Audit quality and earnings
management for Taiwan IPO
firms
Ken Y. Chen
College of Management, National Cheng Kung University, Tainan, Taiwan
Kuen-Lin Lin
School of Management, Cheng Shiu University, Kaohsiung, Taiwan, and
Jian Zhou
School of Management, SUNY at Binghamton, Binghamton, New York, USA
Abstract
Purpose – This paper investigates the relationship between audit quality (as measured by auditor
size and industry specialization) and earnings management (as measured by unexpected accruals) for
Taiwan IPO firms.
Design/methodology/approach – First uses unexpected accruals in the modified Jones model to
measure earnings management in the IPO process. Then uses auditor type (big five versus non-big
five) and industry specialist to measure audit quality. The hypothesis predicts that Taiwanese firms
with higher quality auditors engage less in earnings management in the IPO process. The sample
consists of 367 new issues between 1999 and 2002 from the Taiwan Economic Journal database.
Findings – It is found that big five auditors are related to less earnings management in the IPO year
in Taiwan. This shows that higher quality auditors constrain earnings management for Taiwan IPO
firms.
Research limitations/implications – The finding shows that high quality auditors constrain
earnings management and provide more precise information. This is important, given that
management has incentive to engage in earnings management in the IPO process to garner greater
proceeds and at-issue earnings management is negatively related to post-issue earnings performance
and stock returns.
Practical implications – The research might be of interest to investors in IPO firms, given that
at-issue unexpected accruals are opportunistic.
Originality/value – The study contributes to the literature in that it shows that audit firm size is an
important determinant in earnings management for Taiwan IPO firms.
Keywords Quality audit, Earnings, Taiwan

associated with higher audit quality. Among all these scandals, the Enron scandal
attracted the greatest attention partly because it was associated with the collapse of
Arthur Andersen. We briefly summarize the Enron and Andersen events as follows.
On October 16, 2001, Enron announced that third-quarter earnings would include an
unexpected nonrecurring charge of $1.01 billion after tax, which triggered the informal
inquiry of SEC the next day. SEC changed its informal inquiry into a formal
investigation on October 31. On December 2, Enron filed for chapter 11 bankruptcy
protection. On January 10, 2002, Andersen notified the SEC and the Department of
Justice that the Houston office had shredded a significant number of documents related
to the Enron audit. On February 2, the Powers report provided by a special
investigation committee of Enron’s board of directors was released suggesting that the
headquarters of Andersen were aware of the problems with Enron audit. Andersen
was indicted for obstruction of justice on March 14 and was found guilty on June 15,
2002. Andersen ceased conducting audits of public companies by August 31, 2002. The
increased lack of investor confidence in financial statement information resulting from
these corporate scandals involving once well-respected companies such as Enron and
WorldCom, and auditors such as Arthur Andersen served as a catalyst for the
Sarbanes-Oxley Act that was signed into law on July 30, 2002. The primary goal of the
Sarbanes-Oxley Act is to help restore investors’ confidence in the integrity of financial
information, and auditors play an important role in the process. So it is important to
investigate whether there is audit quality difference, especially during IPO process
where firms are found to engage in opportunistic earnings management. We choose
1999-2002 as the sample period since IPOs are relatively clustered for this period. The
average number of IPOs is around 90 each year for this period compared to the average
number of 40 for 1991-1998. The Enron fiasco and the enacted Sarbanes-Oxley Act of
2002 may not affect the IPO market in Taiwan for our current study, because the
regulation and procedures with regard to the IPO firms have been enacted before the
Enron scandal. However, the demand for higher auditor quality can be reasonably
expected for Taiwanese companies listed in three major stock exchanges in the
post-Enron era.

related to post issue earnings performance (Teoh et al., 1998b) and post issue stock
returns (Teoh et al., 1998a). As a result, at the issuing stage, earnings management has
significant resource allocation implication. Third, APB 20 allows IPO firms to change
accounting principles in the prospectus as long as financial statements of previous
years are restated. This may give management an opportunity to engage in earnings
management. Fourth, there is significant information asymmetry between the
owners-managers and investors (Leland and Pyle, 1977), and between informed and
uninformed investors (Rock, 1986; Beatty and Ritter, 1986).
Theoretical research shows that auditors play an important role in reducing the
adverse impact of information asymmetry in the IPO process. Titman and Trueman
(1986) develop a model in which the price of shares in an IPO is increasing in tandem
with the quality of information provided by the offering company. Datar et al. (1991)
find that the information asymmetry in the IPO process is mitigated by the role of
auditor and audit quality. The choice of auditor is made jointly with other decisions
such as the percentage of retained ownership in the offering (Copley and Douthett,
2002). Empirical evidence indicates an increased demand for audit quality at the time
of the IPO; companies frequently change to a big five auditor at the time of an IPO
(Carpenter and Strawser, 1971; Menon and Williams, 1991)[3].
Audit quality research has focused primarily on differences between big five and
non-big five firms. Research in the Australian audit market (Craswell et al., 1995)
indicates that industry specialist auditors receive a fee premium that represents a
significant portion of the premium to big five firms in the Australian audit market[4,5].
Elder (1999) finds that IPO underpricing is lower for companies that use an industry
specialist auditor. This evidence indicates that industry specialist auditors provide
higher quality of audits compared with non-industry specialist auditors.
Becker et al. (1998) find that unexpected accruals are reduced when existing
publicly-traded companies use a big five auditor. They find that clients of non-big five
auditors report unexpected accruals that are higher than unexpected accruals of clients
of big five auditors. They interpret this as indicating that lower audit quality is
associated with greater accounting flexibility.

suggesting that the big five auditors are associated with reduced management
discretion over earnings. However, we do not find that firms audited by industry
specialist auditors engage in less earnings management.
The remainder of the paper is organized as follows. The next section describes
earnings management in the IPO environment and reviews research on audit quality
and introduces the research hypotheses. Section III describes the research design.
Sample selection and tests of the relation between auditor reputation and unexpected
accruals are discussed in section IV. Section V is the summary and conclusion.
II. Earnings manag ement, audit quality and IPOs
Earnings management and initial public offerings
An extensive body of earnings management literature has developed (see Healy and
Wahlen (1999) for a review of the literature). Most earnings management studies
examine whether companies manage earnings in response to some economic incentive.
One setting where management has an incentive to manipulate earnings is at the time
of an IPO, since greater earnings may be reflected in a higher offering price and greater
proceeds to the company and offering shareholders.
Whether a company benefits from earnings management depends upon whether the
market can see through the earnings manipulation. The IPO environment is
Audit quality for
Taiwan IPO
firms
89
characterized by information asymmetry between management and investors (Leland
and Pyle, 1977), and between informed and uninformed investors (Rock, 1986; Beatty
and Ritter, 1986).
Several analytical models demonstrate that the extent of earnings management
increases with the level of information asymmetry. For example, Dye (1988) and
Trueman and Titman (1988) demonstrate that the existence of information asymmetry
between management and shareholders is a necessary condition for earnings
management, because shareholders cannot perfectly observe a firm’s performance and

Touche on June 1, 2003. The clients of T.N. Soong were also transferred to Deloitte and
Touche, which is different from the situation in the US, where Andersen’s clients chose
other big five or non-big five audit firms as successor auditors. Given quality
monitoring systems which operate across all accountancy forms, the client’s demand
for auditor reputation and auditor quality should not have changed, since all Andersen’s
clients in Taiwan were transferred to Deloitte and Touche. Becker et al. (1998) find that
companies with non-big five auditors (a proxy for lower audit quality) report
unexpected accruals that significantly increase income compared to companies with big
MAJ
20,1
90
five auditors. In Taiwan, non-big five auditors, especially for those local or regional
audit firms instead of national audit firms, are usually recognized as lower quality
auditors when compared to big five auditors, which can be evidenced by the clients’
selection of big five auditors for their IPO process. They also find that managers
respond to debt contracting and income-smoothing incentives by strategically reporting
unexpected accruals. In addition, companies with incentives to smooth earnings
upwards (downwards) report significantly greater income-increasing (decreasing)
unexpected accruals when they have non-big five auditors.
Francis et al. (1999) argue that high-accrual firms have greater opportunity for
opportunistic earnings management and have an incentive to hire a big five auditor to
provide assurance that earnings are credible. They find that high accrual firms are
more likely to hire a big five auditor, but report lower unexpected accruals, consistent
with big five auditors constraining opportunistic reporting of accruals.
The Becker et al. (1998) and Francis et al. (1999) studies provide evidence in non-IPO
settings that higher quality auditors are associated with reduced levels of earnings
management. Previous research suggests that the auditor can play a role in reducing
information asymmetry at the time of the IPO. Balvers et al. (1998) and Hogan (1997)
find that big five auditors are associated with lower under-pricing of the offering.
Balvers et al. (1998) argue that a high quality auditor provides better information

91
under-pricing is lower for companies that use an industry specialist auditor. Zhou and
Elder (2003) find that auditor industry specialists can be used to constrain earnings
management in the IPO process in the US. Because of the expertise and experience of
industry specialists, we also expect that industry specialists are likely to constrain
earnings management in the IPO process. This leads into the second hypothesis:
H2. Firms audited by industry specialist engage less in earnings management in
the initial public offering process in Taiwan.
The following section describes the research design, including the model used to
estimate unexpected accruals and models used to test the research hypotheses.
III. Research design
Unexpected accruals
We first use unexpected accruals to measure earnings management in the IPO process.
Unexpected accruals (also called discretionary accruals) are used in earnings
management studies such as Jones (1991) and Subramanyam (1996). Dechow et al.
(1995) provide evidence that the modified Jones model is the most powerful to detect
earnings management among the alternative models to measure unexpected accruals.
The model is estimated as follows:
TACC
it
¼ðDCA
it
2 DCASH
it
2 DCL
it
2 DSTD
it
2 DEP
it

it
¼ change in current assets for firm i in year t.
D
CASH
it
¼ change in cash for firm i in year t.
D
CL
it
¼ change in current liabilities for firm i in year t.
D
STD
it
¼ change in short-term debt for firm i in year t.
DEP
it
¼ change in depreciation for firm i in year t.
D
REV
it
¼ change in revenue for firm i in year t.
D
REC
it
¼ change in receivables for firm i in year t.
PPE
it
¼ net property, plant and equipment for firm i in year t.
TA
it21

X
J
ik
j¼1
ffiffiffiffiffiffiffi
A
ijk
q
X
I
k
i¼1
X
J
ik
j¼1
ffiffiffiffiffiffiffi
A
ijk
q
where:
A
ijk
¼ total sales of client firm j in industry k audit by auditor i.
i ¼ 1; 2; ; I ¼ an index for audit firms.
j ¼ 1; 2; ; J ¼ an index for client firms.
k ¼ 1; 2; ; K ¼ an index for client industry.
I
k
¼ the number of audit firms i in industry k.

of size on earnings management in the IPO process. Large firms may have less
incentive to engage in earnings management because they are subject to more scrutiny
from financial analysts and investors. Leverage may also be associated with earnings
management in the IPO process. DeFond and Jiambalvo (1994) and Sweeney (1994) find
that managers use unexpected accruals to satisfy debt covenant requirements. The
electronics industry (ELEC) is the largest industry in Taiwan, and the matter of
earnings management is more likely to be a concern. Therefore, ELEC is also used as a
control variable. Further, Taiwan Stock Exchange (TSE) is used as a control variable
because of the requirements to be a listed firm in TSE is stricter than the firms in the
over-the-counter market, and thus earnings management is more likely to be
constrained in TSE.
Inclusion of these control variables results in the following regression model:
DAC
it
¼
b
0
þ
b
1
BIG5 þ
b
2
SPEC
it
þ
b
3
OCF
it

þ
b
10
ELEC þ
b
11
TSE
þ 1
it
DAC
it
¼ unexpected accruals.
BIG5
it
¼ 1 if the auditor is member of big five; 0 otherwise.
SPEC
it
¼ 1 if the auditor is an industry specialist; 0 otherwise.
OCF
it
¼ operating cash flow deflated by lagged total assets.
ABSTA
it
¼ absolute value of total accruals.
LOSS
it
¼ 1 if the firm incurs a loss; 0 otherwise.
INCCHG
it
¼ 1 if this year’s income is greater than previous year’s income;

necessary data for calculating total accruals, unexpected accruals, industry
specialist, market-to-book ratio and leverage are available from the database.
Table I provides details about the sample selection. After deleting 21 financial services
and insurance companies (as in previous literature, the unexpected accruals does not
apply to financial industries) and 42 companies with missing data, the final sample
between 1999 and 2002 amounted to the 367 firm-year observations. Table II provides
details about the sample distribution by year and by auditor type. The number of IPO
companies is around 80 each year from 1999 to 2001, down to 56 in the year 2002. The
big five auditors audit more than 80 percent of the IPOs in any given year, except for
the year 2002, which is around 90 percent of the IPOs.
Table III provides the industry distribution of the sample firms. The sample
includes 17 separate TEJ industry codes, indicating a wide distribution of industries.
Electronics industry has the largest concentration of IPOs, with more than 66 percent
of the total observations. The remaining sample firms are widely distributed across
1999-2002 IPOs 430
Financial services and insurance 21
Missing data 42
Total 367
Note: Sample characteristics for 367 firms conducting initial public offerings during the period of
1999 to 2002 from December 2002 Taiwan Economic Journal (TEJ) database
Table I.
Sample selection
1999 2000 2001 2002 Total
Year n % n % n % n % n %
B5 84 81.55 83 77.57 77 81.05 56 90.32 300 81.74
NB5 19 18.45 24 22.43 18 18.95 6 9.68 67 18.26
Total 103 107 95 62 367
Freq 28.06 29.15 25.89 16.90 100
Table II.
Sample IPO firms by year

Steel and iron AA, KPMG, EY RSM, other AA, KPMG
Electronics AA, KPMG, PWC, EY, DT BDO, RSM, CH, MRI, other AA, KPMG PWC, EY
Constructions AA, KPMG, PWC, EY RSM, other AA, KPMG
Transportations KPMG, PWC other KPMG
Notes: AA (merged into Deloitte and Touche, June 1, 2003); KPMG; PWC; Diwan EY; Deloitte and
Touche (DT); BDO Taiwan Union & Co.; RSM International; Chien Hsing (CH); Pyramid (MRI_Moores
Rowland International); TC (MRI)
Table IV.
Auditors operating in
different industries in
Taiwan
Industry TEJ codes Freq. % B5 NB5 SPEC
Food 12 3 0.82 2 1 2
Plastics 13 8 2.18 7 1 2
Textiles 14 21 5.72 16 5 11
Electrical and machinery 15, 16 20 5.45 14 6 3
Chemicals 17 21 5.72 14 7 0
Steel and iron 20 7 1.91 3 4 2
Electronics 23 245 66.76 218 27 159
Constructions 25 17 4.63 10 7 5
Transportations 26 4 1.09 3 1 2
All others 11, 18, 21, 22, 27, 29, 40 21 5.72 13 8 7
Total 367 100.00 300 67 193
Table III.
TEJ codes distribution
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96
Table VI shows the correlation among the dependent and independent variables. Total
accruals and unexpected accruals are significantly positively correlated with each

LOSS 0.109 0.312 0 0 0
INCCHG 0.564 0.497 0 1 1
MTB 2.251 2.321 1.067 1.443 2.592
SIZE 14.126 1.295 13.476 14.042 14.751
LEV 0.393 0.155 0.269 0.384 0.516
ELEC 0.668 0.472 0 1 1
TSE 0.300 0.459 0 0 1
Notes: TAC: total accruals, defined as ðDCA
it
2 DCASH
it
2 DCL
it
2 DSTD
it
2 DEP
it
Þ=TA
it21
;
DAC: unexpected accruals; BIG5: 1 if the auditor is member of big five; 0 otherwise; SPEC: 1 if the
auditor is an industry specialist; 0 otherwise; OCF: operating cash flow deflated by lagged total assets;
ABSTA: absolute value of total accruals; LOSS: 1 if the firm incurs a loss; 0 otherwise; INCCHG:1if
this year’s income is greater than previous year’s income; 0 otherwise; MTB: market to book ratio;
SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC: 1 if the firm is
member of electronic industry; 0 otherwise; TSE: 1 if the firm is member of TSE; 0 otherwise
Table V.
Variable descriptive
statistics (n ¼ 367)
Audit quality for

auditor is an industry specialist; 0 otherwise; OCF: operating cash flow deflated by lagged total assets; ABSTA: absolute value of total accruals; LOSS: 1 if the firm incurs a loss; 0 otherwise; INCCHG:
1 if this year’s income is greater than previous year’s income; 0 otherwise; MTB: market to book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets;
ELEC: 1 if the firm is member of electronic industry; 0 otherwise; TSE: 1 if the firm is member of TSE; 0 otherwise
Table VI.
Pearson correlation
matrix for dependent and
independent variable
(n ¼ 367)
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98
as an important element of audit quality by the IPO companies in Taiwan. The
multivariate regression results in Table VII indicate that big five auditors reduce
earnings management for IPO firms in the offering year.
Several control variables are significantly related to unexpected accruals. Operating
cash flow is found to be negatively related to unexpected accruals, which suggests
firms with strong operating cash flow position are less likely to use unexpected
accruals to increase earnings in the IPO offering year. Firm size is found to be
positively related to earnings management, suggesting large firms engage more in
income increasing earnings management in the IPO year. Leverage is found to be
negatively related to earnings management, suggesting that these firms are not using
earnings management to satisfy debt covenant requirements. This shows that
earnings management in the IPO year is unlikely due to concern over debt covenants.
ELEC is significantly and negatively related to unexpected accruals, indicating
electronics companies engage in income increasing earnings management more than
companies in other industries in the IPO year.
Additional analyses
In Table VIII, we test for variable difference between big five and non-big five clients.
We find that the DAC for big five clients is significantly different from that of non-big
five clients, which further supports our finding in Table VII that big five auditors

percent industry
specialization ratio)
(n ¼ 367)
Audit quality for
Taiwan IPO
firms
99
In Table IX, we regresses unexpected accruals on industry specialization for big five
clients only, and subdivide big five variable by using four dummy variables to
examine whether specific big five is recognized by its client as more likely to constrain
earnings management in the IPO process in Taiwan. We find that EY is the only big
five firm that is recognized by its client to constrain earnings management, although
the coefficients of AA, DT, and PWC are insignificantly and negatively related to
unexpected accruals.
We also use total accruals as the dependent variable to test our hypotheses and
conduct additional analyses, and the results (not reported) are qualitatively similar to
the unexpected accruals.
V. Summary and conclusions
In this study, we examine whether auditor size and industry specialization are
associated with lower earnings management (lower unexpected accruals) for IPO
companies in Taiwan. We find that auditor size is associated with lower unexpected
BIG5 n Mean STD t-statistic
DAC 1 300 0.061 0.490 2 1.767*
0 67 0.181 0.555
SPEC 1 300 0.643 0.480 10.963***
0670 0
OCF 1 300 0.044 0.183 2 0.290
0 67 0.051 0.096
ABSTA 1 300 0.302 0.387 0.872
0 67 0.254 0.503

INCCHG: 1 if this year’s income is greater than previous year’s income; 0 otherwise; MTB: market to
book ratio; SIZE: log of total sales; LEV: leverage, defined as total liabilities over total assets; ELEC:
1 if the firm is member of electronic industry; 0 otherwise; TSE: 1 if the firm is member of TSE;
0 otherwise
Table VIII.
Test for variable
difference between big
five and non-big five
clients
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100
accruals, consistent with high quality auditors constraining earnings management and
providing more precise information. This is important given that management has
incentive to engage in earnings management in the IPO process to garner greater
proceeds and at issue earnings management is negatively related to post issue earnings
performance and stock returns. This is also important given investors have very little
information about these firms prior to the IPO process to evaluate or undo the earnings
management. Our research might be of interest to investors in IPO firms, given that at
issue unexpected accruals are opportunistic, and Teoh et al. (1998a) find that at issue
unexpected accruals are negatively related to post issue earnings performance and
stock return. Our study also contributes to the literature by showing that auditor
quality constrains earnings management in Taiwan, thus complementing the findings
in Zhou and Elder (2003).
Notes
1. See Healy and Wahlen (1999), Beneish (2001) for a review of the earnings management
literature, and Teoh et al. (1998b) and Teoh et al. (1998a) for a discussion of earnings
management for IPO companies.
2. On July 1, 2004, Security and Future Commission has been renamed as Securities and
Futures Bureau, which is directly governed by the Financial Supervisory Commission,

specialization for big five
clients only (n ¼ 300)
Audit quality for
Taiwan IPO
firms
101
performance of professional services by the members. The Statements of Financial
Accounting Standards and Statements of Auditing Standards are issued by the Financial
Accounting Standard Committee and Auditing Standard Committee of the Accounting
Research and Development Foundation. There are three stock markets in Taiwan: Taiwan
Stock Exchange (TSE), Over-The Counter (OTC), and Emerging Stock. The IPO criteria such
as net worth, profitability, and diversification of stock ownership for securities listings in the
three major stocks are different where the strictest criteria apples to the listed firms in
Taiwan Stock Exchange.
3. Other signals in addition to auditor choice, such as the percentage of retained ownership, can
be used as signals to reduce the extent of information asymmetry. Copley and Douthett
(2002) find that auditor choice and retained ownership are substitutes that are jointly chosen
to minimize the cost to the entrepreneur.
4. CPA firms typically market themselves as industry specialists. For example,
PricewaterhouseCoopers’ homepage indicates that “we have organized ourselves to
deliver our industry expertise to some 24 market sectors and have grouped these market
sectors into three clusters consistent with effective delivery to the marketplace”. Quote is
available at: www.pwcglobal.com/gx/eng/about/ind/index.html
5. Ferguson and Stokes (2002) do not find strong support for the presence of industry specialist
premiums in the post big eight/six mergers.
6. Income smoothing is different from income increasing behavior because income smoothing
also includes income decreasing behavior when current performance is relatively good and
future expected performance is relatively poor.
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