Chapter 3
In this chapter we will reexamine theories near to the intent of this research. Key aim of this research is to happen out the influence of audit on net incomes direction. We will besides develop the research hypothesis in this chapter.
3.1 Audit Quality in FTSE 100 and AIM Companies
Measuring audit quality is non an easy undertaking. All public limited companies ( FTSE companies ) are required to hold their fiscal statements audited. The statutory hearer provides stakeholders of the company the confidence sing the truth of the fiscal statements, the absence of fraud in fiscal statements and the traveling concern position.
There is a good opportunity that bureau struggles may be strong in public houses compared to private houses. This is because ownership and control are extremely detached which increases the demand for fiscal statements for monitoring directors and a high quality audit.
Now the inquiry is how to mensurate that an audit is of high quality. As portion of this research we pointed out the following factors which might be index of audit quality –
Size of the audit house: It is assumed that the large four audit houses conduct high quality audit ;
Audited account term of office: It is assumed that the more the clip spent in scrutinizing the more the quality of the audit would be ;
Client significance: Irrespective of other issues when the client company is a important entity, hearers provide more attempt to keep audit quality ;
Audit Fee: Though audit fee has a positive relationship with size of the audit house, a weak nexus can be made that high audit fee may do the hearer give up some quality in favor of client direction.
In position of audit market, audit quality is dependent on ( 1 ) the chance that stuff misstatements and signals of fiscal hurt are discovered and ( 2 ) the chance that the hearer will describe these misstatements and signals ( DeAngelo, 1981 ) .
The procedural capableness of hearers or the likeliness that the hearer will happen out material misstatements and traveling concern breaches is frequently assumed to be invariable across different hearers ; audit quality is hence a map of hearer independency. The hearers would non compromise their independency when there are commissariats of judicial proceeding and disciplinary actions.
It provides inducements to the hearer to restrain net incomes direction or publish a qualified sentiment when necessary. Other than the countenances, even controversial actions or disciplinary countenances damage the hearer ‘s repute. From this position, it is assumed that larger audit houses are less likely to execute low quality audits because they will lose in footings of clients and audit fees in instance of an audit failure. Auditor independency is hence a good will capital ( DeAngelo, 1981 ) . However, when the hazard of audit failure sensing and judicial proceeding is low, case and repute costs of offering a low quality audit are expected to be decreased which lowers the inducements of large audit houses to provide a high quality audit.
Harmonizing to certification of assorted empirical surveies ( e.g. Maijoor and Vanstraelen, 2006 ; Francis and Wang, 2008 ) , Big 4 audit houses are less inclined to provide public client houses with high quality audits in states investor protection is weaker, lower degree of enforcement and lower hazard of legal action. In private companies, case and good will costs are likely much lower, despite the presence of stronger investor protection or legal enforcement as fiscal statements of private houses are non scrutinized as much by investors, fiscal analysts or modulating governments of stock exchanges ( Chaney et al. , 2004 ; Vander Bauwhede and Willekens, 2004 ) .
3.2 Net incomes Management in FTSE 100 and Aim Companies
Many surveies have investigated net incomes quality and its determiners among public houses ( see Beatty and Harris, 1998 ; Beatty et al. , 2002 ; Coppens and Peek, 2005 ; Burgstahler et al. , 2006 ) . Public companies are widely held holding small managerial ownership, stockholders have really small insider entree to corporate information and stockholders can non take active function in direction. Furthermore, their fiscal statements are widely distributed to the populace and are more likely to be influenced by stockholder aims and managerial public presentation issues.
The chief users of public houses ‘ fiscal statements are equity investors. To protect the involvements of these equity investors, all FTSE companies are required to hold their fiscal statements audited.
Net incomes direction in public houses deprives the users of fiscal statements of obtaining dependable information. The duty of the statutory hearer is protecting the stakeholders ‘ involvements. Them chief involvement of this research is to happen out at what extent audit quality constrains on net incomes direction in public houses.
3.2.1 Proxy of Earnings Management for FTSE and AIM Companies
Harmonizing to our treatment in earlier subdivisions, discretional accumulations are really strong step of net incomes direction. However for the intent of simpleness we used a simpler method – ratio of entire accumulations and entire assets. The more the ratio size is the more there is opportunity of accrual direction. This measuring is used to maintain the research end product simple and apprehensible to broad group of comptrollers and non-accounting directors.
Reported net incomes figure of a house is typically a focal point of the analysts and the media. Aspects other than these in fiscal statements may be overlooked, despite these points provide valuable information about the quality of houses ‘ reported net incomes.
In finding net incomes quality, accounting analysis by and large relies on subjective input. It ‘s needed to integrate sentiments sing the graduated table of accounting accumulations: the macro-micro concern environment, control, insider trading, sentiments of hearers, and fees and direction inducements to pull strings fiscal statement consequences. Accounting analysis is non a standalone methodological analysis for finding the investing virtues of a security. This accounting analysis fits into a larger construction of analysis, which includes strategic scrutiny, fiscal ratio analysis and rating analysis.
3.2.2 Net incomes Management and Audit Quality
Few anterior surveies have looked at the relation between net incomes direction and audit quality. These surveies besides examined the impact of hearer quality on direction inducements to pull strings the reported net incomes. Hirst ( 1994 ) used an experimental design to verify the consequence of hearers ‘ belief that directors may hold inducements to pull off reported net incomes on their outlook of stuff misstatements in fiscal statements ( Ebrahim, 2001 ) . Harmonizing to Defond ( 1993 ) houses that changed the hearer after a client-auditor dissension are leveraged extremely and more likely to hold debt compact misdemeanor. These houses besides are more likely to hold a diminution in reported net incomes. The findings besides show that in the presence of questionable accounting processs, this would ensue in smoothened net incomes Numberss or level growing in net incomes. However we found really few surveies on audit quality and net incomes direction of FTSE and specially AIM companies.
3.2 Hypothesis Development
In this subdivision we will show the research subjects in relevancy with the research hypothesis.
3.2.1 Size of the Audit Firm and Earnings Management
It is assumed that large audit houses with many spouses have strong construction, method and policy to carry on better quality audit. This is why these audit houses have gone big. Besides large hearers are influential and concentrate client keeping based on quality of audit. As a consequence our first hypothesis is as following –
H1: The size/rank of the audit house reduces the chance of gaining direction, i.e. , net sum accruals/average plus would hold a negative relationship with the size of the hearers.
3.2.2 Audit Tenure and Earnings Management
If auditing map takes longer clip, the hearers can verify more minutess and there the audit can happen out more material information. Therefore longer audit term of office can de-motivate both the discretional and non-discretionary accumulations. Therefore our 2nd hypothesis is as following –
H2: Longer audit term of office reduces the chance of both the discretional and non-discretionary net incomes direction.
3.2.3 Client Significance and Earnings Management
As we discussed earlier, significance of the client company may promote the hearers to carry on high quality audit irrespective of the size of the audit house or audit term of office. Therefore our 3rd hypothesis is as following –
H3: Size and significance of the client may restrict the chance of net incomes direction.
3.2.4 Audit Fees and Earnings Management
Though theoretically there is no direct nexus between audit fees and net incomes direction, grounds were found that audit fee can restrain the net incomes direction or increase the chance of net incomes direction. Our research hypothesis is –
H4: High audit fee may promote the hearers to retain its client for long clip and work alongside direction and let net incomes to be managed. The opposing issue is that lower audit fee may cut down the audit quality and there increases the audit quality.
3.2.5 Auditor ‘s Opinion as Signal of Earnings Management
As we have discussed earlier that hearer expresses his/her sentiment on the fiscal statements. Such sentiment should be presented reasonably in conformity with relevant coverage model and states whether the fiscal statements are prepared in conformity with statutory demands. Normally, higher magnitude of net incomes direction should be reflected in hearer ‘s sentiment. Therefore our concluding hypothesis as following –
H5: Auditor ‘s sentiment reflects the possibility of net incomes direction. For illustration, larger Net Accruals/Average Asset would be reflected in hearer ‘s sentiment.
