Management Fraud Control And Audit Quality

It's well-known that accounting information is important for decision making. Poor quality of accounting information usually leads to serious economic consequences, what's even worse, management frauds. However, since 18th century when South Sea Company fraud gave birth to independent auditing, auditors and managements of companies have been play the game of cat and mouse owing to the prevalence of management frauds. In view of this, management fraud control and auditing quality have become inevitably historical and ever-existing research projects.Financial statements are prepared by management and audited by CPAs according to GAAPs. The accounting information illustrated by financial statements is after all financial and historical. The exposure of the information lags far behind the occurrences of business transactions in term of time. Nevertheless, auditing by CPA is regarded as an important line of defence against management fraud. In management fraud control, auditors enjoy their professional advantages and at the same time suffer from professional disadvantages. What's the theoretical basis for auditor controlling management fraud? Theoretically, high quality of auditing should have good performance in controlling management fraud and the other way round, controlling management fraud can help improve auditing quality. Can this theory be supported by data derived from empirical research? This article has 7 chapters.Chapter One is preface, introducing the background, issues and research methodology.Chapter Two is an overview of management fraud control and auditing quality. Firstly, the great influence of management fraud suing upon auditing code, process, information exposure, responsibility is reviewed. The ruling of management fraud cases demonstrates an increasingly conspicuous trend, that is, the auditor has increased responsibility to expose management fraud. The auditing circle is driven to modify and renew the auditing standards and the outdated auditing concepts to correspond to the changes of the legal environment and to upgrade their service. As a result, the auditing capacity for controlling management fraud has increased and narrowed expectation gap of the general public, leading to better operational quality. Secondly, the literature related to all the issues dealt with in this article has been examined, posing some revelation to definition of management fraud, subject sampling and arrangement of research content.Theoretical aspects of management fraud control and auditing quality research have been discussed in Chapter Three. When putting forth his theories of accountability and audit control, Professor Cai Chun (1991,2002) pointed out that auditing is a special economic control practice to secure full and effective fulfilling of accountability. Based on this theory, the author recognizes that accountability is the link between management fraud control and auditing quality, and controlling management fraud is social public's expectation of high-quality auditing and thus the prerequisite for auditing quality improvement. The well-known American Treadway Commission takes auditing by CPA as one of the four lines of defence against management fraud. In controlling management fraud, auditors have both professional advantages and disadvantages. The author argues that auditors can be guided by auditing principles like concepts of reasonable skepticism and due care, fraud reasoning, auditing judgment and auditing analytical techniques, although their independence can be undermined as rational economic people seeking personal interests.Research design is explained in Chapter Four and presents a sampling basis for follow-up positive research. First of all, sampling of government supervision and management fraud is structured. The scandal companies reported by CSMAR database of regulation breaching companies are used as the sample source.198 sample companies in the database have been selected. (1)The year of 1998 is used as the starting time for the samples because cash flow data are used in the empirical research. (2)Since the data quoted in the auditing reports used in the research are from the annual accounting statements of the sample companies, the sample regulation-breaching companies with only half-year, quarterly or temporary reports, prospectus for listed company, listed company statement, prospectus for right share issuing and new share issuing are sifted out.The indicators of fraud identification in accounting reports are selected in the following way: (1)Scandal-free companies in the same industries, in the same accounting period, with similar assets, with the management fraud companies are found as the matching samples; (2)Non-parametric tests are done to the financial indicators of management fraud sample group and their matching sample group to obtain 3 indicators showing remarkable difference between the two groups. (3)The 3 indicators are used as explanatory variables for regression analysis, showing that the degree of connected transaction is the most remarkable financial indicator in recognizing management fraud. Based on this indicator, 198 management fraud sample companies are sorted out owing to their excessive connected transactions. Finally, Modified Jones Model is employed to measure earnings management and identify 198 samples in which management fraud is possible due to excessive earnings management. Hence, 594 management fraud samples are acquired for follow-up empirical research.Chapter Five is about examination of the relationship between high-quality auditing and management fraud control by positive research. As is indicated by examination of the correlation between auditing statements and management through positive research, although a huge number of cases about auditors failing to identify the frauds in financial states of listed companies have been covered by both Chinese and foreign presses, triggering off public's suspicion of auditors'role in social economies and their capabilities for exposing management fraud, on the whole, auditors can give their audit opinions in a scrupulous way and can say"No"by presenting modified audit opinion(MAO).Secondly, the nine biggest Chinese auditors and the five biggest auditing companies in the world in Chinese auditing market are used as the alternative variables for the high-quality auditing to examine the performance of high-quality auditing in management fraud control. As is shown in the results of positive research, in Chinese auditing market from 2001 to 2003, the Chinese"Big Nine"performed quite well in management fraud control but poorly in controlling the risk of management fraud, while the World"Big Five"performed poorly in both the above-mentioned fields. The findings of the positive research in this article and findings by other scholars show that the so-called"highly qualified auditors"can't play their roles in Mainland China if the institutional arrangement for independent auditing remains the same.The correlation between management fraud control and auditing quality is examined by positive research is discussed in Chapter Six. Using auditor's response to conservatism and discretionary accruals as alternative variables of audit quality, the author examines the correlation between management fraud control and conservatism, the correlation between management fraud control and discretionary accruals by positive research. The first correlation research reveals that auditors recognized that discrepancies in conservatism among the listed companies conducting management fraud. This represents a new perspective for accounting information users to reason conservatism of listed companies. The second correlation research demonstrates that auditor's controlling of management fraud and its risk helped decrease the discretionary part of profit appearing in the listed company's reports and thus improved the quality of earnings of the listed company.Conclusions, limitations and suggestions for follow-up research makes Chapter Seven. In this chapter, the major conclusions are summarized, limitations pointed out, suggestions on future research put forth.Based on the existing research work, the author has tried to make the following innovations:First, the author not only has selected sample companies conducting management fraud utilizing the results of government supervision, following common practices of research, but expanded the field of management fraud research by sampling the companies exposing to management fraud risks by recognizing fraud in accounting reports and measuring earning management.Second, the author inherited the definition of conservatism by Ball and Shivakumar (2005) so that the confirmation of economic losses can be conducted much easier and quicker than that of economic gains. The introduction of management fraud control variables has helped to reexamine and upgrade Ball and Shivakumar's piecewise-linear regression model (2005). The conclusions drawn from positive research sheds light on the fact that auditors recognized the discrepancies in conservatism among listed companies harboring management fraud on the whole. This can serve as a new perspective for accounting information users to reason out the conservatism of listed companies.Third, as is indicated by the results of nonparametric test using discretionary accruals as the alternative variables of audit quality, the discretionary accruals of the sample companies under management fraud control are lower than those of the sample companies under no management fraud control. This implies that the reported earnings of listed companies is the outcome of interaction between managements and auditors. The auditors controlled the risk of management fraud and decreased the discretionary part of the earnings in the reports of listed companies, providing data support to the argument that controlling the risk of management fraud can help improve the earnings quality of audited companies.