Is auditor tolerant of earnings management in socially responsible firms? Evidence from China

Abstract

PurposeThis study examines the effect of audit quality on earnings management to beat earnings targets among Chinese listed firms, taking into account the firms’ corporate social responsibility (CSR) practice.Design/methodology/approachThe sample consists of all A-shares listed in the Chinese stock market from 2001 to 2019, except firms in the financial industry. Probit estimator is employed to observe the effect of audit quality, proxied by a binary variable indicating whether a firm is audited by a Big 4 audit firm, on the behavior of earnings management to beat earnings targets. Industry and year fixed effects are incorporated into the models to control for differences among industries and time periods.FindingsThe result of this study reveals that audit quality disciplines earnings management to beat earnings targets in Chinese firms. This result holds across different specification and endogeneity tests. The authors further find that auditors seem to be more tolerant to earnings-managed firms that actively disclose CSR activities. However, this moderating effect of CSR disclosure only exists among firms that manage earnings less aggressively.Practical implicationsThe findings of this study suggest that market participants should be mindful of the earnings management phenomenon and make their investment decisions after carefully dissecting and confirming the truthfulness of firms’ financial reporting. Regulators should raise the requirement on the capacity of auditing services to ensure the quality of the audit outcome.Originality/valueThis study is the first to investigate the effect of audit quality on earnings management to beat earnings targets in Chinese firms. Moreover, this study pioneers in observing the moderating effect of CSR disclosure on the relationship between audit quality and earnings management.

Is earnings management impacted by audit fees and auditor tenure? An analysis of the Big Four audit firms in the US market

“…This study has interesting implications for both policymakers and legislators. The results suggest that implementing a cap on audit fees or introducing a mandatory auditor rotation system, as practiced in Europe or China (Hoang et al, 2022), may not be advisable. Furthermore, our findings indicate that, in order to reduce earnings management (EM), further research should be conducted on the internal aspects of audit firms related to their ethical culture.…”

“…The connection between audit fees and EM or audit quality has been explored in previous literature, as EM is considered a countermeasure of audit quality (Ali et al, 2022;Hoang et al, 2022). However, the findings obtained are contradictory.…”

“…This stance, expressed in the European Commission's Green Paper, led to the adoption of the mandatory rotation policy prescribed in the 2014 EU Regulation . A similar situation exists in China, where auditor rotation is legally established (Hoang et al, 2022). In contrast, the United States do not have a law mandating the rotation of auditors, although the Public Company Audit Oversight Board (PCAOB) has previously explored this possibility and has put forth regulations that would necessitate periodic auditor rotation.…”

“…The scientific literature offers a large number of studies that focus on external threats to independence, especially on the effect of rotations and audit fees (Duong Thi, 2023;Gandía & Huguet, 2018;Lohwasser & Zhou, 2023;Nekhili et al, 2022;Salehi et al, 2022;Usman et al, 2022), with inconclusive results. Some authors, such as Zgarni et al (2016), Choi et al (2022b) and Hoang et al (2022), have even focused on analyzing these threats within the so-called Big Four accounting firms. However, few studies have considered that auditor independence also depends on internal aspects such as corporate culture.…”

Cross-Cultural Auditing: Challenges in Global Practice

“…By demonstrating cultural sensitivity and flexibility, auditors can bridge cultural divides and foster more meaningful interactions with clients. The use of interpreters can also facilitate effective communication in cross-cultural audit engagements, particularly in situations where language barriers are significant (Nguyen & Pham, 2017). Interpreters play a crucial role in facilitating communication between auditors and clients, ensuring that messages are accurately conveyed and understood.…”