Earnings Management and Audit in Private Firms: The Effect of Financial Recuperation

Earnings Management and Audit in Private Firms: The Effect of Financial Recuperation

Inna Sousa Paiva (Business Research Unit, Instituto Universitário de Lisboa, Portugal) and Paulo Varela Dias (Instituto Universitário de Lisboa (ISCTE-IUL), Portugal)
DOI: 10.4018/978-1-5225-7817-8.ch007


This chapter examines the relationship between the level of earnings management and the audit in private firms under the influence of financial crisis recuperation, using a sample of Ireland and Portuguese firms from 2008 to 2016. The authors use accruals methodology, namely four earnings management measures to capture earnings management in private firms. Multivariate statistical analysis was applied using the traditional multiple regression technique. Empirical results show that private firms with audited financial statements have powerful incentives to expropriate wealth from minority shareholders, pursuing their own interests at the expense of non-controlling shareholders. They also find that the private firms with audited financial statements in years under adjustment programs demonstrated lower level of earnings management. This study contributes to the accounting literature by providing empirical evidence for the effects of audit and earnings management in private firms in a financial recuperation context.
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Earnings management and its role in the economy have been widely studied in the academic literature with main highlights in worldwide listed firms and have often been linked to accounting practice with objectives that potentially affect managers’ discretionary behaviour (Bharath, Sunder, & Sunder, 2008; Doyle, Ge, & McVay, 2007; Zhao & Chen, 2008). Some previous literature aim do detect earnings management (Beneish, 1999; Dechow, Sloan, & Sweeney, 1995; Jones, 1991), others focus on numerous incentives for earnings management in listed companies (Aharony, Lin, & Loeb, 1993; Teoh, Welch, & Wong, 1998; Teoh & Wong, 2002; Healy, 1985; Holthausen, Larcker, & Sloan, 1995; Beneish & Vargus, 2002; Warfield, Wild, & Wild, 1995; Cheng & Warfield, 2005; Gabrielsen, Gramlich, & Plenborg, 2002; DeFond, Hu, Hung, & Li, 2012; Sweeney, 1994; Cahan, 1992; Francis, Khurana, & Pereira, 2005).

The trend of research on earnings management has focussed on the private firms and audit (Burkart, Panunzi, & Shleifer, 2003; Faccio & Lang, 2002; La Porta, Lopez-de-Silanes, & Shleifer, 1999; Wang, 2006). Prior research on auditor choice and audit fees in private firms presents two possible scenarios. Due to lower conflict of interest between owners and managers agency problems in private firms, it is expected that private firms will have lower demand for audit quality (Ho & Kang, 2013; Burgstahler, Hail, & Leuz, 2006). On the other hand, the presence of strong incentives in private firms to engage in fraudulent activities may increase audit risk (Cano-Rodriguez, 2010). The presence of such conflicting arguments makes auditor choice in private firms an interesting research area. The private companies suffered significant impact which struck both their performance and their auditor options, forcing adjustments in the latter, imposed by the rise of financing conditions.

The programmes of macroeconomic adjustment induce processes which seek not only the change of politics but also of behaviours which should be adopted by the countries, acting over variables such as consumption, investment and imports, to increase competition after periods of great shock (Alcidi et al., 2016). From November 2010 Ireland would be the first country to seek the adjustment programme, leaving it successfully in December 2013. Portugal would follow a similar programme in the first semester of 2011, marking its exit, also successfully, in May 2014 (European Stability Mechanism, 2014).

Key Terms in this Chapter

Private Firms: A private firm can be a corporation, a limited liability company, a partnership, or a sole proprietorship, as long as the shares are privately held and not traded publicly. Although private companies are legally required to file certain documents with their state and follow required compliance laws for shareholders, public companies must follow strict government regulations.

Agency Theory: Agency theory is concerned with resolving problems that arise in agency relationships. An agency relationship is described as a situation in which one party (the principal) delegates work to another party (the agent). This principal-agent relationship exists between employers and employees, lawyers and clients, or buyers and suppliers. Agency theory attempts to explain two problems. The first is the agency problem that arises when the goals of the principal and the agent diverge, and it is difficult for the principal to verify the agent’s actions. The second is the problem of risk sharing which occurs when the principal and the agent have different attitudes towards risk.

Economic Adjustment Programme for Ireland: Usually referred to as the Bailout Programme, is a memorandum of understanding on financial assistance to the Republic of Ireland in order to cope with the Irish financial crisis.

Economic Adjustment Programme for Portugal: Usually referred to as the Bailout Programme, is a Memorandum of understanding on financial assistance to the Portuguese Republic in order to cope with the Portuguese financial crisis.

Financial Crisis: The financial crisis of 2007–2008, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s. It began in 2007 with a crisis in the subprime mortgage market in the United States, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008. In 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act was enacted in the US following the crisis to promote the financial stability of the United States. The Basel III capital and liquidity standards were adopted by countries around the world. The European sovereign debt crisis started in 2008 with the collapse of Iceland's banking system and spread primarily to Portugal, Italy, Ireland, Greece and Spain in 2009. The debt crisis has led to a loss of confidence in European businesses and economies.

Big Four Accounting Firms: The Big Four (Ernst & Young [EY], Deloitte & Touche, KPMG, and PricewaterhouseCoopers [PwC]) accounting firms are the four biggest professional services networks in the world, offering audit, assurance services, taxation, management consulting, advisory, actuarial, corporate finance and legal services. They handle the vast majority of audits for public companies as well as many private companies.

Financial Auditing: The process of examining an organization's (or individual's) financial statements to determine if they are accurate and in accordance with any applicable rules (including accounting standards), regulations, and laws.

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