Do audit firm and audit costs/fees influence earnings management in Swedish municipalities?
| DOI | 10.1177/0020852317748730 |
| Author | Mattias Haraldsson,Torbjörn Tagesson,Pierre Donatella |
| Date | 01 December 2019 |
| Published date | 01 December 2019 |
| Subject Matter | Articles |
Review of
Administrative
Article
Sciences
International Review of
Do audit firm and audit
Administrative Sciences
2019, Vol. 85(4) 673–691
!
costs/fees influence
The Author(s) 2018
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earnings management in
DOI: 10.1177/0020852317748730
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Swedish municipalities?
Pierre Donatella
University of Gothenburg, School of Public Administration,
Sweden
Mattias Haraldsson
Lund University, School of Economics and Management,
Department of Business Administration, Sweden
Torbj€
orn Tagesson
Link€
oping University – Department of Management and
Engineering, Sweden
Abstract
Previous research on the private sector shows that auditors and auditing firms are
important actors in ensuring high-quality reporting based on accrual accounting. The
aim of this study is to explore whether audit firms and audit costs/fees influence
municipalities’ probability of applying earnings management in their annual accounts.
The empirical data, which covered the financial years 2011–13, were handpicked from
annual reports or retrieved from other sources. In general, our study shows that the
probability of earnings management increased if audit costs/fees increased. However,
there were differences regarding the probability of earnings management relating to
which audit firm was engaged. This implies that audit quality is a factor that affects the
probability of earnings management in Swedish municipalities. The study also indicates
that different audit firms make different trade-offs between professional versus com-
mercial logics, and that this is reflected in the clients’ propensity to engage in earnings
management.
Corresponding author:
Torbj€
orn Tagesson, Link€
oping University – Department of Management and Engineering, Campus Valla
Link€
oping SE-581 83, Sweden.
Email: torbjorn.tagesson@liu.se
674
International Review of Administrative Sciences 85(4)
Points for practitioners
Today a majority of developed countries have adopted accrual-based accounting for
municipalities. Along with accrual-based accounting follows the risk of earnings man-
agement. Problems regarding accounting quality imply an increased importance of the
financial audit. However, our study shows that there is no obvious positive relationship
between audit cost/fees and audit quality. The ability to constrain earnings management
seems to vary between audit firms. The important implication for practitioners is that
auditing must have quality standards that are subject to follow-up and control, which
applies both on a system level and also when municipalities procure and contract audit
firms for audit assignments.
Keywords
audit cost, audit fee, audit firm, earnings management, municipality
Introduction
Today a majority of developed countries have adopted accrual-based accounting
for the public sector (Brusca et al., 2015), yet there are still major differences
between different countries’ accounting systems (PwC, 2014). In recent years,
Eurostat has initiated a project to investigate introducing common accounting
standards for the public sector within the European Union (Caperchione, 2015;
Tagesson, 2014). However, common standards would not necessarily lead to de
facto harmonization (e.g. Pope and McLeay, 2011). Achieving this also requires an
institutional context that supports enforcement and compliance with the standards
(e.g. Haraldsson and Tagesson, 2014; Pope and McLeay, 2011). This is particularly
important in an accrual- and principle-based system, which requires judgement
from preparers, as there will be a risk of manipulation of discretionary accruals
(Jones and Caruana, 2015). Studies from the private sector show that in some
countries
the
introduction
of
IFRS
(International
Financial
Reporting
Standards) actually led to an increased degree of earnings management (Callo
and Jarne, 2010; Jeanjean and Stolowy, 2008). Further, there is also evidence in
previous research that, given the right incentives, municipalities adjust reported
financial performance via discretionary accruals (Arcas and Martı´, 2016;
Donatella, 2016; Ferreira et al., 2013; Pilcher and Van der Zahn, 2010;
Stalebrink, 2007).
Several private sector studies indicate that monitoring strength is an important
factor for successful enforcement (Brown et al., 2014; Daske et al., 2008; Jeanjean
and Stolowy, 2008; Li, 2010; Preiato et al., 2015) and that auditors are important
actors in institutionalizing accounting standards (J€
onsson, 1985; Touron, 2005).
However, research also suggests that auditors influence earnings management
(Francis, 2011; Walker, 2013). Whether the latter is true in a municipal context
Donatella et al.
675
has not been fully addressed in previous studies (Arcas and Martı´, 2016; Donatella,
2016; Ferreira et al., 2013; Pilcher and Van der Zahn, 2010; Stalebrink, 2007).
Thus, in this study we focused on the role of audits and the relationship between
audit firms, audit costs/fees and discretionary accruals.
Although the audit regime is considered weak in Sweden (Tagesson and
Eriksson, 2011), there are several reasons that make Sweden a good case for
studying this relationship. Firstly, as early adopters of accrual-based accounting
(Tagesson and Grossi, 2015), Swedish municipalities have a high accounting matu-
rity with an accounting system that, to a great extent, corresponds with the stand-
ards developed by the International Public Sector Accounting Standards Board
(Brusca and Martine´z, 2016; Christiaens et al., 2010; PwC, 2014). Second, previous
studies have shown that the resources spent on audits vary among different munic-
ipalities (Collin et al., 2017) and that there is a competitive audit market (Tagesson
et al., 2015). Finally, previous studies have demonstrated the existence of earnings
management (Donatella, 2016; Stalebrink, 2007). However, neither Stalebrink
(2007) nor Donatella (2016) included audit firms or audit costs/fees as explanatory
factors in their models. The aim of this study is to explore whether audit firms and
audit costs/fees influence the presence and the extent of earnings management in a
municipal context.
The Swedish municipal sector
Sweden has 289 municipalities. The largest municipality has approximately
912,000 inhabitants while the smallest has fewer than 2500 (the median population
of a municipality being 15,300). Differences between municipalities, due to differ-
ent demographic conditions and tax bases, are adjusted by an equalization system
where central government provides and redistributes resources between the munic-
ipalities (Tagesson et al., 2013).
The power of local governments is based on representative democracy; elections
are held every four years. According to the Local Government Act (the Act), the
council is responsible for appointing political auditors, an election committee and
an executive board with overall duties. After an election, the new assembly must
elect a minimum of five auditors for the next four-year term. The auditors are
elected from the various political parties and as such they can be labelled political
auditors (e.g. Tagesson and Eriksson, 2011). The council also decides the size of the
budget for auditing (Collin et al., 2017). According to the Act, the auditors are to
scrutinize whether operations have been conducted consistently with their purpose
and the stated goals of the council and in accordance with legislation.
Furthermore, they are to examine whether this was done in an effective manner.
The auditors should also scrutinize whether the financial reports give a true
and fair view and whether the internal control is sufficient (Local Government
Act ch. 9).
The Act states that the auditors shall be assisted in their inspection by experts –
termed professional auditors. The council and the political auditors can either
676
International Review of Administrative Sciences 85(4)
create an internal audit office or hire professional auditors from the market.
External auditors are to be hired through public procurement and in Sweden
there is quite a concentrated market for auditing, dominated by the Big 4
(Tagesson et al., 2015).
There are no sanctions against political auditors who do not fulfil their obliga-
tions (Tagesson and Eriksson, 2011). The professional auditors’ liability is also
unclear, considering that they are not the auditors responsible for determining the
assessments regarding risk and materiality. This system of auditing is criticized
because of the political auditors’ lack of independence and the professional audi-
tors’ lack of competence (Tagesson and Eriksson, 2011).
Theory: audit characteristics and earnings management
The standard approach to study earnings management is agency theory (Walker,
2013). Agency theory typically highlights potential conflicts of interest and infor-
mation asymmetry between the agent and the principal (Jensen and Meckling,
1976). The basic assumptions of agency theory (goal conflict, information asym-
metry, utility maximization and costs of monitoring) are essentially the same for
the public sector, even though the complexity increases due to multiple non-profit
goals and many layers of agency relationships between the voters, the politicians
and the public managers (Zimmerman, 1977). The task of the audit is to scrutinize
and express an opinion (provide assurance) on the quality of the accounting infor-
mation regarding whether the information is usable for decision-making and
accountability.
The simple linkage between audit quality and earnings management is...
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