e-sRC

CHAPTER ONE
INTRODUCTION
1.1 Background to the study
The financial scandals that rocked the UK and the USA towards the end of the 1990s and the
beginning of the 21st century have brought about a major awareness on the need for more
transparency and credibility in order to protect shareholders and stakeholders alike. Earnings
management, which has always been the phenomenon at the core of these scandals, has received
considerable attention in accounting literature because it has been a consistent cause of concern
among practitioners and regulators, and has become one of the most important challenges
confronting corporate governance mechanisms in trying to resolve the negative impact of
earnings management on financial reporting.
The practice of earnings management involves altering the earnings figures being reported,
through the use of the judgmental discretions as allowed by the generally accepted accounting
principles (GAAP), so as to either mislead the users into believing what is actually not true in
respect of the earnings‟ figures, and hence secure favorable response (like increased demand for
the firm‟s shares); or to influence contractual outcomes which depend on the reported earnings
(Okolie, 2014)(b). From this, it is evident that the practice of earnings management can only be
carried out by the managers, on whose shoulders lies the responsibility of reporting the firm‟s
earnings figures. Also, looking at agency theory relations, especially the part that explained how
managers‟ interests are at conflict with that of the shareholder, it is clear that managers will
always try to influence the contractual outcomes in their favor. This is so because managers are
employees of the shareholders and their performance is usually measured using the earnings they
reported, and based on it, they receive their rewards
In Nigeria, the Security and Exchange Commission (SEC) has made it mandatory for public
companies to publish and make available their audited financial statements annually which must
conform with guidelines, formats, and regulations issued by the apex accounting institution and
other regulatory and supervisory agencies. Yet, management of corporate organizations often
embark on earnings management in order to increase market value and thus maximize
shareholders wealth (Ekoja, 2002). The regulatory inconsistency and the choice available in
accounting policies have often called for the exercise of judgments in preparing financial
statements. The implication of exercising such judgments is that information provided by
management which invariably arouses a certain decision by different users may make them to
take wrong decision when preparers decide to convey self-serving information (Farouk, 2014).
The demand for audit of companies‟ accounts is created by the agency problems which are
related to the separation of corporate ownership from control (Gerayli, Yanesari&Ma‟atoofi,
2011). The agency problem arises from the existence of asymmetric information in the principal
– agent contracts (Jenson& Messier, 2000). Some studies (Trueman& Titman, 1988; Dye, 1988;
Schipper, 1989; Warfield, Wild & Wild, 1995) have shown that the existence of information
asymmetry between corporate management and shareholders is a necessary condition for the
perpetration of earnings management practice. The audit of a company‟s accounts is a
monitoring and control mechanism that diminishes information asymmetry and protects the
interests of the principal.
Auditing, as an external monitoring mechanism, has become a fundamental requirement in the
business environment and has been established as a regulated activity in most industrialized
countries (Piot, 2001) due to its important role in offering more confidence and transparency in
financial reporting. Recent financial scandals have increased the question of whether an external
audit is effective in constraining earnings management and the wave of audit failure in the
capital market has also increased concerns about audit quality (Velury, 2005).
The link between audit quality attributes and earnings management stems from a general belief
which exists among the public that creative accounting is employed opportunistically by
managers for their own selfish gains rather than the interest of the shareholders and other
stakeholders. External audit therefore became an important instrument for shareholders, to
ensure the transparency and credibility of financial reporting. External auditors are responsible
for verifying that the financial statements are fairly stated in conformity with GAAP and that
these statements reflect the „true‟ economic condition and operating results of the entity, thus, the
external auditor‟s verification adds credibility to the company‟s financial statements, therefore, a
quality audit is expected to constrain opportunistic earnings management.
Audit services may not ensure that falsified materials have been detected; but the amount of
manipulation discovered depends on the quality of audit services. The quality of audit services in
turn depends on the experience of the auditors, their knowledge of the industry (industry
specialization), their size, and their independence, amongst others. Such knowledge and
experience will help the auditor to diagnose the complex issues in specific industries. According
to agency theory, Gul, Kim and Qui (2009), state that higher quality audits can restrain insiders
from abusing accounting-based contractual constraints and manipulating earnings as a result of
the separation of ownership and control.
Audit committee plays the pivot role of monitoring to ensure the quality of financial reporting
and corporate accountability. It serves as a liaison and bridge the information asymmetry
between the external auditor and the board, facilitates the monitoring process, and enhances the
independence of an auditor from management. A properly functioning audit committee is
therefore essential in enhancing effective oversight of the financial reporting process and
achieving high quality financial controls. Abbott, Parker & Peters (2004) reported that an
effective audit committee is negatively associated with the occurrence of earnings management.
The decision to focus on manufacturing firms stems from the fact that these firms play a very
significant role towards the economic development of Nigeria. The variety of firms in the sector
gives room to study different firms that are into different lines of operations within the sample.
Some of the monumental fraud and remarkable earnings management scandals in Nigeria were
carried out by manufacturing giants such as Cadbury Nigeria plc.
1.2 Statement of the problem
Despite the existence of codes of best practice for corporate governance in Nigeria, corporate
financial scandals continue to evolve in the business environment. These scandals have cast
doubt on the quality of reported earnings and the ability of the audit process to effectively
constrain earnings management. As a result, earnings management has received considerable
attention from business strategists and academic researchers. Though earnings management does
not violate accounting rules, its practice by managers is highly unethical and negates the
principles of agency relationship. Hence the need to assess this assertion in listed Manufacturing
firms in Nigeria
A large number of studies have been conducted on audit quality and earnings management (such
as Salim, 2012; Khrishnan, 2003; Balsam, Khrishnan&Yand, 2003; DeFond,
Raghunandan&Subramanyam, 2002; Abbott & Parker, 2000; Craswell, 1999) most of which
recognized the audit quality mechanisms as effective factors that restrain excessive opportunistic
behavior among managers. However, these studies were conducted in developed economies,
hence it is uncertain if such evidence on audit quality can be generalized to the developing
countries like Nigeria that have different litigation environment.
Some studies have been conducted in Nigeria (such as Okoh, 2015; Jibril, 2014; Okolie, 2014;
Okolie, 2013). However, most of these studies have ignored the use of auditors‟ industry
specialization as an attribute of audit quality. Okolie (2013) used only one variable (audit firm
size). Similarly, Okolie (2014)(b) used only two variables (auditor tenure & auditor
independence), while Jibril (2014) used three variables (audit fee, audit firm tenure& auditor
type). The importance of industry specialized auditors is attributable to the foreign research
findings that auditor industry expertise is associated with better auditor performance and higher
audit quality. Therefore, this study includes auditor industry specialization as a variable to
establish its influence on earnings management of listed manufacturing firms in Nigeria.
Okoh (2015) employed the modified jones model for capturing earnings management which has
been criticized for ignoring manipulations of sales because it assumes that all sales in the period
are non-discretionary and estimates are stationary and, overtime, may generate a survivorship
bias. Consequently, this study adopt performance matched discretionary accruals model
developed by Kothari, Leone and Wasley (2005).
Also, most sighted literatureson the effect of audit quality attributes on earnings management
(such as Okoh, 2015; Jibril, 2014; Okolie, 2014; Okolie, 2013) only looked at their direct
relationship without considering the use of a moderator or mediator variables. Thus, this study
make attempt to examine the moderating effect of audit committee on the relationship between
audit quality attributes on earnings management in listed Manufacturing firms in Nigeria.
Additionally, the period covered by most of the previous studies leaves a gap. For instance, the
works of Okolie (2014) covered a period of 2006-2012, Jibril (2014) covered 2006-2012, Okoh
(2015) covered 2006-2011, Bala (2014) covered the period from 2006 to 2012. These studies can
be said to be not too recent as some of the findings have been overtaken by events such as the
FRCN‟s newly released national code of corporate governance 2016. Furthermore, most studies
in this area were focused on the banking and other sectors of the economy, and none has
specifically covered the listed manufacturing firms in Nigeria despite the diversity of the firms in
this sector and the role they play in the economic development of Nigeria.
In view of the above, it is needful to conduct a study with a vision of filling these gaps identified
in the literature. Therefore, this study examines the moderating effectof audit committee on the
relationship betweenaudit quality attributes and earnings management of listed manufacturing
firms in Nigeria.
1.3 Research Questions
In view of the foregoing paragraphs, this study raised the following questions;
i. To what extent does auditor size affect earnings management of listed manufacturing
firms in Nigeria?
ii. What is the effect of auditor independence on earnings management of listed
manufacturing firms in Nigeria?
iii. How does auditor industry specialization affect earnings management of listed
manufacturing firms in Nigeria?
iv. How does auditor tenure influence earnings management of listed manufacturing firms in
Nigeria?
v. What is the moderating effect of audit committee on the relationship between audit
quality attributes and earnings management of listed manufacturing firms in Nigeria?