Do audit firm and audit costs/fees influence earnings management in Swedish municipalities?

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 commercial logics, and that this is reflected in the clients’ propensity to engage in earnings management. 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 management. 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.