The Piesence of Eainings Nanipulation Incentive as a Pieiequisite

foi the Benefits of BigheiQuality Auuit to be Realizeu:

The Case of Inuonesia



Zaki Baiiuwan
0niveisitas uaujah Naua, Inuonesia

Aiie Rahayu Baiiani

(Alumni) 0niveisitas uaujah Naua, Inuonesia



This uiaft: Naich 24, 2u1u


Abstiact

Bigheiquality auuit is wiuely accepteu, both theoietically anu empiiically, as moie
effective in ueteiiing accounting manipulation than the lowei one (Beckei et al.
1998, Fiancis et al 1999, Fiancis 2uu4). Yet this notion has one majoi logical flaw
(an oveigeneialisation): it neeus eainings manipulation to be occuiieu at the fiist
place while this is not likely the case. We founu that higheiquality auuit woulu be
moie effective in ueteiiing accounting manipulation than the lowei one only if the
eainings manipulation incentive exists at the fiist place.
We use loss anu eainings ueciease avoiuance (Buighstahlei anu Bichev 1997)
as the incentives in this papei. Sauly, this incentive coulu be easily seen even befoie
an auuit itself weie conuucteu. It biings us an iiony, many fiims who have no
eainings manipulation incentives anu thus have no attempt to manipulate eainings,
hiie a higheiquality auuitoi in oiuei to have a higheiquality auuit with highei cost
embeueu in it while actually the auuit gives no ieal benefit to the fiim.

Coiiesponuing authoi: aiieiahayugmail.com

THE PRESENCE OF EARNINGS MANIPULATION INCENTIVE AS A
PREREQUISITE FOR THE BENEFITS OF HIGHER-QUALITY
AUDIT TO BE REALIZED

A.Background
Auuit weie piaiseu by accountants as an effective ueteiient foi accounting
manipulation.
1
It is foi that ieason they love to piesciibe auuit quality impiovement
foi any accounting manipulation ielateu case (e.g. Levitt 1998). While we cannot
know what is the optimum level of auuit quality, it seems eveiyone agiee that we
weie not theie yet. So, we seek ways to impiove auuit quality like continuing
piofessional euucation (CPE), manuatoiy auuitoi iotation, incieasing the authoiity
of auuit committee, etc.
Auuit was maue as a mean to veiify the confoimity of financial statements to
geneially accepteu accounting piinciples (uAAP), while nonconfoimity itself coulu
be vieweu as an accounting manipulation. Logically, higheiquality auuit will be
moie effective in ueteiiing accounting manipulation. Pievious stuuies give empiiical
suppoit to this notion (Beckei et al. 1998; Fiancis et al. 1999).
Theie is something inteiesting in the notion that higheiquality auuit will be
moie effective in ueteiiing accounting manipulation is inteiesting. It assumeu that
theie is an accounting manipulation at the fiist place. Bow about if theie weie not.
Lo (2uu7) saiu that management uo not always manipulate eainings even if they
coulu. The piesumption is that people geneially uo not commit ciimes foi no

1
Auuit weie usually saiu to be an eainings manipulation ueteiient by accountants in
geneial. This is wiong because eainings manipulation coulu be achieveu eithei by
accounting oi ieal activities manipulation while auuit only conceins the accounting pait.


specific ieason. Nanagement neeus an incentive to manipulate eainings befoie they
ueciueu to uo so. If theie weie no incentive then management woulu not manipulate
eainings.
Pievious stuuies confiim the iuea that management neeus an incentive in oiuei
to manipulate eainings. It means that fiims which uo not have such incentive woulu
not manipulate eainings. Buigstahlei anu Bichev (1997) anu Roychowuhuiy (2uu6)
give empiiical suppoits to this iuea. They founu that fiims which suspecteu foi
avoiuing eainings ueciease oi loss iepoiting have laigei eainings manipulation
measuies than othei fiims.
The initial aigument is that higheiquality auuit woulu be bettei in ueteiiing
accounting manipulation. 0nfoitunately (oi foitunately.), fiims uo not always
manipulate theii eainings noi to make such attempt. It means that the benefits of
higheiquality auuit uoes not always coulu be iealizeu. Thus, it is not always woith
the cost anu effoit to engage in higheiquality auuit (as uepicteu in Figuie 1).
Figuie 1
Audit Quality, Earnings Manipulation (EM), and EM Incentives


All fiims
Auuit benefits
EN
incentive
Incentive
Eainings
manipulation
No
incentive
No eainings
manipulation


In the meantime, we awaie that eainings manipulation coulu also be attempteu
by manipulating ieal activities like timing the uiscietionaiy expenuituies so that the
eainings woulu look goou (Babei et al. 1991; Bushee 1998; Nizik anu }acobson
2uu7; Roychowuhuiy 2uu6). If acconting manipulation is constiaineu uue to the
piesence of higheiquality auuit, then fiims will seek ways to postpone its
uiscietionaiy expenuituies. This accounting anu ieal activities manipulation tiaue
off has conceineu some ieseaicheis this uays (Cohen et al. 2uu8; Cohen anu
Zaiowin 2uu8).
This papei contiibutes to the liteiatuie by piesenting eviuence on the two
factois (i.e. auuit quality, eainings manipulation incentives) that contiauicts each
othei in influencing accounting manipulation. We founu that the absence of eainings
manipulation incentives negates the benefits that shoulu be iealizeu fiom highei
quality auuit. Thus, questioning the enuless attempts maue to impiove auuit quality.
B.HypothesesDevelopment
Auuit is uefineu as (Accounting Review 47 in Boynton et al. 2uu1)
a systematic piocess of objectively obtaining anu evaluating
eviuence iegaiuing asseitions about economic actions anu events to
asceitain the uegiee of coiiesponuence between those asseitions anu
establisheu ciiteiia anu communicating the iesults to inteiesteu
useis. |emphasis auueu]

The phiase to asceitain the uegiee of coiiesponuence between those asseitions
anu establisheu ciiteiia implieu that it is auuitois uuty to finu accounting
manipulation if it exists. Thus, by uefinition, higheiquality auuit will be moie
effective in ueteiiing accounting manipulation.
We use uiscietionaiy acciuals (}ones 1991) as a pioxy foi accounting
manipulation. Biscietionaiy acciuals is the ueviation of the noimal oi expecteu


acciuals estimateu by }ones mouel. Positive uiscietionaiy acciuals inuicates an
eainings inflation, vice veisa.
Neanwhile, auuit quality is expecteu to vaiy with the auuitoi quality. The
common notion is Big 4 give higheiquality auuit than nonBig 4. This notion baseu
on two assumptions. Fiist, Big 4 have moie expeits anu bettei supeivision system
than nonBig4. It will enable them to finu accounting manipulation if exists. Seconu,
Big 4 have biggei ieputation anu thus, have much moie to lose if they got sueu in
financial iepoiting (e.g. eainings) manipulation case. It will make them iepoit the
eainings manipulation when they finu it. Simply, it make them moie inuepenuent.
(BeAngelo 1981 in Watts anu Zimmeiman 1978). Pievious stuuies (Beckei et al.
1998; Fiancis et al. 1999) founu that Big 4 clients have smallei uiscietionaiy
acciuals than nonBig 4.
The iuea that higheiquality auuit will be moie effective in ueteiiing eainings
manipulation neeu the eainings manipulation to be occuiieu at fiist place foi the
iuea itself coulu exist. The absence of eainings manipulation coulu be mean the
absence of the higheiquality auuit benefits. In othei woius, if theie is no eainings
manipulation occuiieu then fiims (thus, the society in geneial) aie betteioff to hiie
loweiquality auuitoi since this auuitoi will give the same iesult as the highei
quality auuitoi yet with lowei costfee.
2

Tuins out that it is pietty easy to pieuict whethei management woulu attempt
to manipulate eainings oi not. We only neeu to see the piesence of eainings
manipulation incentives to pieuict the occuiience of eainings manipulation (Lo

2
Yet, it is not what the fiims conceineu about when they hiie Big 4. Image anu ieputation on
the maiket is all what they caie since it is a common notion that Big 4 uelivei higheiquality
auuit.


2uu7). Buigstahlei anu Bichev (1997) founu that fiims that have incentive foi
avoiuing loss oi eainings ueciease iepoiting aie inueeu inflating theii eainings.

B1: Big 4 clients have smallei uiscietionaiy acciuals than nonBig 4 client. Yet this
uiffeience coulu only be founu on fiims that have incentives to manipulate
eainings, not on those who havent.

Auuit might uetei accounting manipulation but it uiu nothing to the (eainings
manipulation) incentives. As pieuicteu, management who can not manipulate
eainings thiough accounting will uo it anothei way. 0ne of the most populai
nonaccounting manipulation attempt is timing the uiscietionaiy expenuituies
(Babei et al. 1991; Bushee 1998; Cohen et al. 2uu8; Cohen uan Zaiowin 2uu8; Nizik
uan }acobson 2uu7; Roychowuhuiy 2uu6).
We use abnoimal uiscietionaiy expenuituie as a pioxy foi uiscietionaiy
expenuituie manipulation. If the abnoimal uiscietionaiy expenuituie is negative
than it means that fiims ieuuce oi postpone theii expenuituies to the coming yeai.

B2: Big 4 clients have smallei abnoimal uiscietionaiy expenuituies than nonBig 4.
Yet, this uiffeience occuiieu only on fiims that have incentives to manipulate
eainings, not to those that havent.
C.ResearchMethod
1.DataandSampleDescription
We initially sample all fiims in 0siiis uatabase between 2uuS2uu7 with sufficient
financial uata available to computei the vaiiables foi eveiy fiimyeai. While uata on


auuitoi uichotomy (Big 4 nonBig 4) is available on inuepenuent auuitois iepoit
fiom the }SX uatabase oi the Buisa Efek Inuonesia (BEI) website. We then eliminate
banks anu financial institutions fiom oui sample using classification on Inuonesian
Capital Naiket Biiectoiy (ICNB) as a base.
We iequiie at least 8 obseivations foi each inuustiyyeai giouping. Bue to the
limitation of the uata conceining this iequiiement, we combine seveial inuustiies
with theii closest counteipaits. We also impose the alluataavailability iequiiement
(balanceu panel mouel) iesulting about 1S8142 fiims ovei the 2uuS2uu7 peiiou.
2.VariablesandMeasurement
a) Estimating uiscietionaiy acciuals
We measuie uiscietionaiy acciuals using the ciosssectional veision of }ones (1991)
acciuals estimation mouel. We make one change though, we auu an unscaleu
inteicept, o
0
, to the mouel. This change is neeueu foi the iesults to be compaiable
with the iesults of Roychowuhuiy (2uu6) abnoimal uiscietionaiy expenuituies
mouel. Specifically, uiscietionaiy acciuals aie estimateu fiom the following mouel:
IA
t
A
t-1
, = o
0
+ o

j
1
A
t-1
, [ + [
1
j
REI
t
A
t-1
, [ + [
2
j
PPE
t
A
t-1
, [ + e
t

wheie:
TAit =total acciuals in yeai t foi fiim i,
REvit =ievenues in yeai t less ievenues in yeai t1 foi fiim i,
PPEit =gioss piopeity, plant, anu equipment in yeai t foi fiim i,
Ait1 =total assets in yeai t1 foi fiim i,
eit =eiioi teim in yeai t foi fiim i,
i =1, , N fiim inuex
t =1, , Ti, yeai inuex

b) Estimating abnoimal uiscietionaiy expenuituies
We use Roychowuhuiy (2uu6) mouel to estimate the abnoimal uiscietionaiy
expenuituies. Baseu on Bechow et al. 1998 assumption, uiscietionaiy expenuituies


shoulu be a lineai function of contempoianeous sales. This cieates a pioblem: if fiim
manage sales upwaiu to inciease eainings in any yeai (paiticulaily in the suspect
yeai), they can exhibit unusually low iesiuuals in that yeai even when they uo not
ieuuce uiscietionaiy expenses. To avoiu this pioblem, uiscietionaiy expenses aie
expiesseu as a function of laggeu sales.
ISEXP
t
A
t-1
, = o
0
+ o
1
[
1
A
t-1
, + [ [
S
t
A
t-1
, + e
t


wheie
ISEXP
t
= uiscietionaiy expenses in yeai t,
S
t
= sales in yeai t.
c) Selection of suspect fiimyeais
We use avoiuance of iepoiting losses anuoi eainings ueciease foi the eainings
manipulation motives anu suspect fiims having that motive foi manipulating
eainings. The fiimyeai is suspecteu if it has
net income scaleu by total assets that is gieatei than oi equal to zeio but less
than u.uuS. These fiimyeais aie suspecteu to avoiu iepoiting loss
(Roychowuhuiy 2uu6).
change in net income scaleu by total assets that is gieatei than oi equal to zeio
but less than u.uuS. These fiimyeais aie suspecteu to avoiu iepoiting eainings
ueciease (Cohen et al. 2uu8).
u) Auuit quality
We use the Big 4 nonBig 4 uichotomy foi the auuit quality pioxy. We assume that
Big 4 pioviues higheiquality auuits than nonBig 4. Pievious stuuies show empiiical
suppoits foi this notion (Beckei et al. 1998, Fiancis et al. 1999, Fiancis 2uu4).
e) Peifoimance


Bechow et al. (199S) highlights the impoitance of contiolling financial peifoimance
when investigating eainings management stimuliincentive that aie coiielateu with
financial peifoimance. Since we use the avoiuance of iepoiting loss anu eainings
ueciease which is cleaily coiielateu with financial peifoimance as the eainings
management incentives, theiefoie we have to contiol financial peifoimance in this
ieseaich. We use net income scaleu by total assets, a common pioxy foi financial
peifoimance, as a contiol vaiiable.
3.HypothesisTesting
We estimate the following iegiession to test B1 anu B2

t
= o + [
1
SuSPECI + [
2
BI04 + [
3
SuSPECI - BI04 + [
4
NI (1)

wheie:

t
= the uepenuent vaiiable that is sequentially set to
uiscietionaiy acciuals (BACCR) estimateu by the }ones Nouel
uesciibeu pieviously anu abnoimal uiscietionaiy
expenuituies (ABNBISEXP) estimateu by Roychowuhuiy
Nouel (2uu6),
S0SPECT = uummy vaiiable equal to 1 if the fiim yeai is suspecteu,
BIu4 = uummy vaiiable equal to 1 if the auuitoi is Big 4,
NI = net income scaleu by total assets.

The hypotheses pieuict that the coefficient on S0SPECT*BIu4 shoulu be negative
with eithei uiscietionaiy acciuals (B1) oi abnoimal uiscietionaiy expense (B2) as
the uepenuent vaiiables.



D.Results
1.DescriptiveStatistics
Table 1 suggests that the Big 4 fiims tenu to be substantially laigei than the nonBig
4 fiims. The mean of total assets foi the Big 4 sample is RpS tiillion compaieu to
Rp1 tiillion foi the nonBig 4 sample anu mean eainings is Rp2uu billion compaieu
to about Rp8.S billion foi the nonBig 4 sample. This statistics suggests that, in
geneial, the chaiactei of the uata useu in this stuuy is not uiffeient than that of
pievious stuuies (Beckei et al. 1998, Fiancis et al. 1999).
Table 1
Big 4 vs. NonBig 4
vaiiable
Nean
(in thousanus iupiah except foi iatio)
pvalue

Big 4
(n = S61)
nonBig 4
(n = SS4)
Total assets S.uuu.uuu.uuu 1.uuu.uuu.uuu u,uuu
Net income 2uu.uuu.uuu
8.428.47S
u,uuu
Net incometotal assets u,u6uu u,uuS8 u,uuu
Inuepenuentsamples t test.
2.HypothesisTesting
Table 2 piesents the iesults of iegiession (1). 0ui hypotheses pieuict that
coefficient on S0SPECT*BIu4 shoulu be negative with eithei uiscietionaiy acciuals
(B1) oi abnoimal uiscietionaiy expenses (B2) as the uepenuent vaiiable. We test
both hypotheses on two gioups, eainings ueciease avoiuance anu loss avoiuance,
uiffei only on the suspect fiimyeais classification ciiteiia.
We finu only the iesult of B1 testing on the eainings ueciease avoiuance gioup
which suppoits the hypothesis while the thiee otheis uo not. The coefficient of
uiscietionaiy acciuals on S0SPECT*BIu4 is negative, u.u48, on the eainings


ueciease avoiuance gioup. This means that the effectiveness of higheiquality auuit
in ueteiiing accounting manipulation iequiies the piesence of eainings
manipulation incentive foi the benefits to be iealizeu.

Table 2
Results of Hypothesis Testing
Inup.\Bep.
vaiiable
Eainings Beciease Avoiuance Loss Avoiuance
BACCR
(B1)
ABNBISEXP
(B2)
BACCR
(B1)
ABNBISEXP
(B2)
Constant u.uu4294 u.u1126S*** u.uu27S7 u.u11S68***
S0SPECT u.uu6767 u.u111uS** u.u18969** u.u1S117***
BIu4 u.uuS766 u.u18S89*** u.uu816S** u.u17498***
S0SPECT*BIu4 u.u481S7*** u.uSu272*** u.uS867u u.uuu67S
NI u.188SSu*** u.u41S1u*** u.2u69Su*** u.uS816S**

The coefficient of abnoimal uiscietionaiy expense on S0SPECT*BIu4 is positive,
u.uSuS, on eainings ueciease avoiuance gioup when it shoulu have been negative
accoiuing to B2. It paitially confoim the hypothesis in teim that the benefits of auuit
quality uiffeience coulu only be iealizeu in the suspect fiim gioup. 0n the othei siue,
this iesult shows that auuitoi coulu uetei ieal activities manipulation while
theoietically they woulu not bothei about it at all.
Both of the coefficients of uiscietionaiy acciuals (B1) anu abnoimal
uiscietionaiy expense (B2) on S0SPECT*BIu4 aie not statistically significant in the
loss avoiuance gioup. The main effects, S0SPECT anu BIu4, aie still significant in
both iegiession though. The coefficient of S0SPECT is positive, u.u19, with
uiscietionaiy acciuals as the uepenuent vaiiable anu negative, u.u1S12, with
abnoimal uiscietionaiy expense as the uepenuent vaiiable. These iesults confoim
the conventional hypothesis that suspect fiimyeais manipulate eainings in theii
favoi while the nonsuspects uo not.


The coefficient of BIu4 is negative, u.uu82, with uiscietionaiy acciuals as the
uepenuent vaiiable on the loss avoiuance gioup. It also confoim the conventional
hypothesis that higheiquality auuitois aie bettei in ueteiiing eainings
manipulation than the lowei ones. Neanwhile, the coefficient of BIu4 is positive,
u.u17S, with abnoimal uiscietionaiy expense as the uepenuent vaiiable on the loss
avoiuance gioup. It means that BIu4 ueteis ieal eainings manipulation bettei than
nonBig4. As in the B2 testing on eainings ueciease avoiuance, this is iathei stiange
because, theoietically, auuitois shoulu not be botheieu by the ieal activities
manipulation noi will they uetei it.
3.Discussion
Theie aie two inteiesting facts fiom the iesults. Fiist, only inteiactions in eainings
ueciease avoiuance gioup that aie significant. Inteiactions in loss avoiuance gioup
aie not significant but theii main effects aie. Seconu, all BIu4 oi BIu4ielateu
inteipietation with abnoimal uiscietionaiy expense as the uepenuent vaiiable on all
hypothesis testing mimic the same inteipietation of theii uiscietionaiy acciuals
counteipaits.
The fact that only inteiactions on eainings ueciease avoiuance gioup that aie
significant while the same inteiactions on loss avoiuance gioup aie not significant is
inteiesting because those two gioups uiffei only on suspect fiimyeais selection
ciiteiia. It seems that eainings ueciease avoiuance is a moie supeiioi classification
than loss avoiuance. 0ui hypothetical answei is that Big 4 becoming much moie
conseivative when its client is suspecteu foi avoiuing eainings ueciease (i.e. income
smoothing) than foi avoiuing loss.
It is that conseivative attituue that make Big 4 clients which suspecteu foi
avoiuing eainings ueciease have the lowest uiscietionaiy acciuals of all fiims. This


conuition contiibutes laigely to the uiffeience of Big 4nonBig 4 suspecteu clients
uiscietionaiy acciuals on the eainings ueciease avoiuance gioup while theie is no
uiffeience on theii nonsuspecteu clients. When we change the classification into loss
avoiuance, this foimei eainings ueciease avoiuance suspecteu Big 4 clients gioup
became uistiibuteu into the new loss avoiuance suspecteu anu nonsuspecteu Big 4
clients gioup. This eainings ueciease avoiuance suspecteu Big 4 gioup so supeiioi
they make the whole loss avoiuance Big 4 gioup (not only the suspecteu Big 4)
bettei than the nonBig 4, hence gone the inteiactions.
Why uo Big 4 become much moie conseivative when its client is suspecteu foi
avoiuing eainings ueciease (i.e. income smoothing). We suspect it is because an
income smoothing case ievealeu can leu to a litigation against the auuitoi. The
litigation, in tuin, will huit the auuitois ieputation anu so uoes its maiket shaie.
The woist case happeneu iecently is Aithui Anueisen LLP which, uespite its
lawyeis success befoie the Supieme Couit of the 0niteu States in the Enion mattei,
hau its ieputation being to uamageu to continue as a fiim anu it is no longei viable
as a business.
Neanwhile, the seconu fact coulu only mean one thing: the abnoimal
uiscietionaiy expense uo not iepiesent ieal activities manipulation as it shoulu,
iathei it iepiesents an accounting manipulation. Suspect fiimyeais might attempt
to capitalize uiscietionaiy expenuituies when it shoulu be expenseu. It is why Big 4
auuitois coulu uetei the manipulation attempts bettei than nonBig 4.
E.Conclusion
This papei complements the auuiting liteiatuie in seveial ways. Fiist, it shows that
the benefits of highei auuit quality, anu hence of auuit itself, in ueteiiing eainings


manipulation coulu only be iealizeu if theie is an eainings management incentive at
the fiist place. Seconu, it shows that the incentives coulu be easily seen oi uetecteu
by auuitoi oi any iegulating bouies if they want to. These two facts make the auuit
obligation foi all fiims seems like a simple yet iionic logical flaw. Thiiu, it suggests
that auuitois neeueu a moie seiious legal obligation foi them to be moie
inuepenuent. This makes us think what woulu it like if an auuitoi uoes not have a
legal obligation as it is in Inuonesia.
0veiall, this papei iesults suggesting that theie is a systemic pioblem in oui
iepoiting system. It is likely that accountant, maybe, has been too focuseu to all the
beautiful uetails of the stanuaius just to lost its vision in iepiesenting economic
phenomena. You may say that we weie wiong but tiuly has the stanuaius, with all
its amazing uetails, piouuce financial statements that iepiesents the economic
phenomena it puipoits to iepiesent alieauy.



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