Is auditor tolerant of earnings management in socially responsible firms? Evidence from China

Purpose This study examines the effect of audit quality on earnings management to beat earnings targets among Chinese listed firms, taking into account the firms' corporate social responsibility (CSR) practice. Design/methodology/approach The sample consists of all A-shares listed in the Chinese stock market from 2001 to 2019, except firms in the financial industry. Probit estimator is employed to observe the effect of audit quality, proxied by a binary variable indicating whether a firm is audited by a Big 4 audit firm, on the behavior of earnings management to beat earnings targets. Industry and year fixed effects are incorporated into the models to control for differences among industries and time periods. Findings The result of this study reveals that audit quality disciplines earnings management to beat earnings targets in Chinese firms. This result holds across different specification and endogeneity tests. The authors further find that auditors seem to be more tolerant to earnings-managed firms that actively disclose CSR activities. However, this moderating effect of CSR disclosure only exists among firms that manage earnings less aggressively. Practical implications The findings of this study suggest that market participants should be mindful of the earnings management phenomenon and make their investment decisions after carefully dissecting and confirming the truthfulness of firms' financial reporting. Regulators should raise the requirement on the capacity of auditing services to ensure the quality of the audit outcome. Originality/value This study is the first to investigate the effect of audit quality on earnings management to beat earnings targets in Chinese firms. Moreover, this study pioneers in observing the moderating effect of CSR disclosure on the relationship between audit quality and earnings management.