Essays on Earnings Management: International Evidence

Abstract

This dissertation is comprised of two essays on earnings management. The first essay, entitled The Effect of Earnings Management and Legal Regime on Audit Fee Decisions: International Evidence, investigates whether the auditors incorporate their clients real earnings management (REM) in addition to accrual-based earnings management (AEM) into their pricing decisions. Using 79,904 firm-year observations from 24 countries, I find a positive association between audit fees and the magnitude of both AEM and REM, suggesting that auditors perceive that AEM and REM increase audit complexity and audit risk, thus exerting more effort on the clients that manage earnings through AEM or REM. This positive relation between AEM/REM and audit fees is more pronounced in countries with a stronger legal regime due to the heightened litigation risk in these countries. Furthermore, the association between AEM and audit fees is greater than that between REM and audit fees, suggesting that auditors are more cautious in detecting and restricting AEM than they are in detecting and restricting REM. Additional analyses show that these findings are more pronounced for Big 4 clients or risky clients. Overall, the results provide valuable insights into how auditors behave when their clients engage in risk-increasing earnings manipulations. The second essay, entitled The Effect of Ownership Divergence and Legal Regime on Cost Stickiness: International Evidence, examines whether the degree of cost stickiness depends on the ownership divergence of ultimate owners and the strength of country-level legal regime. Using 52,361 firm-year observations from 22 countries, I find that the magnitude of cost stickiness decreases as the ownership divergence increases. It is because firms with large ownership divergence are more likely to engage in earnings management. Second, the magnitude of cost stickiness decreases as country-level legal regime gets stronger. Since strong legal regime restricts managers empire building incentives, it renders a decrease in cost stickiness in strong legal regime countries. And the degree of cost stickiness is the smallest in firms with large ownership divergence and in countries with strong legal regime. This paper, by examining the effect of ownership structure and legal regime on cost behavior as well as its underlying mechanism, broadens the understanding of sticky costs behavior and contributes to the growing body of literatures on convergence of financial and managerial accounting.