Academic journal article Academy of Accounting and Financial Studies Journal

Big 4 Auditor Office Size, Analysts' Annual Earnings Forecasts and Client Earnings Management Behavior

Academic journal article Academy of Accounting and Financial Studies Journal

Big 4 Auditor Office Size, Analysts' Annual Earnings Forecasts and Client Earnings Management Behavior

Article excerpt

INTRODUCTION

The extant literature provides evidence to suggest that larger audit firm offices provide higher quality audits than smaller audit offices (Francis & Yu, 2009; Choi, Kim, Kim & Zang, 2010; Francis, Michas & Yu, 2013). This study extends the office-level audit quality literature by investigating the association between Big 4 office size and client earnings management related to analysts' annual earnings forecasts. The question of whether larger Big 4 audit offices are more likely than smaller Big 4 audit offices to constrain earnings management around analysts' forecasts is important given that (1) management's zeal to meet consensus analysts' forecasts in recent years has called into question the quality of SEC registrants' reported earnings and the quality of their auditors (Levitt, 1998) and (2) the Big 4 firms audit "more than 98 percent of the global market capitalization of U.S. issuers" (Franzel, 2013). (1)

The office-level audit quality literature has examined audit quality in terms of whether auditors seem to influence earnings management behavior relative to two earnings benchmarks--small positive profits and small earnings increases (Francis & Yu, 2009). Based on these benchmarks, the larger Big 4 offices appear to provide higher quality audits than the smaller Big 4 offices. Specifically, companies audited by auditors associated with the larger Big 4 offices are less likely to report small profits or small earnings increases, indicating less aggressive earnings management behavior. While prior literature indicates that auditors place great importance on preventing management from managing earnings around these two earnings benchmarks, auditors appear to be less concerned about preventing earnings management around the analysts' annual earnings forecasts benchmark (Nelson, Elliott & Tarpley, 2002; Frankel, Johnson & Nelson, 2002; Ng, 2007). Conversely, management appears to place greater importance on meeting analysts' forecasts than avoiding losses and/or reporting small earnings increases (Dechow, Richardson & Tuna, 2003; Brown & Caylor, 2005; Graham, Harvey & Rajgopal, 2005 & 2006). Thus, it is an empirical question whether the association between Big 4 office size and earnings management around earnings benchmarks found in prior literature will hold for the analysts' forecasts benchmark.

We use two measures to assess whether the positive association between Big 4 office size and earnings quality found by Francis and Yu (2009) translates to analysts' annual earnings forecasts: (1) minimization of the absolute value of analysts' forecast error; and (2) just meeting or beating analysts' forecasts. Payne (2008) argues that the absolute value of forecast error will capture management's overall tendency to manage earnings around forecasts. It is very possible that firms seek to minimize positive, as well as negative, forecast error (Payne & Robb, 2000; Graham et al., 2005; Payne, 2008). For example, firms may want to minimize positive forecast errors in order to create accrual reserves for the future (Graham et al., 2005; Payne, 2008). In this study, higher absolute levels of analysts' forecast errors represent lower levels of earnings management.

Because missing analysts' forecasts yields adverse consequences, firms that see that unmanaged earnings will fall short of analysts' annual earnings forecasts may attempt to "push" earnings upward to meet the forecast. Consequently, some firms that just meet or beat analysts' earnings expectations may have managed earnings upwards when the firm may have fallen short of the analysts' annual earnings benchmark otherwise (Reichelt & Wang, 2010). In our study, we use firms that just meet or beat analysts' annual earnings forecast benchmarks to represent higher levels of earnings management.

To test our hypotheses, we conduct OLS and logistic regressions of SEC registrants audited by domestic Big 4 auditors from 2003-2008. …

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