Fourthly, concerning the research methods, the Performance-Matching Discretionary Accruals Model (Kothari et al. 2005) will be applied to calculate the discretionary accruals as proxy for accrual-based earnings management. It is regarded as an effective and reliable way to capture management choices and discretion reflected in the financial statements since it takes firm performance into consideration which can better reflect discretionary accruals. In their study, Ronen and Yaari (2008) argue that the Performance Matching Model yields stronger results than the Jones Model. Similarly, Dechow et al. (2012) also mention that the Performance Matching Model can to some extent mitigate model misspecification which is better than the Modified Jones Model that is widely used in the previous studies. On the other hand, in terms of real activities manipulation, I adopt the model developed by Roychowdhury (2006) through three main manipulation methods, which are sales manipulation, reduction of discretionary expenditures and overproduction, or increasing production to report lower COGS. Following, I try to measure the quality of audit from four main aspects; those are audit firm size, audit tenure, industry specialization of auditor and audit independence applied in the prior researches, of which will be illustrated in Chapter 2. (Becker et al., 1998; Francis and Krishnan, 1999; Krishnan, 2003; Francis and Yu, 2009; Lin and Huang, 2010) Lastly, aims to investigate the relations between the different variables in this research, a regression analysis in SPSS would be performed according to all the data collected which will be described in Chapter 7. 1.7 Limitations This study is subject to some limitations. First of all, in terms of earnings management measurement, managers can manipulate earnings in various patterns and consequently no one can really find the perfect proxy to accurately indicate the behaviors of earnings management. This paper examines the earnings management from two main aspects, accrual-based and real activities earnings management by using Performance-Matching Discretionary Accruals Model and Roychowdhury
Appendix: Literature Review Appendix A: Earnings Management Title Author (S) Object of the study Sample Research Methodology Outcome 1. A review of the earnings management literature and its implications for standard setting Paul M. Healy and James M. Wahlen (1999) This paper mainly reviews the previous academic studies with regard to earnings management and point out some implications for accounting standard setters and regulators. n/a They make reviews on the previous literatures. 1. The current earnings management literatures provide only moderate insights for standard setters; 2. The underlying reasons for the appearance of earnings management are the stock market perception, management compensation, contracts and avoidance of regulatory intervention. 2. Earnings management to avoid earnings decreases and losses David and Ilia Dichev (1997) This paper provides evidence on the phenomenon that firms manage reported earnings in order to avoid earnings decreases and losses. A sample of 64466 observations in the context of American firms. They use the distributions of earnings changes and earnings to test the hypotheses. 1. They find unusually low frequencies of small decreases in earnings and small losses as well as unusually high frequencies of small increases in earnings and small positive income; 2. Two components of earnings, cash flow from operations and changes in working capital are used to achieve increases in earnings.
3. Auditor and earnings Jeong-Bon Kim, Richard Chung and Michael Firth (2003) This paper examines the reactions between Big 6 and non-Big 6 auditors with regard to two types of earnings carried out by managers, which are and earnings A sample of 33163 observations which is composed of 4810 non-Big 6 observations and 28353 Big 6 observations with sufficient data during the period from 1984 to 1998 in America. 1. They adopt two proxies for earnings management; those are discretionary accruals and abnormal working capital accruals and calculate them through the extended version of the modified Jones 1991 model; 2. Then they use the treatment effects model which consist of two stages. Firstly, they estimate a multivariate probit model by defining the dependent variable as the probability of managers’ choice for Big 6 auditor. Next, they run the second regression by including the managers’ accrual choices and the auditor choice as well as other firm-specific variables. 1. When managers carry out income-increasing earnings management, Big 6 auditors are more effective than non-Big 6 auditors; 2. When managers have incentives to make income-decreasing earnings management, non-Big 6 auditors are effective than Big 6 auditors. 4. Auditor tenure, auditor and earnings Larry R. Davis, Billy Soo and Greg Trompeter (2001) This paper examines the between auditor tenure and earnings A sample of 855 firms during the period from 1981 to 1998 in America. 1. They adopt the original Jones (1991) model to estimate discretionary accruals; 2. They classify the sample into two groups, one concludes the firms employing a single auditor and the other one includes the firms with changing audit; 3. Then they run the regression model to test the relationship between discretionary accruals and auditor tenure. 1. When auditor tenure increases, the absolute discretionary accruals increases and the absolute forecast errors decline; 2. The longer the auditor tenure is, the more earnings management the mangers carry out aiming to meet earnings forecast; 3. When auditor tenure increases, the discretionary accruals become more negative indicating that clients save earnings for future use.
7. The relation between auditors’ fees for non-audit services and earnings Richard M. Frankel, Marilyn F. Johnson and Karen K. Nelson (2002) This paper tests the between auditor fees and earnings as well as the market reaction towards the auditor fees disclosure A sample of 3074 firms during the period from February 5, 2001 to June 15, 2001 based on SEC’s EDGAR database and Compustat in America. 1. In terms of auditor fees, they adopt three specifications, those are the ratio of non-audit fees to total fees, the percentile rank of the amount of fees and audit fees as well as the percentile rank of the amount of total fees, by auditor, which disclosed by each firm; 2. They run the regression model by defining earnings benchmark (surprises) as the dependent variable to proxy for earnings management; 3. They also adopt another proxy to represent earnings management, discretionary accruals using the cross-sectional modified Jones model. 1. There is positive relationship between fees and small earnings surprises; 2. Non-audit fees positively relates to absolute discretionary accruals as well as income-increasing and income-decreasing discretionary accruals; 3. Audit fees negatively relates to discretionary accruals; 4. There is no relationship between total fees and earnings management; 5. There is no association between non-audit fees and the possibilities of reporting a small increase in earnings; 6. The disclosure of fees negatively associates with share values.