An Investigation of Audit Committee Characteristics on Audit Quality towards the Changes on Real Earnings Management: Evidence from Jordan

Although, the characteristics of an audit committee were always considered as a protective tool for the stakeholder's interest in the capital market yet the manipulation of the Real Earnings Management activities also created a major threat among the stakeholders whenever the audit committee was engaged with the top management of the business organizations. This paper is aimed to reveal the mediating effect of audit quality on the relationship between the characteristics of an audit committee and real earnings management. To this, the previous literature related to the characteristics of an audit committee regarding audit committee, audit quality, and real earnings management was reviewed and found that studies on the characteristics of an audit committee, audit quality, and real earnings management presented miscellaneous results. Consequently, the previous studies permit further research to find the mediating effect. Background of the Study The regulators' trust in financial statements was affected because of the WorldCom accounting scandals and owing to the accounting scandals that occurred in the US companies such as (Waste Management, Sunbeam, Cendant, Enron, and WorldCom), the main cause of these fraudulent accounting scandals was generally attributed to the earnings management (e.g. Cullinan, 2004). The media was reasonably wondering about the purposes that made the auditors conceal these unusual accounting transactions. Also, the financial reports are considered significant characteristics of the communication in the capital market; to which the auditor is considered as an effective third party role who helps to reduce information asymmetry and the conflict of interests that arise between investors and the management of the company (Kitiwong, 2014). Subsequently, the downfall of several high-profile corporations due to the financial misdemeanors of their managers, more attention has been devoted to real earning International Journal of Academic Research in Business and Social Sciences Vol. 9 , No. 10, October, 2019,E-ISSN:2222-6990 © 2019 HRMARS 244 management and its relationship with the audit quality in the world (Abdulmalik & CheAhmad, 2016; Osemeke & Adegbite, 2016). Especially, in developing countries such as Jordan which has been affected by the financial crises in the financial market of the recent decade. Thereafter, the investors have repeatedly questioned the role of both the audit committee and the external auditors because the audited financial reports have been confirmed to be illusive in several recent financial scandals (Alves, 2013). Moreover, (Habbash, 2010) contended that earnings management revealed the exact business' financial performance and covered the facts from stakeholders. Rusmin, (2010) added that practicing the earnings management reduced the trustworthiness of the investors about the financial reporting quality by preventing the effective flow of the capital in the financial markets. From heretofore, an increasing number of studies embarked upon addressing earnings management. Corporate stakeholder's attention had applied significantly a great amount of attention to earnings management. The main aim of the present study is to investigate the effect of the audit committee and audit quality on earnings management in a developing country like Jordan. Thus, there is a need to employ the advanced technique to examine the influence of the audit quality on an audit committee in relation to the earning management. The reason is that; it has been ascertained that the complementary functions of the characteristics of an audit committee related to the audit quality are complex. It goes beyond a direct relationship and permits further research to be carried out to explore the effect of the audit committee and audit quality on earnings management (Goodwin-Stewart & Kent, 2006). In addition, this study adds value to the agency theory by providing initial insight into how the complementary effects of the characteristics of an audit committee and audit quality can reduce the agency conflicts and limit the earning management. The literature on the relationship between an audit committee, audit quality, and real earning management was, therefore, reviewed. Based on this assumption formulated in the previous studies, a framework was purposed to exhibit how an audit quality can mediate the association between the characteristics of an audit committee and real earning management. This was an issue that received limited attention to the prior literature. The proposed framework in the present study is expected to be tested using mediation analysis advanced in the prior studies in the social psychology literature (Baron & Kenny, 1986; Hayes & Rockwood, 2017; Holmbeck, 1997; Wu & Zumbo, 2008). Literature Review Agency Theory Agency theory originated from the study of Berle and Means (1932) and was advanced by Jensen and Meckling (1976). Agency theory has been broadly employed in the managerial studies and appeared to be the dominant paradigm in several aspects of the corporate governance research (Dedman, 2004; Davis, Schoorman, & Donaldson, 1997). Agency theory has been used in the prior literature to create a link between the audit committee and real earnings management and likewise between the audit quality and real earnings management (DeFond & Zhang, 2014; Menon & Williams, 1994). Agency theory proposes that the primary duty of the audit committee is to confirm that managers are acting in the best interests of shareholders. DeFond and Zhang (2014) affirmed that higher audit quality provides better assurance to reduce real earnings International Journal of Academic Research in Business and Social Sciences Vol. 9 , No. 10, October, 2019,E-ISSN:2222-6990 © 2019 HRMARS 245 management as well as manipulation of financial statements. It has been maintained that external auditors play a significant role in corporate governance, which serves as a complementary mechanism for enhancing the legal protection of shareholders (Kausel & Slaughter, 2011). This may, in turn, reduce agency conflict between management and stakeholders because shareholders depend heavily on external auditors’ monitoring efforts. The present study proposes that the characteristics of an effective audit committee demand better audit assurance from the external auditors to provide the real earnings management as the characteristics of an audit committee and audit quality are two complementary monitoring mechanisms (Al-dhamari, Almagdoub, & Al-gamrh, 2018; Goodwin-Stewart & Kent, 2006). Audit Committee Characteristics The audit committee is one of the board’s committees that are constituted to help boards and to carry out the specific duties. The role of the audit committee, in particular, is directly related to overseeing the financial reporting and auditing activities (Dobija, 2015). Therefore, given this role of the audit committee, it is expected to contribute to improving the quality of audit services. Moreover, Rickard (1993) describes the Audit Committee that is consisted of a group of senior staff, chaired by the chief executive officer or his deputy. The committee's responsibility is to safeguard the independence of the internal audit function and ensure continual improvement in management performance and accountability by seeking actions on internal audit and external audit reports. " Furthermore, another definition sees the Audit Committee in terms of its functions and expected responsibilities; "The Audit Committee is a committee which is composed of independent, non-executive directors charged with oversight functions of ensuring responsible Corporate Governance, a reliable financial reporting process, an effective internal control structure, a credible audit function, and informed whistleblower complaint process and an appropriate code of business ethics with the purpose to create long-term shareholder value by protecting the interests of other stakeholders" (Rezaee, 2009). Real Earnings Management Past studies also revealed that earnings management had various strategies from which they could manage it such as real earnings management by Dechow et al. (2012) and Kothari et al. (2012). Moreover, Gunny (2010) defined earnings management as it has some negative impacts of economic value on long term firm's value because of having the direct effect of cash flow. In addition to this, real earnings management activities have a direct impact on cash flows which is a fact and it is considered more difficult as compared to accrual-based earnings management. Also, the researchers provided evidence that the real earnings management garbed the market as it was associated with the level of information asymmetry (Abad, Cutillas-Gomariz, Sánchez-ballesta, & Yague, 2018). Recently, previous studies provided evidence that financial illusive companies engaged in real earnings management practices before the fraud event occurred (Nasir, Ali, Razzaque, & Ahmed, 2018; Perols & Lougee, 2011). This evidence provides more gap to further investigate to engage in real earnings management. Therefore, this research focuses International Journal of Academic Research in Business and Social Sciences Vol. 9 , No. 10, October, 2019,E-ISSN:2222-6990 © 2019 HRMARS 246 on the Characteristics of the audit committee and audit quality on real earnings