Does Audit Quality Curb Real Earnings Management? New Insights From Quantile Regression in FTSE 350 Firms

Abstract

In this article, we tend to investigate the effect of audit quality (AQ) on real earnings management (REM) among the nonfinancial listed UK firms. This article employs a sample of 145 UK firms listed on the London Stock Exchange (LSE) covering the period from 2010 to 2019. Utilising the quantile regression technique, we investigate how AQ (proxied by audit committee independence, financial expertise and the auditor fees ratio) affects REM, operationalised via abnormal operating cash flows, production costs and discretionary expenses. We employed the principal component analysis (PCA) to measure AQ and aggregate REM. The study finds a nonlinear relationship between AQ and REM, indicating that AQ restrains managers from engaging in various forms of REM. However, the results show that AQ is ineffective in mitigating aggregate REM. For robustness, we employed the modified Jones model as an alternative form of earnings management to measure discretionary accruals (AEM), yielding similar results. Our findings also confirm that UK managers switch from REM to AEM and vice versa. This study benefits UK firms, as it suggests strengthening their audit committees to curb REM effectively. For policymakers, the results indicate that strengthening AQ standards is crucial to enhancing the integrity of financial reporting. Unlike prior studies, we used the quantile regression approach instead of conventional regression techniques to clarify the mixed findings.