Earnings quality under financial crisis of 2008: a global empirical investigation

Abstract

This PhD paper investigates a) the impact of the financial crisis of 2008 on earnings quality, b) the joint effect of financial crisis of 2008 and investor protection on audit quality, c) the joint effect of audit quality and investor protection on earnings quality and d) the cost of capital and the changes of audit quality and earnings quality influencing on it due to financial crisis of 2008 in publicly listed firms in advanced countries as per level of investor protection. The sample is categorized into three clusters. Cluster 1 is referred as outsider economies with strong outsider protection and legal enforcement and clusters 2 and 3 are referred as insider economies with better and weaker legal enforcement systems respectively. Using linear regression analysis, 137.091 firm-years observations are analyzed, the earnings quality is examined by using 10 different measures (conservatism, value relevance, accruals quality, earnings persistence, earnings predictability, loss avoidance analysis and earnings smoothness), the audit quality is examined by using 6 different measures (audit fees, modified audit report opinion, auditor switch, status of audit firm, existence of audit committee and demand for auditing), the investor protection is examined by using 8 different metrics adopted from World Economic Forum (property rights, judicial independence, transparency of government policymaking, strength of auditing and reporting standards, efficacy of corporate boards, protection of minority shareholders' interests, strength of investor protection and legal rights index), and the cost of equity capital under constant growth model introduced by Palea (2007) and under PEG ratio method introduced by Easton (2004) is examined. The results are mixed among clusters and research periods. Specifically, first, the results show that during the financial crisis, earnings quality is decreased. However, this deterioration on earnings quality appears to be more severe in clusters 2 and 3 which are characterized by medium and weak shareholder protection. Particularly, for all clusters, the study shows that in an attempt to cope with recession, managers have an incentive to choose more aggressive conservatism, lower the earnings predictability and book more accruals. Countries in clusters 2 and 3 report more relevant financial numbers and follow artificial smoothing during the financial crisis while the countries in cluster 1 are to some conflicting. Second, the results show that all measures of audit quality is positively associated with most of institutional factors of investor protection in all clusters except audit fees which is not correlated with none of investor protection indexes. Third, against of expectations, it is found that audit quality is lower during financial crisis in all clusters and in most of audit quality measures. Fourth, the findings indicate that audit quality is higher (lower) in firms with strong (weak) investor protection and legal enforcement during financial crisis in all clusters except from audit fees. Fifth, it is reported that earnings quality is stronger (weaker) in countries with strong (weak) investor protection in all clusters in pre and crisis period. Sixth, the results confirm the findings of vast majority of previous literature that higher (lower) audit quality implies higher (lower) earnings quality in all clusters, irrespective of the financial crisis. Seventh, this PhD paper indicates that higher (lower) audit quality implies higher (lower) earnings quality in countries with high (low) investor protection in all clusters, irrespective of the financial crisis. Eighth, the results show that the financial crisis of 2008 has had positive impact on the cost of equity capital for all clusters and the cost of debt for clusters 1 and 2. The cost of equity is negatively associated with firms that are audited by Big Four auditors and have an audit committee in all clusters, and with firms that switch auditors in cluster 2. Firms that are audited by Big Four auditors in cluster 1, firms with a modified audit report in cluster 2 and firms that have an audit committee in cluster 3 have a negative association with the cost of debt. This study also shows that the association between earnings quality attributes and cost of capital is significantly negative before and during the crisis. Overall, the findings offer crucial insights to post crisis management, auditors, regulators and accounting standard setters in stabilizing investors’ confidence and enhancing firm growth after the 2008 financial crisis.