A model to assess the relationship between management opportunism and auditor reaction. Simulation on financial restatements and on a sample of Brazilian companies listed on NYSE.
| Autor | Deaconu, Adela |
1 Introduction
In light of the many well-known financial scandals that have occurred, it is highly recommended for the users of accounting information to be able to evaluate financial reporting quality (FRQ hereinafter) and to filter related effects in order to understand the reported figures (Beneish, Press, & Vargus, 2012; Zang, 2012). The International Accounting Standards Board (IASB) documents (2012) highlight the need for corporate financial statements to provide a high level of relevance--one of the two fundamental qualitative characteristics of financial information in order for it to be useful.
It is therefore important to understand the extent to which accounting estimates and other disclosures (for example, the classification of elements in financial statements and the capitalization of expenditures), as well as elements of accounting reasoning and management discretion, can affect the information disclosed. These effects are not only relevant for the users of financial statements, but also for auditors. Users are concerned about FRQ, particularly earnings quality. Auditors are aware of the difficulty of auditing accounting estimates and other elements of the accounting professional's reasoning (hereinafter referred to, for convenience, as estimates), which affect the accuracy of the information disclosed by their clients. In addition, auditors provide FRQ guarantees for users.
Company management can willingly or unwillingly influence estimates in accounting. Recent literature has emphasized the need to identify explicit indicators of management bias in judgments related to estimates (Abernathy, Hackenbrack, Joe, Pevzner, & Wu, 2015). In response to such concerns, analysts have developed tools for pinpointing the risks faced by the users of accounting information and the elements to be taken into consideration when comparing between financial years. Audit Analytics (AA), a database dedicated to financial information and auditing (AA, 2018), provides a matrix for assessing accounting quality and risks (AQRM), covering financial reporting, internal controls, stakeholders, and auditors. Among other things, AA intends to highlight indicators of potential earnings management.
Our paper focuses on financial restatements (restatements hereinafter) as corrections of material misstatements observed in previously issued financial statements. In our view, restatements are a possible consequence of the way estimates are provided by audited companies and one of the financial reporting red flags for risk. They are also representative of FRQ and potential management opportunism or bias (Ettredge, Scholz, Smith, & Sun, 2010). The data were collected from the AA database, as restatements are one of the items pertaining to financial reporting in the AQRM matrix, and are relevant to achieving our objective.
We also focus on the perceptions of the auditors in charge, who must provide reasonable assurance for the financial statements of a company. Potentially biased estimates, due to subjective assessments and reasoning, are a real burden for the auditors who have to deal with them. Glover, Taylor, and Wu (2014) highlighted the need for more clarity and guidance for auditors regarding estimates in general, and fair value measurements in particular. The audit risk associated with estimates and the effects on auditors' decisions are at the core of several recent studies (e.g. Bratten, Gaynor, McDaniel, Montague, & Sierra, 2013; Christensen, Glover, & Wood, 2012; Griffin, 2014). At a regulatory level, the Public Company Accounting Oversight Board (PCAOB) (2014) launched an invitation for public comments on its Staff Consultation Paper 'Auditing Accounting Estimates and Fair Value Measurement,' in response to the need to update audit standards for accounting estimates. This proposal was submitted for approval to the Securities and Exchange Commission in 2019.
Our intention is to analyze the relationship between restatements and management bias, the latter of which is expressed by earnings management tactics. Although the literature is rich in studies related to restatements and their relationship with audit quality and/or FRQ (see DeFond & Zhang, 2014 for a review), papers on the correlation between restatements and earnings management are scarce. Hence, our study is an attempt to enrich this specific area of literature by pursuing the following objective: to find some of the red flags or indicators that are useful to auditors for minimizing their audit risks linked to accounting estimates, re-classifications, capitalizations/ decapitalizations, and other accounting options and policies --all issues that are affected by management discretion. These issues, especially accounting estimates, cause greater measurement uncertainty and, hence, higher risks for the audit mission. Financial restatements are supposed to remediate such errors in financial statements. Based on this, we try to demonstrate if financial restatements and management discretion (measured by earnings management tactics) are correlated and, moreover, depend on each other. Therefore, our main research question is the following: when auditors have requested in the previous year for managers to restate their financial statements, are those managers less willing to resort to earnings management practices?
Furthermore, there are environments where business conditions can increase management pressure to achieve a certain level of financial performance and, as a result, there is a higher possibility of management estimates being biased (PCAOB, 2011). This is also the case of emerging markets. Therefore, our subject of inquiry is the Brazilian audit context and the Brazilian companies listed on the US market (New York Stock Exchange--NYSE). Other reasons for this choice include (1) Brazil's place among the 10 Big Emerging Markets (we intended to form as consistent a sample as possible, considering that restatements are relatively rare events); (2) our intention to explore the behavior of companies belonging to an emerging country for which earnings management has not been sufficiently revealed; and (3) the availability of data to test our model (provided by the AA database).
Therefore, as main contributions of our research, we examine whether managers manipulate earnings (shown by one measure of earnings management, i.e. discretionary accruals, in a regression model we designed). In order to enable auditors to minimize the risk associated with accounting estimates and similar issues, we provide empirically tested indicators that could suggest management opportunism (discretionary accruals), revealing its direct relationship with restatements required in previous years. As a secondary contribution, we observe the correlation between this measure of earnings management and auditee-related features, such as company size, quality of corporate governance, and investing and financing policies.
To achieve our goal, Section 2 provides a review of the literature; section 3 presents the model to be applied and the construction of the sample; section 4 provides comments on the empirical results obtained; and the final section presents the concluding remarks.
2 Literature Review
The theoretical basis for our research is the concept of FRQ. In the literature, the topic has been approached from an accounting theory and normalization perspective (e.g. Demsey, 1989; Nobes & Parker, 2006), from a conceptual point of view (e.g. Lillrank, 2003), and based on the effects of financial reporting on users' decision usefulness (Staubus, 2000). Based on Staubus' (2000) theory of the decision usefulness of accounting, we analyzed papers that measure the extent to which the quality of published accounting information influences users' decisions (e.g. Barron & Stuerke, 1998; Lee & Masulis, 2009).
Our study is exploratory and observed how the interests of managers in financial reporting and those of the auditors who verify that information are manifested. It combines items related to (1) accounting estimates and audit risk, (2) earnings management, and (3) the link between restatements and earnings management. Therefore, we reviewed three groups of studies.
The first literature group relates to the uncertainty of the estimates as an audit risk likely to influence the auditor's decisions on potential adjustments (restatements) of financial statements. In this respect, Bratten et al. (2013) identify the uncertainty of estimates as an environmental factor that may have an impact on the measurement of estimates. The research of Griffin (2014) provides empirical evidence about how auditors make decisions related to fair value and other uncertainty in measuring. The author asserts that auditors are most likely to require auditees to adjust their estimates when both subjectivity and imprecision are high. A lack of objective data is linked to a high degree of uncertainty in some estimates. Due to the high uncertainty in reported estimates, management can be tempted to show bias (Christensen et al., 2012). This complicates the process of reducing audit risk and influences the level of materiality. Under such circumstances, the burden for auditors increases and this is why many studies (e.g. Abernathy et al., 2015; Christensen et al., 2012) suggest potential revisions of the auditing standards, in order to clarify the auditor's responsibilities with respect to estimates that contain extreme measurement uncertainty. For example, Christensen et al. (2012) recommend that the audit report should include a list of the accounts with extreme measurement uncertainty. This has been achieved through International Standard on Auditing (ISA) 700 (Revised), Forming an Opinion and Reporting on Financial Statements after December 15, 2016, issued by the International Federation of Accountants (IFAC, 2015), through the insertion of the key audit matters (KAM) paragraph in the auditor's report. However...
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