Relation Between Real Earnings Management And Audit Quality

Abstract

Net income is composed of CFO and accruals. Auditors generally detect discretionary accruals to raise reliability of financial reporting and call upon managers to correct their financial reports according to the materiality. From these viewpoints, prior researches use the size of discretionary accruals as proxies for the audit quality. However, manager can also use CFO factors as means of earnings management. We confirm whether abnormal CFO factors, that is, real activity earnings management (hereafter RAM) by Roychordhury model(2006), can be as a proxy for the audit quality with comparing the size of RAM with existing proxies of audit quality such as auditors’ size (e.g. big4), audit time and audit fee. Our results show that the size of RAM is positively correlated with some existing proxies of audit quality. Also, we find discretionary accruals positively correlated with RAM in Korea. The result implies managers in Korea simultaneously use RAM as well as discretionary accruals as a means of earnings management.