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IJAIM
29,3
368
Received 2 October 2020
Revised 28 December 2020
Accepted 22 January 2021
International Journal of
Accounting & Information
Management
Vol. 29 No. 3, 2021
pp. 368-391
© Emerald Publishing Limited
1834-7649
DOI 10.1108/IJAIM-10-2020-0156
The impact of audit quality on real
earnings management in the
UK context
Syed Numan Chowdhury
School of Business and Entrepreneurship, Independent University,
Bangladesh (IUB), Dhaka, Bangladesh, and
Yasser Eliwa
School of Business and Economics, Loughborough University, Loughborough, UK
and Faculty of Commerce, Cairo University, Cairo, Egypt
Abstract
Purpose – The purpose of this paper is to examine whether audit quality influence real earnings
management activities using a sample of UK listed firms that have strong incentives to manage earnings
upward through meeting past year’s earnings as a benchmark in the post-adoption period of International
Financial Reporting Standards (IFRS).
Design/methodology/approach – The authors use a sample of 4,774 firm-year observations of UK
listed firms during the period 2005–2018. Univariate and multivariate analyses have been conducted to test
the association after controlling for firm characteristics and institutional variables.
Findings – The study reports that the presence of Big 4 auditors is significantly and positively related with
greater levels of sales and discretionary expenses manipulation. Though the authors do not find any
conclusive evidence on production costs manipulation, the aggregated measure of real earnings management
shows a significant positive association with the presence of Big 4 auditors.
Practical implications – The study implies that managers who have incentives to manage earnings
upward around the UK firms take advantage of the accounting flexibility in defining policies while reducing
information asymmetry among the investors to signal better future performance. The approach to detect
earnings manipulation as described in the auditing standards fails to limit the managerial use of real activities
due to limited scope and unclear guidance. Thus, due to the significant impact on public policies, the results
should, therefore, be of interest to the regulators and standard setters.
Originality/value – To the best of the authors’ knowledge, this is the first study that examines the
association between audit quality and real earnings management for the UK all-purpose operational firms in
sampled data that just meet past year’s earnings as a benchmark in the post-IFRS period.
Keywords IFRS, Real earnings management, Audit quality, Earnings benchmark
Paper type Research paper
1. Introduction
The purpose of this paper is to contribute to the accounting literature by investigating the
relationship between audit quality and real earnings management. Whilst the extant
literature has mostly investigated the impact of audit quality on accruals earnings
management (Becker et al., 1998; Francis and Wang, 2008; Chen et al., 2011; Persakis and
Iatridis, 2016; Houqe et al., 2017; Alzoubi, 2018), a limited number of studies provide
The authors are thankful for the constructive and stimulating comments received from the editor,
Professor Maggie (Chunhui) Liu, and the two anonymous reviewers.
evidence on real earnings management (Chi et al., 2011; Alhadab and Clacher, 2018; Choi Impact of audit
et al., 2018). Even though the findings are consistent in prior studies that the presence of a quality
Big 4 auditor restricts accruals earnings management, it is unclear whether real earnings
management is also constrained by the Big 4 auditors. In this study, we examine whether
the Big 4 auditors influence the managerial use of real activities when the UK firms have
strong incentives to manage earnings upward (i.e. firms that just meet or beat an earnings
benchmark) post the implementation of International Financial Reporting Standards (IFRS).
The UK setting inspires this study in two ways. First, the mandatory adoption of IFRS in 369
2005 is considered as a major regulatory change in the UK capital market. The cost-benefit
analysis of IFRS adoption has been a prevalent area of empirical studies (Jeanjean and
Stolowy, 2008; Khlif and Souissi, 2010; Doukakis, 2014; De George et al., 2016; Oz and
Yelkenci, 2018). Previous work suggests that the implementation of IFRS has decreased the
level of reporting discretion and created managerial opportunities to explore real earnings
management. The disclosure requirement promotes greater flexibility of accounting choices
due to unclear guidance and subjective estimates, leading to an increase in the managerial
use of real activities (Byard et al., 2010; Capkun et al., 2016; Li, 2019). Second, the UK capital
market presents an interesting setting to evaluate upward earnings management using real
activities for firms that meet or beat earnings benchmarks. Prior studies (Ball et al., 2000;
Brown and Ngo Higgins, 2001; Beaver et al., 2003) find that the UK firms are subject to less
regulatory scrutiny compare to other common law countries, such as the USA, in which
managers are more likely to achieve target earnings through manipulating accruals or real
activities to avoid reporting a loss or a decline in profit (Zalata and Roberts, 2017).
Athanasakou et al. (2009) find insignificant use of accruals in the UK firms that have
incentives to manage earnings upward, indicating a possibility of managerial dependence in
using real activities than to incur the cost of using discretionary accounting choices. Zhao
et al. (2012) report that firms meeting benchmarks to manage earnings upward achieve
better future performance compare to those that miss the targets. This supports the
signalling argument that managers use real activities to signal better future performance to
the capital market without impairing firms’ value or future growth potentials (Bartov et al.,
2002; Jiang, 2008; Taylor and Xu, 2010).
The extant literature provides inconsistent evidence in evaluating the impact of audit
quality on real earnings management. For instance, Alhadab and Clacher (2018) examine the
UK initial public offering (IPO) firms during the period 1998–2008, comprising financial
information from both the UK generally accepted accounting principles and IFRS eras. They
report that real earnings management activities are partially constrained where
discretionary expenses manipulation decreases, and sales manipulation increases in the
presence of a Big 4 auditor. Sitanggang et al. (2019) find opposing evidence on the UK
manufacturing firms, suggesting that managerial use of discretionary expenses increases,
whereas sales manipulation decreases in the presence of enhanced audit quality. Further,
Choi et al. (2018) document the joint effect of the Big 4 auditors and a country’s legal regime
on real earnings management in a cross-country analysis. Using data from 22 countries, the
study reports that stronger legal regimes are positively, and the presence of Big 4 auditors is
negatively related with real earnings management. This suggests that firms’ real earnings
management activities in a strong legal regime are constrained by Big 4 auditors. Whilst
extant studies provide mixed evidence, very little research has explored the association
between audit quality and real earnings management, especially for firms that have strong
incentives to manage earnings upward. To the best of authors’ knowledge, there is only one
study by Chi et al. (2011) that examines the impact of audit quality on accruals and real
earnings management in a setting involving the US firms with incentives to meet earnings
IJAIM benchmarks. Using a sample of 925 observations during the period 2001–2008, they report a
29,3 positive association between real earnings management and enhanced audit quality,
suggesting that Big 4 auditors restrict the use of accruals while managers resort to more
costly real earnings management.
Our study addresses the mixed empirical evidence by examining whether the Big 4
auditors influence the managerial use of real activities around the UK firms that meet or
370 beat past year’s earnings, post the adoption of IFRS. We examine a UK sample consisting of
4,774 firm-year observations over the period 2005–2018. The results show evidence that the
presence of Big 4 auditors is associated with greater levels of real earnings management,
suggesting that the Big 4 auditors do not limit the managerial use of real activities when the
firms have a strong motivation for upward earnings management. In particular, the
presence of Big 4 auditors is found to be significantly and positively related with sales and
discretionary expenses manipulation. Though we do not find any conclusive evidence on
production costs manipulation, the aggregated measure of real earnings management shows
a significant positive association with the presence of Big 4 auditors. Our study implies that
managers take advantage of the accounting flexibility in policy decisions to signal future
growth, while the auditors fail to detect the managerial use of real activities due to limited
scope and unclear guidance in the auditing standards.
Our paper contributes to the accounting literature in several ways. First, it adds to the
existing research on the association between audit quality and real earnings management
through presenting empirical evidence that the Big 4 auditors fail to constrain earnings
management using real activities for the UK firms that have strong incentives to manage
earnings upward. To the best of authors’ knowledge, this is the first study in the UK context
that examines the impact of audit quality on real earnings management around firms that
just meet past year’s earnings as a benchmark. Although meeting benchmarks as an
incentive-driven measure to manipulate earnings upward is an important aspect of earnings
management, a few studies have examined this in the context of the UK (Athanasakou et al.,
2009, 2011; Zalata and Roberts, 2017; Al-Shattarat et al., 2018), whereas the US-based studies
have been more dominant in this area of research (Roychowdhury, 2006; Cohen et al., 2008;
Gunny, 2010; Cohen and Zarowin, 2010; Zhao et al., 2012; Kothari et al., 2016). Second, by
focussing on the period after the UK mandatory adoption of IFRS, this study adds to the
literature that analyses the cost and benefit of IFRS amendment. Our results support
previous work (Byard et al., 2010; Choi et al., 2013; Doukakis, 2014; Morris et al., 2014;
Capkun et al., 2016; Oz and Yelkenci, 2018) that the IFRS adoption has provided greater
accounting flexibility to the managers, which might have caused an increase in the
managerial use of real activities, especially for firms that just meet past year’s earnings.
The remainder of the paper is designed as follows. Section 2 provides the literature
review and hypothesis development; Section 3 outlines the sample and variables
measurement; Section 4 reports and discusses the empirical findings; and Section 5
concludes the paper.

2. Literature review and hypothesis development

Real earnings management has been an extensive engagement tool to pursue creative
accounting that involves misrepresenting financials in a favourable condition to the
stakeholders (Watts, 2003). Roychowdhury (2006) defines real earnings management as a
method of manipulating earnings by taking suboptimal managerial decisions on the scales
and timings of economic events, using three specific measures of operational activities. First,
managers intend to improve their sales volumes through manoeuvring credit sales and price
reduction policies to meet short-term sales targets. Such activities may distort customers’
expectations of future discounts, and the margin of sales may decline. Second, managers go Impact of audit
beyond their regular production capacity through increasing operational margin and quality
decreasing cost of sales. This imposes higher costs of holding inventory due to
overproduction. Third, managers misrepresent operational expenditures to increase the
marginal benefits of annual earnings. Though it is certain that the managerial use of real
activities improves the current period’s income, the extant literature provides opposing
views in explaining the motives and consequences of real earnings management.
Agency theory considers real earnings management as an act of costly consequences 371
because it reduces the value and growth potentials of a firm, while adversely affecting future
cash flows (Dechow et al., 2003; Xu et al., 2007; Zang, 2012; Achleitner et al., 2014; Kothari
et al., 2016; Gao et al., 2017; Md Nasir et al., 2018). That is, managers are likely to engage in
real earnings management to employ opportunism by prioritising their own benefit over the
firms’ value. On the contrary, the signalling theory suggests that firms with strong financial
position utilise real activities to reduce information asymmetry in the capital market and
signal future economic growth (Beaver et al., 2003; Taylor and Xu, 2010; Al-Shattarat et al.,
2018), suggesting that real earnings management may not cause diminishing economic
performance in the subsequent periods. Bartov et al. (2002) report that firms use real
activities to convey inside information to the stakeholders as an attempt to signal future
economic growth in performance whilst differentiating from poor performance. Jiang (2008)
documents that firms with a strong position in the capital market do not endure financial
consequences on their operating performances, even if they manage earnings using sales,
production costs and discretionary expenses.
Focussing on the signalling argument, Gunny (2010) evaluates the impact of real
earnings management on subsequent operating performances for the US firms that meet
incentive-driven measures of upward earnings management, namely zero earnings growth
and past year’s earnings. She reports that managers use real activities to meet earnings
benchmarks while exhibiting positive joint signals on future economic performance.
Athanasakou et al. (2011) find that earnings informativeness increases due to the signalling
of managerial competence towards the capital market when the managers meet target
earnings by engaging in real earnings management. The signalling approach emphasises on
the managerial discretion in explaining the likelihood of whether a firm is capable to
outweigh the negative impact of real earnings management while meeting target earnings
(Zhao et al., 2012). This implies that firms with relatively weak financial positions are less
likely to engage in real earnings management due to costly consequences on future cash
flows and increased risk of litigation. Drawing on the survey of Graham et al. (2005), a high
percentage of managers consider that the credibility towards the capital market increases
when earnings benchmarks are met as it helps to signal future growth potentials. The value
of the firm benefits from such undertakings to that extent where the gains surpass the costs.
DeAngelo (1981) defines audit quality as the market-assessed likelihood of detecting and
reporting deviations in the financial statements from the regulated standards. Prior studies
(Francis and Wang, 2008; Lawrence et al., 2011; Hammami and Hendijani Zadeh, 2019;
Shahzad et al., 2019) suggest that the Big 4 auditors critically assess the risk of managerial
opportunism in order to identify material errors and misrepresentations in the accounting
system. Signalling theory suggests that the presence of Big 4 auditors enhances the
credibility and reputation of firms, which enables them to send positive signals to the
market (Morris, 1987). Boone et al. (2010) find that firms have a tendency to hire Big 4
auditors when there are uncertainties around earnings, suggesting that Big 4 auditors
improve the quality of earnings and signals the market about future economic growth. Since
financial statements audited by the Big 4 auditors are considered to be more reliable than
IJAIM those audited by the non-Big 4 auditors, firms’ choice of auditors works as a signalling
29,3 method to mitigate the information asymmetries among the investors, creditors and
analysts (Firth and Smith, 1992; Francis, 2004). Considering the regulatory environment,
both the auditing and accounting standards determine the extent of signalling activities.
International Standards on Auditing (ISA) 580 written representations state that the
managerial use of real activities is important to the auditors in two ways:
372 (1) the management might cross the line by misstating financials due to both internal
and external influences; and
(2) the audit risk might increase due to the higher probability of facing litigations,
indicating that a grey area exists where the auditors’ discretion on real earnings
management varies between opportunistic and signalling motivations.

Whilst the line of misconduct belongs to the auditors, managerial intentions determine the
possibility of either jointly signalling future profitability or restricting opportunism (Firth
and Liau-Tan, 2003). Preceding studies suggest that accruals manipulation primarily falls
under the scope of audit procedures, whereas real earnings management hold a lesser
amount of priority (Kim and Park, 2014). Therefore, auditors usually rely on their
professional judgement and scepticism using financial ratios, trend analysis and operating
cash flows to identify managerial use of real activities (Van Tendeloo and Vanstraelen,
2008). Commerford et al. (2016) find that the auditors are aware of the managers’ deliberate
usage of real activities to meet short-term target earnings. Since the auditing standards are
mostly focussed on preventing accruals manipulation, the existence of real earnings
management threatens their comfort.
The implementation of IFRS has brought noteworthy benefits, such as enhanced
transparency, lower capital costs, higher opportunities for offshore investments and
comparability of financial information (Capkun et al., 2016; Oz and Yelkenci, 2018; Eliwa
et al., 2019), providing managers with greater flexibility in defining accounting policies
either to employ opportunism or signal future prosperity. Jeanjean and Stolowy (2008)
provide evidence that earnings management using real activities continued even after the
mandatory adoption of IFRS in the UK. Though the stringent standards might have
increased the quality of earnings, it has offered a limited improvement on the quality of
financial reporting (Choi et al., 2013; Li, 2019). Leuz et al. (2003) find that the mandatory
adoption of IFRS did not reduce the managerial use of real activities, and in fact, increased in
a few countries, such as France. Ewert and Wagenhofer (2005) state that the auditors find it
difficult to ensure high-quality auditing due to difficulty in complying with the revenue
recognition principle of IFRS. Morris et al. (2014) report on the Australian firms that the
auditors fail to attain an accurate annual income in compliance with the IFRS as they were
either understated or overstated due to complications in realising earned revenues.
In summary, a positive relationship between the presence of Big 4 auditors and real
earnings management is consistent with three explanations. First, firms that meet target
earnings using real activities intend to reduce information asymmetry while signalling
future economic growth. Signalling through earnings, managerial competence and choice of
auditors enables a firm with strong financial position to communicate private information to
the market without adversely effecting its value and future cash flows (Firth and Liau-Tan,
2003; Jiang, 2008; Gunny, 2010). Since auditors add value to the financial reports, they might
allow such undertakings to a limit that would not increase the risk of litigation and
operating failure. Second, the scope of audit is limited for real earnings management due to
unclear guidance in the auditing standards. Further, empirical studies on the IFRS
amendment provide evidence that greater accounting flexibility in the policy matters
increases the likelihood of real earnings management. Third, the extant literature (Chi et al., Impact of audit
2011; Alhadab and Clacher, 2018; Sitanggang et al., 2019) presents evidence that managers quality
with different motivations, such as meet or beat earnings benchmarks, initial public
offerings and seasoned equity offerings, utilise real activities to manipulate earnings even in
the presence of a Big 4 auditor. Hence, our hypothesis is as follows:

H1. In the UK, the presence of Big 4 auditors is associated with greater levels of real
earnings management for firms that just meet past year’s earnings, post the 373
adoption of IFRS.

3. Research methodology
3.1 Sample and data description
Our initial sample for panel data analysis of 4,774 firm-year observations comprises FTSE
350 companies listed on the London Stock Exchange (LSE). The sample period covers from
2005 to 2018, taking into account the requirement of preparing financial statements in
accordance with IFRS for the financial year 2005 and onwards. Data associated with real
earnings management, audit quality and other control variables are extracted from the
Bureau van Dijk’s Fame database.Table 1 (Panel A and B) presents descriptive information
on the sample selection and industry distribution. Due to differences in regulatory and
reporting standards, we exclude 1,372 observations related to 98 financial institutions and
84 observations related to 6 utility companies. Also, missing data in the database results
loss of 835 observations related to the real earnings management proxies and 227
observations associated with various independent variables. In line with prior studies
(Rosner, 2003; Athanasakou et al., 2009), our control sample releases firm-years with less
than six observations for each industry-year grouping.
Finally, we follow Gunny (2010) to identify firms that just meet or beat past year’s
earnings by focussing on the change in net income (pre-tax) of the firm-year observations
that fall under the interval of [0, 0.01]. We use a dummy variable (CNI) that takes the value of
1 when the changes in pre-tax earnings from past year are greater than or equal to zero but
less than 0.01, and 0 otherwise. Consequently, we release 1,945 firm-year observations that
have less incentives to manipulate earnings using real activities. Therefore, after excluding
observations based on the explanations presented above, we have an unbalanced panel of
311 observations to test the hypothesis. Previous studies find that both balanced and
unbalanced panels provide reliable estimations, in consideration of the consistency of the
regression estimator (Arellano and Carrasco, 2003; Bai, 2009). The industries that comprise
the majority of the sample are as follows: Manufacturing industry (27.0%), Wholesale and
retail trade industry (24.4%), Information and communication industry (17.0%) and
Transportation and storage industry (10.0%).

3.2 Measurement of variables

3.2.1 Real earnings management metrics. This study estimates the proxies associated with
real earnings management based on the model developed by Dechow et al. (1998).
Roychowdhury (2006) initially applied the model in the accounting literature, which was
followed by other researchers (Cohen et al., 2008; Chi et al., 2011; Shawn et al., 2016). In
association with abnormal cash flows from operating activities (henceforth, ABN_CFO), the
normal operating cash flows is deducted from the actual operating cash flows, using
estimated coefficients related to total sales and lagged total assets of firm-year observations.
Firms can manipulate earnings through misrepresenting the actual revenue (i.e. sales-based
IJAIM Panel A: Sample selection Firm-year obs
29,3 Observations available in Fame of FTSE 350 companies from 2005 to 2018 4,774
Observations with data of companies related to financial institutions (1,372)
Observations with data of companies related to utility services (84)
Missing data to calculate measures associated with real earnings management (835)
Missing data for the independent variables (227)
Available observations for regression analysis 2,256
374 Observations without clear incentives to manage earnings using real activities (1,945)
Final sample of firm-years just meeting the earnings benchmark 311
Panel B: Sample composition by industry
Industry groups No. of firm-years No. of firm-years % of firm-years
in Fame in sample in sample
Mining and quarrying 238


Manufacturing 602 84 27.0
Construction 364 12 3.9
Financial institutions 1372


Wholesale and retail trade 462 76 24.4
Utility services 84


Transportation and storage 210 31 10.0
Accommodation and food service 168 15 4.8
Information and communication 364 53 17.0
Real Estate 126 9 2.9
Scientific and technical 420 20 6.4
Administrative and support service 182 11 3.5
Table 1.
PA and defence; CSS 84


Descriptive Human health and social work 14


information on Other services 28


sample selection and Arts, entertainment and recreation 56


industry distribution Total 4774 311 100

manipulation) by aggressively discounting the sales price and/or changing the regular
credit policies. Such activities cause an abnormal increase in the volume of sales that
opportunistic management uses to present a favourable economic condition at the end
of a period (Roychowdhury, 2006). Since normal operating cash flows possess a linear
association with the revenue and change in revenue, we apply the model below to
estimate the corresponding residual value of abnormal cash flows from operating
activities:

CFOi; t=Assetsi; t
1 ¼ a1tð1=Assetsi; t
1Þ þ a2tðSalesi; t=Assetsi; t
1Þ

þ a3tðDSalesi; t=Assetsi; t
1Þ þ « i; t: (1)

Regarding abnormal production costs (henceforth, ABN_PROD), the normal production

costs are deducted from the actual production costs using estimated coefficients related with
total sales, lagged total sales and lagged total assets of firm-year observations. Here,
production costs are measured by adding costs of sales and changes in inventory.
Production costs manipulation could be used to manipulate earnings upward by increasing
the volumes of production to reduce the cost of sales, hence, increasing the margin of profit
(Zang, 2012). We apply the model below to estimate the corresponding residual value of
abnormal production costs:
 PRODi; t=Assetsi; t
1 ¼ b1tð1=Assetsi; t
1Þ þ b2tðSalesi; t=Assetsi; t
1Þ Impact of audit
þ b3tðDSalesi; t=Assetsi; t
1Þ quality
þ b4tðDSalesi; t
1=Assetsi; t
1Þ þ « i; t: (2)

Abnormal Discretionary Expenses (henceforth, ABN_DISCEXP) is calculated by deducting

the normal discretionary expenses from the actual discretionary expenses using estimated 375
coefficients of lagged total sales and lagged total assets associated with the firm-year
observations. Discretionary expenses are calculated by adding up promotional expenses,
research and development expenses and sales, general and administrative expenses.
Reduction in discretionary expenses facilitates the management to increase net income at
the end of a period. Moreover, if it involves cash payment, reducing those discretionary
expenses will increase the cash flows of that period (Cohen and Zarowin, 2010). We apply
the model below to estimate the corresponding residual value of abnormal discretionary
expenses:

DISCEXPi; t=Assetsi; t
1 ¼ c1tð1=Assetsi; t
1Þ þ c2tðSalesi; t
1=Assetsi; t
1Þ

þ « i; t: (3)

While evaluating the impact of Big 4 auditors on real earnings management, we recognise
that reporting on the basis of ABN_CFO, ABN_PROD and ABN_DISCEXP might carry
different implications on the associated earnings. Using only the components of real
earnings management to report might weaken the regression findings. Therefore, we follow
Cohen et al. (2008) and construct an aggregated measure of real earnings management
(henceforth, REM_INDEX), computed as the sum of standardised abnormal operating cash
flows, standardised abnormal production costs and standardised abnormal discretionary
expenses. Our findings are reported on the basis of both the aggregated measure and the
individual components of real earnings management.
3.2.2 Audit quality metrics. Following preceding literature (Van Tendeloo and
Vanstraelen, 2008; Chi et al., 2011; Houqe et al., 2017; Alzoubi, 2018; Alhadab and Clacher,
2018), this study considers the presence of high-quality auditors (i.e. whether the client firms
are audited by a Big 4 or a non-Big 4 auditor) as the proxy for audit quality. The reputational
standing of an auditor has been widely recognised and applied in the literature as an
alternative for explaining audit quality. The presence of Big 4 auditors (henceforth, BIG_N)
is a dummy variable that takes value 1 for Big 4 audit firms, and 0 otherwise. Introducing a
framework of auditors’ reputation cycle, Lawrence et al. (2011) find that the earned
reputation by the auditors works as an incentive for delivering high-quality audit. Francis
and Wang (2008) document a significant positive association between auditors’ quality and
their reputation, as top-tier audit firms intend to protect their goodwill that has been
obtained over the years. The Big 4 audit firms provide equal treatment towards their clients
regardless of being large or small for the virtue of their brand name (Reynolds and Francis,
2001; Francis, 2004; Boone et al., 2010). Chen et al. (2011) find that companies consider the
presence of Big 4 auditors as an important signal to the investors, as it increases the
confidence among the investors regarding the quality and reliability of the financial
statements.
3.2.3 Control variable metrics. Following prior studies (Cohen et al., 2008; Gunny, 2010;
Chi et al., 2011; Zang, 2012; Houqe et al., 2017; Sitanggang et al., 2019), we have included a set
of variables in the regression models to control for firm characteristics and institutional
IJAIM effects. Return on assets (ROA) controls for firm’s profitability and calculated as the ratio of
29,3 the annual net income over the book value of total assets. Previous work presents evidence
that managers use real activities to improve current period’s earnings and signal better
future performance through meeting earnings benchmarks (Bartov et al., 2002; Graham
et al., 2005; Jiang, 2008; Taylor and Xu, 2010; Zhao et al., 2012; Al-Shattarat et al., 2018).
Thus, we predict a positive coefficient sign between financial profitability and real earnings
376 management activities. Natural logarithm of the market value of equity (LN_MVE) controls
for the potential effect of firm’s size. We incorporate market price to book value (MPBV)
ratio in the regression models to control for firm’s growth opportunities, calculated as the
market price per share divided by the book value per share. Cohen and Zarowin (2010) find
that the components of real earnings management might have correlations with the size and
growth opportunities of the firm caused by the measurement errors associated with the
residual estimations of ABN_CFO, ABN_PROD and ABN_DISCEXP. Hence, we do not
predict any sign (6) of coefficients regarding (LN_MVE) and (MPBV).
Negative earnings (NE) is an indicator variable that takes the value of one when a firm’s
net income before extraordinary items is negative and zero otherwise. Firms with negative
earnings lack persistence and engage in earnings manipulation using real activities to evade
the consequences of reporting a loss (Beaver et al., 2003). Operating cash flows (OCF) as
reported in the cash flows statement has been included in the regression models to control
for the variances in firms’ performance across different industries and for the impact of
financial activities on earnings manipulation (Kothari et al., 2016). We also control for the
change in earnings (DE), calculated as the change in annual income divided by the previous
year’s total assets. Further, we include the level of debt of a firm in respect to its equity
(LVG) in the regression models, calculated as the ratio of the total debt divided by the total
equity. Finally, we include (YD) and (ID) dummies in our longitudinal data models to control
for time effects and industry effects, respectively (Baltagi et al., 2003). Table 2 summarises
the descriptive measures of the variables.

3.3 Models specification and statistical inferences

To test the impact of audit quality measured by the presence of Big 4 auditors (BIG_N), on
the aggregated and individual components of real earnings management after the UK
implementation of IFRS, we develop the following unbalanced panel data model:

REM_INDEXi; t ¼ a0 þ a1*BIG_Ni; t þ a2*ROAi; t þ a3*OCFi; t þ a4*MPBVi; t

þ a5*DEi; t þ a6*NEi; t þ a7*LN_MVEi; t
þ a8*LVGi; t þ Year Dummies þ Industry Dummies þ « i; t:
(4)

We re-run the model for the three individual components (i.e. ABN_CFO, ABN_PROD and
ABN_DISCEXP) of real earnings management, as well. We emphasise on the UK post-IFRS
adoption period by covering the sample data interval from 2005 to 2018. This confirms that
our regression results incorporate the impact of IFRS adoption of the selected listed
companies and could be considered in comparison to the studies associated with the pre-
IFRS period. Additionally, we limit our panel data sample with only those observations that
meet or beat past year’s earnings as a benchmark, similar to the stated criteria in the
previous studies (Roychowdhury, 2006; Gunny, 2010; Li, 2019). Moreover, to observe the
relative impact of the regression outcomes and the stated assumptions, it is important to
Variables Description of variables
Impact of audit
quality
Assetsi,t-1 The total assets reported by firm (i) of the previous year (t–1)
Salesi,t The total reported revenue by firm (i) of the current year (t)
Salesi,t-1 The total reported revenue by firm (i) of the previous year (t–1)
D Salesi,t The change in total reported revenue by firm (i) of the current year (t)
D Salesi,t-1 The change in total reported revenue by firm (i) of the previous year (t–1)
ABN_CFO Abnormal cash flows from operational activities of firms; [Model (1)] 377
ABN_PROD Abnormal production costs of firms, where production cost is the sum of the cost of
sales and changes in inventory; [Model (2)]
ABN_DISCEXP Abnormal discretionary expenses of firms, where discretionary expenses are the sum of
R&D expenses, SG&A expenses, and promotional expenses. [Model (3)]
REM_INDEX Aggregated real earnings management index, estimated by combining the standardised
abnormal levels of cash flows from operations (sales-based manipulation), production
costs, and discretionary expenses
BIG_N BIG_N is a representative measure of audit quality; an indicator variable that signifies 1
for big four audit firms (PWC, Deloitte, E&Y, KPMG) and 0 otherwise
ROA Return on assets for a firm (i) at period (t), formulated as (Net Income/Total Assets)
OCF Operational cash flows for a firm (i) at period (t)
MPBV Market price to book value ratio for a firm (i) at period (t), calculated as market price per
share divided by book value per share
DE Change in earnings for a firm (i) from period (t–1) to period (t), calculated as the change
in annual income divided by the previous year’s total assets
NE Negative earnings (NE) is an indicator variable that takes the value of 1 when a firm’s
net income before extraordinary items is negative, and 0 otherwise
LN_MVE Natural logarithm of the market value of the equity where market value of equity
(market capitalisation) has been calculated as market price per share multiplied by
number of shares outstanding
LVG Leverage ratio represents a measure to express the firms’ capacity to meet their financial
obligations, i.e. debt to equity ratio, calculated as the ratio of the total liabilities divided Table 2.
by the total equity Summarised
CNI CNI is an indicator variable that takes the value 1 when change in pre-tax earnings from measures of
past year falls under the interval of [0, 0.01], and 0 otherwise descriptive variables

perform sensitivity analysis. We check for robustness by addressing the Global Financial
Crisis (GFC) of 2007–2008, as it had a substantial impact not only in the UK but globally
(Arnold, 2009). The world economy endured volatility and unusual circumstances during
the period of the financial crisis. Emphasising on a stable economic environment, this study
excludes the observations associated with the GFC period to document whether the results
are consistent with the main regression findings.
The sample of this study satisfies the conditions of panel (longitudinal) data where cross-
sectional units, n = 108 firms and number of time periods, T = 14 years. The stated model is
estimated on the pooled cross-sectional time-series data (unbalanced). Drawing on Arellano
and Carrasco (2003), there are three noteworthy advantages in evaluating a panel data
model. First, it increases the precision of the regression estimates as a higher number of
observations are available due to the inclusion of time-series data. Second, it avoids the issue
of aggregation bias that may occur in studies associated with time-series data analysis while
considering the temporal effects in the data model. Third, it can deal with the problem of
correlated omitted variables through absorbing individual fixed effects into the undetectable
components of the model. Pooled ordinary least squares (OLS), Fixed effects (FE) and
Random effects (RE) are the three estimators associated with the panel data models (Bai,
2009). We have applied Breusch–Pagan Lagrangian Multiplier (BPLM) and the Hausman
IJAIM specification tests for the specified model of an unbalanced sample of panel data to attain an
29,3 appropriate estimator for the regression analyses.
Table 3 reports the findings associated with the BPLM and the Hausman specification
tests. We have considered the model of aggregated (REM_INDEX) real earnings
management as it represents the cumulative outcome of the three individual components.

378
Pooled OLS Model Random effects model
Variables Coefficient (t-stat) Coefficient (z-stat)

Intercept
4.084*** (–4.91)
2.027*** (–4.16)

BIG_N 3.146*** (3.87) 1.533*** (3.53)
ROA 0.087*** (7.31) 0.054*** (4.53)
OCF 0.191 (0.29)
0.355 (–0.65)
MPBV
0.033 (–1.26)
0.009 (–0.40)
DE
1.268 (
0.20)
4.890 (–1.30)
NE 0.752 (1.57)
0.211 (–0.37)
LN_MVE 0.373** (2.52) 0.422*** (3.86)
LVG 0.0178 (0.80) 0.004 (0.25)
Industry/year dummies No No
N (n) 311 (108) 311 (108)
Fj x 2 value 16.08*** 77.35***
R2 0.32 0.28 (Overall)
BP LM test for RE chibar2 (01) = 181.26; Prob > chibar2 = 0.000
Random effects model Fixed effects model
Intercept
2.027*** (–4.16)
1.232** (–2.25)
BIG_N 1.533*** (3.53) 1.070** (2.29)
ROA 0.054*** (4.53) 0.032** (2.19)
OCF
0.355 (
0.65) 0.742 (0.57)
MPBV
0.009 (–0.40)
0.037 (–1.33)
DE
4.890 (–1.30)
3.770 (–1.00)
NE
0.211 (
0.37)
0.485 (–0.79)
LN_MVE 0.422*** (3.86) 0.591*** (4.61)
LVG 0.004 (0.25) 0.023 (1.22)
Industry/year dummies No No
N (n) 311 (108) 311 (108)
x 2jF-value 77.35*** 7.42***
Overall R2 0.28 0.15
Hausman test for FE chibar2 (08) = 11.98; Prob > chibar2 = 0.152

Notes: *,**,***denote significance levels at 10%, 5% and 1%, respectively. Table 2 is referred for detailed
description of all the variables. This table illustrates the findings of BPLM and Hausman specification tests.
First, we apply BPLM statistics to test RE model against OLS model. Test result rejects the H0: variance (u)=0,
at 1% significance, suggesting that RE model is more appropriate than OLS. Last, we apply Hausman statistics
Table 3. to test between RE model and FE model. Test result fails to reject the H0: difference in coefficients not
Breusch–Pagan systematic, due to lack of significance (p-value = 0.15 > 0.10). This implies that RE estimator is better fitted for
Lagrangian our unbalanced panel data model of firm-years just meeting past year’s earnings. As FE estimator cannot
incorporate time-invariant industry dummies, we do not include year and industry dummies while running
multiplier test for
these tests. “N” represents number of firm-years, whereas “n’ represents number of the UK FTSE 350
random effects and companies. As aggregated real earnings management is the standardised cumulative measure of ABN_CFO,
Hausman ABN_PROD, and ABN_DISCEXP, we only consider REM_INDEX for the model specification tests. All
specification test for financial continuous data have been winsorized at 1st and 99th percentiles to avoid the impact of extreme values
fixed effects in the data set
First, we compare between OLS and RE using the BPLM test to find whether the individual Impact of audit
effects are uncorrelated with the regressors. Referring to Table 1 (Panel B), our sample quality
composition comprises the UK FTSE 350 companies from various industries. This may
influence our dependent variable, where the RE model will be a better fit compared to the
OLS model. Results show that RE estimator is more appropriate than OLS estimator as
the computed critical value surpasses the x 2 (tabularised) value at 1% level of significance
(p-value < 0.01). Later, we apply the Hausman specification test to check between the
uncorrelated (RE) and the correlated (FE) individual effects with the regressors (Baltagi 379
et al., 2003). That is, testing the level of significance associated with the difference between
parameter estimations of RE and FE. We find that the RE estimator is a better fit for the
model of unbalanced panel data sample than the FE estimator. As the differences in
coefficients are not systematic, we could not reject the null hypothesis of the Hausman test
due to lack of significance (p-value = 0.15 > 0.10). Hence, we conduct our regression
analyses on the panel data using random-effects generalised least squares (GLS) to address
the question of whether the presence of Big 4 auditors influences the managerial use of real
activities around the UK firms that have strong motivations to manage earnings upward in
the post-IFRS period.

4. Empirical results
4.1 Descriptive statistics and correlations
Table 4 (Panels A and B) illustrates a comparison of descriptive statistics for the panel data
sample based on the criterion of meeting an earnings benchmark. Total assets and market
capitalisation have been used interchangeably as a proxy for incorporating the effects of the
firm size. The mean total assets for companies without incentives is 10.08 billion, and for
companies that meet past year’s earnings is 1.04 billion. The companies with substantially
lower mean total assets may have the incentive to misrepresent earnings to signal better
future performance. The difference of 6.18 billion in the mean market value of the equity
suggests similar possibility. Other figures namely, net income and turnover show that the
companies without clear incentives have a higher level of operating performance than the
companies with incentives. The mean (median) net income and turnover for the companies
without incentives are 0.52 (0.11) billion and 7.87 (1.46) billion, respectively, whereas the
mean (median) net income and turnover for the companies with incentives are 0.07 (0.04)
billion and 1.10 (0.47) billion, respectively. Further, Table 4 (Panels C and D) report the
descriptive statistics from the perspective of Big 4 auditors in consideration to the firm-
years just meeting past year’s earnings. The mean market value of the equity for firms
audited by the Big 4 auditors is 1.37 billion and for firms audited by the non-Big 4 auditors is
0.63 billion. The difference of 0.73 billion in market capitalisation is consistent with the view
of Lawrence et al. (2011), who find that firms audited by the Big 4 auditors are larger in size
compared to the firms audited by the non-Big 4 auditors.
Table 5 (Panel A) reports the model parameters associated with the estimation of real
earnings management. Most of the estimated coefficients are found significant in explaining
the components of aggregated real earnings management. These outcomes are similar to
those reported in Roychowdhury (2006) and Chi et al. (2011). Table 5 (Panel B) illustrates the
descriptive statistics of all the variables associated with the firm-year observations just
meeting past year’s earnings. Consistent with the reported findings of Cohen et al. (2008), the
mean aggregated real earnings management is
0.05, suggesting firm-years that just meet
past year’s earnings engage in earnings manipulation using real activities. The negative
means of ABN_CFO and ABN_DISCEXP provide preliminary evidence that firms meeting
target earnings exhibit greater levels of sales-based and discretionary expenses-based
IJAIM Total assets Net income Market value Turnover
29,3 Particulars (£ billion) (£ billion) (£ billion) (£ billion)

Panel A: Panel data sample of firm-years without clear incentives to manage earnings, CNI = 0
Mean 10.08 0.52 7.52 7.87
Median 2.12 0.11 2.05 1.46
Std. deviation 25.07 1.53 15.08 24.42
380 Minimum 0.05
4.39 0.04 0.03
Maximum 212.95 16.54 129.40 253.09
N 1,945 1,945 1,945 1,945
Panel B: Panel data sample of firm-years just meeting past year’s earnings, CNI = 1
Mean 1.04 0.07 1.35 1.10
Median 0.44 0.04 0.74 0.47
Std. deviation 2.03 0.16 3.01 1.93
Minimum 0.05
0.05 0.04 0.07
Maximum 24.77 2.49 47.19 17.84
N 311 311 311 311
Panel C: Big 4 auditors and firm-years just meeting past year’s earnings, CNI = 1
Mean 1.06 0.07 1.37 1.12
Median 0.45 0.04 0.74 0.50
Std. deviation 2.06 0.16 3.05 1.96
Minimum 0.05
0.05 0.04 0.07
Maximum 24.77 2.49 47.19 17.84
N 302 302 302 302
Panel D: Non-Big 4 auditors and firm-years just meeting past year’s earnings, CNI = 1
Mean 0.50 0.05 0.63 0.34
Median 0.14 0.02 0.32 0.28
Std. deviation 0.99 0.08 0.63 0.20
Minimum 0.07 0.01 0.17 0.14
Maximum 3.13 0.25 1.94 0.66
N 9 9 9 9

Notes: Panels A and B report a comparison of descriptive statistics for the panel data sample based on the
criterion of just meeting earnings benchmark over the period 2005–2018. Following Gunny (2010), we
identify firm-years just meeting past year’s earnings by focussing on the pre-tax change in net income of
the firm-year observations that fall under the interval of [0, 0.01]. We use CNI, as a dummy variable where
0 [CNI = 1] <0.01. Panels B and C report descriptive statistics of the sorted firm-years (N) based on the
Table 4.
clients of BIG_N audit firms, and non-BIG_N audit firms. Total assets and turnover represent the
Descriptive statistics associated year-end value. Market value defines the market capitalisation at the end of the year, calculated
for sample firms as market price per share multiplied by number of shares outstanding. Net income is the annual net income
during the post-IFRS before extraordinary items. All financial continuous data have been winsorized at 1st and 99th percentiles
period (2005–2018) to avoid the impact of extreme values in the data set

manipulation. Table 4 (Panels C and D) and Table 5 (Panel B) report that a significant
number of companies in the sample (where, CNI = 1) are audited by Big 4 auditors compared
to the companies audited by non-Big 4 auditors. Since the sample has been pooled based on
the weighted stock market index, listed companies with higher market capitalisation tend to
hire one of the Big 4 auditors to review their financials (Reynolds and Francis, 2001; Boone
et al., 2010; Kim and Park, 2014). Considering the performance and growth measures,
the mean (median) ROA and MPBV are positive 13.82 (11.31) and 4.20 (3.32), respectively.
The frequency of negative annual earnings (NE) is 1.30%, and the mean (median) LVG is
positive 0.88 (1.15) for firms with strong incentives to manage earnings upward.
Panel A: REM_INDEX model parameters
Impact of audit
CFOi,t/Assetsi,t-1 PRODi,t/Assetsi,t-1 DISEXPi,t/Assetsi,t-1 quality
Coefficient (t-stat) Coefficient (t-stat) Coefficient (t-stat)
Intercept 0.080*** (24.99) 0.007*** (4.97) 0.075*** (5.19)
1/Assetsi,t 0.011*** (14.57)
0.001*** (
3.37) 0.006* (1.75)
Salesi,t/Assetsi,t-1 0.029*** (10.05)
0.002 (
1.31)


DSalesi,t/Assetsi,t-1 0.063*** (5.48) 0.067*** (12.64)


DSalesi,t-1/Assetsi,t-1

0.003 (0.55)

381
Salesi,t-1/Assetsi,t-1



0.338*** (26.57)
Adjusted R2 0.26 0.08 0.28
F-value (Prob > F) 261.07 (0.0000) 51.44 (0.0000) 430.72 (0.0000)
Panel B: Distribution of all variables
Variables 25th percentile Mean Median 75th percentile Standard Deviation
REM_INDEX
1.039
0.054 0.008 1.122 1.693
ABN_CFO
0.066
0.003
0.006 0.057 0.102
ABN_PROD
0.010 0.002
0.002 0.009 0.029
ABN_DISCEXP
0.274
0.027
0.097 0.183 0.476
BIG_N
0.971

0.168
ROA 7.509 13.822 11.311 18.554 9.252
OCF 0.033 0.114 0.057 0.118 0.191
MPBV 1.890 4.203 3.316 5.344 9.021
DE 0.004 0.017 0.010 0.022 0.021
NE
0.013

0.113
LN_MVE
0.939
0.299
0.308 0.291 1.015
LVG 0.623 0.876 1.147 1.833 11.651

Notes: *,**,***denote significance levels at 10%, 5% and 1%, respectively. Table 2 is referred for detailed
description of all the variables. Panel A illustrates the model parameters of real earnings management in
relation to Models 1, 2, and 3. Following Roychowdhury (2006), we apply linear regression on all available
observations of the UK FTSE 350 companies in Bureau van Dijk’s Fame database before implementing
additional data requirement (i.e. just meeting past year’s earnings). Panel B reports the distribution of all Table 5
variables based on the firm-years that meet our specified earnings benchmark. Drawing on Gunny (2010),
Model parameters of
we identify firm-years just meeting past year’s earnings by focussing on the pre-tax change in net income of
the firm-year observations that fall under the interval of [0, 0.01]. We use CNI, as a dummy variable where real earnings
0 [CNI = 1] <0.01. Regarding the indicator variables, only the mean and standard deviation have been management and
reported (Alhadab and Clacher, 2018). All financial continuous data have been winsorized at 1st and 99th distribution of all
percentiles to avoid the impact of extreme values in the data set variables

Table 6 provides information about the pairwise correlations matrix of all variables
associated with the main regression models. Notably, BIG_N is positively related to the
aggregated measure of real earnings management at 5% level of significance (p-value <
0.05). It also shows significant and positive relations with ABN_CFO and
ABN_DISCEXP. These associations imply that the level of real earnings management
is an increasing function of the presence of Big 4 auditors. Additionally, the mean-
variance inflation factors (VIF) for all the explanatory variables that have been applied
in the random effects GLS regression is 3.33, indicating that the findings are free from
the issue of multicollinearity.

4.2 Regression analysis

Table 7 reports the findings of our analysis of whether Big 4 auditors influence real earnings
management activities around the UK FTSE 350 companies that just meet past year’s
IJAIM Variables (A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L)
29,3
(A) REM_INDEX 1.000
(B) ABN_CFO 0.645 1.000
(C) ABN_PROD 0.282
0.111 1.000
(D) ABN_DISCEXP 0.678 0.046
0.077 1.000
(E) BIG_N 0.313 0.221 0.085 0.194 1.000
382 (F) ROA 0.380 0.561
0.080 0.063
0.061 1.000
(G) OCF 0.139 0.176
0.053 0.067 0.079
0.124 1.000
(H) MPBV 0.103 0.151
0.048 0.033
0.019 0.325
0.028 1.000
(I) DE 0.030 0.018
0.091 0.080
0.204 0.516
0.261 0.188 1.000
(J) NE
0.060
0.088
0.030 0.014 0.020
0.202
0.046 0.061
0.060 1.000
(K) LN_MVE 0.259 0.343
0.008 0.053 0.092 0.005 0.655 0.108
0.421
0.062 1.000
(L) LVG
0.014 0.003 0.012
0.030
0.003 0.015
0.012 0.875 0.001 0.033 0.048 1.000

Notes: This table reports the pairwise correlations matrix for all the variables associated with the panel
Table 6. data sample based on the criterion of just meeting past year’s earnings over the period 2005–2018.
Pairwise correlations Characters with italic representation specify significance at the 5% level (p-value < 0.05). Table 2 is referred
matrix for detailed description of all the variables

earnings, after the implementation of IFRS. For sales-based manipulation (ABN_CFO), we

find a significant and positive coefficient (0.084) on BIG_N, implying that even in the
presence of Big 4 auditors, incentivised firms manipulate earnings either through
aggressively discounting the sales price or altering the regular credit policies to boost their
short-term cash inflows (Roychowdhury, 2006). Whilst considering the UK IPO firms,
Alhadab and Clacher (2018) similarly report a significant and positive association on the
presence of Big 4 auditors in the regression of abnormal operating cash flows. This suggests
that IPO managers would rather rely on sales manipulation to improve the current period’s
income than manipulating other real activities in the presence of Big 4 auditors. The
extensive use of sales manipulation is a common phenomenon for firms that have extra
incentives to manage earnings upward through meeting earnings benchmarks (Xu et al.,
2007). Consequently, it is difficult to detect such manipulation of earnings from the
perspective of an auditor (Leuz et al., 2003; Graham et al., 2005; Boone et al., 2010). However,
our findings are opposing to those reported in Chi et al. (2011) and Shawn et al. (2016). In line
with the opportunistic motivations of the managers, they provide evidence on the negative
association between Big 4 auditors and sales manipulation, indicating that the presence of a
Big 4 auditor reduces the agency cost through constraining sales-based manipulating
activities for upward earnings management.
In association with discretionary expenses (ABN_DISCEXP) regression, BIG_N shows a
positive coefficient (0.204) at 5% level of significance (p-value < 0.05). This suggests that
Big 4 auditors exhibit greater levels of discretionary expenses manipulation for those firms
that just meet past year’s earnings during the post-IFRS era. Reduction in discretionary
expenses facilitates the incentivised managers to portray increased net income at the end of
a period. The involvement of cash payments increases the cash outflow further when the
discretionary expenses are managed (Cohen and Zarowin, 2010). Taylor and Xu (2010)
report that firms that meet past year’s earnings to achieve target earnings are more likely to
engage in discretionary expenses manipulation compare to other benchmark meeting tools,
such as zero earnings. As our findings are based on the analysis of firms that have strong
incentives to manage earnings upward through meeting past year’s earnings, a positive
association is justified following the signalling perspective of the managers where the choice
 REM_INDEX ABN_CFO ABN_PROD ABN_DISCEXP
Impact of audit
Independent variables Coefficient (z-stat) Coefficient (z-stat) Coefficient (z-stat) Coefficient (z-stat) quality
Intercept
1.153 (
1.40)
0.102** (
2.30)
0.012 (
0.66) 0.150 (
0.76)
BIG_N 1.500*** (3.30) 0.084*** (3.29) 0.006 (0.53) 0.204** (2.45)
ROA 0.052*** (4.16) 0.007*** (10.76)
0.000 (
0.87)
0.010*** (
4.24)
OCF
0.854 (
1.43) 0.006 (0.20)
0.015 (
1.15)
0.198 (
1.38)
MPBV 0.003 (0.13)
0.003** (
2.16) 0.000 (0.22) 0.011** (2.21) 383
DE
5.780 (
1.46)
0.805*** (
3.47)
0.028 (
0.26) 1.480** (2.12)
NE
0.030 (
0.05) 0.039 (1.18)
0.010 (
0.68)
0.022 (
0.21)
LN_MVE 0.537*** (3.75) 0.026*** (3.39) 0.003 (0.88) 0.056* (1.88)
LVG
0.004 (
0.21) 0.002* (1.95) 0.000 (
0.19)
0.007** (
2.16)
Year dummies Yes Yes Yes Yes
Industry dummies Yes Yes Yes Yes
Wald x 2 – value 109.97*** 276.58*** 64.96*** 61.71***
N (n) 311 (108) 311 (108) 311 (108) 311 (108)
Overall R2 0.35 0.57 0.19 0.14

Notes: *,**,***denote significance levels at 10%, 5% and 1%, respectively. Table 2 is referred for detailed
description of all the variables. Illustrated table represents our main regression findings that document the
impact of audit quality, proxied by BIG_N, on the real earnings management proxies, namely sales-based
manipulation (ABN_CFO), production costs-based manipulation (ABN_PROD), discretionary expenses-based
manipulation (ABN_DISCEXP), and aggregated measure of real earnings management (REM_INDEX) in the
context of the UK FTSE 350 companies just meeting past year’s earnings, during the period 2005–2018 (post-
IFRS era). Here, REM_INDEX is computed as the sum of standardised measures of ABN_CFO, ABN_PROD,
and ABN_DISCEXP (Cohen et al., 2008). Drawing on Gunny (2010), we identify firm-years that just meet past
year’s earnings by focussing on the pre-tax change in net income of the firm-year observations that fall under Table 7.
the interval of [0, 0.01]. We use CNI, as a dummy variable where 0 [CNI = 1] <0.01. We release firm-years with
Regressions of
less than six observations for each industry-year grouping. Hence, we drop observations from “Mining and
quarrying” and “PA and defence, CSS” industries. “N” represents the number of firm-years and “n” represents BIG_N on each real
the number of listed firms. We use random effects GLS estimator to regress and the overall R2 value has been earnings
presented as it represents the weighted average value from R2 within and R2 between. All financial continuous management proxies
data have been winsorized at 1st and 99th percentiles to avoid the impact of extreme values in the data set and control variables

of a Big 4 auditor could be used to signal the market about potential economic growth
(Morris, 1987; Firth and Liau-Tan, 2003). The extant literature (Chi et al., 2011; Shawn et al.,
2016; Alhadab and Clacher, 2018) mostly reports on the negative relationship between audit
quality and real earnings management using discretionary expenses. However, in a study of
the UK manufacturing sector, Sitanggang et al. (2019) find evidence that audit quality is
significantly and positively related with abnormal discretionary expenses for firms that
operate in the post-IFRS period (2010–2013), supporting the findings of our study that Big 4
auditors may also fail to limit the use of discretionary expenses-based real earnings
management.
We also report positive, but statistically insignificant coefficient (0.006) on BIG_N in the
regression of production cost-based manipulation (ABN_PROD). Notably, Chi et al. (2011)
also report statistically insignificant findings similar to our study that when the US firms
have incentives to meet earnings benchmarks, even the presence of a Big 4 auditor is not
sufficient to limit production costs-based real earnings management. However, results of the
individual components explained so far suggest that firms with Big 4 auditors are not
perpetrating all forms of real earnings management at the same time, as this could raise
concerns among the stakeholders due to increased risk of litigation. This is in line with the
findings of previous studies. For instance, Alhadab and Clacher (2018) find significance on
IJAIM Big 4 auditors in association with sales and discretionary expenses manipulation. Shawn et
29,3 al. (2016) document that audit quality has a significant relationship with production costs
and discretionary expenses manipulation. That is, managers are aware of the negative
outcomes on the firms’ future value if they exceed the limit as it would have a value-
destroying impact rather than signalling future growth. Further, manipulation of earnings
using production costs is primarily used by the manufacturing firms (Xu et al., 2007). Thus,
384 the statistical insignificance could also be attributed to the lower percentage (27%) of
observations from the manufacturing industry in our panel data sample.
We find a significant and positive coefficient (1.500) on BIG_N in the aggregated real
earnings management (REM_INDEX) regression, suggesting that incentivised companies
audited by the Big 4 auditors are associated with greater levels of real earnings
management. Our result on the association between the presence of Big 4 auditors and
REM_INDEX is consistent to those reported by Chi et al. (2011) that show evidence that
managers manipulate earnings using both accruals and real earnings management but shift
towards the latter in the presence of a Big 4 auditor, hence, a significantly positive
relationship has been documented. Further, Sitanggang et al. (2019) report a positive but
insignificant relationship between Big 4 auditors and REM_INDEX for the UK firms that
operate in the manufacturing industry. However, our finding in REM_INDEX regression is
contrary to Shawn et al. (2016), Alhadab and Clacher (2018) and Choi et al. (2018), who all
point out the costly consequences of opportunistic earnings manipulation drawn from the
agency theory. For example, Choi et al. (2018) evaluate multiple countries on the basis of
different legal regimes. The cross-country analysis shows that the presence of Big 4 auditors
is significantly and negatively associated with real earnings management, indicating that
Big 4 auditors are supposed to constrain real earnings management due to the managerial
tendency to employ opportunism by prioritising their own benefit over firms’ value.
The level of significances and coefficient signs of the control variables shows consistency
to the findings of previous studies (Cohen et al., 2008; Chi et al., 2011; Zang, 2012; Houqe
et al., 2017). Controlling for firm’s profitability and size, we find significant and positive
coefficients on ROA and LN_MVE in the regressions of aggregated real earnings
management and sales-based manipulation. This is comparable to the results of Gunny
(2010) and Zhao et al. (2012), who document the joint signalling impact on financial
performances. They find that managers who just meet past year’s earnings using real
activities, jointly exhibit higher financial performance as a signalling approach to the
investors and analysts. Controlling for firm’s growth opportunities, the coefficient’s estimate
on MPBV is statistically significant and positive in the regression of ABN_DISCEXP,
suggesting that the managers are approaching towards better future performance as a
signalling effect through meeting past year’s earnings using real activities. We find similar
evidence on LVG in explaining ABN_CFO, where the coefficient is positive, but at a lower
level of significance (p-value < 0.10). In respect to the random effects GLS regression
models, we only report for the overall R2 value as it represents the weighted average
measure of within and between R2 values. For an example, considering ABN_CFO
regression, the explanatory variables of the model account for 43% (within), 57% (between)
and 57% (overall) of the variations in sales-based manipulation within each of the firm-years
over time.
In summary, we reject the null and accept the stated H1, as we find a significant and
positive relationship between the presence of Big 4 auditors and real earnings management
proxies (except, ABN_PROD). Hence, the presence of Big 4 auditors is associated with
greater levels of real earnings management around the UK firms that meet past year’s
earnings in the post-IFRS period. The evidence presented in this paper reports consistent
associations between Big 4 auditors and the components of real earnings management. Prior Impact of audit
studies document mixed evidence that shows partial limiting of real earnings management quality
by the Big 4 auditors (Shawn et al., 2016; Choi et al., 2018; Alhadab and Clacher, 2018) or
limited engagement success to avoid auditors’ scrutiny by the managers (Chi et al., 2011;
Sitanggang et al., 2019). Drawing on the signalling concept for firms with strong financial
positions that utilise real activities to reduce information asymmetry in the market, our
findings imply one of the two possibilities:
385
(1) Whilst signalling over earnings, managerial competence and choice of auditors
(Bartov et al., 2002; Graham et al., 2005; Jiang, 2008), the auditors are aware of the
signalling impact and decide to act against constraining real activities to that
extent where the firms’ litigation risk is at minimum, and the future value will not
have adverse effects (Firth and Liau-Tan, 2003); or
(2) Since the auditing standards are more focussed on constraining accruals than real
activities, the scope of audit is limited for real earnings management (Leuz et al.,
2003; Roychowdhury, 2006).

Therefore, when managers intend to signal better future performance, the auditors fail to
limit the managerial use of real activities.

4.3 Sensitivity analysis

To check for robustness, we follow Houqe et al. (2017) by addressing the effect of the GFC of
2007–2008 in our regressions. The quality of auditing was questioned by many economists
due to the impact of information asymmetry during the era of the financial crisis. Big 4
auditors experienced a sudden increase in evaluated audit risk and charged higher audit fees
to compensate against the volatility of the economic environment (Sikka, 2009). Persakis and
Iatridis (2016) document a negative association of the financial crisis on the audit quality,
suggesting that the managers were able to manipulate earnings due to the uncertainty in the
market caused by the global financial crisis, even in the presence of Big 4 auditors. So,
considering the crisis period in our regression model may produce outcomes that are not
appropriate in representing the normal impact of audit quality on real earnings
management. Therefore, we exclude firm-year observations of the financial crisis period
from our control sample and re-run the regression to check whether the results are robust
and consistent in comparison to the main regression findings, reported earlier. Table 8
reports the findings of our sensitivity analysis. We find consistency with the main results
reported in Table 7, after excluding the firm-years associated with the financial crisis. For
example, BIG_N is significantly and positively related to three of the four proxies of real
earnings management, namely REM_INDEX, ABN_CFO and ABN_DISCEXP. Notably, the
significance level increases from 5% (p-value < 0.05) to 1% (p-value < 0.01), in respect to the
positive association between the audit quality proxy and discretionary expenses-based
earnings manipulation.

5. Concluding remarks
Empirical studies that investigate the impact of audit quality on upward earnings
management mostly provide evidence on the managerial use of accruals (Francis and Wang,
2008; Chen et al., 2011; Houqe et al., 2017), where a recent body of research point out the
necessity to further investigate real earnings management, especially in the UK setting
(Athanasakou et al., 2011; Alhadab and Clacher, 2018; Sitanggang et al., 2019). Opportunistic
earnings management, driven from the agency theory suggests that manipulation of
IJAIM REM_INDEX ABN_CFO ABN_PROD ABN_DISCEXP
29,3 Independent variables Coefficient (z-stat) Coefficient (z-stat) Coefficient (z-stat) Coefficient (z-stat)

Intercept
1.408 (
1.56)
0.101** (
2.13)
0.002 (
0.09) 0.013 (
2.41)

BIG_N 1.831*** (3.58) 0.091*** (3.24) 0.001 (0.07) 0.305*** (3.22)
ROA 0.042*** (3.04) 0.007*** (9.73)
0.001 (
1.60)
0.011*** (
4.26)
OCF
0.853 (
1.26)
0.013 (
0.39)
0.010 (
0.72)
0.200 (0.33)
386 MPBV 0.021 (0.77)
0.003** (
2.03) 0.000 (0.72) 0.014** (3.21)
DE
4.394 (
0.93)
0.877*** (
3.29)
0.044 (
0.44) 2.342*** (2.45)
NE 0.333 (0.47) 0.054 (1.39)
0.005 (
0.36)
0.024 (
0.45)
LN_MVE 0.621*** (3.60) 0.032*** (3.63) 0.002 (0.62) 0.069* (0.18)
LVG
0.021 (
1.04) 0.002 (1.54)
0.000 (
0.74)
0.009** (
3.13)
Year dummies Yes Yes Yes Yes
Industry dummies Yes Yes Yes Yes
Wald x 2 - value 106.96*** 242.25*** 69.84*** 60.22***
N (n) 259 (103) 259 (103) 259 (103) 259 (103)
Overall R2 0.36 0.57 0.20 0.17

Notes: *,**,*** denote significance levels at 10%, 5% and 1%, respectively. Table 2 is referred for detailed
description of all the variables. Illustrated table represents our regression findings that excluded the GFC
period to check for robustness whereas documenting the impact of audit quality, proxied by BIG_N, on the
real earnings management proxies, namely sales-based manipulation (ABN_CFO), production costs-based
manipulation (ABN_PROD), discretionary expenses-based manipulation (ABN_DISCEXP), and aggregated
measure of real earnings management (REM_INDEX) in the context of the UK FTSE 350 companies just
meeting past year’s earnings. We exclude years 2007 and 2008 to test whether our main regression findings
are robust in association with the GFC. Here, REM_INDEX is computed as the sum of standardised
Table 8. measures of ABN_CFO, ABN_PROD, and ABN_DISCEXP (Cohen et al., 2008). Drawing on Gunny (2010),
Regressions of we identify firm-years that just meet past year’s earnings by focussing on the pre-tax change in net income
BIG_N on each real of the firm-year observations that fall under the interval of [0, 0.01]. We use CNI, as a dummy variable
where 0 [CNI = 1] <0.01. We release firm-years with less than six observations for each industry-year
earnings
grouping. Hence, we drop observations from “Mining and quarrying” and “PA and defence, CSS”
management proxies industries. “N” represents the number of firm-years and “n” represents the number of listed firms. We use
and control variables, random effects GLS estimator to regress and the overall R2 value has been presented as it represents the
excluding the GFC weighted average value from R2 within and R2 between. All financial continuous data have been winsorized
years at 1st and 99th percentiles to avoid the impact of extreme values in the data set

earnings reduces the value of a firm whereas the Big 4 auditors are obligated to detect and
report such employment of opportunism (Achleitner et al., 2014; Gao et al., 2017; Alzoubi,
2018). However, this study builds on the signalling aspects of earnings manipulation by
empirically examining the association between Big 4 auditors and real earnings
management for a sample of UK listed firms in the post-IFRS era, that have strong
incentives to manage earnings upward and hold a strong financial position in the market.
We consider only those firms that just meet past year’s earnings because these firms are
more likely to engage in real earnings management to signal better future performance
while mitigating information asymmetry among the investors (Jiang, 2008; Gunny, 2010;
Zhao et al., 2012).
Our study reports that the presence of Big 4 auditors is significantly and positively
related with sales, discretionary expenses and aggregated measure of real earnings
management for the UK firms that just meet past year’s earnings in the post-IFRS period.
The results contribute to the literature by providing evidence that the presence of a Big 4
auditor is not enough to restrict the managerial utilisation of real activities, considering that
managers intend to signal the market about future economic growth. Since the auditors add
value to the reporting quality, they might allow such undertakings as long as it does not Impact of audit
increase the risk of litigation and operating failure. However, as the scope of audit is limited quality
in the auditing standards for detecting real earnings management, this might be a reason
that explains the failure of Big 4 auditors in constraining the managerial use of real
activities. Further, in support to our findings, the cost-benefit analysis of IFRS adoption
literature suggests that the managers operate with a certain level of flexibility in defining
accounting policies that may have caused an increase in the managerial use of real activities
for firms that have strong incentives for upward earnings management. 387
There are several implications of this study for audit quality and earnings management
literature. Our study implies that the auditors’ approach to detect earnings management as
described in the auditing standards fails to limit the use of sales and discretionary expenses to
manipulate earnings for firms that meet past year’s earnings, in the presence of a Big 4 auditor.
The declining quality of audit across the Big 4 audit firms in the UK has been considered as an
issue under the microscope in recent years. Auditors’ failure to identify financial problems at
several high-profile corporations, such as Carillion, Rolls-Royce, BT, Sports Direct, Ted Baker,
etc., has called for increased scrutiny from the standard setters. Insufficient scepticism has been
considered as a recurring finding, where the Big 4 auditors have failed to attain a target of
“limited improvement requirement”. As a result, the regulators have proposed the separation of
statutory audits of FTSE 350 companies between two Big 4 auditors. Therefore, our findings
are in line with the recent issue of the declining quality of reputed auditors in the UK. Further,
managers take advantage of the provided accounting flexibility from the adoption of IFRS in
defining accounting policies and engage in real activities, even in the presence of a Big 4
auditor. Specifically, in the context of the UK listed companies, there is no evidence of whether
Big 4 auditors influence real earnings management in the post-IFRS era. Our results
incorporate the effect of IFRS earnings and could be considered in comparison to studies that
analyse data from the pre-IFRS period.
Finally, we consider certain limitations of this study. First, due to data access caveats, our
study has limited its scope to a relatively small sample size, after sorting observations that
have strong incentives to manage earnings upward. As the data associated with audit quality
(whether a Big 4 auditor or a non-Big 4 auditor) has been collected manually, we could not
consider more than FTSE 350 companies listed in the LSE. Second, while evaluating the
association with audit quality, we do not report on all the available forms of real earnings
management, such as sales of long-term assets, structuring investing and financing
transactions, stock repurchases and financial instruments. Future research can address this
area. Finally, we have only considered the institutional setting of the UK, and it would be
interesting to see whether our results remain consistent in regard to different legal and
regulatory systems.

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Further reading
Ifac.org (2006), “International standard on auditing 580 written representations”, available at: www.
ifac.org/system/files/downloads/a032-2010-iaasb-handbook-isa-580.pdf

Corresponding author
Yasser Eliwa can be contacted at: Y.Eliwa@lboro.ac.uk

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