Auditor Competence andEarnings Management: Analysis of the Association and the Impact of Ownership Structure as the Moderating Variable
Indah Permata Sari
Desi Adhariani
Department of Accounting, Faculty of Economics and Business, Universitas Indonesia
Abstract
This study aims at examiningthe effect of external auditor competence on the earnings management using ownership structure as a moderating variable. Using 204 observations of companies in the manufacturing industry for the period 2011-2013, this study cannot find evidence on the effect of auditor competence. However, this study provides an empirical evidence that the presence of institutionalinvestors helps auditors provide better audit quality due to an effective controlperformed by the investors. This study shows that users of financial statements should be keen on using information in the financial statements; they should not only pay attention to corporate financial information but also the ownership structure.
Keywords: earnings management, external auditor competence, ownership structure
Introduction
The relationship between a company owner and a manager who manage the company can create a conflict of interest. The agency theory states that a company owner tends to worry if the manager who runs the company is incompetent and ultimately makes the company lose. The manager is suspected of fraud that will harm the company owner and act to maximize his personal profit. Financial statements are a form of managerial liability to the company owner at the end of each year. The financial statements will provide information to the company owner and other stakeholders concerning the management performance during the current period. The financial information of concern to the company owner and other stakeholders is profit. Many other factors can reflect the management performance, but the size of profit can affect the perception of all users of the financial statements. It is the importance of profit value in the financial statements which can lead to management intensive to perform the earnings management.According to Healy and Wahlen (1998), the earnings management is one of the management efforts to mislead investors in making decisions when assessing the company performance. The earnings management is performed by the aim at obtaning personal gain by making changes to the financial statements (Schipper, 1989).
One attempt to resolve this agency conflict is to audit the company's financial statements. The audit is conducted to see if there are any errors or fraud in the financial statements that make the information in it unreliable. In addition to the audit of the financial statements, the ownership structure is also expected to overcome any asymmetric information problem that occurs between the manager and the company owner (Jones, 2011). Performing regular audits and good corporate ownership structure are also expected to have implication on declining the earnings management levels (Johnson and Waidi, 2013). Good audit quality can be seen from all aspects, one of which is the auditor competence seen through audit tenure.According to the study, the longer a person becomes an auditor the more experienced he/she is expected to be able to find fault or fraud in the financial statements. However, if an auditor makes avery longaudit contract for a company, the quality of the audit is diminished due to the auditor independence is also diminished.
In addition to the quality of the auditor, the agency conflict can also be influenced by the ownership structure in the company. The asymmetry information between the company owner and the management makesthe management take action to maximize its personal gain by overriding the interests of the company owner. This problem can be minimized by using the ownership structure as the management supervisor (Putri and Yuyetta, 2013). The ownership structure acting as the management supervisor is expected to facilitate the external auditorto conduct an audit. A company can also become a shareholder by collecting funds from a third party to reinvest in another company; this company is called an institutional investor or institutional shareholder. The institutional investor may be investment companies or other financial institutions that collect funds from third parties, such as banks, insurance, pension funds and so forth (Siregar and Utama, 2005). This institutional investor has a better ability to read the company's financial statements, thus control functions can work effectively (Lee, 2008). This effective control can suppress management opportunities to perform the earnings management practices.
In Asian countries especially Indonesia, the ownership structure is still concentrated, in contrast to the United States and other developed countries where the ownership structure is scattered. Therefore, the authors are interested to replicate Kouaib and Jarboui's study (2014) by adjusting to the conditions in Indonesia. The centralized ownership structure in Indonesia differs from the scattered ownership structurein Tunisia, thus this will affect the supervisory function in the company (Turki and Sedrine, 2012). The research will be conducted on companies in the manufacturing industry listed in the Indonesia Stock Exchange during the study period of 2011-2013.
Based on the background of the writing above, there are several issues raised in this study, among others: (1) Do auditor competence, ownership concentration and institutionalinvestors have a negative effect on theearnings management? (2) Does ownership concentration strengthen negative relationship between the auditor competence and the earnings management? (3)Do institutional investors strengthen the negative relationship between the auditor competence and the earnings management? This study aims at providingan empirical evidence that the ownership concentration strengthens the negative relationship between the auditor competence and the earnings management and institutional investors also strengthen the negativerelationship between the auditor competence and the earnings management.
Theoretical Review
Auditor Competence
The competence of an auditor will affect the quality of the audit results. If an auditor has good competence, so does the quality of the audit resulted. According to De Angelo (1981), audit quality is an opportunity for an auditor to find errors and violations in his/her client's accounting system. In other words, a good audit quality is when an auditor, in checking the company's financial statements, can find errors, both intentional (fraud) and unintentional (error), thus the information in the financial statements really representsanactual company's financial condition. The auditor competence in this study is seenthrough audit firm tenure. Firm audit tenure is anengagement period for a Public Accounting Firm to audit an organization's financial statements. The relationship period built between the Public Accounting Firm and the company will affect the auditquality. Shafie, Hussin and Yusof (2009) said that audit tenure positively affects the audit quality. It means, the longer the audit engagement period the better the competence of an auditor, thus the auditor can be more reliable in detecting the earnings management. In contrast, according to Deis and Giroux (1992), the longer the relationship between the auditor and the company is feared to damage theindependence of the auditor and ultimately reduce the auditor competence in auditing.Herusetya (2012) said that the best audit engagement period is within a medium term (4-8 years) because within that time the auditor has understood the client's business well without losing its independence.
Concentration of Company Ownership
Concentration of Ownership in a company is characterized by a controllingshareholder and non-controlling shareholder. The controlling shareholders have control and participate in the company's decision-making process. This position can be utilized by the controlling shareholder to control the manager running the company in accordance with the wishes of the controlling shareholder. This of course can provide benefits to the controlling shareholder and cause harm to the non-controlling shareholders. The control by the controlling shareholder can be obtained in 2 ways, namely through cash flow or crossholding (Diyanti, 2012). The control through cash flow is obtained by investing some money into the company, regarded as the controlling shareholder if the percentage of ownership exceeds 50%. The control through crossholding is obtained by means of a shareholder keeps having a small percentage of share ownership but increasing its control rights through investments in other companies. Therefore, Siregar (2007) said that the percentage of share ownership of more than 10% can already be categorized as a controlling shareholder.
Institutional Investors
Institutional investors are companies that collect funds from third parties for further reinvestment to other companies. Lee (2008) argued that the control function will be effective if shareholders have good knowledge in running business and in general this ability is owned by institutional investors. Mintzberg (1983) said that institutional investors can put pressure to the company on an issue or activity to be able to control the company through the membership of the company's board of directors.
Earnings management
The earnings management is usually done by the management to make the company performance look good by investors. This is due to the profit earned by the company in the current period is one measure of performance seen by investors when investing in a company.As revealed by Healy and Wahlen (1998) that the earnings management is one of the management's efforts to mislead investors in making decisions when assessing the company performance. Similar to Schipper's opinion(1989), theearnings management is done with anaim at obtaining personal gain by making changes to financial statements. When associated with the agency theory, the management is given freedom in managing the company in order to achieve the company’s objectives.This will be utilized by the management to make the earnings management in achieving the company’s objective.
Hypothesis Development
The practice of earnings management in a company can be minimized by employing an external auditor to audit the financial statements. The higher the competence of an auditor, the better the audit quality and the more reliable the auditor detects the existence of theearnings management practices within a company.
H1: Auditor competence has a negative impact on the earnings management practices in a company
The ownership structure concentrated in Indonesia causes the presence of controlling shareholders and non-controlling shareholders. The controlling shareholder will be involved in the management of the company, causing the controlling shareholder to have more control over the management, thus the chance of the earnings management practice can be reduced. Therefore, the second hypothesis of this study is
H2: The concentration of ownership has a negative relationship with the earnings management
In addition to individual investors, a company may also be an investor of another company where funds used to make investments are obtained from third party funds.Companies included in the institutional investor are financial institutions such as banks,insurance, pension funds and other financial institutions (Siregar and Utama, 2005). Unlikeindividual investors, institutional investors have responsibility for the investments they make because they come from a third party. It is responsibility that makes the institutional investor exercise strict control over the company. This can make the management focus by improving the company performance and not emphasizing on personal gain by doing the earnings management. Therefore, the third hypothesis of this study is as follows
H3: The investor institutional has a negative relationship with theearnings management
The presence of controlling shareholdersin a company can provide effective control over the management, thus managers focus on running the company at best and do not seek personal gain. Cooperation that occurs between the controlling shareholder and external auditors can reduce the chances of the earnings management in the company. This is due to the tight control exercised by the controlling shareholder and the increasing competence of the external auditors. Of the explanation, the fourth hypothesis of this study is as follows
H4: The concentration of ownership in a company will strengthen the negative relationship between auditor competence and the earnings management
External auditors with a high competence are expected to provide better audit quality thus institutional investors are not wrong in making decisions (Mitra et al, 2007). The presence of the institutional investors also makes the management improve their performance thus the opportunities for the earnings management practices can be reduced. Therefore, the hypothesis 5 of this study is as follows
H5: The presence of institutional investors in a company will strengthen the negative relationship between auditor competence and the earnings management
Study Method
StudyDesign
The following is a study design that analyzes the relationship ofthe external audit quality and the ownership structure with the earnings management in a company.
Population, Sample and Data
The population used in this study is all companies from the manufacturing industry listed in the Indonesia Stock Exchange (BEI).The use of manufacturing industry in this study is in an effort to obtain a sufficient number of samples to be used in this study. The periods of study conducted are2011, 2012 and 2013. The company criteria that can be sampled in this study is as follows: (1) Manufacturing company listed in the Indonesia Stock Exchange, (2) The company publishes audited and complete financial report in 2011-2013, (3) The financial statements should use rupiah currency in its financial reporting, (4) The financial statements have complete data for the measurements undertaken in this study.
The data in this study uses secondary data, i.e. data obtained indirectly or already processed. The data to be used in this study is obtained from the company's annual report from the official website of the Indonesia Stock Exchange ( and the company's official website and the Economic and Business Data Center owned by the Faculty of Economics and Business of Universitas Indonesia.
Study Model
To test the hypothesis that has been made, this study replicates the study model used by Kouaib and Jarboui (2014). The models used in this study areas follows
1. First Study Model
This model is used to test how the relationship of auditor competence, concentration ofownership and institutional investors with the earnings management. The first research model is as follows
2. Second Study Model
The hypothesis tested through this model is that an interaction between external auditquality and concentrated ownership has a negative relationship with the earnings management.
3. Third Study Model
The hypothesis to be tested through this model is the interaction between the quality of external audit and institutional investors having a negative relationship to the earnings management.
Remarks:
= The effect test of the interaction between the external audit quality and the institutional investor
=Dummy variable of auditor seniority, value 1 if the auditor experience is more than or equal to 3 years and value 0 if it is vice versa
=Total percentage of share ownershipwith the value of more than 10%
=Percentage of share owned by the institutional investor
=Natural logarithm of the total asset of the company
=Company debt structure
=Interference variable in the company
Operationalization of Study Variables
Dependent Variables
Dependent variables are variables influenced by other variables. The dependent variable in this study is the earnings management. The proxy used to measure the earnings management in this study is accrualdiscretionary based on the journal of Kothari et al (2005).The model owned by Kothari et al (2005) is a modified model of a mode owned by modified Jones (2001) by adding ROA as a control variable. The use of proxy owned by Kothari et al (2005) in this study is better because it represents the accrualdiscretionary compared to other models. This proxy is considered better because ROA as a control variable in this proxy has been shown to be part of the accrual discretionary policy component (Fitriany, 2011; Minar, 2012).
The accrual discretionary model used in this study is
Remarks:
The accrual discretionary value is obtained through the error value generated from the above calculation. In other words, the accrual discretionary is obtained by subtracting total accruals with other variables, to obtain an error value indicating the discretionary value of the accruals for each firm. The dependent variable used in this study is the absolute value of the accrual discretionary that has been obtained from the above equation. This accrual discretionary value indicates the accrual discretionary value regardless of whether the firm performs the earnings management to lower the value of profit or raise the value of profit.
=Total accrue of the company in the year of t
=Average total assets of the company in the year of t
=Change in the company sale in the year of t less the change in the company receiveables in the year of t and then divided by average total assets of the company in the year of t
=Gross fixed asset of the company in the year of t divided by average total assets of the company in the year of t
=Return on asset in the company in the year of t
=Interference variable in the company
The value of the accrual discretionary is obtained from the error value resulted from the above calculation. In other words, the accrual discretionary is obtained by deducting other variables from total accrual discretionary, thus an error value is resulted indicating the value of the accrual discretionary for each company. The dependent variable used in this study is the absolute value of the accrual discretionary obtained from the above equation. The absolute value of the accrual discretionary shows the value of the accrual discretionary without seeing whether the company performs theearnings management to lower profit value or increase the profit value.