Audit quality, materiality & threshold-induced earnings management

Several prior studies (see e.g. Burgstahler and Dichev, 1997; Degeorge, Patel and Zeckhauser, 1999; Gore, Pope and Singh, 2001; Holland and Ramsay, 2003) document statistically significant discontinuities in the distribution of reported earnings figures around certain targets (i.e. zero earnings, analysts' earnings forecasts and prior year's earnings). These discontinuities are then ascribed to threshold-induced earnings management. Relying on a sample of listed UK firms and employing a similar methodology, I examine whether high-quality audits serve as a constraint on such threshold-induced earnings management practices. In order to proxy for audit quality, I rely on both the traditional brand name variable (i.e. Big5 vs. non-Big5) and a measure for Big5 auditors' industry expertise (i.e. specialist Big5 vs. non-specialist Big5). Whereas results clearly show that high-quality audits (i.e. specialist Big5 audits) serve as a constraint on loss avoidance, this is clearly not true for earnings management aimed at meeting last year's earnings figure. This discrepancy in obtained results might be attributable to the fact that the latter type of earnings enhancement will often not be quantitatively material (i.e. as opposed to loss avoidance) and that auditors (i.e. both high- and low-quality auditors) neglect qualitative factors in assessing materiality.