Cosmetic earnings management and audit quality: evidence from the U.S.

This research examines the correlation between audit quality and cosmetic earnings management. Here cosmetic earnings management stands for small rounding of income statement figures that aims to influence the perceptions of financial statement users. The existence and level of cosmetic earnings management is measured by comparing the deviations of observed percentages of second digits to the expected probabilities constituted by Benford’s law. Significant deviations of zeros and nines from Benford’s law argue for the existence of cosmetic earnings management. This research investigates whether cosmetic earnings management exists less (more) in circumstances where audit quality is perceived to be of higher (lower) quality. As the variables for audit quality, three dimensions are used, i.e. audit firm size, auditor tenure and the level of non-audit services purchased from the audit firm. The research was conducted as a single-country study including over 75 000 observations from the U.S. during 2000-2016. The findings indicate that cosmetic earnings management is practiced in the U.S. and especially net sales and net profit figures are manipulated. It was also found that the size of the audit firm affected the level of cosmetic earnings management, i.e. companies audited by large audit firms practice less cosmetic earnings management than companies audited by smaller auditors. In addition, companies that have had an auditor-client relationship of over four years practice less cosmetic earnings management than companies that have had only a short, 2-3 years relationship with their auditor. The level of non-audit fees was not seen to affect the magnitude of cosmetic earnings management