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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
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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
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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).
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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
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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
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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.
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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.
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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
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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
Audit Committees and Earnings Management in France 449
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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
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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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