International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 66 (2011)

EuroJournals Publishing, Inc. 2011
http://www.eurojournals.com/finance.htm

Impact of Audit Quality on Earnings Management:

Evidence from Iran
Mahdi Safari Gerayli
Ph. D. Student, Department of Accounting, Bandargaz Branch
Islamic Azad University, Bandargaz, Iran
E mail: safari@bandargaziau.ir
Abolfazl Momeni Yanesari
M.A. in Accounting, Behshahr Payame Noor University, Behshahr, Iran
E mail: momeniPNU@yahoo.com
Ali Reza Ma'atoofi
Ph. D. Student, Department of Management
Gorgan Branch, Islamic Azad University, Gorgan, Iran
E-mail: alirezamaetoofi@gmail.com
Tel: +98-171-2245961; Fax: +98-171-2247958
Abstract
The aim of the research presented in this paper is to provide empirical evidence on
the impact of Audit Quality on Discretionary Accruals, as a measure of Earnings
Management, in Iranian listed firms. Multiple regression analysis is used in the study in
estimating the relationship between the Audit Quality and firms Discretionary Accruals.
Using three different measures of Audit Quality (i.e. Auditor size, Auditor industry
Specialization and Auditor Independence) and based on a sample of 90 non-financial
Iranian listed firms from 2004 to 2009, the results reveal that Discretionary Accruals are
negatively related to Auditor size and Auditor industry Specialization. Our findings also
support our hypothesis of the negative association between auditor independence and
Discretionary Accruals. Overall, this study provides evidence that firms which are audited
by high quality auditors are more likely to have less Discretionary accruals, a finding that is
consistent with prior research.
Keywords: Audit Quality, Earnings Management, Discretionary Accruals

1. Introduction
The agency problems associated with the separation of ownership and control create the demand for
external audit. Initially, the agency problems arise from the asymmetric information in the Principalagent contracts. Asymmetric information refers to a situation where one party to a transaction has more
information than the other party. Analytical models have demonstrated that the existence of
information asymmetry between firm management and firm shareholders is a necessary condition for
the practice of earnings management (Trueman and Titman, 1988; Dye, 1988). When information
asymmetry exists, shareholders have insufficient resources, incentives, or access to relevant
information to monitor manager's actions, earnings management can also occur (Schipper, 1989;
Warfield, Wild, and Wild, 1995).

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Many studies have been done in the area of corporate governance and Audit quality all of
which know the two mechanisms as effective factors to restrain excessive opportunistic behavior
amongst corporate management. Prior research on the relationship between Audit quality and earnings
management has been done in the developed countries, however, a few studies have been done to
examine this relationship in the emerging countries, which is the motivate for the present study.
Therefore, the study is intended to find an acceptable answer to the question that whether the audit
firm's independence, industry specialization and size, as criteria of audit quality, can limit the applying
of earnings management in Iranian firms.
The remainder of this study is organized as follows. The background and hypotheses
development are discussed in Section 2. The research sample and design are discussed in Section 3,
and the results of testing the hypotheses are discussed in Section 4. Section 5 contains the summary
and conclusion that includes identified limitations and suggestions for further research.

2. Background and Hypothesis Development

The role of auditing in ensuring the quality of reported earnings and constraining client earnings
management has come under considerable scrutiny due to recent corporate accounting scandals. Audit
quality differences result in variation in credibility offered by the auditors, and in the earnings quality
of their audit clients. The current paper concentrates on discussing and analyzing the effect of audit
quality on earnings management. Hence, several hypotheses are developed that identify and link some
specific aspects of audit quality to earnings management.
2.1. Auditor Size and Earnings Management
DeAngelo (1981) argues that Big4 auditors provide better quality audits than non-Big4 auditors, which
is supported by extensive subsequent empirical research. Teoh and Wong (1993) find higher ERCs for
clients audited by Big4 firms compared to those audited by non-Big4 firms. Becker et al (1998),
Francis et al (1999) and Krishnan (2003) demonstrate that Big4 auditors are better at constraining
client earnings management compared to non-Big4 auditors; they find that clients of non-Big4 auditors
have higher levels of discretionary accruals. In addition, Zhou and Elder (2003) and Chen et al (2005)
find that Big 4 auditors associate with less earnings management in the firms. Hence, the following
hypothesis is proposed:
H1: There is a significantly negative association between auditor size and the occurrence of
earnings management.
2.2. Auditor Industry Specialization and Earnings Management
In addition to auditor size, auditors industry specialization is considered to be another proxy for audit
quality. Several prior studies show that client firms with industry specialists are associated with higher
quality of financial reporting (e.g. Balsam et al, 2003; Krishnan, 2003). Therefore, the use of an auditor
with industry specialization will help curb earnings management. These findings are consistent with
the theory that auditors specialize in various industries to achieve product differentiation and provide
higher quality audits (Simunic and Stein, 1987; Dunn and Mayhew, 2004). Higher quality of audits by
industry specialists is also attributed to the fact that they invest heavily in technologies, physical
facilities, personnel, and organizational control systems that enable them to detect irregularities and
misrepresentations more easily (Simunic and Stein, 1987). Their ability to provide higher quality audits
comes from their experience in serving other clients in the same industry and learning and sharing best
practices across the industry (Dunn and Mayhew, 2004).
Similarly, PricewaterhouseCoopers (2002) argue that audit quality depends on numerous
factors including an auditors knowledge and understanding of the company being audited and the
industry in which it operates. Furthermore, Zhou and Elder (2003) and Rusmin (2010) argue that the
discretionary accruals of industry specialist auditor clients are lower than discretionary accruals of nonindustry specialist clients. These arguments thus suggest that auditors with industry expertise are more
likely to detect misrepresentations and irregularities than auditors without industry expertise, especially

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in the early years of the audit assignment. The linkage is based on the assumption that industryspecialist auditors have the industry expertise that results in better understanding of the clients
business. Hence, H2 is as follows:
H2: There is a significantly negative association between Auditor industry specialization and
the occurrence of earnings management.
2.3. Auditor Independence and Earnings Management
Prior studies contend that high fees paid by a company to its external auditor increase the economic
bond between the auditor and the client and thus the fees may impair the auditors independence (e.g.
Frankel et al, 2002; Li & Lin, 2005). The impaired independence results in poor audit quality and
allows for greater earnings management (resulting in lower earnings quality). This discussion leads to
the development of H3:
H3: There is a significantly negative association between Auditor independence and the
occurrence of earnings management.

3. Sample selection and Measurement of Variables

3.1. Sample Selection
We select all publicly- listed companies in Tehran Stock Exchange (TSE) over the entire duration of
the estimation time period (20042009) as initial samples. Of these initial 735 firm- year observations,
firms that are either missing financial variables or that have insufficient data are eliminated. Financial
institutions, banking, finance and investment firms are also eliminated, since their accounting and
reporting environments differ from those in other industries. This gives a final sample of 540 firm-year
observations from the fiscal years 2004 to 2009.
3.2. Measurement of Variables
3.2.1. Dependent Variable
In order to analyze the effect of Audit quality on the earnings management, discretionary accruals was
used to measure earnings management (EM) as the dependent variable. The practice of using
discretionary accruals to proxy for EM is consistent with the extant EM literature (for example,
Johnston and Rock, 2005; Cahan et al, 1997; Hall and Stammerjohan, 1997). While there are many
ways to estimate discretionary accruals, this study employs the Modified-Jones Model (Dechow et al,
1995). The Modified-Jones Model has been shown to outperform other discretionary accrual models in
detecting EM (Dechow et al, 1995) and is frequently used in the accounting literature (DeFond and
Subramanyam, 1998; Guidry et al, 1999). Prior to estimating discretionary accruals, total accruals
(TAC) are calculated as:
TACi,t= CAi,t - CASHi,t - CLi,t + STDEBTi,t DPNi,t
Where:
TACi,t= total accruals for firm i in time period t; CAi,t= change current assets for firm i from
time period t1 to t; CASHi,t= change cash balance for firm i from time period t1 to t; CLi,t=
change current liabilities for firm i from time period t1 to t; STDEBTi,t= change in short-term debt
for firm i from time period t1 to t ;and DPNi,t= depreciation & amortization expense for firm i from
time period t1 to t.
To estimate Discretionary accruals (DAi,t) for firm i in year t, we perform the following crosssectional regression for each firms in each year:
(1)
TAi,t/Ai,t-1= 1(CFO/Ai,t-1) + 2 (REVi,t/Ai,t-1) + 3(PPEi,t/Ai,t-1) + i,t
Where:
REVi,t= firm is change in revenues in year t, PPEi,t= firm is gross value of property, plant,
and equipment in year t, and we have deflated by firm is total assets in year t-1(Ai,t-1).
We then use the firm-specific parameter estimates from (1) to estimate firm-specific
Discretionary accruals (DAi,t ) for firm i in year t as a percent of lagged total assets; that is,
NDAi,t= 1(1/Ai,t-1)+ 2 (REVi,t ARi,t)/Ai,t-1 + 3(PPEi,t/Ai,t-1)

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Where:
ARi,t = firm is change in accounts receivable in year t.
In turn, Discretionary accruals (DAi,t) for firm i in year t are:
DAi,t= TAi,t/Ai,t-1 NDAi,t
3.2.2. Independent Variables
With regards to the independent variables, because there is no agreed-upon metric for the audit quality
construct, it was measured using three different measures as follows:
3.2.2.1. Auditor Size
Regarding the significance of auditor size, DeAngelo (1981) and Datar et al (1991) claim that large and
more prestigious public accounting firms concerned about protecting their investment in reputation
capital have more incentive than do other auditors to supply a high-quality audit. Further, Craswell et
al (1995), and Francis and Reynolds (2000) find that the large audit firms have brand-name reputation,
charge higher audit fees, and/or behave qualitatively differently from smaller audit firms. Overall,
these studies generally suggest that audit quality is likely to be positively related to audit firm size. We
set Auditor size equal to 1 if the company audited by Big 4 audit firm, otherwise, 0.
3.2.2.2. Auditor Industry Specialization
A dichotomous variable was used to denote if the auditor was an industry specialist or not. Following
Dunn et al (2000), an auditing firm was classified as industry specialist (SPL_20) if its market share
was greater than or equal to 20% of total market share of its specific industry. Similar to prior studies
(Velury et al., 2003; Dunn et al, 2000; Craswell et al, 1995), auditor industry market share was defined
as the proportion of industry revenue audited by an individual accounting firm relative to the total
industry revenue for all companies in that industry audited by all public accounting firms.
M S

ik

i=1

ik

S A L E

j= 1
J

ik

j= 1

ijk

S A L E

ijk

Where:
SALEijk = total sales of client firm j in industry k audit by auditor i.
i=1, 2,..., I = an index for audit firms.
j=1, 2,..., J = an index for client firms.
k=1, 2,..., K = an index for client industry.
Ik = the number of audit firms i in industry k.
Jik = the number of clients served by audit firm i in industry k.
When auditor js market share is greater than 20 percent in Industry k, the auditor j is treated as
an industry specialist.
3.2.2.3. Auditor Independence
There is no agreement on how to measure the Auditor independence. Prior studies have used a number
of variables: fee ratio (non-audit fee over total fee), total fees, and separate audit and non-audit fees. In
this study, because the data related to non-audit fees are unavailable, the natural log of audit fees are
used as the opposite criterion of audit independence. Large (small) values of audit fees imply poor
(good) Auditor independence.
3.2.3. Control Variables
We control for variables that have been identified in prior literature as likely to affect the reporting of
discretionary accruals such as firm size, operating cash flows, growth prospects and leverage.
Large firms are less likely to engage in earnings management due to more scrutiny from
financial analysts and investors (Zhou and Elder, 2001). Becker et al (1998) and Reynolds and Francis
(2001) report cash flow from operations influences corporate management actions in managing
earnings. In addition, researchers such as Skinner and Sloan (2002) and, Matsumoto (2002) suggest
that firms with higher growth prospects are more likely to manage earnings. Finally, Leverage is
included as prior studies show that firms with a higher likelihood of violating debt agreements are

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more likely to have an incentive to engage in earnings management to increase earnings (Healy and
Palepu, 1990; Sweeney, 1994).
3.3. Regression Model
A linear-multiple regression analysis was used to test the association between the dependent variable of
Discretionary accruals and the independent variables of Audit Quality. The following model is
estimated:
DAi,t= 0+ 1 AudSIZEi,t + 2 SPECi,t + 3 AudINDi,t + 4OCFi,t+ 5 GWTHi,t+ 6SIZEi,t+ 7LEVi,t+i,t i,t

Where, for sample firm i at the end of year t:

DA= Discretionary Accruals estimated using Modified-Jones Model.
AudSIZE = dummy variable, 1 if the firm is audited by a Big 4 auditor, 0 otherwise.
SPEC= dummy variable, 1 if MS > 20 percent, and 0 otherwise.
AudIND = auditor independence defined as log of firms total audit fees.
OCF= operating cash flows divided by total assets at fiscal year-end.
GWTH = growth prospect defined as the market value of equity divided by book value of equity.

SIZE = firm size defined as natural log of firms total assets.

LEV = ratio of total debt to total assets.
i,t = the error term.

4. Results and Discussion

4.1. Descriptive Statistics
Table I presents a summary of descriptive statistics of the dependent and independent variables used in
the study. The mean (median) value for discretionary accruals (DA) is 0.741 (0.896). 47.5 percent of
the sample are audited by the Big 4 auditors. The mean (median) audit fee is IRR 336.33m (IRR
221.99m) and it ranges from IRR71m to IRR 3800.35m.On average, 63 percent of the firms are audited
by industry specialists. as shown in Table I the mean (median) value of ratio of total debt to total assets
is 0.712 (0.735); this result suggests that about 71 percent of total assets of Iranian listed firms are
financed by debt, this is consequently suggests that Iranian listed firms operate with high level of
financial leverage.
4.2. Regression Results
Table II presents the results of testing the Association between Audit quality measured by three
different proxies namely: Auditor Size, Industry specialist auditors and Auditor independence with
earnings management measured by Discretionary Accruals. To investigate the existence of
multicollinearity, the variance inflation factors (VIFs) for each of the independent variables are
computed. As reported in column 5 of Table II, VIFs for the explanatory variables are always below
2.0, suggesting that multicollinearity is not likely to be a major factor driving our results.
Table I:

Descriptive statistics for all variables

Variables
DA
AudSIZE
SPEC
Audit Fee(000000s)
AudIND
OCF
GWTH
SIZE
LEV

N
540
540
540
540
540
540
540
540
540

Mean
0.741
0.475
0.631
336.33
5.5460
0.050
1.632
5.116
0.712

Median
0.896
0.000
1.000
221.99
5.4026
0.031
1.452
5.097
0.735

Minimum
0.283
0.000
0.000
71.00
4.2627
0.002
0.632
2.718
0.472

Maximum
1.865
1.000
1.000
3800.35
8.2428
0.326
2.112
7.652
0.869

Std. Deviation
0.147
0.454
0.321
417.80
0.6353
0.055
0.431
0.612
0.198

Notes: DA-Discretionary Accruals estimated using Modified-Jones Model; AudSIZE-dummy variable, 1 if the firm is
audited by a Big 4 auditor, 0 otherwise; SPEC-dummy variable, 1 if MS > 20 percent, and 0 otherwise; AUDFEEtotal audit fees (in IRR million); AudIND-auditor independence defined as natural log of firms total audit fees;
OCF-operating cash flows divided by total assets at fiscal year-end; GWTH-growth prospect defined as the market
value of equity divided by book value of equity; SIZE-firm size defined as natural log of firms total assets; LEVratio of total debt to total assets.

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As shown in this table, the Adjusted R2 of 52.68 percent gives confidence in the explanatory
power of the model. The coefficient of AudSIZE in the Model is negative, as expected, and is
significant at the 0.01 level. This result indicates a significant negative relationship between auditor
size and Discretionary Accruals; the analysis thus supports H1.
The SPEC coefficient in the Model is also negative, as predicted, and statistically significant at
the 0.05 level, which indicates a significant negative relationship between industry specialist auditors
and Discretionary Accruals; hence H2 is also supported.
As shown in Table II, The coefficient for AudIND is negative, as expected, and is significant
(at the 0.05 level). This result supports our hypothesis of the negative association between auditor
independence and Discretionary Accruals.
The control variables, GWTH, and LEV are positively and significantly associated with
Discretionary accruals that was expected and is in line with prior research. We also find that the larger
the firms, the lower the Discretionary Accruals, suggesting that Large firms due to more scrutiny from
financial analysts and investors are less likely to engage in earnings management. On the other hand,
the coefficient of OCF is not statistically significant at the 0.05 level; this indicates that OCF has no
significant effect on DA.
Table II:

Multiple regression results

Collinearity Statistics
VIF
Intercept
?
0.2654*
2.044
AudSIZE
-1.0414**
-4.3315
1.015
SPEC
-0.7579*
-2.0226
1.288
AudIND
-0.5643*
-2.1684
1.421
OCF
?
-0.4121
-1.0124
1.394
GWTH
+
0.5311*
2.1216
1.047
SIZE
-0.3224**
-3.3745
1.007
LEV
+
0.7541*
1.9821
1.346
Adjusted R2
52.68
F-value
14.256
Durbin Watson
2.148
P-value of F-test
0.000
Notes: * statistically significant at the <5 percent level, one-tailed test;** statistically significant at the <1 percent level,
one-tailed test; AudSIZE- dummy variable, 1 if the firm is audited by a Big 4 auditor, 0 otherwise; SPEC- dummy
variable, 1 if MS > 20 percent, and 0 otherwise; AudIND-auditor independence defined as log of firms total audit
fees; OCF-operating cash flows divided by total assets at fiscal year-end; GWTH-growth prospect defined as the
market value of equity divided by book value of equity; SIZE-firm size defined as log of firms total assets; LEV ratio of total debt to total assets.
Explanatory variable

Expected Sign

Coefficients

t-statics

5. Conclusion
A vast literature investigates the implications of Audit quality since the seminal work of DeAngelo
(1981). Most of these studies investigate these implications in the developed countries, very little is
empirically known about such implications in emerging or transition economies such Iran. The study
investigates the impact of audit quality on earnings management of listed firms in Iran, as one of
emerging or transition economies.
Based on a sample of 540 firm-year observations from the TSE for fiscal years 2004 to 2009,
and using three measures of Audit quality (AudSize, SPEC, and AudIND), the study finds that Auditor
size is negatively associated with the earnings management measured by DA, thus indicating that firms
which use big 4 auditors will engage in less earnings management than firms with non-big 4. Our
results are consistent with those of Zhou and Elder (2003) and Chen et al (2005) that suggest, the big-5
auditors are associated with reduced management discretion over earnings. We also find that firms
audited by industry specialist auditors engage in less earnings management. This is consistent with the
findings of Zhou and Elder (2003) and Rusmin (2010) that auditor industry specialists can be used to
constrain earnings management.The results from testing the association between the Auditor
independence and earnings management suggest that the more an audit firm enjoys from independence,

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International Research Journal of Finance and Economics - Issue 66 (2011)

the more the quality of auditing will enhance, which is by itself considered as one of the obstacles for
applying earnings management in firms.
Like any other research, the present research has also some limitations which seem necessary to
be mentioned. First of all, the sample only covers six years of Iranian data and an external validity
problem exists that the results may not be so generalizable to cover different periods of time and
different locations. Secondly, in the study, the effect of inflation and other economical conditions on
the figures related to financial statements and the calculation of discretionary accruals were ignored.
Future research should include other factors that may affect the occurrence of earnings management in
the firms such as corporate governance mechanisms.

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