7. external auditos & eanings management in france_piot et janin_2007

7/28/2019 7. External Auditos & Eanings Management in France_Piot Et Janin_2007

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External Auditors, AuditCommittees and EarningsManagement in France

CHARLES PIOT & REMI JANIN

GSCM Montpellier Business School, CEROM, Montpellier, France and CERAG-CNRS, Pierre Mendes France University, Grenoble Business School,

Grenoble, France

ABSTRACT We investigate the effect of various audit quality dimensions (i.e. auditorreputation and tenure, audit committee existence and independence) on earnings

management in France. We thus contribute to the empirical audit quality literature in aContinental European environment that markedly differs from the USA in terms ofauditing and corporate governance. The main findings are that: (1) the presence of anaudit committee (but not the committees independence) curbs upward earningsmanagement; and (2) the presence of a Big Five auditor makes no difference regardingearnings management activities. Implications of these findings are discussed with regardto the specificities of the French auditing and governance settings. In particular, althoughthe audit committee acts as a device to control the more egregious (i.e. income-increasing) forms of earnings management, the monitoring incentive of outside directorsmay be hampered by the collective board responsibility for financial reporting quality.Second, the lack of differentiation among Big Five auditors in terms of accounting

conservatism is consistent with the lower litigation risk offered by the French Civil Code(vs. the US Common Law system), which is likely to eliminate the deep pocketsincentive for investors.

European Accounting Review

Vol. 16, No. 2, 429454, 2007

Correspondence Address: Charles Piot, Associate Professor, CEROM Research Centre, Montpellier

Business School, 2300, avenue des Moulins, F-34185 Montpellier Cedex 4, France. Tel.: 33 4 67

10 28 02; Fax: 33 4 67 45 13 56; E-mail: [email protected]


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1. Introduction

In the context of the many financial scandals challenging the credibility of the

audit function, numerous studies tend to establish a positive relation between

audit quality surrogates auditor and audit committee characteristics and

the quality of financial reporting by listed companies. Among these empiricalworks, a growing number address earnings management,1 which can be

defined as the use of managerial discretion to influence the accounting figures

published to the companys stakeholders (Degeorge et al., 1999, p. 2). Virtually

all these studies address US firms.

In this paper, we extend the earnings management literature to the French

context, which proves especially interesting in a Continental European environ-

ment that markedly differs from the Anglo-Saxon systems in terms of auditing

and corporate governance. First, the strong legal protection of auditor indepen-

dence in France (i.e. a six-year audit engagement, mandatory joint-auditing) vs. the more self-regulated Anglo-Saxon model suggests a greater ability of

auditors to resist managerial pressure and keep earnings management practices

in check. Second, however, the lower litigation risk, as compared to the respon-

sive US litigation system, may increase the tolerance of audit firms toward oppor-

tunistic accounting practices. Third, the setting up and organisation of audit

committees are currently recommendations, thus allowing listed companies

important discretion whether to involve corporate directors in audit quality

matters. Hence, following the US investigations by Klein (2002a) and Bedard

et al. (2004), the French setting offers the opportunity to appraise the role of

audit committees with regard to the quality of earnings, and to provide some

insight into normative developments regarding the functioning of these monitor-

ing devices.

In this paper we perform empirical tests using abnormal accruals estimated by

cross-sectional versions of the Jones Model (1991), for the main French listed

companies over a three-year period (19992001). Abnormal accruals are con-

sidered in signed value form (proxying for conservatism), and in absolute

value (measuring the overall propensity to earnings management). The main

empirical findings are that: (1) signed abnormal accruals decrease when an

audit committee is present, but the audit committees independence has no sig-

nificant effect on accruals measurements; and (2) that Big Five-audited compa-

nies do not differ from others in terms of absolute and signed abnormal accruals.

These findings contribute to the institutional debates regarding financial report-

ing quality, in relation to the French characteristics of auditing and corporate gov-

ernance. First, audit committees stand as potentially valuable audit quality

devices, because they constrain the more egregious (i.e. income-increasing)

form of earnings management. However, contrary to the US findings of Klein

(2002a) and Bedard et al. (2004), the role of independent audit committees

does not emerge. This could be due to the lack of explicit guidelines about themonitoring duties of outside directors, and to the collective board responsibility

430 C. Piot & R. Janin


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for financial reporting quality. This French collegial liability system may render

sterile any further recommendation or regulation regarding the role of outside

directors: reforming the corporate law on this question might then be of interest.

Second, the lower litigation risk offered by the French Civil Code (vs. the more

responsive US Common Law system) makes the large audit firms less exposed to

the deep pockets incentive. Therefore, they do not have to handle this litigation

threat by adopting a more conservative attitude with respect to earnings manage-

ment, as empirically documented in the US market (Becker et al., 1998; Kim

et al., 2003).

Section 2 reviews the literature on relations between accruals and audit quality

attributes, and then specifies the research hypotheses with reference to the French

setting. Section 3 deals with methodological aspects. Section 4 reports and dis-

cusses the empirical results, and Section 5 reviews the main contributions of

the paper.

2. Literature, Institutional Background and Hypotheses

Conceptually, audit quality is the joint probability that the external auditor

detects an anomaly in financial statements, and then reveals it to the external

users (DeAngelo, 1981). The probability of detection is a matter of competence,

whereas the probability of revelation depends on independence, that is, the audi-

tors willingness to face the pressure exerted by the preparers of financial

statements.

In reaction to financial scandals, efforts implemented in the last few years torestore investors confidence in financial reporting suggest that audit quality

does not solely focus on external auditors, but also includes a monitoring over-

sight by audit committees. In the USA, this reaction finds expression by challen-

ging the self-regulation of the accounting profession (e.g. the Public Company

Accounting Oversight Board), and by more restrictive rules on audit committees

(e.g. SarbanesOxley Act, Sections 301 and 407). In France, the institutional

context is markedly different. Historically, the auditing profession has been

strictly state-regulated, especially with regard to independence. However, audit

committees are not required, but only recommended by corporate governancereports (Vienot, 1995, 1999; Bouton, 2002). This allows listed companies import-

ant latitude whether to involve directors in the audit process.

2.1. External Auditors and Earnings Management

The quality of the external audit, unobservable to the public, is commonly

proxied by auditor size or reputation (DeAngelo, 1981; Klein and Leffler,

1981), or by the length of the auditorclient relationship (Knapp, 1991).

Auditor reputation and earnings management. In contrast with the scandals

that challenge the credibility of well-known audit firms, many academic

studies tend to demonstrate that the brand name audit networks (the Big Eight

Audit Committees and Earnings Management in France 431


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todays Big Four) are statistically more conservative in their opinions, and

are more likely to constrain opportunistic accounting practices. DeFond and

Jiambalvo (1993) find that auditorclient conflicts relating to income-increasing

accounting practices are more likely to occur if the auditor is one of the Big Eight,

and conclude that these audit firms are more likely to resist managerial pressure

and maintain an independent opinion. Becker et al. (1998) observe a positive

relation between abnormal accruals and the presence of a non-Big Six auditor.

On the NASDAQ, Francis et al. (1999) also observe a lower level of abnormal

accruals among Big Six-audited companies. These findings are commonly

interpreted by the fact that Big N auditors have to maintain their reputation

capital, and therefore provide quality-differentiated services which imply a

lower tolerance towards earnings management in general. Given that this

quality differentiation is perceived to operate homogenously worldwide, we

state the following first hypothesis in the French context:

H1a: Big Five-audited companies exhibit less earnings management in general.

However, researchers also bring forward auditors asymmetric monitoring of

the earnings management problem, that is, less tolerance in the case of

income-increasing earnings management, and more leniency toward income-

decreasing accruals. Francis and Krishnan (1999) find that firms with largely

positive abnormal accruals are more likely to receive a modified audit report.

Nelson et al. (2002) emphasise that audit adjustments are more frequent in

income-increasing (vs. income-decreasing) situations. In the UK, Gore et al.(2001) find that the Big Five curb threshold-induced, income-increasing abnor-

mal accruals. An explanation for this conservative attitude is generally believed

to be the risk of legal action, and more specifically the deep pockets incentive

commonly attached to brand name auditors. Kim et al. (2003) show that the

Big Five are more cautious than other auditors only in situations of income-

increasing earnings management. They interpret this asymmetric monitoring as

a consequence of the pressure the US judicial system exerts on the Big audit

firms.

The deep pockets argument is less likely in France because of the lowerresponsiveness of the Civil Law litigation system in protecting investors

rights (La Porta et al., 1997, 1998). Also, Coffee (2001) stresses the historical

passivity of the French stock market authority in developing a self-regulatory

structure and high-quality disclosure standards. The litigation system remains

specifically more protective; by imposing a heavier formalism than Common

Law principles, the Civil Code implicitly limits auditors third-party liability.

Notably, it is difficult to establish an auditors professional fault in view of his

due diligence (i.e. an obligation of means), and it is frequently impossible to

prove a direct causality between this fault and the damages suffered by the plain-

tiffs. In practice, the reluctance of French judges to convict management and

auditors stands out in two recent court decisions namely the Credit Lyonnais



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and Pallas-Stern affairs (Stolowy, 2005). Further, the US judicial system allows

class action suits and contingent fees. According to the Securities Act, it is

enough for investors to claim that they trusted audited financial statements

when investing in a company, that these statements proved to be deceptive or

fraudulent, which caused a drop in stock prices (Menon and Williams, 1994).

Class actions and contingent fees are not allowed in France, and the activism

of minority shareholders generally requires a formal association of plaintiffs,

thus reducing the deep pockets incentive for investors. Consistently, Piot

(2005) finds that riskier firms do not necessarily appoint high-profile auditors.

Hence, the asymmetric monitoring of earnings management by large auditors

should not prevail in France.

H1b: Big Five-audited companies do not differ from others with respect to the

conservatism of reported earnings.

Auditor tenure and earnings management. Standard-setters tend to argue that an

overly long auditorclient association is a threat to independence. They assert

that personal ties and familiarity tend to develop and may lead to less vigilance

by the auditor, and even to a tolerant attitude towards the companys manage-

ment. Aside from this threat to independence, the audit engagement may

become routine over time, and the auditor may devote less effort to identifying

the weaknesses in internal control and potential risks. Knapp (1991) studied

auditor tenure and competence using the perception of US audit committee

members, finding that the likelihood that an auditor detects an anomaly increasesin the first years of appointment, and then decreases gradually, reaching its

weakest level after 20 years of service. As a whole, it is commonly assumed

that audit quality decreases with auditor tenure. In reaction, and without mandat-

ing auditor rotation,2 stock market authorities generally impose a rotation of

engagement partners. In the USA, this rotation was reduced from seven to five

years by the SarbanesOxley Act. In May 2002, the European Commission rec-

ommended a seven-year rotation of engagement partners. Most Member States,

including the French market authority, have followed this recommendation.

However, the theory that auditor tenure is inversely related to audit qualityis far from being corroborated empirically. Lys and Watts (1994) report that

the likelihood of an auditor being sued is not related to his tenure. Geiger and

Raghunandan (2002) find that the issuance of a going-concern report prior to

bankruptcy is a positive function of auditor tenure, suggesting that the quality

of auditor reporting improves over time. Furthermore, the magnitude of abnormal

accruals is found to be negatively associated with auditor tenure (Frankel et al.,

2002; Myers et al., 2003), and positively influenced by a dummy indicating a

short, two- or three-year tenure (Johnson et al., 2002). Finally, Ghosh and

Moon (2005) document that the perceived quality of earnings, proxied by earn-

ings response coefficients, increases with auditor tenure. Hence, these US studies

refute the hypothesis that audit quality deteriorates over time



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In France, auditors are appointed for six fiscal years. Their mandate and to

some extent their tenure thus enjoys a legal protection, initially enforced to

mitigate opinion-shopping opportunities.3 But this protection may have adverse

effects; by cutting market forces, it accelerates the formation of rents and the

auditors economic dependence on his client (Pige, 2000). If so, the capacity to

resist managerial pressure is likely to decrease over time. In line with this, the

hypothesis of a positive association between earnings management and auditor

tenure is proposed.

H2: Auditor tenure is associated with higher levels of earnings management.

2.2. Audit Committees and Earnings Management

An effective audit committee adds to the quality of the audit process at two levels.

First, by supervising major accounting choices, the committee should mitigateearnings management practices. Second, by coordinating the internal and exter-

nal audits, and by protecting external auditors independence from managerial

pressure (McMullen, 1996), the audit committee should maximise the likelihood

that irregularities discovered by auditors will be reported at a sufficiently high

level.

US empirical studies tend to highlight a negative relation between the indepen-

dence and/or expertise of the audit committee and the magnitude of abnormalaccruals, although the consensus is unclear due to the diversity of the approaches

used. Klein (2002a) finds that board or audit committee independence measured either by the proportion of independent directors or by their majority

in both structures reduces abnormal accruals in absolute value. However,

she reports insignificant effects for completely independent audit committees.

Bedard et al. (2004) find that the likelihood of aggressive earnings management

(i.e. markedly positive or negative abnormal accruals) decreases if the audit com-

mittee includes a financial expert or an expert in corporate governance, and if it is

composed entirely of independent directors. Their findings are thus in line with

SarbanesOxley regarding fully independent audit committees, contrary to the

study by Klein (2002a). However, Xie et al. (2003), studying the S&P500, asdid Klein, do not observe any impact of the proportion of independent audit com-

mittee members on abnormal working capital accruals. In the UK, Peasnell et al.

(2000a) find that the presence of an audit committee4 has no direct influence on

abnormal working capital accruals, but allows board independence to mitigate

income-increasing earnings management, and thus indirectly enhances the moni-

toring role of independent directors.

Audit committees have developed among French listed companies since the

first Vienot Report in 1995. Although they now tend to be present in the

largest companies, their creation remains a voluntary decision, and no explicit

regulation exists on audit committees (except for financial institutions).

However advisory panels have defined the role and missions of audit committees



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similar to the American model. The Vienot 1 Report states that the committee

should: (1) examine the relevance and consistency of accounting methods

with a special focus on transactions potentially associated with conflicts of inter-

ests; (2) appreciate the reliability of internal control and reporting systems; and

(3) meet privately with the CFO, internal and external auditors. The Vienot 2

Report (1999) completes this framework insisting on the appreciation of external

auditors independence, and on the examination of accounting standards for con-

solidated financial statements. Piot (2004) documents that the existence of audit

committees in France is positively associated with the extent of shareholder

manager and debtholder conflicts. Therefore, audit committees seem to

respond to a monitoring demand by fund providers, either outside shareholders

or debtholders. We then formulate the following third hypothesis:

H3: The existence of an audit committee is associated with less earnings

management.

However, as evidenced by institutional debates and empirical research,

the question of independence is essential to effective monitoring by audit

committees. The related French guidelines remain well behind the stricter

US requirements. The Vienot 2 Report recommends a minimum of only

one-third of independent directors on audit committees; the Bouton Report

(2002) mentions an objective of two-thirds. This evolution suggests an

increasing pressure for more independent audit committees, but still provides

listed companies with a lot of discretion on that question. Piot (2004)observes a negative relation between several measures of audit committees

independence and inside ownership, supporting the view that more indepen-

dent committees are a response to monitoring needs. We then test the follow-

ing fourth hypothesis:

H4: The independence of the audit committee is associated with less earnings

management.

3. Data and Methodology

3.1. Sample

We investigate the main companies on the French stock market, and more specifi-

cally the SBF 120 Index companies, of which approximately half had set up an

audit committee by the end of 1998 (Thiery-Dubuisson, 2002). These companies

offer relatively precise disclosures about their auditors and their corporate gov-

ernance organisation. To avoid the limitations of purely cross-sectional analyses,

we considered three consecutive financial years: 1999, 2000 and 2001. In the

French corporate governance context, this timeframe spans the second Vienot

Report (July 1999) and the Bouton Report (September 2002) The targeted



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sample comprises 102 non-financial firms5 which were included in the SBF 120

Index at least once during 19982002. Details about the sampling procedure are

provided in the Appendix.

3.2. Determination of Abnormal Accruals

We assume that the discretionary component of accounting earnings is mostly

found in accruals. Total accruals are calculated for each firm i in the year t

with the following indirect formula:6

TAit DSTAit DSTLit DepExpit AmortExpit DLTDefExpit DProvit

where i 1102, t 1999, 2000, 2001 and:

. DSTA change in Short-Term Assets (STA inventories customersreceivables other receivables short-term deferred expenses, all in gross

values),

. DSTL change in Short-Term Liabilities (STL payables to suppliers

social and fiscal payables other payables deferred revenues),

. DepExp Depreciation Expenses relating to Short-Term Assets,

. AmortExp Amortisation Expenses concerning fixed assets,

. DLTDefExp change in Long-Term Deferred Expenses,

. DProv change in Provision for risks and charges.

We further estimate the abnormal component of total accruals using the Jones

(1991) cross-sectional industry model. Industries are classified according to the

three-digit NAF code (French codification roughly similar to the US SIC one).

Industries that do not contain at least six companies in the Diane database

used to estimate regression coefficients are dropped. Formally, the following

Jones Model is estimated for each industry j and year t:

TAjt a1 b1:GPPEjt g1:DREVjt 1jt

where (all variables including the intercept a1 are scaled by lagged total assets):

. TA Total Accruals,

. GPPE Gross Property Plant and Equipment Long-Term Deferred

Expenses,7

. DREV change in Revenue,

. e random error term.

The sign of coefficient b1 is expected to be negative due to the increase in

amortisation expenses when companies invest. The sign of g1, generally

expected to be positive accounts for the normal increase in working capital



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when companies turnover grows.8 For each firm i and year t, the abnormal

accruals according to the Jones Model (designated by AbnAcc1) are then calcu-

lated by difference between total and expected accruals:

AbnAcc1it TAit a1 b1:GPPEit g1:DREVit:

Furthermore, Dechow et al. (1995) have shown that the Jones Model is not

well specified for companies with extreme cash flows. Hence, given the

usually strong correlation between accruals and cash flows (Dechow, 1994),

the following CFO Model (Jeter and Shivakumar, 1999) is also estimated for

each industry j and year t:

TAjt a2 b2:GPPEjt g2:DREVjt d2:CFOjt 1jt

with CFO obtained by difference between net income before goodwill amortisa-tion and total accruals (all scaled by lagged total assets). The sign of coefficient

d2 is expected to be negative. Abnormal accruals according to the CFO Model

(designated by AbnAcc2) are then calculated as follows:

AbnAcc2it TAit a2 b2:GPPEit g2:DREVit d2:CFOit:

Descriptive statistics for the 146 industry-year OLS regressions9 to estimate

the accruals models are disclosed in the Appendix. As expected, the coefficient

of DREV is positive on average and in the median, and the coefficients ofGPPE and CFO are negative. When CFO is introduced in the accruals model,

the coefficient of GPPE decreases sharply in absolute value (from 20.081 to

20.019), while the coefficient of DREV increases noticeably (from 0.027 to

0.055).

Descriptive statistics for total and abnormal accruals are reported in Table 1. Of

the 306 firm-years initially targeted, we obtain 255 usable observations. This loss of

observations is attributable to: (1) missing data in the Diane database, (2) the

minimal requirements of six firms to estimate the accruals models, and (3) the elim-

ination of outliers, when the observed value for AbnAcc1 or AbnAcc2 falls out of arange of three standard deviations around the average. Total accruals are signifi-

cantly negative on average (p , 0.01), reflecting the weight of income-decreasing

components (e.g. amortisation expenses, provisions for risks and charges). The

ANOVA does not reveal any significant differences for TA over the three years.

Abnormal accruals are significantly positive on average (p , 0.01) when esti-

mated with the CFO Model, and not statistically different from zero when

derived from the Jones Model. Also, the Jones Model produces more dispersed

abnormal accruals as evidenced by the extrema (20.439 and 0.478 compared to

20.242 and 0.290 for the CFO Model). These statistics suggest that model specifi-

cation affects the estimated abnormal component of accruals; it is thus of interest to

run empirical tests using both approaches in parallel



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3.3. Audit Quality Variables

As for the global audit market, the Big Five dominate the segment of French

listed companies during 19992001. The legislation requires that consolidated

financial statements be certified by at least two distinct statutory auditors

(Commerce Code, article L823-2), who are jointly liable for the opinion deliv-

ered.10 This joint-auditorship, which applies to the entire sample of this study,

is perceived to promote audit quality in two ways: (1) by offering a reciprocal

check of auditors diligences; (2) by diluting managers pressure However the

Table 1. Descriptive statistics for the pooled sample (19992001)

Variable Meana Median Std. dev. Min Max NANOVAf-stat.b

Accruals variables

TA 20.026 20.030 0.103 20.380 0.482 255 0.482AbnAcc1 0.004 0.003 0.113 20.439 0.478 255 0.643AbnAcc2 0.019 0.021 0.074 20.242 0.290 255 2.631

jAbnAcc1j 0.077 0.050 0.083 0.000 0.478 255 3.250

jAbnAcc2j 0.055 0.035 0.053 0.000 0.290 255 1.948Audit quality variablesBig5 0.833 1 0.373 0 1 246 0.604AudTen 9.647 7.553 7.966 0.504 46.559 221 0.081AC 0.627 1 0.485 0 1 241 0.851ACInd50 0.355 0 0.479 0 1 234 1.258Control variables

%Managers 0.139 0.005 0.215 0.000 0.932 247 0.716Lev 0.965 0.715 1.181 0.000 14.630 254 0.613Assets (ME) 10,774 2,485 20,782 57 150,738 255 0.513BdInd 0.417 0.429 0.235 0.000 1.000 239 0.172CFO 0.079 0.083 0.121 20.397 0.455 255 1.604

at-Statistic from the nullity test: TA (23.96 ), AbnAcc1 (0.58), AbnAcc2 (4.00 ). Percentage of

positive observations: TA (30%), AbnAcc1 (53%), AbnAcc2 (67%).bOne-way ANOVA according to the year distribution (1999, 2000 or 2001)., and denote significance at p , 0.05, 0.01 and 0.001, respectively (two-tailed).

Variables definition: TA Total Accruals, AbnAcc1 Abnormal Accruals derived from the Jones

Model, AbnAcc2 Abnormal Accruals derived from the CFO Model, jAbnAcc. . .

j absolutevalue of Abnormal Accruals, Big5 1 if one of the statutory auditors (at least) is a Big Five

auditor, and 0 otherwise, AudTen time (in years) between the financial year end and the date of

first nomination of the leading auditor, AC 1 if an audit committee is present, and 0 if not,

ACInd50 1 if an audit committee with a majority of independent directors is present, and 0 if

not, %Managers proportion of common shares owned by top executives, Lev debt-to-equity

ratio, Assets total consolidated assets (in million euros), BdInd proportion of independent direc-

tors on the board, CFO (net income before goodwill amortisation total accruals)/lagged totalassets.

The accruals variables, firm size, leverage and CFO are extracted or calculated from the

Diane database. Other exogenous variables have been coded manually from the companies annual

reports.



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effectiveness of this mechanism is based, to a large extent, on the allocation of

equivalent means of control to both auditors. In practice, joint-auditorship is

often characterised by a leading auditor, who imposes its quality standards,

and a second auditor of a lower calibre. Investigations by Le Maux (2004)

show, in a more disquieting manner, that the distribution of fees between the

co-auditors and probably the budgeted audit hours is far from being

equal. In this context, the quality of the external audit can be proxied by the

characteristics of the dominant auditor. Auditor reputation is captured with a

dummy variable (Big5), coded 1 if the firm has at least one Big Five among

its auditors, and 0 if not. Auditor tenure refers to the leading auditor, based

on the market structure. Piot (2001) identifies four categories of auditors

according to size and reputation criteria: (1) the Big Five, (2) the two largest

national networks (Mazars & Guerard, Salustro Reydel), (3) the five other

Majors, and (4) the smaller audit firms.11 When both co-auditors pertain

to the same category, the tenure retained is that of the oldest, assumed to bethe leader. Hence, AudTen designates the time elapsed (in years) between

the financial year end and the date when the leading auditor first entered

into function.

The presence of an audit committee is captured by a dummy variable (AC).

Independent audit committees are qualified according to the majority rule

(Klein, 2002a), which is overall consistent with the two-thirds of independent

members recommended by the Bouton Report given that most audit committees

comprise three members. The dummy variable ACInd50 is then coded 1 if

the firm has an audit committee composed of more than 50% of independentdirectors, and 0 if not.12 The concept of an independent director in France is

comparable to the Anglo-Saxon views: a director is independent if he has no

relationship whatsoever with the company, its group or its managers, which

could compromise his freedom of judgement (Bouton, 2002, p. 9, translation).

Practically, directors qualify as independent if they conform to the following

criteria:

. They are not part of the top management nor have the same family lineage as

one of the top managers (presumption of family ties).. They hold neither executive functions in a company of the group nor in the

parent company, if any.

. They are not themselves, or do not represent, a significant shareholder of the

company.13

3.4. Control Variables

We control for contracting motivations regarding earnings management, and for

the monitoring constraint offered by the whole board of directors.

Contracting motivations. Agency conflicts are likely to provide incentives and

opportunities for accounting manipulations If the separation between ownership



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and control is important, managers may be tempted to manipulate earnings to

maximise their bonus, improve their performance and reputation, or protect

themselves from hostile takeovers (Salamon and Smith, 1979). Thus, the

weaker the managerial ownership, the more likely a strategy of income-increas-

ing earnings management exists. The direct and indirect ownership fraction of top

managers (%Managers) is used to control for the extent of shareholder manager

agency conflicts (Jensen and Meckling, 1976).

The intensity of shareholderdebtholder conflicts increases with leverage. The

higher the leverage ratio, the greater the risk that some debt covenants will be

breached (Smith and Warner, 1979), and the higher the cost of debt financing.

As debt increases, companies may therefore resort to income-increasing account-

ing practices in order to present a more favourable financial position when nego-

tiating with lenders. A positive relation should then be observed between

abnormal accruals and the debt-to-equity ratio (Watts and Zimmerman, 1986).

This ratio is denoted by variable Lev in our model.Finally, large companies may engage in income-decreasing earnings

management in order to mitigate political pressure (Watts and Zimmerman,

1986). This political costs hypothesis suggests a negative relation between abnor-

mal accruals and firm size, measured with the natural logarithm of total assets

(LnAssets).

Monitoring constraint offered by the board of directors. The board of directors

is ultimately responsible for the quality of financial reporting. Vigilant monitor-

ing by the board itself may keep opportunistic earnings management in check.

Given that effective monitoring requires directors who are sufficiently indepen-dent from those proposing the accounting policy, an independent board is a

priori more inclined to cast a critical eye over accounting choices made by man-

agers. Empirical studies tend to document a negative relation between abnormal

accruals and board independence (Peasnell et al., 2000a; Klein, 2002a; Xie

et al., 2003). We control for this effect with the proportion of independent

directors on the board (BdInd), defined according to the independence criteria

mentioned above.

Table 1 provides descriptive statistics. It can be seen that 83% of financial

statements are certified by at least one Big Five, and that the average tenure ofthe leading auditor is 1.5 times the six-year legal mandate (9.6 years). In addition,

63% of observations mention the existence of an audit committee; but when

present, the committee comprises a majority of independent directors in only

55% of the cases. Independent directors account for 42% of the board on

average; the recommended minimum threshold increasing over the period from

33% (Vienot 2 Report, 1999) to 50% for companies with diffused ownership

(Bouton Report, 2002). The correlation matrix in Table 2 confirms the strong

negative correlation between abnormal accruals drawn from the Jones Model

and the CFO variable (20.613, p , 0.0001), whereas this correlation is virtually

not different from zero (20.104, p 0.096) if the CFO Model is used to estimate

abnormal accruals



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Table 2. Spearman rank correlation ma

AbnAcc1 AbnAcc2 jAbnAcc1j jAbnAcc2j Big5 AudTen AC

AbnAcc2 0.585

jAbnAcc1j 0.014 0.085jAbnAcc2j 0.256 0.381 0.385

Big5 20.004 20.013 20.061 0.032AudTen 0.006 20.020 20.008 20.157 20.146

AC 20.144 20.190 20.066 20.186 0.313 20.052ACInd50 20.028 20.069 20.021 20.165 0.168 20.028 0.586

%Managers 20.008 0.060 0.072 20.012 20.248 20.055 20.407

Lev 20.025 20.164 0.025 20.250 0.175 0.087 0.178

LnAssets 20.061 20.077 20.082 20.255 0.192 0.073 0.488

BdInd 20.072 20.062 20.078 20.072 0.282 0.075 0.159

CFO 20.613 20.104 20.021 20.096 20.057 0.026 20.004

, and denote significance at p , 0.05, 0.01 and 0.001, respectively (two-tailed).


14/27

4. Empirical Results

4.1. Univariate Tests

Table 3 reports univariate tests on abnormal accruals after having

partitioned the sample according to external auditors characteristics (repu-

tation, tenure).

In absolute values, Big Five-audited companies exhibit slightly inferior

abnormal accruals according to the Jones Model, but similar ones according

to the CFO Model. In both cases, the comparison proves insignificant, thus

rejecting H1a. In signed values, although abnormal accruals are lower for

Big Five-audited companies on average, insignificant comparison tests

suggest that the Big Five are not more conservative than other audit firms,

consistent with the absence of deep pockets incentive in France (H1b). Con-

cerning auditor tenure, abnormal accruals are statistically equivalent in

signed value, and appreciably more important in absolute value for lowtenure observations when derived from the CFO Model (p , 0.10). These

findings are then contrary to the hypothesis that audit quality decreases over

time (H2).14

Table 4 groups the observations into three sub-samples: (A) no audit com-

mittee, (B) existence of an audit committee not having a majority of inde-

pendent directors, and (C) existence of an audit committee that is majority

independent. The firms with no audit committee display the highest levels

Table 3. Univariate tests according to the external auditor characteristics

The leading auditor is aBig Five (H1)

Audit tenure of the leadingauditor . annual median

valuea (H2)

No(N 41)

Yes(N 205) t -Stat.

No(N 111)

Yes(N 110) t -Stat.

Abnormal accruals in signed value b

AbnAcc1 0.021 0.002 0.953 20.003 0.008 20.770AbnAcc2 0.023 0.017 0.447 0.014 0.017 20.311

Abnormal accruals in absolute value b

jAbnAcc1j 0.088 0.077 0.802 0.071 0.079 20.755jAbnAcc2j 0.055 0.055 0.063 0.058 0.046 1.791

Reported are the mean values for measures of abnormal accruals, and Student t-statistics (adjusted for

heterogeneity of variances when necessary) for the comparison of independent No Yes sub-

samples. Non-parametric Mann Whitney U-tests (untabulated) provide similar results., and denote significance at p , 0.10, 0.05 and 0.01, respectively (two-tailed).aMedian values (in years) for the tenure of the leading auditor are 8.00 (N 71), 6.90 (N 78) and

7.54 (N 72) for 1999, 2000 and 2001, respectively.bAbnAcc1 Abnormal Accruals derived from the Jones Model; AbnAcc2 Abnormal Accruals

derived from the CFO Model



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Table 4. Univariate tests according to audit committee pres

No auditcommittee (A)

Non-independentACa (B)

IndependentACa (C) (A) vs. (B) (A) vs. (

(N 90) (N 61) (N 83) t -stat. t-stat.

Abnormal accruals in signed value b

AbnAcc1 0.024 20.026 0.000 2.635 1.387AbnAcc2 0.032 0.006 0.015 1.959 1.516

Abnormal accruals in absolute value b

jAbnAcc1j 0.084 0.073 0.074 0.773 0.791jAbnAcc2j 0.066 0.052 0.045 1.582 2.557

Reported are the mean values for measures of abnormal accruals, and Student t-statistics (adjusted for h

of independent sub-samples. Non-parametric Mann Whitney U-tests (untabulated) provide consisten, and denote significance at p , 0.10, 0.05 and 0.01, respectively (two-tailed).aAn audit committee is classified as independent if it is composed of more than 50% of independ

connection with top executives or significant shareholders).bAbnAcc1 Abnormal Accruals derived from the Jones Model; AbnAcc2 Abnormal Accruals de


16/27

of signed abnormal accruals, whereas those with a non-independent commit-

tee display the lowest. The difference in mean between groups (A) and (B)

is 5% of total assets using the Jones Model, and 2.6% using the CFO Model.

Both are statistically significant, whereas they remain generally insignificant

in comparisons of (A) vs. (C), (B) vs. (C) and (A B) vs. (C). Hence, two

comments arise. First, consistent with H3, the presence of an audit commit-

tee may prevent income-increasing earnings management. Second, however,

a greater independence of the audit committee does not seem to be associ-

ated with more conservative accounting earnings. Nonetheless, the tests on

absolute values confirm that an independent audit committee may constrain

the overall magnitude of earnings management, but only for abnormal

accruals derived from the CFO Model, thus making the support for H4

quite weak.

4.2. Multivariate Analysis

Table 5 reports regression results of the following model, estimated to appraise

the marginal effect of each predictor on earnings management (see the table

notes for the definitions of variables):

Abnormal Accruals a b1:Big5 b2:AudTen b3:AC b3:ACInd5015

b4:%Managers b5:Lev

b6:LnAssets b7:BdInd b8:CFO16

b9:Y1999 b10:Y2000 1:

Regarding the audit quality variables, the presence of a Big Five auditor does

not affect abnormal accruals, whatever their form. Two other variables have a

significant effect on abnormal accruals derived from the CFO Model. On the

one hand, the presence of an audit committee drives down the level of signed

abnormal accruals, offering a partial corroboration of H3 (p , 0.05 one-

tailed). On the other hand, contrary to H2, auditor tenure slightly mitigatesabnormal accruals in absolute value. These findings are open to three main

interpretations. First of all, involving directors in the audit process through

audit committees seems, at the very least, to curb income-increasing earnings

management. Audit committees are associated with a greater conservatism of

reported earnings (approximately 2% of total assets according to the coefficient

of AC). However, untabulated regressions substituting ACInd50 for AC show

no significant impact of audit committees with an independent majority on

earnings management,17 in contrast with US findings (Klein, 2002a; Bedard

et al., 2004), and questions the role of independent directors in the French

model of corporate governance. Legal exposure considerations may explain

this point Specifically the strong collegiality principle reaffirmed by the



17/27

Bouton Report (2002, p. 6) in the sense that board sub-committees have a con-

sultative role, not being able to substitute for board responsibilities renders

the board of directors collectively responsible for financial reporting quality,which is likely to hamper the individual monitoring incentives of independent

directors. Second, Big Five auditors do not mitigate earnings management in

France, contrary to what has been documented in the USA. Weaker enforcement

mechanisms, resulting in a less risky litigation environment, may explain the

absence of asymmetric monitoring by these large audit firms (H1b). Third,

auditor tenure does not seem to threaten the quality of reported earnings; even

the contrary is supported, although the effect is weak in magnitude. Regarding

French audit regulation, one could then argue that the time protection of the audi-

tors mandate is likely to promote audit quality, or that the reciprocal monitoring

engendered by joint-auditorship preserves the respective scrutiny of co-auditors

over time

Table 5. Time-series adjusted regressions for the pooled sample (19992001)a

Abnormal Accruals ab1.Big5b2.AudTen b3.AC b4.%Managers b5.Lev b6.LnAssets b7.BdInd [ b8.CFO] b9.Y1999 b10.Y2000 e

Abnormal accruals in signed value Abnormal accruals in absolute value

AbnAcc1 AbnAcc2 jAbnAcc1j jAbnAcc2j

Intercept 0.035 (0.49) 20.062 (20.81) 0.078 (1.24) 0.192 (4.84)

Big5 ?/ 20.023 (21.11) 20.007 (20.47) 20.005 (20.37) 0.006 (0.57)AudTen 0.000 (0.68) 20.001 (20.98) 0.000 (20.49) 20.001 (23.03)

AC 20.018 (21.21) 20.021 (21.74) 0.007 (0.56) 20.007 (20.80)%Managers 20.027 (20.59) 20.001 (20.03) 0.052 (1.98) 20.019 (20.77)Lev 20.016 (23.80) 20.014 (24.09) 0.005 (1.13) 0.007 (2.54)

LnAssets 0.004 (0.88) 0.007 (1.62) 20.001 (20.32) 20.009 (23.72)

BdInd 20.033 (21.08) 20.012 (20.42) 20.030 (21.16) 20.011 (20.63)CFO 20.620 (26.33) Omitted 0.002 (0.03) OmittedY1999 ? 0.037 (2.57) 0.010 (0.89) 0.020 (1.53) 0.005 (0.80)Y2000 ? 0.015 (1.53) 0.021 (2.27) 0.039 (3.19) 0.018 (2.49)

R 2 0.427 0.106 0.077 0.188F-Stat. 14.37 6.14 1.92 5.09

N 216 216 216 216

aCluster Regression procedure from the STATAw Software, allowing for the potential time-series

dependence of observations relating to the same firm. The initial pooled sample provides N 216

observations with non-missing data, representing 84 firms or clusters. The White estimator is used

to compute standard errors and t-statistics.

Reported items are regression coefficient and t-statistic between parentheses., and denote significance at p , 0.10, 0.05 and 0.01, respectively (two-tailed).

Variables definition: AbnAcc1 Abnormal Accruals derived from the Jones Model, AbnAcc2

Abnormal Accruals derived from the CFO Model, Big5 1 if one of the statutory auditor (atleast) is a Big Five, and 0 otherwise, AudTen time (in years) between the financial year end and

the date of first nomination of the leading auditor, AC 1 if an audit committee is present, and 0

if not, %Managers proportion of common shares owned by top executives, Lev debt-to-equity

ratio, LnAssets natural logarithm of total assets, BdInd proportion of independent directors on

the board, CFO (net income before goodwill amortisation total accruals)/lagged total assets,Y1999 (Y2000) year dummies to control for fixed time effects over the 19992001 period.



18/27

Regarding control variables, our results are in contradiction with the positive

accounting hypotheses of earnings management. It seems that managers do not

have strong incentives in income-increasing practices. As explained by Coffee

(2005), this is consistent with the ownership concentration that characterises

European countries and France in particular. The frequent presence of a dominant

(or even controlling) shareholder provides a direct monitoring of managers and

reduces the use of bonuses and stock options in remuneration packages. The

shareholder manager agency problem then turns into a dominantminority

shareholder conflict, in which the use of expropriation mechanisms is more

likely than earnings management strategies. Else, if large firms resort to less earn-

ings management in absolute value (using the CFO Model), the political cost

hypothesis cannot be retained given the insignificant effect of firm size on

signed abnormal accruals.

Most notably, the negative relation between leverage and signed abnormal

accruals has contracting and legal interpretations that are consistent with theFrench setting of debtholders protection. First, it is in contradiction with the

positive accounting view that managers resort to income-increasing earnings

management to avoid covenant breaches. The lesser use of covenants in

France probably eliminates the income-increasing earnings management incen-

tive. Second, this finding is consistent with a conservative accounting attitude

that responds to debtholders concerns in assessing potential loans, or in monitor-

ing borrowers ability to pay back existing loans (Watts, 2003, p. 212). The strong

emphasis placed on prudence in the French accounting framework (e.g. limited

re-evaluation possibilities, extensive use of provisions for risks and charges) pri-marily addresses these concerns. As debt increases, managers may report more

conservatively, by recording assets at their orderly liquidation value (e.g. impair-

ments, write-offs), in order to maintain the debt contracting efficiency and to

minimise potential bankruptcy costs. The latter point is supported by legal pro-

visions that managers can be held personally liable for a bankrupt companys

debt on several grounds, notably imprudence or negligence, once a judicial liqui-

dation phase has been pronounced (Fried Frank Harris Shriver & Jacobson LLP,

2005).

4.3. Simultaneity Issues

The relation between audit committees and abnormal accruals, as previously esti-

mated, may be biased by a joint-determination, or a simultaneity problem.

Empirically, the setting-up of an audit committee depends on agency and govern-

ance variables, which may also intervene as explanatory factors of earnings

management. Therefore, to some extent, the existence of an audit committee

might be endogenous to the accounting strategy. We control for this issue

using a two-stage least squares method (e.g. Klein, 2002b). The first stage con-

sists of predicting the existence of an audit committee with a group of exogenous

instruments Consistent with the literature we estimate an audit committee



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Table 6. Time-series adjusted two-stage least squares (2SLS) regressions with AC instru-mented for the pooled sample (19992001)a

Abnormal Accruals a b1.Big5 b2.AudTen b3.ACinstrumented b4.%Managers b5.Lev b6.LnAssets b7.BdInd [ b8.CFO] b9.Y1999 b10.Y

2000 e

First stageProbit [AC]

Secondstage

Dep. Var. AbnAcc1

Secondstage

Dep. Var. AbnAcc2

Intercept 25.480 (23.54) 20.058 (20.62) 20.117 (21.30)Big5 1.527 (3.78) 20.008 (20.45) 0.001 (0.06)AudTen 20.010 (20.59) 0.000 (0.61) 20.001 (21.01)AC 20.016 (22.49) 20.011 (22.03)

%Managers 21.135 (21.39) 20.052 (21.13) 20.013 (20.40)Lev 20.066 (20.87) 20.016 (23.96) 20.014 (24.22)

LnAssets 0.384 (3.76) 0.009 (1.64) 0.010 (1.87)BdInd 0.494 (0.64) 20.033 (21.09) 20.011 (20.40)CFO 20.619 (26.40) OmittedY1999 20.648 (23.05) 0.031 (2.25) 0.007 (0.60)Y2000 20.292 (21.72) 0.012 (1.30) 0.020 (2.17)

Control 20.151 (20.43)BdSize 0.229 (4.87)

Dual 20.640 (21.40)UsList 0.620 (1.52)Complex 21.548 (21.48)

R 2 0.456 0.438 0.108

Chi2

/f-stat. 65.11 13.13 5.87 N 216 216 216

aCluster 2SLS Regression procedure from the STATAw Software, allowing for the potential time-

series dependence of observations relating to the same firm. The initial pooled sample provides

N 216 observations with non-missing data, representing 84 firms or clusters. The White estimator

is used to compute standard errors and t-statistics.

Reported items are regression coefficient, and z- or t-statistic between parentheses., and denote significance at p , 0.10, 0.05 and 0.01, respectively (two-tailed).

Variables definition: Big5 1 if one of the statutory auditor (at least) is a Big Five auditor, and 0

otherwise, AudTen time (in years) between the financial year end and the date of first nomination

of the leading auditor, AC

1 if an audit committee is present, and 0 if not (AC is the predictedvalue of AC), %Managers proportion of common shares owned by top executives, Lev debt-

to-equity ratio, LnAssets natural logarithm of total assets, BdInd proportion of independent

directors on the board, CFO (net income before goodwill amortisation total accruals)/laggedtotal assets, Y1999 (Y2000) year dummies to control for fixed time effects over the 19992001

period.

Additional instruments for AC: Control 1 if one shareholder controls more than 50% of the compa-

nies voting rights, and 0 if not, BdSize residuals from the univariate OLS regression of the number

of directors on LnAssets, that is, marginal effect of board size over firm size (procedure used due to the

high correlation between board and firm sizes), Dual 1 if the positions of CEO and Chairman of the

board are separated (two-tiered board), and 0 if not, UsList 1 if the firm is listed on a US stock

market, and 0 if not, Complex (proxy for audit risk/complexity)

(gross inventories receivables)/total assets.



20/27

Probit model including the predictors of the accruals model and other exogenous

variables recognised for their impact on the voluntary formation of an audit com-

mittee.18 The second step is the estimation of the accruals model itself, using the

predicted value of AC derived from the first stage. The results are reported in

Table 6 for signed abnormal accruals as dependent variables.

The first stage regression underlines the main determinants of the existence of

an audit committee found in the literature, that is, auditor reputation, firm size and

board size. The second stage regressions confirm a negative relation between

signed abnormal accruals and the instrumented AC variable (p , 0.05).

Although the magnitude of coefficients is slightly lower relative to their OLS

equivalent, their significance is globally stronger. This suggests that endogeneity

may overestimate the real magnitude of the effect of audit committees on signed

abnormal accruals, while disturbing the power of this relation. If anything, the

2SLS results are consistent with the univariate tests on that point.19 Finally,

regarding abnormal accruals in absolute value, the 2SLS analyses (not reportedfor clarity) provide qualitatively similar regression coefficients as the one dis-

closed in Table 5.

5. Conclusion

This paper investigates the effect of various audit quality dimensions on earnings

management in France. We extend the earnings management literature to an

auditing environment that differs from the Anglo-Saxon systems in at leastthree ways: (1) the legal requirement for joint-auditorship and a guaranteed

mandate of six fiscal years for auditors; (2) the relatively lower litigation risk

for audit firms as compared to Common Law countries; (3) the non-required for-

mation of audit committees, as well as the less stringent guidelines on audit com-

mittees independence (vs. the corresponding US rules). In this context, we adopt

a composite view of audit quality, based on external auditors characteristics and

on the potential contribution of audit committees to, notably, the probability that

irregularities are revealed. We hypothesise that brand name auditors curb earn-

ings management as a whole, but, that there is no differentiation between auditorsin terms of accounting conservatism; that auditor tenure is positively associated

with earnings management; and that the presence of an audit committee, and its

independence, mitigates earnings management.

Empirical tests address the main listed companies from 1999 to 2001. Abnor-

mal accruals are considered in signed value as a proxy for earnings conserva-

tism, and in absolute value as a proxy for the overall extent of earnings

management. The main findings are that signed abnormal accruals decrease

when an audit committee exists, but that the audit committees independence

has no significant effect on accruals measurements. Also, Big Five-audited com-

panies do not differ from others in terms of absolute and signed abnormal

accruals Finally we find no evidence that earnings management increases



21/27

with auditor tenure. In fact, the opposite relation is partially supported, depending

on the accruals measurement.

These findings contribute to the debates on financial reporting quality regard-

ing the role of audit committees and the status of external auditors in France.

Audit committees act as potentially valuable audit quality devices in the sense

that they control the most egregious (i.e. income-increasing) form of earnings

management. However, our findings challenge the role of independent directors

in French corporate governance. Are they competent to appreciate earnings

quality? Do they have real monitoring incentives? The question of competence

has been addressed in very general terms by the Bouton Report (2002). The indi-

vidual monitoring incentives might be hampered by the liability regime of direc-

tors, as the full board remains collectively responsible for financial reporting

quality matters. Factual evidence supporting this view has recently been reported

in the Rhodia affair, when Thierry Breton the former President of Rhodias

audit committee tried to dilute his responsibility among the other directorsby claiming that the audit committee has no judicial existence.20 Hence,

future recommendations or regulations about audit committees independence

are likely to be sterile if the duties and responsibilities of outside directors are

not clearly specified.

Regarding external auditors, Big Five audit quality differentiation does not

operate in France with respect to accounting earnings, contrary to the US find-

ings. Specifically, the absence of asymmetric monitoring regarding abnormal

accruals is consistent with the lower litigation risk incurred by audit firms in

France, compared to the US Common Law environment, where investorsbenefit from easier lawsuit opportunities (e.g. class actions, contingent fees).

Thus, large audit firms, less exposed to the deep pockets incentive, would not

have to deal with this threat by adopting more conservative attitudes with

respect to earnings management.

In summary, our findings have implications for policy-makers regarding audit

quality and legal matters in France. In line with prior studies, we find no evidence

that earnings quality decreases with auditor tenure, suggesting that the legal time

protection of audit engagements is not a threat to audit quality. Further, reforming

the litigation system may stimulate the monitoring exerted by large audit firms,and the vigilance of independent directors who sit on audit committees. Future

research on earnings management in France may investigate two important

issues: (1) the competence of audit committee members (Bedard et al., 2004);

and (2) the relation (if any) between earnings management and the position in

time of financial statements with respect to the renewal date of the auditors

mandate.

Acknowledgements

We thank the Research Alliance on the New Economy, funded by the Social

Sciences and Humanities Research Council of Canada as well as the Chair in



22/27

Governance and Forensic Accounting at HEC Montreal, for their financial

support. We are also grateful to workshop participants at the 28th EAA Congress

in Gothenburg, the 25th Congress of the Francophone Accounting Association in

Orleans, the Third International Conference on Governance and Forensic

Accounting at HEC Montreal and the CERAG-Finance Group for their com-

ments. Special thanks to C. Richard Baker, Claude Laurin and Calin Gurau for

fruitful suggestions on previous drafts. Two anonymous reviewers have also con-

tributed to the quality of this paper.

Notes

1See, for instance, DeFond and Jiambalvo (1993), Dechow et al. (1996), Becker et al. (1998),

Francis et al. (1999), Peasnell et al. (2000a), Frankel et al. (2002), Klein (2002a), Kim et al.

(2003), Xie et al. (2003) and Bedard et al. (2004).2The effectiveness of such regulation, for example, in Italy, has not been demonstrated. In prac-

tice, it is more likely to result in a game of musical chairs than in a strengthening of auditorsindependence.

3It is not possible for a manager to dismiss an auditor during the course of his mandate, other

than by a Court decision. Judges may revoke the auditor if it can be proved that the latter

has committed a fault which caused damages to the audited company (this is an extremely

uncommon situation).4The formation of audit committees is not mandatory in the UK.5The methodology used for estimating abnormal accruals does not apply to financial companies.6Some authors (Peasnell et al., 2000b, Xie et al., 2003) posit that only the short-term component

of accruals can actually be manipulated, and as such keep only these in their model. We prefer

considering also the long-term component of accruals, because of the importance placed on pro-

visions for risks and charges in the French accounting system. The indirect formula, based onbalance sheet and income statement items, is preferred given that cash flow statements are not

systematically supplied in the French Diane database at the time of our study. The items used in

this formula are the ones prescribed by the French accounting format, replicated in Diane.

English translations of these items are recommended by the authors so that the reader may

be able to appreciate the equivalent in an Anglo-Saxon accounting system.7Long-term deferred expenses constitute amortisable entries in French financial statements; as

such, they are added to the amortisable fixed assets.8If this coefficient is expected to be positive for industries where companies have a structural

need for working capital, it should be negative for industries in which companies post a

surplus in working capital.9

The initial 102 listed companies were classified into 54 industries. Of the resulting 162 industry-years, 16 did not meet the minimum data requirement of six observations to estimate the

accruals models.10The professional standard states that the two co-auditors agree on the audit opinion. In a case of

deep divergence, it remains possible to include both opinions in the audit report (extremely rare

case).11Early 1998, three groups of auditors are identified on the French market of listed companies: (1)

the Big Six; (2) seven national networks called the Majors (Mazars & Guerard, Salustro Reydel,

Amyot Exco, Fidulor, Calan Ramolino, Constantin, BDO Gendrot); and (3) the other Local

audit firms. Among the Majors, two networks (Mazars & Guerard and Salustro Reydel) are dis-

tinguishable by their revenues which are fairly close to those of the Big Six (Piot, 2001, p. 492).12

We have also considered the fact that audit committees may be composed of 100% independentmembers. But this alternative concerns only 11% of available observations, which severely

limits the power of statistical tests



23/27

13The question of the shareholder linkage is not addressed in detail in the Vie not Reports of 1995

and 1999. The Bouton Report (2002, p. 10) stipulates that Beyond a threshold of 10% in

capital or in voting rights, it is suitable that the board, based on the report of the nomination

committee, should systematically inquire into the independent qualification, taking into account

the capital structure of the company and the potential for conflicts of interest. By default, all the

directors who hold more than 10% of the capital or voting rights are not considered to be

independent; the same applies to the representatives of other companies that pass one of

these thresholds.14The results reported are potentially biased by the arbitrary dichotomy used. It is also possible

that the relation between a high tenure and a loss in audit quality is not linear. Furthermore, con-

sidering only the tenure of the leading auditor inevitably causes a loss of information. In order to

integrate the joint-auditorship, these tests were replicated with the average tenure of co-auditors,

and the results were insignificant.15Given the strong contingency between the presence of an audit committee (AC 1) and the

presence of a committee independent in majority (ACInd50 1), hypotheses H3 and H4 are

tested separately.16This control variable is included only when abnormal accruals are derived from the Jones

Model. The control for cash flows is endogenous when the CFO Model is used.17Regressions with the ACInd50 variable are not reported for clarity. They are qualitatively

similar to those of Table 5, excepted that ACInd50 is never significant.18See Piot (2004) for an empirical analysis in France, and for a review of studies on the determi-

nants of the existence of audit committees.19The univariate effect of the presence of an audit committee has also been tested by regressing

signed abnormal accruals on AC. The results are as follows (both regressions exhibit statisti-

cally significant coefficients for AC at p , 0.05 one-tailed):

AbnAcc1 0:033:AC 0:024,

AbnAcc2 0:020:AC 0:032:

As a whole, regression diagnostics (VIF) show that multicolinearity problems are not likely to

affect the multiple regressions, either traditional or 2SLS analyses.20T. Breton is the current Minister for the Economy. His words are translated from the business

press (Les Echos, No. 19446, 30 June 2005, p. 5).

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Appendix

Table A1. Sampling procedure

Steps N

Companies that compose the SBF 120 Index on 17 December 2002, according tothe French Market Authority (www.cob.fr)

116

Financial, insurance and investment companies 2132 Real estate companies 23 Companies (except those in the above industries) that appeared at least

once on the index between 1998 and 2002, and absent from the beginning lista23

2 Companies recently incorporated or introduced on the market,b or forwhich at least one annual report for financial years 19992001 could not beconsulted

25

2 Companies unreferenced or that do not publish consolidated financial

statements in the Diane database

212

2 Companies for which the industry cannot be clearly identified 24Number of firms remaining 102

aTaken from the Index InOut Movement tables published on www.cob.frbSome research suggests that companies specifically manage their earnings upward just before an IPO

(e.g. Teoh et al., 1998).

Table A2. Accruals models. Descriptive statistics for estimated models parameters basedon a cross-sectional approach of 146 industry-years OLS regressionsa

Mean Median Std. dev. Min Max % Positive

Jones Model: TAjt a1 b1.GPPEjt g1.DREVjt ejta1 125.7 2.8 2,546.8 211,706.3 15,472.4b1 20.081 20.068 0.099 20.594 0.266 14g1 0.027 0.012 0.151 20.283 0.843 55

CFO Model: TAjt a2 b2.GPPEjt g2.DREVjt d2.CFOjt ejta2 419.0 187.1 1,680.7 26,181.2 7,605.8b2 20.019 20.007 0.073 20.369 0.237 44g2 0.055 0.042 0.105 20.284 0.577 75d

22

0.6662

0.667 0.2532

1.528 0.524 1Nb 35 37 22 6 216

TA Total Accruals; GPPE Gross Property Plant and Equipment plus Long-Term Deferred

Expenses; DREV the change in net sales; CFO Cash Flow from Operations.aCorresponding to the total number of industry-years regressions that could be run (i.e. 49 for 1999

and 2000, 48 for 2001), given the minimum data requirement of six observations.bN designates the number of observations included in each regression.



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7. external auditos & eanings management in france_piot et janin_2007

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