It is widely understood that companies can and do exploit the flexibility built into GAAP to manage reported earnings. Earnings management can be 'good', when used to signal information to the markets. But it can also be used to hide bad news.
This creates a demand for monitoring of financial reporting through internal governance mechanisms and the independent external audit.
The SEC has argued that independence is undermined when auditors provide non-audit services. But the independence debate between the profession and regulators has been backed by little serious research. As part of our Governance Research Programme at Lancaster University Management School we are seeking to address this deficiency.
The first stage of the research (with Drs. P Gore and A Singh) reveals clear evidence confirming UK listed companies manage earnings upwards to meet basic targets. What about the role of the auditor in constraining such ‘aggressive’ earnings management? Interestingly, we find earnings management by Big Five-audited companies is generally lower than for other companies, and is unrelated to NAS fees (except for earnings management to meet analysts’ forecasts).
But our results also present challenges for the profession. For the 25% or so of our sample (about 1,200 cases) with non-Big Five auditors we find higher levels of earnings management and a significant association with NAS fees. It seems some auditors are less likely to challenge aggressive financial reporting when NAS fees are high. This is consistent with, but admittedly not conclusive proof of, a link between NAS and reduced independence.
If the link we have uncovered is not related to independence issues, we need to find an alternative explanation – a common factor underlying both NAS fees and estimated earnings management. We have already shown board independence is important and have controlled this in our study.
We plan a closer look at auditor-auditee relationships and particularly the role of the audit committee. There is more to learn and if members of the profession feel our results are missing something, rather than merely unwelcome, we look forward to hearing from them.
I believe our research is good news for the profession, especially the Big Five because it suggests internal organisation structures can be developed to avoid erosion of independence in audit work without eliminating non-audit services.
Links
Auditor independence study under fire
Research supports SEC rule change