The Emerald Research Register for this journal is available at www.emeraldinsight.com/researchregister MAJ 20,1 The current issue and full text archive of this journal is available at www.emeraldinsight.com/0268-6902.htm Audit quality and earnings management for Taiwan IPO firms 86 Ken Y Chen College of Management, National Cheng Kung University, Tainan, Taiwan Kuen-Lin Lin School of Management, Cheng Shiu University, Kaohsiung, Taiwan, and Jian Zhou School of Management, SUNY at Binghamton, Binghamton, New York, USA Abstract Purpose – This paper investigates the relationship between audit quality (as measured by auditor size and industry specialization) and earnings management (as measured by unexpected accruals) for Taiwan IPO firms Design/methodology/approach – First uses unexpected accruals in the modified Jones model to measure earnings management in the IPO process Then uses auditor type (big five versus non-big five) and industry specialist to measure audit quality The hypothesis predicts that Taiwanese firms with higher quality auditors engage less in earnings management in the IPO process The sample consists of 367 new issues between 1999 and 2002 from the Taiwan Economic Journal database Findings – It is found that big five auditors are related to less earnings management in the IPO year in Taiwan This shows that higher quality auditors constrain earnings management for Taiwan IPO firms Research limitations/implications – The finding shows that high quality auditors constrain earnings management and provide more precise information This is important, given that management has incentive to engage in earnings management in the IPO process to garner greater proceeds and at-issue earnings management is negatively related to post-issue earnings performance and stock returns Practical implications – The research might be of interest to investors in IPO firms, given that at-issue unexpected accruals are opportunistic Originality/value – The study contributes to the literature in that it shows that audit firm size is an important determinant in earnings management for Taiwan IPO firms Keywords Quality audit, Earnings, Taiwan Paper type Research paper Managerial Auditing Journal Vol 20 No 1, 2005 pp 86-104 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900510570722 I Introduction Going public is a major corporate event for a company to raise additional capital to fund its growth and enhance the entrepreneur’s personal wealth, where an offering prospectus including externally audited financial statements for up to a certain period (different among different jurisdictions) is needed to be prepared in the initial public offering (IPO) process Accrual accounting provides management with discretion in the reporting of earnings, and thus provides opportunity for managers to engage in earnings management in an IPO Earnings management in general and earnings management in the IPO process in particular, have attracted growing attention in the accounting research[1] The current study is motivated by a study by Zhou and Elder (2003), which finds that big five auditors and industry specialist auditors constrain earnings management for IPO firms in the US Given the different environments across countries and regions, it is useful to conduct an earnings management study for IPO firms besides the US Therefore, the current study investigates whether the relationship between audit quality and earnings management in the fiscal year of IPO exists in Taiwan Audit quality has become a concern after scandals such as Enron, WorldCom, and Ahold, etc These scandals raised concerns about audit quality even among the big five accounting firms, which are normally considered the premier accounting firms and associated with higher audit quality Among all these scandals, the Enron scandal attracted the greatest attention partly because it was associated with the collapse of Arthur Andersen We briefly summarize the Enron and Andersen events as follows On October 16, 2001, Enron announced that third-quarter earnings would include an unexpected nonrecurring charge of $1.01 billion after tax, which triggered the informal inquiry of SEC the next day SEC changed its informal inquiry into a formal investigation on October 31 On December 2, Enron filed for chapter 11 bankruptcy protection On January 10, 2002, Andersen notified the SEC and the Department of Justice that the Houston office had shredded a significant number of documents related to the Enron audit On February 2, the Powers report provided by a special investigation committee of Enron’s board of directors was released suggesting that the headquarters of Andersen were aware of the problems with Enron audit Andersen was indicted for obstruction of justice on March 14 and was found guilty on June 15, 2002 Andersen ceased conducting audits of public companies by August 31, 2002 The increased lack of investor confidence in financial statement information resulting from these corporate scandals involving once well-respected companies such as Enron and WorldCom, and auditors such as Arthur Andersen served as a catalyst for the Sarbanes-Oxley Act that was signed into law on July 30, 2002 The primary goal of the Sarbanes-Oxley Act is to help restore investors’ confidence in the integrity of financial information, and auditors play an important role in the process So it is important to investigate whether there is audit quality difference, especially during IPO process where firms are found to engage in opportunistic earnings management We choose 1999-2002 as the sample period since IPOs are relatively clustered for this period The average number of IPOs is around 90 each year for this period compared to the average number of 40 for 1991-1998 The Enron fiasco and the enacted Sarbanes-Oxley Act of 2002 may not affect the IPO market in Taiwan for our current study, because the regulation and procedures with regard to the IPO firms have been enacted before the Enron scandal However, the demand for higher auditor quality can be reasonably expected for Taiwanese companies listed in three major stock exchanges in the post-Enron era There are significant differences in the IPO process between US and Taiwan with regard to the listing procedures and regulations First, there exists procedural difference for a firm to go public and to be listed in the Taiwan Stock Exchange (TSE) compared to being listed in a US stock exchange In the US, the listing stock exchange is already decided when a firm goes public However, it is not the same in Taiwan A firm goes public first, then the firm files registration statements to the Securities and Futures Commission[2] (SFC, the SEC counterpart in Taiwan) If it meets the listing requirements of the Taiwan Stock Exchange, it will be listed there Second, there are also regulation differences with regard to the audited financial statements in the Audit quality for Taiwan IPO firms 87 MAJ 20,1 88 registration statements The auditor report in the registration statements to SFC in Taiwan is signed by two audit partners in addition to a signature representative of the audit firm, whereas only a signature representative of the audit firm is required in US Third, prior studies suggest that in well-developed capital markets such as the US, there is information asymmetry between management and investors (Leland and Pyle, 1977), and between informed and uninformed investors (e.g Rock, 1986; Beatty and Ritter, 1986), and such information asymmetry is a necessary condition for earnings management The capital market is less developed and the average listed company size is much smaller in Taiwan than in the US major stock exchanges, so the information intermediary role played by the auditor is maybe even more important in Taiwan The three areas of differences between the US and Taiwan make it interesting to examine whether audit quality constrains earnings management in Taiwan Earnings management in the IPO process is of particular concern for several reasons First, management has incentives to engage in income increasing earnings management to ensure that the issue is fully subscribed and/or priced higher to garner greater proceeds, because their compensation and/or reputation depend on the success of the IPO Second, at the issuing stage, earnings management is found to be negatively related to post issue earnings performance (Teoh et al., 1998b) and post issue stock returns (Teoh et al., 1998a) As a result, at the issuing stage, earnings management has significant resource allocation implication Third, APB 20 allows IPO firms to change accounting principles in the prospectus as long as financial statements of previous years are restated This may give management an opportunity to engage in earnings management Fourth, there is significant information asymmetry between the owners-managers and investors (Leland and Pyle, 1977), and between informed and uninformed investors (Rock, 1986; Beatty and Ritter, 1986) Theoretical research shows that auditors play an important role in reducing the adverse impact of information asymmetry in the IPO process Titman and Trueman (1986) develop a model in which the price of shares in an IPO is increasing in tandem with the quality of information provided by the offering company Datar et al (1991) find that the information asymmetry in the IPO process is mitigated by the role of auditor and audit quality The choice of auditor is made jointly with other decisions such as the percentage of retained ownership in the offering (Copley and Douthett, 2002) Empirical evidence indicates an increased demand for audit quality at the time of the IPO; companies frequently change to a big five auditor at the time of an IPO (Carpenter and Strawser, 1971; Menon and Williams, 1991)[3] Audit quality research has focused primarily on differences between big five and non-big five firms Research in the Australian audit market (Craswell et al., 1995) indicates that industry specialist auditors receive a fee premium that represents a significant portion of the premium to big five firms in the Australian audit market[4,5] Elder (1999) finds that IPO underpricing is lower for companies that use an industry specialist auditor This evidence indicates that industry specialist auditors provide higher quality of audits compared with non-industry specialist auditors Becker et al (1998) find that unexpected accruals are reduced when existing publicly-traded companies use a big five auditor They find that clients of non-big five auditors report unexpected accruals that are higher than unexpected accruals of clients of big five auditors They interpret this as indicating that lower audit quality is associated with greater accounting flexibility Our study differs from Becker et al (1998) in several respects First, we use an industry specialist variable in addition to a big five/non-big five measure Previous literature finds that audit firms devote significant resources to the development of industry expertise (Craswell et al., 1995) and audit firms promote themselves as industry specialists Second, we focus on a setting where the direction of earnings management is clear, specifically, IPO companies have incentives to engage in income increasing behavior In contrast, non-IPO companies may not always engage in income increasing behavior For example, DeFond and Park (1997) find that firms engage in income smoothing behavior because of managers’ job security concerns[6] Third, there are significant resource allocation concerns in the IPO process Managers/owners can benefit from higher IPO proceeds; however investors may make incorrect decisions based on reported earnings Fourth, unexpected accruals have been found on average to be opportunistic for IPO companies Teoh et al (1998b) find that earnings at the time of the IPO are high because of high unexpected accruals, and earnings after the issue are low because the earlier high unexpected accruals are not sustained Teoh et al (1998a) find that at-issue earnings management is significantly negatively related to post-issue stock returns Using a sample of IPO firms from 1996-1998 from the December 1998 Compact D New Issue database, Zhou and Elder (2003) find that unexpected accruals for IPO firms are lower when big five auditors are used, suggesting that the big five auditors are associated with reduced management discretion over earnings They also find that firms audited by industry specialist auditors engage in less earnings management Similar to Zhou and Elder (2003), we seek to address these two research questions: (1) Do big five auditors constrain earnings management in the IPO process? (2) Do industry specialist auditors provide higher quality of audits in the IPO process as evidenced by less earnings management? Using 367 IPO observations satisfying all the data requirements from 1999-2002, we find that unexpected accruals for IPO firms are lower when big five auditors are used, suggesting that the big five auditors are associated with reduced management discretion over earnings However, we not find that firms audited by industry specialist auditors engage in less earnings management The remainder of the paper is organized as follows The next section describes earnings management in the IPO environment and reviews research on audit quality and introduces the research hypotheses Section III describes the research design Sample selection and tests of the relation between auditor reputation and unexpected accruals are discussed in section IV Section V is the summary and conclusion II Earnings management, audit quality and IPOs Earnings management and initial public offerings An extensive body of earnings management literature has developed (see Healy and Wahlen (1999) for a review of the literature) Most earnings management studies examine whether companies manage earnings in response to some economic incentive One setting where management has an incentive to manipulate earnings is at the time of an IPO, since greater earnings may be reflected in a higher offering price and greater proceeds to the company and offering shareholders Whether a company benefits from earnings management depends upon whether the market can see through the earnings manipulation The IPO environment is Audit quality for Taiwan IPO firms 89 MAJ 20,1 90 characterized by information asymmetry between management and investors (Leland and Pyle, 1977), and between informed and uninformed investors (Rock, 1986; Beatty and Ritter, 1986) Several analytical models demonstrate that the extent of earnings management increases with the level of information asymmetry For example, Dye (1988) and Trueman and Titman (1988) demonstrate that the existence of information asymmetry between management and shareholders is a necessary condition for earnings management, because shareholders cannot perfectly observe a firm’s performance and prospects in an environment in which they have less information than management In such an environment, management can use its flexibility to manage reported earnings Furthermore, management’s discretionary ability to manage earnings increases as the information asymmetry between management and shareholders increases Richardson (2000) provides empirical evidence consistent with this line of reasoning He finds that the extent of information asymmetry, as measured by the bid-ask spread and the dispersion in analysts’ forecasts, is positively related to the degree of earnings management The information asymmetry in the IPO environment creates an opportunity for management to engage in earnings management because it is difficult for related stakeholders (especially shareholders) to undo this behavior Teoh et al (1998b) evaluate whether accounting accrual choices during an IPO are informative to investors or opportunistic They find evidence consistent with opportunism They find that the net income of IPO firms are significantly higher during the issuing year relative to subsequent years, and to non-issuing industry peers IPO firms are able to report high earnings during the IPO by reporting unexpected accruals aggressively The IPO firms’ earnings under-perform relative to their matched firms and non-issuing industry peers when high unexpected accruals at issue cannot be sustained in the following periods More importantly, they find that unexpected accruals explain the post-issue underperformance in earnings In a related paper, Teoh et al (1998a) find that at issue earnings management is negatively related to post issue stock returns A possible interpretation of their findings is that at issue earnings management helps the company receive a higher issuing price When at issue earnings performance attributable to earnings management cannot be sustained in the following periods, this is negatively reflected in the stock price Audit quality and earnings management Auditor firm size In Taiwan, the big five audit firms are T.N Soong & Co (member of Arthur Andersen), PricewaterhouseCoopers, KPMG, Deloitte and Touche, and Diwan Ernst & Young Due to the Enron scandal and ceased operation of Andersen on August 31, 2002, T.N Soong & Co merged into Deloitte and Touche and became Deloitte and Touche on June 1, 2003 The clients of T.N Soong were also transferred to Deloitte and Touche, which is different from the situation in the US, where Andersen’s clients chose other big five or non-big five audit firms as successor auditors Given quality monitoring systems which operate across all accountancy forms, the client’s demand for auditor reputation and auditor quality should not have changed, since all Andersen’s clients in Taiwan were transferred to Deloitte and Touche Becker et al (1998) find that companies with non-big five auditors (a proxy for lower audit quality) report unexpected accruals that significantly increase income compared to companies with big five auditors In Taiwan, non-big five auditors, especially for those local or regional audit firms instead of national audit firms, are usually recognized as lower quality auditors when compared to big five auditors, which can be evidenced by the clients’ selection of big five auditors for their IPO process They also find that managers respond to debt contracting and income-smoothing incentives by strategically reporting unexpected accruals In addition, companies with incentives to smooth earnings upwards (downwards) report significantly greater income-increasing (decreasing) unexpected accruals when they have non-big five auditors Francis et al (1999) argue that high-accrual firms have greater opportunity for opportunistic earnings management and have an incentive to hire a big five auditor to provide assurance that earnings are credible They find that high accrual firms are more likely to hire a big five auditor, but report lower unexpected accruals, consistent with big five auditors constraining opportunistic reporting of accruals The Becker et al (1998) and Francis et al (1999) studies provide evidence in non-IPO settings that higher quality auditors are associated with reduced levels of earnings management Previous research suggests that the auditor can play a role in reducing information asymmetry at the time of the IPO Balvers et al (1998) and Hogan (1997) find that big five auditors are associated with lower under-pricing of the offering Balvers et al (1998) argue that a high quality auditor provides better information about earnings, which makes it easier for the investment banker to price the issue correctly and preserve reputation quality This information argument is consistent with the model in Titman and Trueman (1986), in which the price of the shares in an IPO is increasing with the quality of the information provided by the offering company, which they argue is partially determined by the quality of the auditor Evidence that big five auditors are associated with lower unexpected accruals for IPO firms would further support the information hypothesis Zhou and Elder (2003) provide evidence supporting the information hypothesis that audit quality provided by big five audit firms is an important constraint in earnings management in the IPO process in the US Therefore, we expect that IPO companies in Taiwan that use big five audit firms will engage in less earnings management than IPO companies with non-big five auditors: H1 IPO firms in Taiwan audited by big five audit firms engage less in earnings management than firms audited by non-big five auditors Auditor industry specialization Recent audit quality research has focused on the role of auditor industry specialization Hogan and Jeter (1999) find that measures of specialization have increased in both regulated and unregulated industries, consistent with returns to specialization Craswell et al (1995) argue that audit firms market themselves in terms of both a general reputation and industry expertise In a test of audit fees in the Australian audit market, they find that industry specialists receive a significant fee premium, and that this fee premium is a significant component of the fee premium received by big five firms Industry specialization is acknowledged in DeAngelo (1981) as one possible reason for the selection of big five auditors by IPO companies In the Titman and Trueman (1986) model, in which the pricing of an IPO is increasing with the quality of information associated with the expertise of the auditor, they suggest that industry knowledge is one element of auditor expertise Elder (1999) finds that IPO Audit quality for Taiwan IPO firms 91 MAJ 20,1 92 under-pricing is lower for companies that use an industry specialist auditor Zhou and Elder (2003) find that auditor industry specialists can be used to constrain earnings management in the IPO process in the US Because of the expertise and experience of industry specialists, we also expect that industry specialists are likely to constrain earnings management in the IPO process This leads into the second hypothesis: H2 Firms audited by industry specialist engage less in earnings management in the initial public offering process in Taiwan The following section describes the research design, including the model used to estimate unexpected accruals and models used to test the research hypotheses III Research design Unexpected accruals We first use unexpected accruals to measure earnings management in the IPO process Unexpected accruals (also called discretionary accruals) are used in earnings management studies such as Jones (1991) and Subramanyam (1996) Dechow et al (1995) provide evidence that the modified Jones model is the most powerful to detect earnings management among the alternative models to measure unexpected accruals The model is estimated as follows: TACC it ¼ ðDCAit DCASH it DCLit DSTDit DEP it ị=TAit21 TACC it ẳ a1 1=TAit21 ị ỵ a2 DREV it DREC it ị=TAit21 ỵ a3 PPE it =TAit21 ỵ 1it where: TACC it ẳ total accruals for firm i in year t, defined as above DCAit ¼ change in current assets for firm i in year t DCASH it ¼ change in cash for firm i in year t DCLit ¼ change in current liabilities for firm i in year t DSTDit ¼ change in short-term debt for firm i in year t DEP it ¼ change in depreciation for firm i in year t DREV it ¼ change in revenue for firm i in year t DREC it ¼ change in receivables for firm i in year t PPE it ¼ net property, plant and equipment for firm i in year t TAit21 ¼ total assets for firm i in year t-1 This equation is estimated cross-sectionally each year for each two-digit Taiwan Economic Journal (TEJ) code industry using all available firms At least ten firm year observations are required in a two-digit TEJ code The residual from the regression is the unexpected accruals Normal levels of working capital accruals related to sales are controlled through the changes in revenue adjusted for changes in accounts receivable Normal levels of depreciation expense and related deferred tax accruals are controlled through the gross property, plant and equipment In addition the total assets of the previous period are used as a deflator to control for potential scale bias The cross-sectional model reflects common industry factors applied to unexpected accruals As a result, estimated unexpected accruals are more likely to reflect management’s choice rather than industry factors Also, since the model is estimated year-by-year, changes in industry conditions are also factored in the model Audit quality for Taiwan IPO firms Auditor industry specialization Craswell et al (1995), and Ferguson and Stokes (2002) use the percentage of the audit firm’s share of total industry audit fees as an industry specialist measure This measure incorporates size weighting into market share (weighted by audit fees) They define an auditor to be an industry specialist if the auditor attains a 10 percent market share from either or both of these two measures Since the audit fee data is not available to us, we cannot use this procedure and instead use a sales-based industry specialist measure Since the Taiwan market is comparatively smaller than the US market, we require there to be at least ten firms in a two-digit TEJ code industry for an auditor to qualify as an industry specialist, rather than the 30 US firms used in Zhou and Elder (2003) Audit firm industry specialization is defined as follows: 93 J ik X qffiffiffiffiffiffiffi Aijk MS ik ¼ j¼1 I k J ik X X qffiffiffiffiffiffiffi Aijk i¼1 j¼1 where: Aijk ¼ total sales of client firm j in industry k audit by auditor i i ¼ 1; 2; ; I ¼ an index for audit firms j ¼ 1; 2; ; J ¼ an index for client firms k ¼ 1; 2; ; K ¼ an index for client industry Ik ¼ the number of audit firms i in industry k J ik ¼ the number of clients served by audit firm i in industry k Industry specialists are calculated yearly based on the firm-year observations from the TEJ database When auditor j’s market share is greater than 15 percent in a two-digit TEJ code industry, the auditor j is treated as an industry specialist Approach to testing Our hypotheses relate earnings management as measured by unexpected accruals to audit quality as measured by auditor type and industry specialization Many other variables may play a role in management’s unexpected accruals decision in the IPO process Becker et al (1998) find that operating cash flows are significantly different for firms audited by big five versus firms audited by non-big five firms The absolute value of total accruals is used as a control variable because Becker et al (1998) provide evidence that this is significantly negatively related to unexpected accruals Also MAJ 20,1 94 Francis et al (1999) find that the likelihood of using a big five auditor is increasing in firms’ endogenous propensity for accruals Burgstahler and Dichev (1997) find that firms manage reported earnings to avoid reporting earnings decreases and losses Accordingly, loss and income change indicator are added as control variables to account for managers’ incentive to avoid earnings decreases and losses Market-to-book value at the end of the IPO offering year is used as a surrogate for growth opportunity because information communication might play a role in some managers’ earnings management decisions, even though Teoh et al (1998b) find that managers use unexpected accruals opportunistically in the IPO process Managers may try to signal the firm’s future prospects through unexpected accruals The log of sales is used as an independent variable to control for the possible effect of size on earnings management in the IPO process Large firms may have less incentive to engage in earnings management because they are subject to more scrutiny from financial analysts and investors Leverage may also be associated with earnings management in the IPO process DeFond and Jiambalvo (1994) and Sweeney (1994) find that managers use unexpected accruals to satisfy debt covenant requirements The electronics industry (ELEC) is the largest industry in Taiwan, and the matter of earnings management is more likely to be a concern Therefore, ELEC is also used as a control variable Further, Taiwan Stock Exchange (TSE) is used as a control variable because of the requirements to be a listed firm in TSE is stricter than the firms in the over-the-counter market, and thus earnings management is more likely to be constrained in TSE Inclusion of these control variables results in the following regression model: DAC it ¼ b0 ỵ b1 BIG5 ỵ b2 SPEC it ỵ b3 OCF it ỵ b4 ABSTAit ỵ b5 LOSS it ỵ b6 INCCHGit ỵ b7 MTBit ỵ b8 SIZE it ỵ b9 LEV it ỵ b10 ELEC ỵ b11 TSE ỵ 1it DAC it ¼ unexpected accruals BIG5it ¼ if the auditor is member of big five; otherwise SPEC it ¼ if the auditor is an industry specialist; otherwise OCF it ¼ operating cash flow deflated by lagged total assets ABSTAit ¼ absolute value of total accruals LOSS it ¼ if the firm incurs a loss; otherwise INCCHGit ¼ if this year’s income is greater than previous year’s income; otherwise MTBit ¼ market to book ratio SIZE it ¼ log of total sales LEV it ¼ leverage, defined as total liabilities over total assets ELEC it ¼ if the firm is member of electronic industry; otherwise TSE it ¼ if the firm is member of TSE; otherwise The model is estimated using unexpected accruals (DAC) as the dependent variable The main research variables of interest are BIG5 and SPEC Consistent with the two research hypotheses, the coefficients on these two variables are predicted to be negative because firms audited by big five auditors and industry specialists are expected to engage in less earnings management in the IPO process Audit quality for Taiwan IPO firms 95 IV Sample selection and results The sample consists of 367 observations of new issues between 1999 and 2002 from the Taiwan Economic Journal (TEJ) database satisfying the following criteria: IPO date, and the auditor for the IPO are available from the database; and necessary data for calculating total accruals, unexpected accruals, industry specialist, market-to-book ratio and leverage are available from the database Table I provides details about the sample selection After deleting 21 financial services and insurance companies (as in previous literature, the unexpected accruals does not apply to financial industries) and 42 companies with missing data, the final sample between 1999 and 2002 amounted to the 367 firm-year observations Table II provides details about the sample distribution by year and by auditor type The number of IPO companies is around 80 each year from 1999 to 2001, down to 56 in the year 2002 The big five auditors audit more than 80 percent of the IPOs in any given year, except for the year 2002, which is around 90 percent of the IPOs Table III provides the industry distribution of the sample firms The sample includes 17 separate TEJ industry codes, indicating a wide distribution of industries Electronics industry has the largest concentration of IPOs, with more than 66 percent of the total observations The remaining sample firms are widely distributed across 1999-2002 IPOs Financial services and insurance Missing data Total 430 21 42 367 Note: Sample characteristics for 367 firms conducting initial public offerings during the period of 1999 to 2002 from December 2002 Taiwan Economic Journal (TEJ) database 1999 2000 2001 2002 Table I Sample selection Total Year n % n % n % n % n % B5 NB5 Total Freq 84 19 103 81.55 18.45 83 24 107 77.57 22.43 77 18 95 81.05 18.95 56 62 90.32 9.68 300 67 367 81.74 18.26 28.06 29.15 25.89 16.90 100 Table II Sample IPO firms by year and by auditor MAJ 20,1 96 Table III TEJ codes distribution Industry TEJ codes Food Plastics Textiles Electrical and machinery Chemicals Steel and iron Electronics Constructions Transportations All others Total Freq % B5 NB5 SPEC 12 13 14 15, 16 17 20 23 25 26 11, 18, 21, 22, 27, 29, 40 21 20 21 245 17 21 367 0.82 2.18 5.72 5.45 5.72 1.91 66.76 4.63 1.09 5.72 100.00 16 14 14 218 10 13 300 1 27 67 2 11 159 193 TEJ industry codes; no other TEJ industry code contains more than percent of the sample firms Table IV presents the distributions of auditors operating in different industries As evident from Table IV, not every big five auditors are industry specialist auditors For example, all the big five audit IPO firms in the electronics industry, Deloitte & Touche is not an industry specialist auditor Table V provides descriptive statistics for the sample The average total accruals are 0.047 The average unexpected accruals are 0.083 and the median of unexpected accruals is 0.062 Big five auditors are used by 81.7 percent of the sample firms, and around 53 percent of firms use industry specialist as auditors The mean and median operating cash flows are 0.046 and 0.058 The mean and median of absolute value of total accruals are 0.294 and 0.153 respectively The median firm has positive net income and positive income change in the IPO year The average market-to-book ratio at the end of the offering year is 2.251, and the average log of sales is 14.126 The mean and median leverage are 0.393 and 0.384, respectively The sample companies from the electronics industry are 66.8 percentage of the sample, and there are 30 percentage of the sample companies listed in the Taiwan Stock Exchange Industry Table IV Auditors operating in different industries in Taiwan B5 (Freq.) NB5 (Freq) SPEC (Freq) Food Plastics Textiles Electrical and machinery Chemicals Steel and iron Electronics Constructions Transportations PWC, DT AA, KPMG, PWC, EY, DT AA, KPMG, PWC, EY, DT Other MRI MRI, CH, other PWC, DT AA, KPMG AA, KPMG, DT KPMG, PWC AA, KPMG, PWC, AA, KPMG, PWC, AA, KPMG, EY AA, KPMG, PWC, AA, KPMG, PWC, KPMG, PWC BDO, BDO, RSM, BDO, RSM, other EY EY, DT EY, DT EY other other other RSM, CH, MRI, other other AA, KPMG AA, KPMG PWC, EY AA, KPMG KPMG Notes: AA (merged into Deloitte and Touche, June 1, 2003); KPMG; PWC; Diwan EY; Deloitte and Touche (DT); BDO Taiwan Union & Co.; RSM International; Chien Hsing (CH); Pyramid (MRI_Moores Rowland International); TC (MRI) Var Mean STD Lower quartile Median Upper quartile TAC DAC BIG5 SPEC OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE 0.047 0.083 0.817 0.526 0.046 0.294 0.109 0.564 2.251 14.126 0.393 0.668 0.300 0.503 0.504 0.387 0.500 0.170 0.410 0.312 0.497 2.321 1.295 0.155 0.472 0.459 20.113 20.084 20.023 0.064 0 1.067 13.476 0.269 0 0.036 0.062 1 0.058 0.153 1.443 14.042 0.384 0.193 0.238 1 0.125 0.344 2.592 14.751 0.516 1 Notes: TAC: total accruals, defined as ðDCAit DCASH it DCLit DSTDit DEP it Þ=TAit21 ; DAC: unexpected accruals; BIG5: if the auditor is member of big five; otherwise; SPEC: if the auditor is an industry specialist; otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: if the firm incurs a loss; otherwise; INCCHG: if this year’s income is greater than previous year’s income; otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: if the firm is member of electronic industry; otherwise; TSE: if the firm is member of TSE; otherwise Table VI shows the correlation among the dependent and independent variables Total accruals and unexpected accruals are significantly positively correlated with each other The big five variable is negatively related to total accruals and unexpected accruals Industry specialist is insignificantly and negatively related to total accruals and unexpected accruals This suggests that big five auditors constrain earnings management in the IPO process, although the formal analyses are based on multivariate analyses As expected, there is a positive correlation (0.50) between the big and industry specialist variables As described in Table V, 81.7 percent of the sample firms (300/367) audited by big five firms, and around 53 percent of firms (193/367) use industry specialist as auditors That is, there are 107 firms out of 300 big five audited firms are not industry specialists Tests of the research hypotheses using unexpected accruals in the fiscal year of IPO offering as the dependent variable are reported in Table VII The first two columns report the results using separate big five and industry specialist auditor reputation measures, and the last column reports the results using both measures The big five measure is associated with lower unexpected accruals at the percent level or better in both model specifications These results suggest that big five auditors are associated with lower unexpected accruals in the fiscal year of IPO offering, and audit quality plays an important role in reducing earnings management The coefficient on the industry specialist variable is insignificantly negative when the big five variable is excluded, and is insignificantly positive when both big five and SPEC variables are included This is not consistent with the findings in Zhou and Elder (2003) and Craswell et al (1995) that industry specialization is an important element in auditor quality The possible explanation is that the Taiwan audit market is comparatively smaller than the US, or the industry specialization is not well recognized Audit quality for Taiwan IPO firms 97 Table V Variable descriptive statistics (n ¼ 367) 0.00 0.10 0.54 0.17 0.00 0.03 0.04 0.00 0.26 0.20 0.50 0.74 20.09 20.04 20.06 0.20 20.11 0.11 0.16 0.03 20.06 20.06 0.03 0.08 0.42 0.22 0.00 0.03 0.04 0.00 0.51 0.24 0.24 0.62 0.50 20.02 0.05 0.07 0.03 0.14 0.06 20.03 0.27 0.05 0.00 0.77 0.38 0.15 0.63 0.01 0.26 0.58 0.00 0.36 0.10 0.03 0.12 20.08 0.08 0.12 20.02 0.35 20.01 0.06 0.53 0.02 0.15 0.11 0.02 0.72 0.00 0.85 20.03 20.14 0.13 0.23 0.04 20.26 20.04 0.05 OCF 0.55 0.01 0.01 0.00 0.40 0.00 0.47 0.37 20.05 0.09 0.09 20.06 0.01 0.01 20.24 0.33 0.09 0.09 0.24 0.86 0.81 0.00 ABSTA 20.38 20.12 20.21 0.05 0.10 20.11 0.00 0.02 0.00 0.34 0.06 0.03 LOSS 0.30 0.23 0.04 0.16 0.17 0.00 0.00 0.40 0.00 0.00 INCCHG 0.06 20.18 0.26 0.27 0.29 0.00 0.00 0.00 MTB 0.35 0.17 0.20 0.00 0.00 0.00 SIZE 0.06 0.16 0.27 0.00 0.05 0.39 ELEC TSE Notes: TAC: total accruals, defined as ðDCAit DCASH it DCLit DSTDit DEP it Þ=TAit21 ; DAC: unexpected accruals; BIG5: if the auditor is member of big five; otherwise; SPEC: if the auditor is an industry specialist; otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: if the firm incurs a loss; otherwise; INCCHG: if this year’s income is greater than previous year’s income; otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: if the firm is member of electronic industry; otherwise; TSE: if the firm is member of TSE; otherwise 0.97 20.09 20.03 20.07 0.18 20.11 0.11 0.17 0.06 20.07 20.03 0.02 SPEC Table VI Pearson correlation matrix for dependent and independent variable (n ¼ 367) TAC DAC BIG5 SPEC OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE BIG5 LEV DAC 98 TAC MAJ 20,1 DAC INTERCEPT (t-statistic) BIG5 SPEC OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE Adj R-sq 20.225 20.134 20.754 21.966** 20.447 0.222 20.066 0.050 0.038 0.035 20.365 20.121 20.011 8.4 22.772*** 3.429*** 20.722 0.842 3.044*** 1.506* 21.896** 22.021** 20.171 DAC 20.293 0.982 20.002 20.441 0.216 20.076 0.052 0.036 0.034 20.360 20.146 20.014 7.4 0.039 2.692*** 3.314*** 0.829 0.869 2.896*** 1.432* 1.859** 2.340*** 0.226 DAC 20.191 20.167 0.060 20.473 0.220 20.071 0.058 0.039 0.033 20.367 20.137 20.009 8.4 0.634 2.186** 0.959 2.892*** 3.389*** 0.770 0.975 3.071*** 1.404* 1.905** 2.203** 0.148 Notes: Significant at the *0.10, **0.05, 0.01 level based on a one-tail test; DAC: unexpected accruals; BIG5: if the auditor is member of big five; otherwise; SPEC: if the auditor is an industry specialist; otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: if the firm incurs a loss; otherwise; INCCHG: if this year’s income is greater than previous year’s income; otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: if the firm is member of electronic industry; otherwise; TSE: if the firm is member of TSE; otherwise as an important element of audit quality by the IPO companies in Taiwan The multivariate regression results in Table VII indicate that big five auditors reduce earnings management for IPO firms in the offering year Several control variables are significantly related to unexpected accruals Operating cash flow is found to be negatively related to unexpected accruals, which suggests firms with strong operating cash flow position are less likely to use unexpected accruals to increase earnings in the IPO offering year Firm size is found to be positively related to earnings management, suggesting large firms engage more in income increasing earnings management in the IPO year Leverage is found to be negatively related to earnings management, suggesting that these firms are not using earnings management to satisfy debt covenant requirements This shows that earnings management in the IPO year is unlikely due to concern over debt covenants ELEC is significantly and negatively related to unexpected accruals, indicating electronics companies engage in income increasing earnings management more than companies in other industries in the IPO year Additional analyses In Table VIII, we test for variable difference between big five and non-big five clients We find that the DAC for big five clients is significantly different from that of non-big five clients, which further supports our finding in Table VII that big five auditors reduce earnings management for IPO firms in the offering year Interestingly, we find that industry specialists for big five clients is significantly different from those of non-big five clients, which indicates that industry specialist firms are highly recognized by big five clients Audit quality for Taiwan IPO firms 99 Table VII Regression of unexpected accruals on auditor size and industry specialization (using 15 percent industry specialization ratio) (n ¼ 367) MAJ 20,1 BIG5 DAC SPEC 100 OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE Table VIII Test for variable difference between big five and non-big five clients n Mean STD 1 1 1 1 1 300 67 300 67 300 67 300 67 300 67 300 67 300 67 300 67 300 67 300 67 300 67 0.061 0.181 0.643 0.044 0.051 0.302 0.254 0.120 0.060 0.570 0.537 2.401 1.582 14.162 13.967 0.391 0.403 0.727 0.403 0.310 0.254 0.490 0.555 0.480 0.183 0.096 0.387 0.503 0.326 0.239 0.496 0.502 2.494 1.075 1.381 0.793 0.159 0.139 0.446 0.494 0.463 0.438 t-statistic 1.767* 10.963*** 0.290 0.872 1.432 0.487 2.630*** 1.117 0.552 5.260*** 0.907 Notes: Significant at the *0.10, **0.05, 0.01 level based on a two-tail test; TAC: total accruals, defined as ðDCAit DCASH it DCLit DSTDit DEP it Þ=TAit21 ; DAC: unexpected accruals; SPEC: if the auditor is an industry specialist; otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: if the firm incurs a loss; otherwise; INCCHG: if this year’s income is greater than previous year’s income; otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: if the firm is member of electronic industry; otherwise; TSE: if the firm is member of TSE; otherwise In Table IX, we regresses unexpected accruals on industry specialization for big five clients only, and subdivide big five variable by using four dummy variables to examine whether specific big five is recognized by its client as more likely to constrain earnings management in the IPO process in Taiwan We find that EY is the only big five firm that is recognized by its client to constrain earnings management, although the coefficients of AA, DT, and PWC are insignificantly and negatively related to unexpected accruals We also use total accruals as the dependent variable to test our hypotheses and conduct additional analyses, and the results (not reported) are qualitatively similar to the unexpected accruals V Summary and conclusions In this study, we examine whether auditor size and industry specialization are associated with lower earnings management (lower unexpected accruals) for IPO companies in Taiwan We find that auditor size is associated with lower unexpected DAC INTERCEPT SPEC AA DT EY KPMG OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE Adj R-sq (%) 20.286 0.065 20.606 20.072 20.086 0.088 0.038 0.037 20.510 20.118 20.058 5.8 20.943 1.048 23.591*** 20.960 20.895 1.339* 2.993*** 1.557* 22.458*** 21.685* 20.840 DAC 0.195 0.628 0.073 0.077 0.112 0.033 0.571 0.079 0.072 0.085 0.037 0.036 0.544 0.098 0.046 5.7 0.828 0.892 1.236 0.393 3.415*** 1.041 0.744 1.314* 2.869** 1.524* 2.594*** 1.452* 0.664 DAC 0.198 0.015 0.074 0.067 0.106 0.030 0.577 0.079 0.073 0.088 0.037 0.036 0.544 0.103 0.046 5.4 0.636 0.181 0.835 0.655 1.109 0.360 3.388*** 1.038 0.752 1.323* 2.868*** 1.495* 2.590*** 1.408* 0.663 Notes: Significant at the *0.10, **0.05, 0.01 level based on a one-tail test; DAC: unexpected accruals; SPEC: if the auditor is an industry specialist; otherwise; AA: if the auditor is AA; otherwise; DT: if the auditor is DT; otherwise; EY: if the auditor is EY; otherwise; KPMG: if the auditor is KPMG; otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: if the firm incurs a loss; otherwise; INCCHG: if this year’s income is greater than previous year’s income; otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: if the firm is member of electronic industry; otherwise; TSE: if the firm is member of TSE; otherwise accruals, consistent with high quality auditors constraining earnings management and providing more precise information This is important given that management has incentive to engage in earnings management in the IPO process to garner greater proceeds and at issue earnings management is negatively related to post issue earnings performance and stock returns This is also important given investors have very little information about these firms prior to the IPO process to evaluate or undo the earnings management Our research might be of interest to investors in IPO firms, given that at issue unexpected accruals are opportunistic, and Teoh et al (1998a) find that at issue unexpected accruals are negatively related to post issue earnings performance and stock return Our study also contributes to the literature by showing that auditor quality constrains earnings management in Taiwan, thus complementing the findings in Zhou and Elder (2003) Notes See Healy and Wahlen (1999), Beneish (2001) for a review of the earnings management literature, and Teoh et al (1998b) and Teoh et al (1998a) for a discussion of earnings management for IPO companies On July 1, 2004, Security and Future Commission has been renamed as Securities and Futures Bureau, which is directly governed by the Financial Supervisory Commission, Executive Yuan Self-regulated bodies of the accounting profession include National Federation of Certified Public Accounts Association of the ROC, which govern the Audit quality for Taiwan IPO firms 101 Table IX Regression of unexpected accruals on industry specialization for big five clients only (n ¼ 300) MAJ 20,1 102 performance of professional services by the members The Statements of Financial Accounting Standards and Statements of Auditing Standards are issued by the Financial Accounting Standard Committee and Auditing Standard Committee of the Accounting Research and Development Foundation There are three stock markets in Taiwan: Taiwan Stock Exchange (TSE), Over-The Counter (OTC), and Emerging Stock The IPO criteria such as net worth, profitability, and diversification of stock ownership for securities listings in the three major stocks are different where the strictest criteria apples to the listed firms in Taiwan Stock Exchange Other signals in addition to auditor choice, such as the percentage of retained ownership, can be used as signals to reduce the extent of information asymmetry Copley and Douthett (2002) find that auditor choice and retained ownership are substitutes that are jointly chosen to minimize the cost to the entrepreneur CPA firms typically market themselves as industry specialists For example, PricewaterhouseCoopers’ homepage indicates that “we have organized ourselves to deliver our industry expertise to some 24 market sectors and have grouped these market sectors into three clusters consistent with effective delivery to the marketplace” Quote is available at: www.pwcglobal.com/gx/eng/about/ind/index.html Ferguson and Stokes (2002) not find strong support for the presence of industry specialist premiums in the post big eight/six mergers Income smoothing is different from income increasing behavior because income smoothing also includes income decreasing behavior when current performance is relatively good and future expected performance is relatively poor References Balvers, R., McDonald, B and Miller, R (1998), “Underpricing of new issues and the choice of auditor as a signal of investment banker reputation”, The Accounting Review, Vol 63, October, pp 605-22 Beatty, R and Ritter, J (1986), “Investment banking, reputation, and the underpricing of initial public offerings”, Journal of Financial Economics, Vol 15 No 1/2, pp 213-32 Becker, C., DeFond, M., Jiambalvo, J and Subramanyam, K.R (1998), “The effect of audit quality on earnings management”, Contemporary Accounting Research, Vol 15, Spring, pp 1-24 Beneish, M (2001), “Earnings management: a perspective”, Managerial Finance, Vol 27, pp 3-17 Burgstahler, D and Dichev, I (1997), “Earnings management to avoid earnings decreases and losses”, Journal of Accounting and Economics, Vol 24 No 1, pp 99-126 Carpenter, C and Strawser, R (1971), “Displacement of auditors when clients go public”, Journal of Accountancy, June, pp 55-8 Copley, P and Douthett, E Jr (2002), “The association between auditor choice, ownership retained, and earnings disclosure by firms making initial public offerings”, Contemporary Accounting Research, Vol 19 No 1, pp 49-75 Craswell, A., Francis, J and Taylor, S (1995), “Auditor brand name reputations and industry specializations”, Journal of Accounting and Economics, Vol 20 No 3, pp 297-322 Datar, S.M., Feltham, G.A and Hughs, J.S (1991), “The role of audits and audit quality in valuing new issues”, Journal of Accounting and Economics, Vol 14 No 1, pp 3-49 DeAngelo, L (1981), “Auditor size and auditor quality”, Journal of Accounting and Economics, Vol No 3, pp 183-99 DeFond, M and Jiambalvo, J (1994), “Debt covenant effects and the manipulation of accruals”, Journal of Accounting and Economics, Vol 17 No 1/2, pp 145-76 DeFond, M and Park, C (1997), “Smoothing income in anticipation of future earnings”, Journal of Accounting and Economics, Vol 23 No 2, pp 115-39 Dechow, P., Sloan, R and Sweeney, A (1995), “Detecting earnings management”, The Accounting Review, Vol 70, April, pp 193-225 Dye, R (1988), “Earnings management in an overlapping generations model”, Journal of Accounting Research, Vol 26, Autumn, pp 195-235 Elder, R (1999), “Audit firm size, industry specialization and initial public offerings of common stock”, working paper, Syracuse University, Syracuse, NY Ferguson, A and Stokes, D (2002), “Brand name audit pricing, industry specialization and leadership premiums post-big and big mergers”, Contemporary Accounting Research, Vol 19 No 1, pp 77-110 Francis, J., Maydew, E and Sparks, H (1999), “The role of big auditors in the credible reporting of accruals”, Auditing: A Journal of Practice and Theory, Vol 18 No 2, pp 17-34 Healy, P and Wahlen, J (1999), “A review of the earnings management literature and its implications for standard setting”, Accounting Horizons, Vol 13 No 4, pp 365-83 Hogan, C (1997), “Costs and benefits of audit quality in the IPO market: a self-selection analysis”, The Accounting Review, Vol 72, January, pp 67-86 Hogan, C and Jeter, D (1999), “Industry specialization by auditors”, Auditing: A Journal of Practice and Theory, Vol 18 No 1, pp 1-17 Jones, J (1991), “Earnings management during import relief investigations”, Journal of Accounting Research, Vol 29, Autumn, pp 193-228 Leland, H and Pyle, D (1977), “Informational asymmetries, financial structure, and financial intermediation”, The Journal of Finance, Vol 32 No 2, pp 371-87 Menon, K and Williams, D (1991), “Auditor credibility and initial public offerings”, The Accounting Review, Vol 66, April, pp 313-32 Richardson, V (2000), “Information asymmetry and earnings management: some evidence”, Review of Quantitative Finance and Accounting, Vol 15 No 4, pp 325-47 Rock, K (1986), “Why new issues are underpriced”, Journal of Financial Economics, Vol 15 No 1/2, pp 187-212 Subramanyam, K.R (1996), “The pricing of discretionary accruals”, Journal of Accounting and Economics, Vol 22, pp 249-81 Sweeney, A (1994), “Debt covenant violations and managers’ accounting responses”, Journal of Accounting and Economics, Vol 17, May, pp 281-308 Teoh, S.H., Welch, J and Wong, T.J (1998a), “Earnings management and the long-run market performance of initial public offerings”, Journal of Finance, Vol 53, December, pp 1935-74 Teoh, S., Wong, T.J and Rao, G (1998b), “Are accruals during initial public offerings opportunistic?”, Review of Accounting Studies, Vol 3, pp 175-208 Titman, S and Trueman, B (1986), “Information quality and the valuation of new issues”, Journal of Accounting and Economics, Vol No 2, pp 159-72 Trueman, B and Titman, S (1988), “An explanation for accounting income smoothing”, Journal of Accounting Research, Vol 26, Supplement, pp 127-32 Zhou, J and Elder, R (2003), “Audit firm size, industry specialization and earnings management by initial public offering firms”, working paper, Syracuse University, Syracuse, NY and SUNY-Binghamton, Binghamton, NY Audit quality for Taiwan IPO firms 103 MAJ 20,1 104 Further reading Dechow, P (1994), “Accounting earnings and cash flows as measures of firm performance: the role of accounting accruals”, Journal of Accounting and Economics, Vol 18 No 1, pp 3-42 Willenborg, M (2002), “Discussion of ‘Brand name audit pricing, industry specialization, and leadership premiums post-big and big mergers’”, Contemporary Accounting Research, Spring, pp 111-16  ... The IPO environment is Audit quality for Taiwan IPO firms 89 MAJ 20,1 90 characterized by information asymmetry between management and investors (Leland and Pyle, 1977), and between informed and. .. significant information asymmetry between the owners-managers and investors (Leland and Pyle, 1977), and between informed and uninformed investors (Rock, 1986; Beatty and Ritter, 1986) Theoretical research... relation between auditor reputation and unexpected accruals are discussed in section IV Section V is the summary and conclusion II Earnings management, audit quality and IPOs Earnings management and