Audit Quality and Earnings Management by Seasoned Equity Offering Firms

Jian Zhou Assistant Professor of Accounting School of Management SUNY at Binghamton PO Box 6000 Binghamton, NY 13902-6000 USA Tel: (607) 777-6067 Fax: (607) 777-4422 Email: jzhou@binghamton.edu

Randal Elder Associate Professor of Accounting School of Management Syracuse University 900 S. Crouse Avenue, Syracuse, NY 13244 USA Tel: (315) 443-3359 Fax: (315) 443-5457 Email: rjelder@som.syr.edu

November 2003 We thank Ferdinand A. Gul (editor) and an anonymous referee for their insightful comments. We also thank Judy Walo and the participants at the 2003 AAA Northeast Region Meeting for their helpful comments. We also thank Feixue Yan for her excellent research assistance and Ralph Hansen for his generous help in data analysis.

Audit Quality and Earnings Management by Seasoned Equity Offering Firms

Abstract

We investigate the relationship between audit quality as measured by audit firm size and industry specialization, and earnings management as measured by discretionary current accruals, for companies making seasoned equity offerings (SEOs). Earnings management in the SEO process is of concern because of the underperformance of seasoned equity offering firms. We find that (1) compared with three years before and three years after the SEO, SEO firms increase earnings through current and total discretionary accruals in the year of SEO; (2) Big 5 auditors and industry specialist auditors are associated with lower earnings management in the year of SEO; (3) compared with three years before and three years after the SEO, industry specialist auditors are associated with lower current and total discretionary accruals only in the year of SEO. Our study contributes to the literature by demonstrating that audit quality reduces earnings management by SEO companies, and that industry specialization, as a measure of audit quality, also constrains earnings management.

Audit Quality and Earnings Management by Seasoned Equity Offering Firms

The underperformance of seasoned equity offering (SEO) firms is well documented in the finance literature (Loughran and Ritter 1995; Spiess and Affleck-Graves 1995). For example, Loughran and Ritter report that SEO firms underperform non-issuing firms by approximately 8% per year. Several studies provide evidence that the underperformance of SEOs is due to earnings management. Teoh, Welch and Wong (1998a) find that SEO firms who report higher net income through earnings management have lower post issue long-run abnormal returns and net income. Rangan (1998) finds that earnings management around the SEO predicts both earnings changes and market-adjusted stock returns in the following year. Shivakumar (2000) finds evidence of earnings management by SEO companies, but he shows that investors infer earnings management and rationally undo the effect of earnings management around seasoned equity offerings. He attributes the results of the two previous studies to test misspecification. Although there is conflicting evidence on whether investors undo or naively extrapolate earnings management at the time of SEO, there is a consensus in these three studies that managers engage in earnings management around the SEO. However there is very little systematic evidence on whether audit quality constrains earnings management in the SEO process.1 Our study examines the relationship between audit quality measured by audit firm size and industry specialization, and earnings management as measured by discretionary current accruals by SEO companies.
1

Shivakumar (2000, p.352) finds that median abnormal accruals are lower for firms with audited quarterly data compared to firms without audited quarterly data. Our study differs from Shivakumar in that we focus on annual data, and the role of audit quality in constraining earnings management.

The information asymmetry between management and investors creates an opportunity for management to engage in earnings management around the SEO. Management also has incentive to engage in earnings management to ensure that the stock price of the firm remains at a reasonable level around the SEO to maximize offering proceeds. The success of the SEO is also likely to affect either directly or indirectly managers compensation and reputation. Although there is little theoretical or empirical evidence on whether auditors reduce information asymmetry in the SEO process, theoretical research shows that auditors play an important role in reducing the adverse impact of information asymmetry in the IPO process. For example, Titman and Trueman (1986) develop a model in which the price of shares in an IPO is increasing in the quality of information provided by the offering company. Becker et al. (1998) find that discretionary accruals are reduced when existing publicly-traded companies use a Big 5 auditor. They find that clients of non-Big 5 auditors report discretionary accruals that are higher than discretionary accruals of clients of Big 5 auditors. They interpret this as indicating that lower audit quality is associated with greater accounting flexibility. Krishnan (2003) finds that discretionary accruals are lower for existing public companies that are audited by Big 5 industry specialists. Zhou and Elder (2002) find that Big 5 and industry specialist auditors are associated with lower discretionary accruals for IPO companies. Our study differs from Becker et al. (1998) in that we use an auditor industry specialist variable in addition to a Big 5/non-Big 5 variable as measures of audit quality. Also, we focus on a setting where the direction of earnings management is clear, as SEO firms have incentive to engage in income increasing behavior prior to the SEO. Teoh, Welch and Wong (1998a) find that managers use discretionary accruals opportunistically in 4

the SEO process. However, whether firms engage in income increasing behavior in general is not clear. For example, DeFond and Park (1997) find that firms engage in income smoothing behavior because of managers job security concerns.2 Zhou and Elder (2002) examine the relation between audit quality and discretionary accruals for IPO companies. In comparison, this study examines the role of audit quality on earnings management for seasoned offerings. Because more information is available for SEO companies, there is likely to be less information asymmetry. Accordingly, this setting provides further evidence on the role of audit quality and industry specialization in reducing earnings management. We examine whether audit quality, including auditor industry specialization, constrains earnings management in the SEO process. The earnings management in the SEO process is of particular concern because of the possible misallocation of resources due to the market underperformance of issuing firms. Using 2199 SEO observations satisfying all the data requirements from 1991 to 1999 from the Securities Data Corporation database, we find that discretionary accruals for SEO firms are lower in the SEO year when Big 5 auditors are used, suggesting that the Big 5 auditors are associated with reduced management discretion over earnings. We also find that firms audited by industry specialist auditors engage in less earnings management in the SEO year. These results are robust to alternative measures of earnings management and measures of industry specialization. The remainder of the paper is organized as follows. The next section describes earnings management in the SEO environment and reviews research on audit quality and includes the research hypotheses. Section III describes the research design. Sample
2

Income smoothing is different from income increasing behavior because income smoothing also includes income decreasing behavior when current performance is relatively good and future expected performance is relatively poor.

selection and tests of the relation between auditor firm size, industry specialization and discretionary accruals are discussed in Section IV. Section V is the summary and conclusion.

II. EARNINGS MANAGEMENT, AUDIT QUALITY AND SEOs Earnings Management and Seasoned Equity Offerings An extensive body of earnings management literature has developed (see Healy and Whalen (1999) for a review). Most earnings management studies examine whether companies manage earnings in response to some economic incentives. One setting where management has an incentive to manipulate earnings is at the time of an SEO, since greater earnings may be reflected in a higher offering price and greater proceeds to the company and offering shareholders. Whether a company benefits from earnings management depends upon whether the market can see through the earnings management. Because earnings management is a costly process, it would be useless for the management to engage in earnings management unless the management believes at least part of the earnings management will not be detected or undone by relevant stakeholders. Several analytical models demonstrate that the extent of earnings management increases with the level of information asymmetry. For example, Dye (1988) and Trueman and Titman (1988) demonstrate that the existence of information asymmetry between management and shareholders is a necessary condition for earnings management, because shareholders cannot perfectly observe a firms performance and prospects in an environment in which they have less information than management. In such an environment, management can use its flexibility to manage reported earnings. Furthermore, managements discretionary ability to manage earnings 6

increases as the information asymmetry between management and shareholders increases. Richardson (1998) provides empirical evidence consistent with this line of reasoning. He finds that the extent of information asymmetry, as measured by the bid-ask spread and the dispersion in analysts forecasts, is positively related to the degree of earnings management. In a related study, Lobo and Zhou (2001) find that there is a statistically significant negative relationship between corporate disclosure and earnings management. Firms that disclose less tend to engage more in earnings management and vice versa. Since corporate disclosure is negatively related to information asymmetry, Lobo and Zhou provide indirect evidence on the relationship between information asymmetry and earnings management. The information asymmetry in the SEO environment creates an opportunity for management to engage in earnings management because it is difficult for related stakeholders (especially shareholders) to undo this behavior. Teoh, Welch and Wong (1998a) find that earnings management is related to the underperformance of SEOs. They find that the annual growth in issuers asset-scaled net income significantly exceeds that of matched non-issuers by a median of 1.69% in the issue year, but is significantly less than that of the matched non-issuers by a median of 1.60% and 0.32% in the two subsequent years. They find that accruals cause the at-issue peak and post-issue underperformance in net income. They also find that issuers in the most aggressive quartile of discretionary current accruals underperform their matched non-issuers by 7.50% in asset-scaled net income in the three years after the issue year. They also find that discretionary current accruals also predict underperformance in postissue stock returns. Using quarterly data, Rangan (1998) finds that earnings management is most significant in the quarter in which the offering is announced and in the following quarter. He interprets this as evidence that issuing firms actively manage earnings in 7

these two quarters. He also finds that a one-standard-deviation increase in earnings management during the year around the offering is associated with a decline in marketadjusted returns in the following year of about 10%.

Audit Quality and Earnings Management Auditor Firm Size Becker et al. (1998) find that companies with non-Big 5 auditors (a proxy for lower audit quality) report discretionary accruals that significantly increase income compared to companies with Big 5 auditors. They also find that managers respond to debt contracting and income-smoothing incentives by strategically reporting discretionary accruals. In addition, companies with incentives to smooth earnings upwards (downwards) report significantly greater income-increasing (decreasing) discretionary accruals when they have non-Big 5 auditors. Francis et al. (1999) argue that high-accrual firms have greater opportunity for opportunistic management and have an incentive to hire a Big 5 auditor to provide assurance that earnings are credible. They find that high accrual firms are more likely to hire a Big 5 auditor, but report lower discretionary accruals, consistent with Big Five auditors constraining opportunistic reporting of accruals. The Becker et al. (1998) and Francis et al. (1999) studies provide evidence in nonSEO settings that higher quality auditors are associated with reduced levels of earnings management. Zhou and Elder (2002) find that Big 5 auditors are associated with lower earnings management for IPO firms. Similarly, we expect that SEO companies that use Big 5 audit firms will engage in less earnings management than SEO companies with nonBig 5 auditors. 8

H1:

SEO firms audited by Big 5 audit firms engage less in earnings management than firms audited by non-Big 5 auditors.

Auditor Industry Specialization Recent audit quality research has focused on the role of auditor industry specialization. Hogan and Jeter (1999) find that measures of specialization have increased in both regulated and unregulated industries, consistent with returns to specialization. Craswell et al. (1995) argue that audit firms market themselves in terms of both a general reputation and industry expertise. In a test of audit fees in the Australian audit market, they find that industry specialists receive a significant fee premium, and that this fee premium is a significant component of the fee premium received by Big 5 firms.3,4 Industry specialization is acknowledged in DeAngelo (1981) as one possible reason for the selection of Big 5 auditors by IPO companies. In the Titman and Trueman (1986) model in which the pricing of an IPO is increasing with the quality of information associated with the expertise of the auditor, they suggest that industry knowledge is one element of auditor expertise. Krishnan (2003) finds that Big 5 industry specialist auditors are associated with lower discretionary accruals for existing publicly-traded companies. Zhou and Elder (2002) find that industry specialist auditors are associated with lower discretionary accruals for IPO companies. However, evidence based on audit fees has been mixed as to whether industry specialization is associated with an audit premium. Evidence from SEOs will

CPA firms typically market themselves as industry specialists. For example, PricewaterhouseCoopers homepage indicates that we have organized ourselves to deliver our industry expertise to some 24 market sectors and have grouped these market sectors into three clusters consistent with effective delivery to the marketplace. Quote is available at http://www.pwcglobal.com/gx/eng/about/ind/index.html. 4 Ferguson and Stokes (2002) do not find strong support for the presence of industry specialist premiums during the post Big Eight/Six merger periods.

provide further evidence as to whether industry specialization is associated with higher audit quality. H2: Firms audited by industry specialist auditors engage less in earnings management in the seasoned equity offering process.

The following section describes the research design, including the models used to estimate discretionary accruals and the model used to test the research hypotheses.

III. RESEARCH DESIGN Discretionary Current Accruals Following Teoh, Wong and Rao (1998) and Teoh, Welch and Wong (1998a), total accruals are decomposed into four types according to time period (current and long-term) and manager control (discretionary and nondiscretionary). Similar to Teoh, Welch and Wong, we focus on discretionary current accruals in the SEO offering year. They find that discretionary current accruals are most likely to be manipulated. Estimating discretionary accruals is the first step in measuring discretionary current accruals. Dechow et al. (1995) provide evidence that the modified Jones model is the most powerful to detect earnings management among the alternative models to measure discretionary accruals. The model is estimated as follows: TACCit/TAit-1= a1(1/TAit-1) + a2 REVit /TAit-1 + a3PPEit/TAit-1 +
it

Similar to previous studies, this equation is estimated cross-sectionally each year for each two-digit SIC industry using all available firms excluding SEO firms. At least 10 firm year observations are required in a two-digit SIC industry. The estimates of a1, a2, and a3 obtained from this regression are then used to estimate nondiscretionary accruals for the SEO firms. We use the Dechow, Sloan and Sweeney (1995) modification which

10

excludes increases in accounts receivables from the change in revenues in the fitted equation that follows: NDACCit/TAit-1 = 1(1/TAit-1) + 2 ( REVit - RECit)/TAit-1 + 3 PPEit/TAit-1 Finally, discretionary accruals are estimated as: TDACCit = TACCit - NDACCit. where: TACCit NDACCit TDACCit REVit RECit PPEit TAit-1 = total accruals for firm i in year t, defined as the difference between net income and operating cash flow = nondiscretionary total accruals based on modified Jones model = total discretionary accruals = change in revenue for firm i in year t, = change in receivables for firm i in year t, = gross property, plant and equipment for firm i in year t, = total assets for firm i in year t-1.

Normal levels of working capital accruals related to sales are controlled through the changes in revenue adjusted for changes in accounts receivable. Normal levels of depreciation expense and related deferred tax accruals are controlled through the gross property, plant and equipment, and total assets of the previous period are used as a deflator to control for potential scale bias. The cross-sectional model reflects common industry factors applied to discretionary accruals. As a result, estimated discretionary accruals are more likely to reflect managements choice rather than industry factors. Also, since the model is estimated year-by-year, changes in industry conditions are also factored in the model. To prevent the undue influence of the extreme observations on discretionary accruals, total accruals, net income and operating cash flow (all deflated by lagged total assets) are winsorized at the top and bottom 1% level. Firms with total assets less than 1 million are also excluded from model estimation to prevent the undue influence of very small firms. 11

The second step in estimating discretionary current accruals is to obtain current accruals. Current accruals are measured as follows: CACCit = ( CAit - CASHit) - ( CLit - CLTDit) where: CACCit CAit CASHit CLit CLTDit = = = = = current accruals for firm i in year t current assets for firm i in year t cash for firm i in year t current liabilities for firm i in year t current portion of long-term debt for firm i in year t

The final step is to decompose current accruals into the discretionary and nondiscretionary components. The discretionary current accruals and discretionary long-term accruals are calculated as follows: CACCit/TAit-1= e1(1/TAit-1) + e2 REVit /TAit-1 +
it

NDCACCit/TAit-1= 1(1/TAit-1) + 2( REVit - RECit)/TAit-1 DCACCit/TAit-1= CACCit/TAit-1 NDCACCit/TAit-1 NDLACCit/TAit-1 = NDACCit/TAit-1 - NDCACCit/TAit-1 DLACCit/TAit-1 = LACCit/TAit-1 - NDLACCit/TAit-1 where: CACCit NDCACCit DCACCit NDLACCit DLACCit REVit RECit TAit-1 = current accruals for firm i in year t = non-discretionary current accruals for firm i in year t = discretionary current accruals for firm i in year t = non-discretionary long-term accruals for firm i in year t = discretionary long-term accruals for firm i in year t = change in revenue for firm i in year t, = change in receivables for firm i in year t, = total assets for firm i in year t-1.

12

Auditor Industry Specialization A market share based measure of auditor industry specialization is used in this study. The market share based industry specialist measure has been used in studies such as Craswell, Francis and Taylor (1995), Ferguson and Stokes (2002), Mayhew and Wilkins (2002). This measure assumes that an audit firm gains expertise and specialization through experience in an industry. Specifically, a client-based industry specialist measure is calculated as follows: Ratio = m / n Where: m = number of firms audited by the same auditor in a two digit SIC industry n = number of firms audited in a two digit SIC industry Industry specialists are calculated yearly based on the firm-year observations from the Compustat database, excluding those without auditor data. When an auditor market share is greater than 15 percent in a 2-digit SIC code industry, the audit firm is classified as an industry specialist. The 15% cutoff is chosen because of the decline in the number of large audit firms. As in Willenborg (2002, p.114), Given the concentration of the audit market form eight to six to five major firms, it seems intuitive to me to ratchet up from a 10 percent scheme to an arbitrarily higher percentage (e.g., 15 percent and 20 percent) The 15% cutoff for industry specialist definition is still ad hoc, so in the robustness section, we also conduct additional tests using a higher 20 percent market share for classifying firms as specialists, and we also use a sales-based market share measure instead of the unweighted client-based measure of market share.

13

Approach to Testing Our hypotheses relate earnings management as measured by discretionary current accruals to audit quality as measured by auditor type and industry specialization. Many other variables may play a role in managements discretionary accruals decision in the SEO process. Becker et al. (1998) find that operating cash flows are significantly different for firms audited by Big 5 versus firms audited by non-Big 5 firms. The absolute value of total accruals is used as a control variable because Becker et al. (1998) provide evidence that this is significantly negatively related to discretionary accruals. Also Francis et al. (1999) find that the likelihood of using a Big 5 auditor is increasing in firms endogenous propensity for accruals. Burgstahler and Dichev (1997) find that firms manage reported earnings to avoid reporting losses and earnings decreases. Accordingly, loss and income change indicator control variables are added to account for managers incentive to avoid earnings decreases and losses. The log of sales is used as an independent variable to control for the possible effect of size on earnings management in the SEO process. Large firms may have less incentive to engage in earnings management because they are subject to more scrutiny from financial analysts and investors. Leverage may also be associated with the earnings management in the SEO process. DeFond and Jiambalvo (1994) and Sweeney (1994) find that managers use discretionary accruals to satisfy debt covenant requirements. Inclusion of these control variables results in the following regression model: DCACCit = 0 + 1BIG5it + 2SPECit + 3OCFit + 4ABSTAit + 5LOSSit + 6INCCHGit + 7SIZEit + 8LEVit + it

14

where: DCACCit BIG5it SPECit OCFit ABSTAit LOSSit INCCHGit SIZEit LEVit = = = = = = = = = discretionary current accruals in the SEO year 1 if the auditor is member of Big 5; 0 otherwise 1 if the auditor is an industry specialist; 0 otherwise operating cash flow deflated by lagged total assets absolute value of total accruals, where total accruals is the difference between net income and operating cash flow deflated by lagged total assets 1 if the firm incurs a loss; 0 otherwise 1 if this years income is greater than previous years income; 0 otherwise log of total sales leverage, defined as total liabilities over total assets

The main research variables of interest are BIG5 and SPEC. Consistent with the two research hypotheses, the coefficients on these two variables are predicted to be negative because firms audited by Big 5 auditors and industry specialists are expected to engage in less earnings management in the SEO process. To prevent the undue influence of the extreme observations on regression results, discretionary accruals, discretionary current accruals and discretionary long-term accruals (all deflated by lagged total assets) are winsorized at the top and bottom 1% level.

IV. SAMPLE SELECTION AND RESULTS Our sample consists of 2199 observations of seasoned equity offerings between 1991 and 1999 from the Securities Data Corporation database satisfying the following criteria: (1) Offering dates and auditors for the SEOs are available from the Securities Data Corporation database; and (2) necessary data for calculating total accruals, discretionary current accruals, industry specialist, and leverage are available from the 2001 annual Compustat database. As in Shivakumar (2000), we exclude utilities and financial industry

15

companies because greater regulation in these industries may hinder the ability of these firms to engage in earnings management. Panel A of Table 1 provides the sample distribution by year and by auditor type. The sample is relatively evenly distributed throughout the period. The greatest number of observations occurs in 1996 with 333 observations (15.14% of the total sample firms), and the least number of observations occurs in 1992 with 195 observations (8.87% of the total sample firms). The Big 5 audit more than 92 percent of the SEOs for the whole sample, and more than 88 percent of the SEOs in any given year. Panel B of Table 1 provides the industry distribution of the sample firms and the number of specialist auditor observations in each industry. The sample includes 48 separate 2-digit SIC codes, indicating a wide distribution of industries. Computer equipment and services industry has the largest concentration of SEOs, with more than 21 percent of the total observations. The remaining sample firms are widely distributed across SIC codes; no other 2-digit SIC industry contains more than 11 percent of the sample firms. [Insert Table 1 about here] Panel A of Table 2 provides descriptive statistics for the sample. The average of total discretionary accruals is 0.019 and the median of discretionary accruals is 0.012. The mean and median discretionary current accruals are 0.052 and 0.024 respectively. Big 5 auditors are used by 92.5 percent of the sample firms, and around 50 percent of the firms use industry specialist as auditors. The mean and median operating cash flows are -0.008 and 0.070. The mean and median of absolute value of total accruals are 0.149 and 0.091 respectively. The median firm has positive net income and positive income change in the SEO year. The average log of sales is 18.639. The mean and median leverage are 0.390 and 0.358 respectively. 16

Panel B of Table 2 shows the average of discretionary current and total accruals for the three years before the SEO year, the SEO year and three years after the SEO year. Similar to Teoh, Welch and Wong (1998, p.74), the discretionary current accruals increase over the three years prior to the SEO and peak in the SEO year. The discretionary total accruals also peak in the SEO year. The pattern of discretionary current and total accruals is consistent with firms engaging in income increasing earnings management behavior during the SEO process. [Insert Table 2 about here] Table 3 shows the correlations between the dependent and independent variables. The Spearman correlation is shown above the diagonal while the Pearson correlation is shown below the diagonal. Discretionary current accruals are significantly negatively related to Big 5 auditors and industry specialists for the Pearson correlation, which suggests that Big 5 auditors and industry specialists constrain earnings management in the SEO process. Discretionary current accruals are negatively related to operating cash flow, which shows that higher operating cash flow firms are less likely to use discretionary current accruals to manage earnings in the SEO process. Discretionary current accruals are positively related to absolute value of total accruals, which suggests that SEO firms with large accruals are more likely to engage in income increasing behavior through discretionary current accruals. Discretionary current accruals are also positively related to the income change variable, which suggests part of the income increase for the SEO firms during the issuing year comes from the use of discretionary current accruals. This provides further evidence that these firms engage in earnings management during the SEO process.

17

As expected, there is a positive correlation between the Big 5 and industry specialist variables. Large companies are more likely to use Big 5 firms and industry specialists as auditors. Firms audited by Big 5 and industry specialists are more likely to make a profit. The Big 5 variable is significantly negatively related to absolute value of total accruals for both the Spearman and Pearson correlation, while industry specialists are significantly negatively related to absolute value of total accruals only for the Spearman correlation. This suggests that Big 5 auditors and industry specialists provide higher quality auditing which forces firms exercise less discretion in their accruals.5 The discretionary current accruals are positively related to the absolute value of total accruals, while the discretionary total accruals are negatively related to the absolute value of total accruals. 6 [Insert Table 3 about here] The tests of the first hypothesis that firms audited by Big 5 auditors engage in less earnings management in the seasoned equity offering process are reported in Table 4. Auditor type is significantly negatively related to discretionary accruals at the 1% level in the first column, which excludes the industry specialist variable, and significantly negatively related to discretionary accruals at the 5% level in the third column when the industry specialist variable is included. These results suggest that Big 5 auditors are associated with lower discretionary accruals, and audit quality plays an important role in reducing earnings management in the SEO process.

This is not consistent with Francis et al. (1999) argument that firms with more total accruals select higher quality auditors. However, our correlation results are consistent with Becker et al. that high quality auditors (Big 5 auditors and industry specialist auditors) constrain managements discretion in accruals. 6 This is consistent with the finding in Becker et al. (1998) that there is negative relation between discretionary accruals and absolute total accruals. The discretionary total accruals in this paper are comparable to discretionary accruals in Becker et al.

18

[Insert Table 4 about here] Tests of the second hypothesis that firms audited by industry specialists engage in less earnings management in the seasoned equity offering process are also reported in Table 4. The coefficient on industry specialists is significantly negative at the 1% level when the auditor type variable is excluded. The coefficient on industry specialists is significantly negative at the 5% level based on a one-tail test when auditor type is included. When the industry specialist variable is included, auditor size still has the expected sign and is still statistically significant. These results are consistent with the findings in Krishnan (2003) and in Zhou and Elder (2002) for initial public offerings that industry specialization is associated with reduced earnings management. It also supports the argument that auditor industry specialization is important in providing finer information in an SEO environment. The multivariate regression results in Table 4 indicate that industry specialists and Big 5 auditors limit earnings management by SEO companies. Several control variables are significantly related to discretionary accruals. Operating cash flow is negatively related to discretionary current accruals, which means firms with strong operating cash flow position are less likely to use discretionary current accruals to increase earnings. The absolute value of total accruals is positively related to discretionary current accruals, which means firms exercising more discretion on accruals are likely to use this discretion to increase earnings in the SEO process. The loss variable is negatively related to discretionary current accruals, which suggests firms may use discretionary current accruals to prevent the occurrence of loss in the SEO year. The income change variable is positively related to discretionary current accruals, which corroborates the evidence in Teoh, Welch and Wong (1998a) that the income increases in 19

SEO process can be partially attributed to the earnings management through discretionary current accruals. Leverage is negatively related to discretionary current accruals, which suggests that debt covenants are not likely to be binding for SEO firms and they do not need to rely on discretionary current accruals to satisfy debt covenants. When we control for both auditor type and industry specialist, the coefficient on industry specialist shows the incremental impact of industry specialization on earnings management during the SEO process. We conduct a direct test for the incremental impact of industry specialist on earnings management focusing only on firms that use Big 5 auditors for the SEO. The last column of Table 4 presents the results only for firms with Big 5 auditors. The industry specialist variable is significantly negatively related to discretionary current accruals, which indicates industry specialists constrain earnings management beyond auditor size, even though every industry specialist is a Big 5 auditor. Table 5 provides the regression results for the seven years centered on the SEO year. That is, regression results for the three years before to three years after the SEO are presented. The auditor type is significantly negatively related to discretionary current accruals in Year 2, Year 1, Year 0, Year 1 and Year 3. The industry specialist is only significant for the Year 0. This finding may be related to the fact that SEO firms engage in more earnings management in the SEO year. [Insert Table 5 about here] Robustness Tests We perform several robustness tests to check whether our results are driven by the measurement of variables of interest. First we use the matched-pair discretionary accruals model in Teoh, Wong and Rao (1998) because the discretionary accruals model is subject to potential measurement issue problems. A non-issuing firm is matched in the same 20

industry as the SEO firm based on net income/sales that is at least 80% of the net income/sales of the SEO firm. We begin matching at the four-digit industry level. If no match is found, we then go to three-digit, two-digit and one-digit industry.7 Table 6 shows that results using pair-matched discretionary accruals. Auditor type is only marginally negatively related to pair-matched discretionary accruals when only the auditor type variable is included and becomes insignificantly negative when both auditor type and industry specialist are included. Industry specialist is significant at the 5% level based on a one-tail test when only the industry specialist variable is included and when both auditor type and industry specialist are included for the full sample. The industry specialist variable is also significant in the last column of Table 6 when the sample is limited to companies audited by Big 5 firms. [Insert Table 6 about here] Secondly, we use total discretionary accruals rather than current discretionary accruals as a measure of earnings management. The results reported in Table 7 provide stronger evidence that both auditor type and industry specialists constrain earnings management through total discretionary accruals in the SEO process. [Insert Table 7 about here]

For the 2199 firms, we are able to find 2179 match firms. There are 1629 observations (74% of the whole sample) are matched on 4-digit SIC, 196 observations (9% of the whole sample) are matched on 3-digit SIC, 266 observations (12% of the whole sample) are matched on 2-digit SIC, 88 observations (4% of the whole sample) are matched on 1-digit SIC. For 20 firms (1% of the whole sample), we are unable to find match firms based on the criteria that net income/sales that is at least 80% of the net income/sales of the SEO firm. The difference in net income/sales between the match firm and sample firm is 5.27% of the absolute value of the net income/sales of the sample firm.

21

Third, we use a different cut-off for industry specialist based on the suggestion of Willenborg (2002). Table 8 presents the results using 20% as a cut-off for industry specialist. The results are quite similar to what we find when we use 15% as a cut-off. [Insert Table 8 about here] Finally, we use alternative definition for industry specialist. We use the following client sales based industry specialization measure. m-firm sales ratio = where: si = firm i's sales, while firm i is audited by auditor j S = the sum of sales, si, for all firms in the industry m = all the firms audited by auditor j in the same industry When an auditors m-firm sales ratio is greater than 15% in a 2 digit SIC industry, the auditor is defined as an industry specialist. The results of using this alternative definition of industry specialist are shown in Table 9. The results using the sales based definition are consistent with the results for the industry specialist measure based on number of clients. [Insert Table 9 about here] V. SUMMARY AND CONCLUSIONS In this study, we examine whether auditor size and industry specialization are associated with lower earnings management (lower discretionary current accruals) in the offering year for SEO companies. We find that (1) compared with three years before and three years after the SEO, SEO firms increase earnings through current and total discretionary accruals in the year of SEO; (2) Big 5 auditors and industry specialist auditors are associated with lower earnings management in the year of SEO; (3) 22

[s
m i =1

ij

/S

compared with three years before and three years after the SEO, industry specialist auditors are associated with lower current and total discretionary accruals only in the year of SEO. Our main results that Big 5 auditors and industry specialist auditors are associated with lower earnings management in the SEO year are robust to alternative definitions of earnings management and industry specialists. Teoh, Welch and Wong (1998a), Rangan (1998) and Shivakumar (2000) find that firms manage earnings in the SEO process. Our research shows that audit quality constrains earnings management in the SEO process. The earnings management in the SEO process is of particular concern because the possible misallocation of resources. For example, Loughran and Ritter (1995) report that seasoned equity offering firms underperform non-issuing firms by approximately 8% per year. Our research might be of interest to investors of SEO firms given the poor performance of SEO firms. Our results show that higher audit quality as evidenced by auditor size and industry specialization is associated with less earnings management. Although we focus on SEOs, our results complement the theoretical proposition of Titman and Trueman (1986) that the auditor provides finer information in the valuation of new issues.

23

References Becker, C., M. DeFond, J. Jiambalvo, and K. R. Subramanyam. 1998. The effect of audit quality on earnings management. Contemporary Accounting Research 15 (1): 1-24 Burgstahler, D. and I. Dichev. 1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics, 24 (1): 99-126. Craswell, A., J. Francis, and S. Taylor. 1995. Auditor brand name reputations and industry apecializations. Journal of Accounting and Economics 20 (December): 297-322. DeAngelo, L. 1981. Auditor size and auditor quality. Journal of Accounting and Economics (December): 183-199. Dechow, P., R. Sloan, and A. Sweeney. 1995. Detecting earnings management. The Accounting Review 70 (April): 193-225. DeFond, M. and J. Jiambalvo. 1994. Debt covenant effects and the manipulation of accruals. Journal of Accounting and Economics 17 (January): 145-176. DeFond, M. and C. Park. 1997. Smoothing income in anticipation of future earnings. Journal of Accounting and Economics 23: 115-139. Dye, R. 1988. Earnings management in an overlapping generations model. Journal of Accounting Research 26 (Autumn): 195-235. Ferguson, A. and D. Stokes. 2002. Brand name audit pricing, industry specialization and leadership premiums post Big 8 and Big 6 mergers. Contemporary Accounting Research (Spring): 77-110. Francis, J., E. Maydew and H. Sparks. 1999. The role of big 6 auditors in the credible reporting of accruals. Auditing: A Journal of Practice and Theory 18 (Fall): 17-34. Healy, P. and J. Wahlen. 1999. A review of the earnings management literature and its implications for standard setting. Accounting Horizons 13 (December): 365-383. Hogan, C. and D. Jeter. 1999. Industry specialization by auditors. Auditing: A Journal of Practice and Theory (Spring): 1-17. Hughes, P. J. 1986. Signaling by direct disclosures under asymmetric function. Journal of Accounting and Economics: 119-142. Krishnan, G. 2003. Does big 6 auditor industry expertise constrain earnings management? Accounting Horizons (forthcoming).

24

References (Continued) Lobo, G. and J. Zhou. 2001. Disclosure quality and earnings management. Asia-Pacific Journal of Accounting and Economics 8 (1): 1-20 Loughran, T. and J. Ritter. 1995. The new issues puzzle. Journal of Finance 50: 23-52. Rangan, S. 1998. Earnings management and the performance of seasoned equity offerings. Journal of Financial Economics 50: 101-122. Richardson, V. 2000. Information asymmetry and earnings management: Some evidence. Review of Quantitative Finance and Accounting 15 (4): 325-347. Shivakumar, L. 2000. Do firms mislead investors by overstating earnings before seasoned equity offerings? Journal of Accounting and Economics 29: 339-371. Spiess, K. and J. Affleck-Graves. 1995. The long-run performance following seasoned equity issues. Journal of Financial Economics 38: 243-267. Sweeney, A. 1994. Debt covenant violations and managers accounting responses. Journal of Accounting and Economics 17 (May) 281-308 Teoh, S. H., I. Welch, and T.J. Wong. 1998a. Earnings management and the underperformance of seasoned equity offerings. Journal of Financial Economics 50: 63-99. Teoh, S. H., I. Welch, and T.J. Wong. 1998b. Earnings management and the long-term underperformance of initial public stock offerings. Journal of Finance 53: 1935-1974. Teoh, S., T.J. Wong, and G. Rao. 1998. Are accruals during initial public offerings opportunistic? Review of Accounting Studies 3: 175-208. Titman, S. and B. Trueman. 1986. Information quality and the valuation of new issues. Journal of Accounting and Economics (June): 159-172. Trueman, B. and S. Titman. 1988. An explanation for accounting income smoothing. Journal of Accounting Research 26 (Supplement); 127-132. Willenborg, M. 2002. Discussion of Brand name audit pricing, industry specialization, and leadership premiums post-Big 8 and Big 6 Mergers. Contemporary Accounting Research (Spring): 111-116. Zhou, J. and R. Elder. 2002. Audit firm size, industry specialization, and earnings management by initial public offering firms. SUNY at Binghamton working paper.

25

Table 1 Sample Selection

Sample characteristics for 2199 firms conducting seasoned equity offerings during the period of 1991 to 1999 from Securities Data Corporation database Panel A: Sample IPO Firms by Year and by Auditor Type Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 All years Total 197 195 276 204 269 333 297 205 223 2199 Freq 8.96% 8.87% 12.55% 9.28% 12.23% 15.14% 13.51% 9.32% 10.14% 100.00% Non-Big 5 20 (10.15%) 19 (9.74%) 32 (11.59%) 15 (7.35%) 22 (8.18%) 22 (6.61%) 19 (6.40%) 12 (5.85%) 5 (2.24%) 166 (7.55%) Big 5 177 (89.85%) 176 (90.26%) 244 (88.41%) 189 (92.65%) 247 (91.82%) 311 (93.39%) 278 (93.60%) 193 (94.15%) 218 (97.76%) 2033 (92.45%) Big 5 Specialist 85 83 135 76 116 144 160 139 159 1097

Panel B: SIC distribution (The percentage may not add up to 100% because of rounding.) # of Specialist Observations 67 7 39 103 66 214 110 40 56 35 116 34 25 45 140

Industry Oil and Gas Food Products Paper and Paper Products Chemical Products Manufacturing Computer Equipment and Services Electronic Equipment Transportation Equipment Scientific Instruments Durable Goods Retail Eating and Drinking Establishments Entertainment Services Health All others

Codes 13 20 24,25,26,27 28 30-34 35,73 36 37,39 38 50 53-57,59 58 70,78,79 80 1,10,14,15,16,17, 22,23,29,51,52, 72,75,76,82,83, 87,99

Freq 129 30 75 241 105 465 216 66 153 87 201 52 62 85 232

% 5.87% 1.36% 3.41% 10.96% 4.77% 21.15% 9.82% 3.00% 6.96% 3.96% 9.14% 2.36% 2.82% 3.87% 10.55%

26

Table 2 Panel A: Variable Descriptive Statistics (n=2199 unless otherwise specified)

Lower quartile -0.057 -0.080 -0.033 -0.079 1 0 -0.065 0.043 0 0 17.480 0.188 Upper quartile 0.102 0.040 0.115 0.141 1 1 0.164 0.175 1 1 19.908 0.554

Var DTACC DLTACC DCACC DCAMCH (n=2179) BIG5 SPEC OCF ABSTA LOSS INCCHG SIZE LEV

Mean 0.019 -0.038 0.052 0.038 0.925 0.499 -0.008 0.149 0.252 0.725 18.639 0.390

Stdev 0.202 0.210 0.206 0.269 0.264 0.500 0.355 0.180 0.434 0.446 2.072 0.247

Median 0.012 -0.013 0.024 0.020 1 0 0.070 0.091 0 1 18.722 0.358

Panel B: Average of Discretionary Current and Total Accruals for the Seven Years Centered on the SEO year
DCACC DTACC N -3 0.001 -0.005 1232 -2 0.016 -0.005 1533 -1 0.019 -0.000 1972 0 0.05 2 0.01 9 2199 1 0.015 -0.008 2043 2 0.001 -0.018 1686 3 0.009 -0.015 1389

DTACC: DLTACC: DCACC: DCAMCH: BIG5: SPEC: OCF: ABSTA: LOSS: INCCHG: SIZE: LEV:

total discretionary accruals discretionary long-term accruals discretionary current accruals pair-matched discretionary current accruals 1 if the auditor is member of Big 5; 0 otherwise 1 if the auditor is an industry specialist; 0 otherwise operating cash flow deflated by lagged total assets absolute value of total accruals, where total accruals is the difference between net income and operating cash flow deflated by lagged total assets 1 if the firm incurs a loss; 0 otherwise 1 if this years income is greater than previous years income; 0 otherwise log of total sales leverage defined as total liabilities over total assets

27

Table 3 Correlation Matrix for Dependent and Independent Variables (n=2199)

DCACC DCACC DTACC BIG5 SPEC OCF ABSTA LOSS INCCHG SIZE LEV 0.556 (0.001) -0.045 (0.035) -0.057 (0.008) -0.206 (0.001) 0.091 (0.001) -0.148 (0.001) 0.124 (0.001) -0.019 (0.373) -0.122 (0.001) -0.062 (0.004) -0.065 (0.002) -0.128 (0.001) -0.216 (0.001) -0.323 (0.001) 0.285 (0.001) 0.049 (0.023) -0.072 (0.001) 0.258 (0.001) 0.063 (0.003) -0.048 (0.024) -0.068 (0.002) 0.048 (0.025) 0.173 (0.001) 0.025 (0.243) 0.029 (0.173) -0.028 (0.188) -0.027 (0.207) -0.008 (0.725) 0.117 (0.001) 0.043 (0.043) -0.334 (0.001) -0.527 (0.001) 0.381 (0.001) 0.459 (0.001) 0.148 (0.001) 0.252 (0.001) -0.215 (0.001) -0.231 (0.001) -0.134 (0.001) -0.613 (0.001) -0.531 (0.001) -0.139 (0.001) 0.307 (0.001) 0.044 (0.041) 0.530 (0.001) DTACC 0.583 (0.001) BIG5 -0.022 (0.294) -0.054 (0.011) SPEC -0.039 (0.069) -0.044 (0.039) 0.258 (0.001) OCF -0.250 (0.001) -0.329 (0.001) 0.096 (0.001) 0.049 (0.021) ABSTA 0.052 (0.014) -0.062 (0.004) -0.087 (0.001) -0.052 (0.014) -0.131 (0.001) LOSS -0.165 (0.001) -0.299 (0.001) -0.068 (0.002) -0.027 (0.207) -0.516 (0.001) 0.177 (0.001) INCCHG 0.140 (0.001) 0.266 (0.001) 0.048 (0.025) -0.008 (0.725) 0.365 (0.001) -0.160 (0.001) -0.613 (0.001) SIZE -0.012 (0.574) 0.015 (0.469) 0.176 (0.001) 0.117 (0.001) 0.343 (0.001) -0.221 (0.001) -0.502 (0.001) 0.283 (0.001) LEV -0.109 (0.001) -0.084 (0.001) 0.032 (0.129) 0.046 (0.032) 0.111 (0.001) -0.140 (0.001) -0.198 (0.001) 0.071 (0.001) 0.606 (0.001)

The Spearman correlation is shown above the diagonal while the Pearson correlation is shown below the diagonal. DCACC: DTACC: BIG5: SPEC: OCF: ABSTA: LOSS: INCCHG: SIZE: LEV: discretionary current accruals discretionary total accruals 1 if the auditor is member of Big 5; 0 otherwise 1 if the auditor is an industry specialist; 0 otherwise operating cash flow deflated by lagged total assets absolute value of total accruals, where total accruals is the difference between net income and operating cash flow deflated by lagged total assets 1 if the firm incurs a loss; 0 otherwise 1 if this years income is greater than previous years income; 0 otherwise log of total sales leverage defined as total liabilities over total assets

28

Table 4 Regression of Discretionary Current Accruals on Auditor Size and Industry Specialization
DCACC 0.005 (0.10) -0.040 (-2.53)*** 0.007 (2.30)** -0.224 (-15.68)*** 0.057 (2.37)** 0.040 (3.47)*** -0.141 (-10.16)*** -0.115 (-5.76)*** 15.36% 2199 Full Sample DCACC -0.013 (-0.24) -0.022 (-2.69)*** 0.006 (2.18)** -0.224 (-15.68)*** 0.057 (2.38)** 0.039 (3.38)*** -0.142 (-10.21)*** -0.112 (-5.65)*** 15.40% 2199 DCACC -0.001 (-0.02) -0.031 (-1.94)** -0.018 (-2.15)** 0.007 (2.46)** -0.225 (-15.72)*** 0.057 (2.35)** 0.039 (3.41)*** -0.141 (-10.15)*** -0.115 (-5.80)*** 15.50% 2199 Big 5 only DCACC -0.048 (-0.90) -0.018 (-2.19)** 0.008 (2.82)*** -0.227 (-15.66)*** 0.041 (1.69)* 0.036 (3.06)*** -0.138 (-9.82)*** -0.120 (-5.85)*** 15.29% 2033

INTERCEPT BIG5 SPEC SIZE OCF ABSTA INCCHG LOSS LEV Adj R-sq N

t-statistic in parentheses *** (**) (*) Significant at the .01 (.05) (.10) level based on a one-tail test. DCACC: BIG5: SPEC: OCF: ABSTA: LOSS: INCCHG: SIZE: LEV: discretionary current accruals 1 if the auditor is member of Big 5; 0 otherwise 1 if the auditor is an industry specialist; 0 otherwise operating cash flow deflated by lagged total assets absolute value of total accruals, where total accruals is the difference between net income and operating cash flow deflated by lagged total assets 1 if the firm incurs a loss; 0 otherwise 1 if this years income is greater than previous years income; 0 otherwise log of total sales leverage defined as total liabilities over total assets

29

Table 5 Regression of Discretionary Current accruals on Auditor Size and Industry Specialization for the Seven Years Centered on SEO Year
DCACCt-3 INTERCEPT BIG5 SPEC SIZE OCF ABSTA INCCHG LOSS LEV Adj R-sq N -0.073 (-1.68) 0.005 (0.32) -0.004 (-0.51) 0.008 (3.42)*** -0.147 (-8.37)*** -0.100 (-3.09)*** 0.011 (1.18) -0.070 (-6.12)*** -0.100 (-6.08)*** 11.71% 1232 DCACC t-2 0.043 (0.98) -0.030 (-1.99) ** -0.003 (-0.32) 0.003 (1.06) -0.180 (-10.92)*** -0.128 (-4.73)*** 0.026 (2.61)*** -0.068 (-5.71)*** -0.047 (-2.99)*** 9.63% 1533 DCACC t-1 -0.044 (-0.96) -0.022 (-1.35) * -0.003 (-0.36) 0.008 (3.10)*** -0.188 (-12.77)*** -0.025 (-1.05) 0.045 (4.17)*** -0.097 (-7.52)*** -0.127 (-7.38)*** 12.91% 1972 DCACC t -0.001 (-0.02) -0.031 (-1.94)** -0.018 (-2.15)** 0.007 (2.46)** -0.225 (-15.72)*** 0.057 (2.35)** 0.039 (3.41)*** -0.141 (-10.15)*** -0.115 (-5.80)*** 15.50% 2199 DCACC t+1 -0.043 (-1.34) -0.015 (-1.47) * -0.0001 (-0.01) 0.007 (3.97)*** -0.159 (-10.43)*** -0.045 (-2.18)** 0.012 (1.83)** -0.069 (-8.52)*** -0.083 (-7.84)*** 11.23% 2043 DCACC t+2 -0.086 (-2.41)** 0.006 (0.58) 0.0003 (0.05) 0.008 (3.96)*** -0.188 (-10.69)*** -0.080 (-3.48)*** 0.012 (1.87)** -0.056 (-7.04)*** -0.077 (-6.54)*** 11.68% 1686 DCACC t+3 0.063 (1.57) -0.021 (-1.80) ** 0.001 (0.11) 0.001 (0.27) -0.149 (-7.36)*** -0.120 (-3.99)*** 0.014 (2.11)** -0.049 (-5.79)*** -0.040 (-3.18)*** 8.89% 1389

t-statistic in parentheses *** (**) (*) Significant at the .01 (.05) (.10) level based on a one-tail test. t: DCACC: BIG5: SPEC: OCF: ABSTA: LOSS: INCCHG: SIZE: LEV: the SEO year discretionary current accruals 1 if the auditor is member of Big 5; 0 otherwise 1 if the auditor is an industry specialist; 0 otherwise operating cash flow deflated by lagged total assets absolute value of total accruals, where total accruals is the difference between net income and operating cash flow deflated by lagged total assets 1 if the firm incurs a loss; 0 otherwise 1 if this years income is greater than previous years income; 0 otherwise log of total sales leverage defined as total liabilities over total assets

30

Table 6 Regression of Pair-matched Discretionary Accruals on Auditor Size and Industry Specialization
Full sample DCAMCH -0.090 (-1.26) -0.023 (-2.04)** 0.009 (2.29)** -0.239 (-12.26)*** 0.141 (4.29)*** 0.034 (2.15)** -0.104 (-5.49)*** -0.123 (-4.59)*** 9.81% 2179 Big 5 only DCAMCH -0.236 (-1.69) -0.041 (-1.92)** 0.017 (2.26)** -0.382 (-10.13)*** 0.226 (3.59)*** 0.044 (1.45)* -0.147 (-4.04)*** -0.145 (-2.73)*** 6.60% 2014

INTERCEPT BIG5 SPEC SIZE OCF ABSTA INCCHG LOSS LEV Adj R-sq N

DCAMCH -0.079 (-1.10) -0.028 (-1.31)* 0.009 (2.30)** -0.239 (-12.26)*** 0.141 (4.29)*** 0.035 (2.23)** -0.104 (-5.47)*** -0.125 (-4.64)*** 9.71% 2179

DCAMCH -0.084 (-1.17) -0.020 (-0.90) -0.020 (-1.80)** 0.010 (2.41)** -0.239 (-12.27)*** 0.141 (4.27)*** 0.034 (2.17)** -0.103 (-5.45)*** -0.125 (-4.65)*** 9.80% 2179

t-statistic in parentheses *** (**) (*) Significant at the .01 (.05) (.10) level based on a one-tail test. DCACC: DCAMCH: BIG5: SPEC: OCF: ABSTA: LOSS: INCCHG: SIZE: LEV: discretionary current accruals discretionary current accruals based on matched sample 1 if the auditor is member of Big 5; 0 otherwise 1 if the auditor is an industry specialist; 0 otherwise operating cash flow deflated by lagged total assets absolute value of total accruals, where total accruals is the difference between net income and operating cash flow deflated by lagged total assets 1 if the firm incurs a loss; 0 otherwise 1 if this years income is greater than previous years income; 0 otherwise log of total sales leverage defined as total liabilities over total assets

31

Table 7 Regression of Discretionary Total Accruals on Auditor Size and Industry Specialization (n=2199)
INTERCEPT BIG5 SPEC SIZE OCF ABSTA INCCHG LOSS LEV Adj R-sq -0.0003 (-0.12) -0.274 (-21.69)*** -0.282 (-13.20)*** 0.070 (6.82)*** -0.205 (-16.63)*** -0.081 (-4.58)*** 31.11% DTACC 0.152 (3.27)*** -0.059 (-4.30)*** DTACC 0.126 (2.73)*** -0.026 (-3.56)*** -0.001 (-0.49) -0.274 (-21.64)*** -0.281 (-13.15)*** 0.068 (6.67)*** -0.206 (-16.71)*** -0.076 (-4.33)*** 30.93% DTACC 0.145 (3.12)*** -0.051 (-3.55)*** -0.019 (-2.61)*** 0.0002 (0.08) -0.274 (-21.75)*** -0.282 (-13.24)*** 0.069 (6.74)*** -0.204 (-16.62)*** -0.081 (-4.62)*** 31.29%

t-statistic in parentheses *** (**) (*) Significant at the .01 (.05) (.10) level based on a one-tail test. DTACC: BIG5: SPEC: OCF: ABSTA: LOSS: INCCHG: SIZE: LEV: discretionary total accruals 1 if the auditor is member of Big 5; 0 otherwise 1 if the auditor is an industry specialist; 0 otherwise operating cash flow deflated by lagged total assets absolute value of total accruals, where total accruals is the difference between net income and operating cash flow deflated by lagged total assets 1 if the firm incurs a loss; 0 otherwise 1 if this years income is greater than previous years income; 0 otherwise log of total sales leverage defined as total liabilities over total assets

32

Table 8 Regression of Discretionary Current accruals on Auditor Size and Industry Specialization (using 20% cutoff) (n=2199)
INTERCEPT BIG5 SPEC SIZE OCF ABSTA INCCHG LOSS LEV Adj R-sq 0.007 (2.30)** -0.224 (-15.68)*** 0.057 (2.37)** 0.040 (3.47)*** -0.141 (-10.16)*** -0.115 (-5.76)*** 15.36% DCACC 0.005 (0.10) -0.040 (-2.53)*** DCACC -0.013 (-0.25) -0.024 (-2.25)** 0.006 (2.04)** -0.225 (-15.70) *** 0.057 (2.35)** 0.040 (3.47)*** -0.141 (-10.14)*** -0.109 (-5.52)*** 15.31% DCACC -0.0004 (-0.01) -0.036 (-2.31)** -0.021 (-2.00)** 0.007 (2.41)** -0.225 (-15.75)*** 0.056 (2.32)** 0.040 (3.49)*** -0.140 (-10.07)*** -0.114 (-5.71)*** 15.48%

t-statistic in parentheses *** (**) (*) Significant at the .01 (.05) (.10) level based on a one-tail test. DCACC: BIG5: SPEC: OCF: ABSTA: LOSS: INCCHG: SIZE: LEV: discretionary current accruals 1 if the auditor is member of Big 5; 0 otherwise 1 if the auditor is an industry specialist; 0 otherwise operating cash flow deflated by lagged total assets absolute value of total accruals, where total accruals is the difference between net income and operating cash flow deflated by lagged total assets 1 if the firm incurs a loss; 0 otherwise 1 if this years income is greater than previous years income; 0 otherwise log of total sales leverage defined as total liabilities over total assets

33

Table 9 Regression of Discretionary Current Accruals on Auditor Size and Industry Specialization (using 15% cutoff based on sales as a measure for industry specialization) (n=2199)
INTERCEPT BIG5 SPEC SIZE OCF ABSTA INCCHG LOSS LEV Adj R-sq 0.007 (2.30)** -0.224 (-15.68)*** 0.057 (2.37)** 0.040 (3.47)*** -0.141 (-10.16)*** -0.115 (-5.76)*** 15.36% DCACC 0.005 (0.10) -0.040 (-2.53)*** DCACC -0.010 (-0.20) -0.018 (-2.15)** 0.006 (2.07)** -0.224 (-15.66) *** 0.056 (2.32)** 0.040 (3.42)*** -0.143 (-10.28)*** -0.110 (-5.54)*** 15.30% DCACC 0.002 (0.03) -0.034 (-2.14)** -0.014 (-1.68)** 0.007 (2.40)** -0.224 (-15.71)*** 0.056 (2.30)** 0.040 (3.45)*** -0.142 (-10.19)*** -0.114 (-5.72)*** 15.43%

t-statistic in parentheses *** (**) (*) Significant at the .01 (.05) (.10) level based on a one-tail test. DCACC: BIG5: SPEC: OCF: ABSTA: LOSS: INCCHG: SIZE: LEV: discretionary current accruals 1 if the auditor is member of Big 5; 0 otherwise 1 if the auditor is an industry specialist; 0 otherwise operating cash flow deflated by lagged total assets absolute value of total accruals, where total accruals is the difference between net income and operating cash flow deflated by lagged total assets 1 if the firm incurs a loss; 0 otherwise 1 if this years income is greater than previous years income; 0 otherwise log of total sales leverage defined as total liabilities over total assets

34