Impact of Audit Quality of Real Earnings Management

Impact of Audit Quality of Real simoleons ManagementAbstractThis study aims to evaluate the square up of scrutiniseed account quality (auditor size and auditor upgrade), policy-making liaison, and institutional self-command toward substantive scratch attention. Purposive call for was conducted and 83 manufacturing companies registered in Indonesian Stock supervene upon during 2010-2014 were acquired as the samples. For exam the hypotheses, panel data retroflection random effect model was employ. The forgets showed that auditor size and institutional ownership had unequivocal influence toward accepted requital charge, while audit tenure and political connections did non influence documentary net focal point. The harbor variable testing showed that leverage and loss had negatively charged influence toward concrete network way, while change ratio had positive effect towards existing lettuce management. These result have implication for the investors to pay trouble to operating cash flow average, because on that point is still a possibility of real mesh management, although the order auditors were from the big-4 auditors.Keywords real earnings management, audit quality, auditor size, audit tenure, political connections, institutional ownership..INTRODUCTIONManagers can apply collection earnings management and real earnings management to achieve the desired profit (Fisher and Rosenzwig, 1995 Roychowdhury, 2006). The real earnings management is impose bigger long-term costs, because it has negative consequences toward afterlife cash flow which reduce firm value (Roychowdhury, 2006 Cohen et al., 2008 Cohen and Zarowin, 2010). Graham et al., (2005) and Cohen et al., (2007) clarify that the reasons wherefore a political party using real earnings management is to avoid auditors and regulators detection. The real earnings management is more difficult to detect because it is almost comparable to a companys operational activity (Kim et al, 2010).Becker et al. (1998) Johnson et al.( 2002) Balsam et al.,(2003) Chen et al. (2011), and Inaam et al. (2012) showed that audit quality (auditor size and auditor tenure) reduce accretion earnings management. Therefore, companies that want to conduct earnings management leave alone shift from accrual earnings management to real earnings management (Chi et al., 2011). Auditor size positively affect real earnings management (Chi et al., 2011 Inaam et al., 2012). Meanwhile, Nihlati and Meiranto (2014) showed that the auditors size negatively daze real earnings management. Chi et al. (2010) constitute that auditor tenure had positive influence toward real earnings management. While Inaam et al.(2012), Herusetya and Pujilestari (2013) found that auditor tenure did not affect real earnings management.Inaam et al., (2012) conducted a research ab appear the influence of audit quality toward the real earnings management in Tunisia and suggested that the future research can inc lude political connection and institutional ownership as independent variables. Pollitically connected companies have bad inform quality (Chaney et al., 2010). Meanwhile, Batta et al. (2014) found that political connection positively affect the reporting quality. The phenomena of pollitically connected companies in Indonesia is state-owned enterprises became disorganized after were interfered by political parties (Muqoddas, 2012). Indonesian decomposition Watch data showed that there were 48 legislators who were entrepreneurs that were overt for corruption case (Gabrillin, 2014).Shleifer Vishny (1986) Bathala et al. (1994) Velury Jenkins (2006) Mehrani et al. (2016) showed that institutional ownership reduce accrual earnings management. The institutional investors monitor toward managerial process and accounting information accuracy are stronger. For avoiding detection by the institutional investors, companies allow shift from accrual earnings management to real earnings manag ement.The aim of this research is to evaluate the influence of audit quality, political connection and institutional ownership toward real earnings management. This study contributes in adding political connection and institutional ownerships as independent variables, as suggested by Inaam et al. (2012). Up to now, studies about real earnings management in Indonesia are rarely conducted and, if any, they have not correlated political connection and institutional ownerships toward the real earnings management study yet, so this study will fill in that gap.As the social organisation of this paper, literature review and hypotheses development will be discussed on the next part. The research mode will be discussed in the third section. This is followed by result and discussion and the final section concludes the study.LITERATURE REVIEW AND HYPOTHESES DEVELOPMENTAuditor Size and Real Earnings ManagementEarnings management can be utilise through accrual and real activities (Roychowdhur y, 2006 Zang, 2007 Cohen and Zarowin, 2010). The methods of real earnings managements are sale manipulation, overproduction, and reducing discretional expenses (Roychowdhury, 2006). DeAngelo (1981), Becker et al. (1998) and Krisnan (2003) found that big size auditors have get out audit quality than small auditors. The Big-4 auditors is considered to be more competent than the non Big-4 auditors if seen from their education, training, and experience (Amijaya and Prastiwi, 2013), their independencies (Zou and Elder, 2003) and their good reputation (Christiani and Nugrahanti, 2014). Big-4 auditors competency will quiet the earnings management detection. Therefore, companies consort to choose real earnings management, so it will be more difficult to be identified. Cohen and Zarowin (2010), Chi et al. (2011), Inaam et al. (2012) found out that auditor size positively influences real earnings management.H1 Auditor size has positive influence toward real earnings management.Auditor tenu re and Real Earnings ManagementAuditor tenure is the number of years of an auditor being assigned by a company (Myers et al., 2003). The longer engagement duration, the uplifteder auditors knowledge about that company, so it ease in detecting earnings management (Giri, 2010). The company will shift from accrual earnings management to real earnings management so that it will not be detected easily. The real earnings management tends to be out of the auditors supervision (Chi et al., 2011) and it will be hard to detect because it is almost the uniform as companys daily operational activity (Kim et al., 2010). Cohen and Zarowin (2010) and Chi et al. (2011) found that auditor tenure has positive influence toward real earnings management.H2 Auditor tenure has positive influence toward real earnings management.Political Connection and Real Earnings ManagementA company can be called politically connected if the biggest shareholder (has minimum 10% of voting rights) or top officers serve s as the parliamenterian, minister, or has close relation with a politician or political party (Faccio, 2006). A company which has political connection will get the benefit such as capital allocation (Fisman, 2001 Goldman et al.,2010), better business opportunities (Fisman, 2001), and bailouts from the government (Faccio et al., 2006).If a company is not able to maintain its reputation and profit, It will loose special previlege from political connection (Braam et al., 2015). For increasing their performance, the companies tend to perform real earnings management. Earnings management detection would lead decreasing in companys reputation, increasing in political cost and the companys external interventions (Watss and Zimerman, 1990 Faccio, 2006 Ramanna and Roychowdhury, 2010 Kothari, 2012). For avoiding that detection, the company will shift the accrual earnings management to real earnings management. Chaney et al., (2011) found out that politically connected companies tend to cond uct earnings management.H3 Political connection has positive influence toward real earnings management.Institutional Ownership and Real Earnings ManagementInstitutional investors generally have a big number of shares, so they carry out strict monitoring to the companies performance and companies information quality (Velury and Jenkins, 2006 Pound, 1988 Shleifer and Vishny, 1986). Bushee (1998) and Potter (1992) found out that institutional investors were too focus on the short-term performance, so they index the managers to achieve that short-term profit. For improving their performance and for avoiding the detection from institutional investors , the managers will prefer real earnings management than accrual earnings management.H4 Institutional ownership has positive influence toward real earnings management.RESEARCH METHODOLOGYSamples and Source of Data This study used the manufacturing companies listed in Indonesia Stock Exchange during 2010-2014 compass points. The criteria fo r purposive sampling method are the companies published annual report sequentially during that periods and the annual reports were finished on the December 31st. There were 83 companies were selected as the samples, so there were 415 firm year observations.The annual reports acquired from the Indonesia Stock Exchange website. The political connection data were acquired from (1) annual report and tracing down the Board of Directors and Board of Commissioners life sentence from the sites in Google, (2) the Indonesian Republic topic Portalwebsite (indonesia.go.id), the Indonesian Republic House of Representative website (www.dpr.go.id), and Tokoh Indonesia Indonesian Leaders (www.tokohindonesia.com).VariablesReal Earnings Management (Dependent Variable)Abnormal notes flow from operation will be used as proxy of real earnings management. When the companies apply real earnings management, the average of CFO will be negative (Roychowdhury, 2006 Chi et al., 2011., Inaam et al., 2012 an d Ratmono, 2010).CFOt= operating cash flow of company i in year tAt-1= the total asset of company i in t-1 yearSt= the total sales of company i during year tt= abnormal cash flow from operation (regression residual, real earnings management proxies, rapid eye movement sleep) free VariablesPolitical connection, auditor size, auditor tenure and institutional ownership are the independent variables. duck 1 Independent Variables MeasurementIndependent VariablesMeasurementPolitical Connection (Political connection variable will be measured by calculating the number of Board of Directors and Board of Commissioners, two the chiefs and the members who are also the House of Representative members, ministers or vice ministers, or related to prominent politicians and political party members (Braam et al., 2015)Auditor size (AUDSIZE)A weed variable, 1 if the firm was audited by a Big 4 auditor, 0 otherwise (Chi et al., 2011 Inaam et al., 2012.,Christiani and Nugrahanti, 2014).Auditor Tenure (TENURE)The number of engagement years or auditing period assigned in which the auditors from the same Public Accountant Firm conduct audit engagement to the auditee during 2010-2014 periods (Chi et al., 2011 Inaam et al., 2012)Institutional Ownership(INSTOWN)The percentage of shares owned by the institutional investors (Velury Jenkins, 2006 Mehrani et al., 2016 Wiranata and Nugrahanti.,2013)Control VariablesLeverage, company loss and cash ratio were used as control variables in this study. Leverage/ LEV (the total debt/ the total asset) positively influence the rapid eye movement (Herusetya and Pujiletari, 2013). The loss of the company is measured using a dummy variable, 1 if company has net loss and 0 otherwise (Herusetya and Pujilestari, 2013). One of the reasons why a company applies real earnings management is to cover up the company loss (Roychowdhury, 2006). Cash ratio (CCE) is the ratio of the cash and cash equivalents toward the total asset (Herusetya and Pujilestari, 20 13). The higher CCE ratio, the faster companys cash flow, so it will ease the manager in utilizing the available cash to have earnings management (Herusetya and Pujilestari, 2013).Regression typePanel data regression abstract was chosen to perform the hypotheses testing because this study used data combination of time series and data dun section (Winarno, 2015). Hypotheses H1, H2, H3, H4 and control variable in this study will be tested using empirical model as followsRESULT AND DISCUSSIONdescriptive StatisticsTable 2 below showed descriptive statistics used in this study.Table 2 Descriptive Statistics (Pooled Sample, n= 415)VariableMeanMaximumMinimumStd .Deviation paradoxical sleep-0.0063520.659900-1.2174700.188328POLCN0.245783200.468655AUDSIZE (dummy variable)100.485552TENURE2.554217511.381844INSTOWN(%)70.4841100019.61332LEV0.4709064.1891900.0002650.321157LOSS (dummy variable)100.339475CASH0.1023450.5002950.0000780.122287From 415 firm years, 157 companies (37.8%) used the big-4 auditors and 258 companies (62.2%) used the Non-Big 4 auditors. Besides, there were 55 companies (13.3%) reported a loss.Real Earnings Management (REM) TestingWilcoxon Signed Ranks Test was conducted to confirm whether REM are validly applied in the sample companies. The result of this test are presented in appendix 1. If the average abnormal CFO was negative, the companies were assumed to apply REM in operating cash flow (Oktorina Hutagaol,2008). The Wilcoxon Signed Ranks Testing result showed that the mean of abnormal CFO was -0.006352 and its significance value was 0.046, so it was confirmed that those companies applied REM through operating cash flow.Panel data Model TestingChow Test and Hausman Test for determining the appropriate estimation method were presented in appendix 2. Based on the Chow Test and Hausman Test results, the estimation method applied in this study was panel data regression using random effect model.Hypotheses TestingThe results of hypotheses testing usin g panel data regression random effect model within 5% important level were presented in Table 3.Table 3 Hypotheses Testing ResultsVariableExpected signCoefficientProbabilityConclusionIntercept-0.0771460.0997AUDSIZE+0.0843730.0031***H1 acceptedTENURE+-0.0085940.0968H2 rejectedPOLCN+0.0019020.9380H3 rejectedINSTOWN+0.0011000.0372**H4 acceptedLEV+-0.0757690.0071***LOSS+-0.0674310.0083***CASH+0.2681740.0043***Dependent variable Real earnings management (REM)R-squared 0.119266Adjusted R-squared 0.104118F-statistic 7.873503Prob(F-statistic) 0.000000** profound on alpha 5%***significant on alpha 1%Auditor Size and Real Earnings ManagementThe H1 testing shows that auditor size positively influence REM. This result is in line with Chi et al. (2010), Cohen and Zarowin (2010), Inaam et al. (2012), Nihlati and Meiranto (2014). The big-4 auditors are assumed to have better skills compared to non big-4 auditors, regarding from their educational backgrounds, trainings, and exp eriences (Amijaya and Prastiwi, 2013), their independencies (Zou and Elder, 2003) and their good reputation (Christiani and Nugrahanti, 2014). The big-4skills will ease the auditors in detecting the accrual earnings management. Hence, companies will cover up the earnings management from the auditors and prefer to apply real earnings management. Real earnings management is harder to be identified than accrual earnings management since it is almost the same as the companies daily operational activity (Kim et al., 2010, Graham et al., 2005 Gunny, 2010 Badertscher, 2011).Auditor tenure and Real Earnings ManagementThe H2 testing result shows that auditor tenure did not had an effect toward REM. This result consistent with Inaam et al.(2012), Herusetya and Pujilestari (2013), Nihlati and Meiranto (2014). Gul et al. (2009) categorized the audit placement period into three categories, the short term (2-3 years), strength term (4-8 years), and long term (9 years). Table 2 show that auditor tenure average is 2.5 years, and the short auditor tenure had not been able to influence real earnings management.By limiting auditor tenure, there will be a gap between the auditor and the company. In order to hold in a company, auditors had to identify in advance the companies characteristics and managements, and it usually took quite a long time (Kono and Yuyetta, 2013). Amijaya and Prastiwi (2013) stated that why audit tenure did not have any influence toward earnings management was the auditors incapability in identifying earnings management.Political Connection and Real Earnings ManagementBased on Table 3, it can be seen that political connection did not had an effect toward REM. This result is in contrast with Braam et al. (2015). Political connection did not had an effect toward real earnings management because the numbers of political connections in the samples was few, which was 27.71% (23 out of 83 companies). There were only one person in board of directors and board of commissioners that were involved in political connection, so political connections did not influence real earnings management.Institutional Ownerships and Real Earnings ManagementThe H4 testing result indicates that institutional ownerships positively influence REM. The institutional ownerships mean was 70.48%. Institutional investors who had a big number of shares will strictly monitor companys performance and companys information quality (Velury and Jenkins, 2006 Pound, 1988 Shleifer and Vishny, 1986). The strict monitoring made the companies that want to apply earnings management shift from accrual earnings management to real earnings management. Institutional investors were too focus on short term performance, so they urged the managers to fulfill that short term profit (Bushee,1998 Potter, 1992). For increasing their performance and for avoiding institutional investors detection, the managers would prefer real earnings management to accrual earnings management.Leverage, Compan y Loss, Cash Ratio and Real Earnings ManagementThe testing results of control variables show that leverage negatively influenced REM. If a company has high levels of debts, it has to pay principal and high debt interest. The obligatory of those payments limit managers in using cash flow, including for real earnings management (Zamri et al.,2013).The company loss negatively influences REM. This finding is in line with Herusetya and Pujilestari (2013) and Roychowdhury (2006). When the company reported positive earnings, the company was assumed that they were covering up the loss through REM. If the company reported negative earnings, the company would be assumed that they did not apply REM, and the company was considered to not cover up the loss (Herusetya and Pujilestari, 2013). Cash ratio positively influence REM. The higher cash ratio, the better companys liquidity, so it would ease the managers in utilizing the provided cash for real earnings management (Herusetya and Pujilestari , 2013).CONCLUSIONAlthough a study about audit quality and real earnings management has been conducted before, this study contributes in adding new independent variables, which are political connection and institutional ownerships. The testing results show that the auditor size and institutional ownerships can increase real earnings management. Meanwhile, audit tenure and political connection do not influence real earnings management. The testing toward control variables showed that leverage and company loss negatively influence real earnings management, while cash ratio had positive influence. The applied implication of these result is the investors direct to see the operating cash flow average , because there is still a possibility of real earnings management, although the company auditors were from the big-4 auditors.The limitation of this study was a few number data of political connection although depth investigation had been carried out by looking at the name of legislative m embers/ ministers and vice ministers/ kinships to members of political parties. For the future study, the political connection criteria can be added by including the Indonesia National Forces retirees or ministry officials (for example the secretary general, directorate general, staff member of ministry, assistance of ministry). 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