Earnings Management and Audit Adjustments: An Empirical Study of IBEX 35 Constituents

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University Pompeu Fabra, Ramon Trias Fagras, 25-27, Barcelona 08005, Spain

Nearly seven years after its collapse, Enron continues to fascinate those interested in earnings manipulation. Although Enron is the most popular example of fraudulent accounting disclosure, it is not clear what happened even after the court trials. Enron was permitted to book profits through means that were volatile and risky, but this specific activity did not break the law. So, how much of Enron's profits came from outright financial chicanery? And, how much profit resulted from exploiting accounting constructs such as mark-to-market accounting and the use of derivative instruments, which are legal and largely unregulated today?
The extent to which earnings are manipulated has long been of interest to analysts, legislators, researchers, and other investment professionals. Finding earnings manipulation is no small task, but despite the difficulties, the body of academic literature on the topic is growing. Today we would expect a company to manage earnings prior to its public securities' offering (Teoh, Welch and Wong, 1998) and when it is in financial distress (Beneish, 1997). Additionally, if a manager's compensation is strongly related to a company's profitability, we might be suspicious about the quality of financial results, especially if they seem to be extremely favorable (Healy, 1985).
When there are some doubts about the reliability of a company's qualitative financial disclosure, we may turn our attention to the auditor's report. In theory, the auditing process is supposed to serve as a monitoring device that reduces management incentives to manipulate reported earnings, as well as to detect earnings manipulation and misstatements. In practice, however, auditors may not be that efficient in enhancing the credibility of financial statements; the auditor-client relationship has peculiarities that could lead to a conflict of interest. Auditors may require an adjustment and a company to correct an earnings misstatement, but they are completely aware of the cost of these actions: An adjustment may strengthen an auditor's good reputation, but it would also reduce the auditor’s fee, which is usually a function of a company's size.
The conflict of interest in the auditor-client relationship casts doubt on the usefulness of external auditing. This empirical study contributes to the debate about the auditor's role in financial markets. It examines first the adjustments required by the auditor and relates them to the financial profile of an earnings manipulator. Then, it distinguishes the market consequences from earnings misstatements that have been made public with the audit adjustments, and concludes about the possible cost of this misstatement. Previous research can help us explain how large the earnings misstatement is on average, but not how it matches the profile of an earnings manipulator and if it has consequences on the stock exchange. This study sheds some light on the topic and concludes about the auditor's role in the efficient functioning of capital markets.

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