macroeconomics condition, the years prior to and the years following the 1997 monetary crisis as experienced in Indonesia. This study hypothesis that client of quality auditors (industry specialist auditors) report lower earnings management compared to client of other auditors both within the years of the Indonesian monetary crisis and within the years prior to and the years following the monetary crisis. Analysis based on 436 matched-sample firms (by specialist auditor/non-specialist auditor) for periods 1995-2000. The results show that the income-increasing management, income decreasing, and absolute earnings management reported by clients of industry specialist auditor are lower than for those the non industry specialist auditor. Audit quality found to be associated with discretionary accruals and differently to across different macroeconomic period. Keywords: Audit quality, Earnings management, Auditor industry specialization, Indonesian monetary crisis. BACKGROUND Since the mind of 1997, Indonesian experienced monetary crisis. This crisis can be viewed as debt crisis. Foreign exchange rate (Rupiahs to US dollars) have large increasing from 2.400 to 8.000-12.000 Rupiahs at the end of 1997. Based on financial statement of 275 firms in Jakarta Stock Exchange, approximately 23% or 63 firms facing the loss. Foreign loans for 219 firms non-bank are 20,233 billion US dollars or 241,624 quintillion Rupiahs. Machfoedz (1999) shows that there are differences in efficiency ratios in the years pre and post the crisis, The profitability and liquidity ratio are lower for the years post the monetary crisis compared to the years pre the monetary crisis. Leverage ratio, however, is higher for the years post the monetary crisis. The evidences show that the monetary crisis as facing Indonesian in the mind of 1997 cause decreasing of efficiency among public firms. The large increase in corporate leverage heightened level of corporate distress and increase likelihood of corporate failure. Do to extreme financial pressure, managers choose to manage earnings contingent on the highly extant of financial leverage (Sweeney, 1991; Defond and Jiambalvo, 1994). Management thought attempt to suppress of delay the dissemination of negative information or select accountingJURNAL AKUNTANSI & BISNIS Vol. 5, No. 2, Agustus 2005: 82-90 method that temporally mask some economic attribute of company’s financial condition. Earnings management occurs whén manager use judgment in financial reporting and in structuring transaction to alter financial reports to either mislead some stakeholders about the underlying economics performance of the company or to influence contractual outcomes that depend on reported accounting numbers.(Healy and Wahlen, 1999, p.368). The practice of earnings management may potentially affect the information of the underlying economic reality of a firm’s financial performance of position to such on the extent that decision with respect to allocation of resources may alter in the absence of such practice. Monitoring and governance mechanisms may work as constraints on both income-increasing and income-decreasing earnings management. Audit is one such constraints. Prior studies (Becker er al., 1998; Francis, 1999) report evidence that is supportive the constraining impact of audit quality in earnings management, as a lower level of discretionary accruals can be observed for firms that appoint Big 6 auditors, Within'the existing earnings management-audit quality literature, it is interesting to examine the auditee earnings management behavior contingent to quality auditor in the different macroeconomic conditions, These conditions raise several interesting question. First, does audit quality itself act as a constraint on earnings management? Second, are the managers. choosing to manage earnings by engage in income-increasing or income-decreasing earnings management contingent on the extent of financial difficulties as result of the 1997 monetary crisis? LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT Prior earnings management studies predict managers will increase earnings in order to increase theit compensation (Healy, 1985; Holthausen ef al., 1995) or reduce likelihood of debt covenant violation (Deakin, 1979; Dhaliwal, 1980; Bowen et al., 1981; Zmijewski and Hagerman, 1981; Sweeney, 1994; DeFond and Jiambalvo, 1994), or to reduce the likelihood of political visibility (Watts and Zimmerman, 1986; Cahan, 1992). Practitioners argue that influencing investor perceptions of firm value provides a primary motivation for earnings manipulation The 1997 monetary crisis cause the financial trouble among companies, For troubled firm, extant theories predict that managers’ accounting choice will be systematically income-increasing. Managers have incentive to increase reported earnings in attempt to keep their job and reduce intervention by firm’s board of directors and or regulation agencies (DeAngelo, 1998). Manager of the subset of troubled firms are close to a debt covenant violation have incentives to take income- increasing action to avoid of defer the cost of breach. Assih (2004) found that there are income-increasing earnings management. in Jakarta Stock Exchange firms and her empirical evidence support the hypothesis that financial leverage significantly positively associates with the level of earnings management. Skinner (1994), however, found income-decreasing earnings management related to the level of debt. Schwarts (1982) found that financially distress company make more income-decreasing earnings management than healthy firms and suggested that carnings management made by 8‘The Effect of Audit Quality to the Eamings Management (Assi) these companies may convey subjective information concerning management’s feeling about company’s well being. ; Francis et al. (1999) and Becker et al. (1998) report evidence that audit quality act as a constraint on both income-increasing and income-decreasing earnings management in public firms. If audit quality indeed work as a constraint on this instance of earnings management, this study expect less discretionary accruals for firms that are audited by quality auditors, This study predict that the level of earning management is lower for auditees of quality auditor compared to auditees of hon-quality auditor firms audit both in the years prior to and the years following the 1997 monetary crisis, or audit quality. is negatively associated with the level of earnings management both in the years prior to and the years following the 1997 monetary crisis. RESEARCH METHOD Data and Sample Data of this study are some information reported in annual financial statement of companies listed on Jakarta Stock Exchange (JSX) covering financial period between 1994-2000, where 1995-1996 deemed the prior to the crisis period, 1997-1998 the crisis, and 1999-2000 following the crisis. Samples of this research consist of manufacturing companies listed on JSX which filled following criteria: 1) Firms are listed in JSX since the first January of 1995; 2) Firms are belong to specific industry in manufacturing which have at least seven members; and 3) firms publish complete financial statement for period 1994-2000. Analysis based on 436 matched-sample firms (by specialist auditor/non-specialist auditor) for periods 1995-2000 Variable and Measurement This study focuses on discretionary accrual as measure of earning management. Measures of managed accounting accrual used in this study are estimated using Dechow ef al. (1995) suggested modification of the Jones (1991) model. Measure of earnings management, discretionary accrual or managed accounting accrual, is estimated using the expected normal accrual from total accounting accrual. Expected accounting accrual, is estimated using cross-sectional approach, which compares the expected level of accruals for the firms in our sample with others in the same industry each year at the test period, then is used to predict the level of expected accrual for the test firms. Therefore the model employed in this paper is expressed as follow. E(AC,=oatoy(AREV, - AREC,) + 0, (PPE)... Where: E(AC)) = expected normal accrual, AREV, = net revenue in year t fess net revenues in year t-1, AREC, = net receivable in year t less net receivable in year t-1, PPE, = property, plant, and equipment at time 1. All variable are deflated by the beginning period of total asset. Consistent with Jones (1991), the accounting accrual (AC, ) is computed as: +l) auJURNAL AKUNTANSI & BISNIS Vol. 5, No. 2, Agustus 2005: 82 - 90 ACi=(ACAj-ACLi-ACashit ASTDit- Dep,). Where: : . ACA; = change in current assets, ACL = change in current liabilities, ACashy = change in cash and cash’ equivalents, ASTD;t = change in debt included in current liabilities, Depi, = depreciation and amortization expense. All variable are deflated by the beginning period of total asset Measure of earnings management, discretionary accrual or managed accounting accrual (MAA,), is estimated using the expected normal accrual, E(AC;,), from total accounting accrual (AC, ). Specially managed accounting accrual (MAA\) is estimated in the following fashion MAA=AC;E(AC). E(AC)), expected accounting accrual, is estimated using cross-sectional approach, which compares the expected level of accruals for the firm in our sample with others in the same industry each year at the test period, then is used to predict the level of expected accrual for the test firms. Debts to equity ratios are used as proxy for the existence and tightness of accounting based debt covenant. Firm size is measured by natural log of total assets. Zmijewski and Hagerman (1981) suggest that political cost increase with firm size. In this study, the number of client in the specific industry proxies for audit quality. This study control for macroeconomic effect, which help account for macroeconomic condition differences in earnings managemen. Models This study propose the following model to test the effect of audit quality on the earnings management. AAM, = y+ ByFinLevy, + ByFirSize, + By Aud Qualy;+ B,PreCrin+ BSCrisy £4. (4) Where AAM is the managed (discretionary) accounting accrual; FinLev is financial leverage; FirSize is firm size; and AudQual is defined as a dichotomous variable, which take the value | if the firms is audited by an industry specialist auditor (biggest market share), and 0 if it audited by non-industry specialist auditor. PreCri is defined as a dichotomous variable, which take the value 1 if the observation year is 1995 or 1996. Cris is defined as a dichotomous variable, which take the value | if the observation year is 1997 or 1998, Partitioning by macroeconomic period, total sample for the match-paired samples are 134 firms in 1995-1996, 196 firms in 1997-1998, and 146 firms in 1999-2000. FinLev and FirSize are control valiables for proxies of managements’ incentive to enggage earnings management. Indipendent variables PreCri and Cris are additional control variables for macroeconomic effects. . Hypothesis Testing ‘The mean differences of the dicretionary accruals for auditees of squality auditor versus non-specilaist auditor will be tested by comparing the mean of discretionary accruals for industry specialist auditees to for those non-industry specialist auditees both in the two years prior to the monetary crisis (1995-1996), two years within the 85‘The Effect of Audit Quality to the Eamings Management (assim) monetary crisis (1997-1998), and the two years following the monetary crisis (1999- 2000), . The effect of quality audit on the level of earnings management both in the years prior to and the years following the 1997 monetary crisis will be tested by estimating A; in the model. Null hypothesis (Ho) and alternatives hypothesis are Hy: 2 >and H,: B< 0, respectively. If 2; is negative and statistically significant at the level of 5%, the hypothesis is supported. Supporting the hypothesis indicate there is a constraining effect of quality audit on the level of earnings management. The income- increasing, income-decreasing, and absolute value of discretionary accruals are used to test the hypothesis. RESULT Descriptive Statistics Table 1 Characteristics of Total Sample of Firms by Years and Macroeconomic Periods (mean, median, and standard deviation) Variables Pre-crisis Crisis Post-crisis Overall (1995-1996) (1997-1998) (1999-2000) (1995-2000) Total sample 134 "196 146 436 Discretionary Accruals 0.0155 + 0.0565 0.0129 0.0331 0.0164 0.0476 0.0178 0.0244 0.0883 ~ 0.0786 0.0648 0.0794 Total asset 682 1380 1400 1190 (in billions rupiah) 178 362 386 318 25.3 3496 3550 3200 Financial Leverage 0,4907 0.8066 0.8469 0.7295 (total debt/total assets) 0.5095 0.7494 0.7494 0.6567 0.2020 0.5865 0.5865 0.4633 Return on Assets 0.0547 0.0517 0.1074 0.0326 (net income/total assets) 0.0541 6.0072 0.0474, 0.0302 0.0726 0.2467 0.5415 0.3569 On the average, samples have positive discretionary accruals in the different macroeconomic condition. Discretionary accruals are positive and higher in the years following the crisis compare to those in the years prior to crisis. The monetary crisis cause large increase in firm's financial leverages level. The means (standard deviations) for financial leverage are 0.4907 (0.2020) in the years prior to the crisis, 0.8066 (0.4148) in the years of crisis, and 0.8464 (0.4633) in the years following the crisis, Profitability decline in the crisis period and recovery in the years following the 86SWRNAL AKUNTANSI & BISNIS Vol. 5, No, 2, Agastus 2005: 82 - 90 crisis petiod. For return on assets, total sample companies have a mean of 0.0326 (0,3569). By macroeconomic periods, the mean return on assets are 0.0547 (0.0726) pre crisis, -0.0517 (0.2467) crisis, and 0.1074 (0.5415) post-crisis. Univariate Results Table 2 reports statistic descriptive of discretionary accruals of the samples partitioned on audit quality. Table 2 Univariate Descriptive for Discretionary Aceruals Partitioned on Audit Quality Item Total Specialist Audit 195-96 *97-98 ——*99-00__—_—*95-00 Discretionary Accruals (DA) 0.033 0.2245 0.4508 + ———-0.1882 0.0108 (Gross discretionary accruals) (0.024) (0.1786) (0.3401) (0.2004) (0.001) Absolute Discretionary 0.059 0.3124 0.5479 0.5301 0,257 Accruals (ADA) (0.040) (0.2303) (0.3555) (0.3398) (0.0123) Income-increasing 0,061 0.0246 0.5363 0.5244 0.4525 Discretionary Accruals (IDA) (0.042) (0.3225) (0.0195) __— (0.0351) (0.3225) Income-decreasing 0.051 -0,2849 = -0.2892 0.3460 0.2849 Discretionary Accruals (DDC) (0.038) _(-0.131) _(-0.143) (0.127) __(-0.124) ‘Non-specialist Audit (95-96 «97.98 “99-00 ___—“95-"00 Discretionary Accruals(DA) 0.033 (0.1512 _0.6382—-0.3338 0.0195 (Gross discretionary accruals) (0.024) (0.1458) (0.5548) (0.419) (0.013) Absolute Discretionary 0.059 0.6414 0.8378 = 0,6859(0.0734 Accruals (ADA) (0.040) (0.3389) (0.6347) (0.5636) (0.037) Income-increasing 0.061 0.0627 0.9748 0.7277 (0.8155 Discretionary Accruals (IDA) (0.042) (0.035) (0.7132) (0.5963) (0.6148) Income-decreasing 0.051 -0.1041 -0.4941 —--0.7140 0.7280 Discretionary Accruals (DDC) (-0.038) _(-0.558) _ (0.471) _—(-0.545)__(-0.532) Test of Null t-statistic (p-value) 195-96 97-98 “99-00 “95-00 Discretionary Accruals (DA) 0.033 -0.513.——-0.513 5.370 0.7160 (Gross discretionary accruals) (0.024) (0.609) (0,609) (0.000) (0.477) Absolute Discretionary 0.059 «2.685 2.685 10.986 0.4503 Acoruals (ADA) (0.040) (0.009) (0.009) (0.000) _—(0.000) Income-increasing 0.061 2.998 2.998 11,348 9.501 Discretionary Accruals (IDA) (0.042) (0.005) (0.005) (0.000) _—(0.000) Income-decreasing 70.051 4.321 4.321 -2.688 ——-0.6514 Discretionary Accruals (DDC) _(-0.038) __ (0.001) (0.001) (0.015) (0.000) Note: Statisctic descriptive is mean (median). Two-tail statistical significance level based on two-tail, In general, each of discretionary: accruals, absolute discretionary accruals, income-increasing discretionary accruals, and income-decreasing discretionary accruals reported by clients of quality auditor (specialist auditor) are lower than those are reported by clients of non-qualiy auditor (non-specialist auditor). The mean 87The Effect of Audit Quality to the Eamings Management passa differences in absolute dicretionary accruals, income-increasing discretionary accruals, and income-decreasing discretionary accruals for: auditiees of industry specialist auditor versus non-specilaist auditor across‘the whole period are significant at 1% fevel. The level (absolute value) of earning management is significantly lower for clients of specialist auditor compared to clients of non-specialist auditor firms audit. The calculated t value is 0.4503 and probability value is 0.000. The mean for each income increasing and income decreasing of discretionary accruals reported by clients of industry specialist auditors are lower than for those of‘non-industry specialist auditors. Respectively, the calculated t value (probability value) are 9.501 (0.000) and 6,514 (0,000). In conclusion, at the significance one side level of 1%, hypothesis that no differences the level of earnings management between auditee of quality auditor and auditees of non-quality auditor firms audit is rejected. ‘The level of discretionary accruals are lower in the years prior to the crisis period than those both in the years of crisis and in the years following the crisis. Mean absolute discretionary accruals increase from 0.3124 to 0.5301 for clients of specialist auditor and 0.6414 to 0.6859 for clients of non-specialist auditor between the years prior to the crisis and the years following the crisis, Mean income-increasing discretionary accruals increase from 0.4252 to 0.5363 for clients of specialist auditor and 0.0627 to 0.7277 for clients of non-specialist auditor between the years prior to the crisis and the years fotiowing the crisis. Mean income-decreasing discretionary accruals decrease from —0.2849 to -0.2167 for clients of specialist auditor but increase from-0.1041 to 0.7140 for clients of non-specialist auditor between the years prior to the crisis and the years following the crisis. The results show that the level of earning management is lower for auditees of quality auditor compared to auditees of non- quality auditor firms audit both in the years prior to and the years following the 1997 monetary crisis and the monetary crisis associated with positive discretionary accruals espicially for auditees of specialsist auditor. Multivariare Results Table 3 show the result of multiple regression The calculated F value of Model 1 is 13.743 and probability value of it is 0.000, statistically significant at level of 1%. Based on the assumption test, the model is free from multicollinearity, heteroscedasticity, and autocorelation. This study then rely on central limit theorem, this study can use normality assumption. There for, the usual test procedures are still valid asymptotically The result of multiple regression across the entire examined time period 1995- 2000 show that the variable of interest, AudQual, are significant in constraining the magnitude of discretionary accruals. The coefficient of 6; in the model is -0.0337 with calculated t value is -6.008 and probability value is 0.000 using absolute discretionary accruals as dependent variable. The result shows that audit quality has negative effect on the level of discretionary accruals. Consistent with Francis ef al. (1999) and Becker et al. (1998), the result of this study shows that audit quality act as a constraint on earnings management in public firms. - The coefficient of FinLev variable is 0,0194 and probability value is 0,006. The coefficient of FirSize is -0.0081 and probability value is 0.088. The 1997 monetary crisis cause the financial trouble among public companies in the Jakarta StockSJURNAL AKUNTANSI & BISNIS Vol. 5, No. 2, Agustus 2005: 82-90 Exchange. Mean of financial leverage increase from 0.4907 in the years prior to the crisis to 0.8066 in the years of crisis, and 0.8464 in the years following the crisis. For troubled firm, managers’ accounting chofce will be systematically income-increasing. Managers have incentive to increase reported earnings in attempt to avoid of defer the cost of debt covenant violation, to keep their job and reduce intervention by firm’s board of directors and or regulation agencies,or to delay the dissemination of negative information, or select accounting method that temporally mask some economic attribute of company’s financial condition. Table 3 OLS Regression of Absolute Discretionary Accruals Dependent Variables Coefficient _ t-statistic value p-value Contant 0.1530 2723 0.006 FinLev 2.768 0.006 FirSize -1.709 0.008 AudQual 6.008 0.000 PreCri 0.501 0.617 Cris 0.0150 2.317 0.021 R2 (Adj R2) 0.138 (0.128) E 13.743 * * significant level at 1% The coefficient of Cris variable is 0,015 and probability value is 0,021. In conclusion, at the significant level of 5%, that coefficient statistically significance. Empirical evidence supports the argument that the monetary crisis is positively associated with the level of earnings management. CONCLUDING REMARK Based on results and analyses, this research concludes the followings. Firstly, this research conclude that the level of earning management is tower for clients of quality auditor compared to clients of non-quality auditor firms audit both in the years prior to and the years following the 1997 monetary crisis, or that audit quality is negatively associated with the level of earnings management. Related prior studies (Becker ef al, 1998; Francis ef al, 1999), without respect to macroeconomic condition, found evidence that is support the constraining impact of audit quality in earnings management. Secondly, the monetary crisis and the level of financial leverage are positively associated with the level of earnings management. Refinement of his research might use other proxies of audit quality. Future research might investigate special component of accruals. 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