chen et al - 2005 - audit quality and earnings management for taiwan ipo firms

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

Paper type Research paper
I. Introduction
Going public is a major corporate event for a company to raise additional capital to fund
its growth and enhance the entrepreneur’s personal wealth, where an offering
prospectus including externally audited financial statements for up to a certain period
(different among different jurisdictions) is needed to be prepared in the initial public
offering (IPO) process. Accrual accounting provides management with discretion in the
reporting of earnings, and thus provides opportunity for managers to engage in earnings
management in an IPO. Earnings management in general and earnings management in
the IPO process in particular, have attracted growing attention in the accounting
research[1]. The current study is motivated by a study by Zhou and Elder (2003), which
The Emerald Research Register for this journal is available at The current issue and full text archive of this journal is available at
www.emeraldinsight.com/researchregister www.emeraldinsight.com/0268-6902.htm
MAJ
20,1
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Managerial Auditing Journal
Vol. 20 No. 1, 2005
pp. 86-104
q Emerald Group Publishing Limited
0268-6902
DOI 10.1108/02686900510570722
finds that big five auditors and industry specialist auditors constrain earnings
management for IPO firms in the US. Given the different environments across countries
and regions, it is useful to conduct an earnings management study for IPO firms besides
the US. Therefore, the current study investigates whether the relationship between audit
quality and earnings management in the fiscal year of IPO exists in Taiwan.
Audit quality has become a concern after scandals such as Enron, WorldCom, and
Ahold, etc. These scandals raised concerns about audit quality even among the big five
accounting firms, which are normally considered the premier accounting firms and

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.

There are significant differences in the IPO process between US and Taiwan with
regard to the listing procedures and regulations. First, there exists procedural
difference for a firm to go public and to be listed in the Taiwan Stock Exchange (TSE)
compared to being listed in a US stock exchange. In the US, the listing stock exchange
is already decided when a firm goes public. However, it is not the same in Taiwan. A
firm goes public first, then the firm files registration statements to the Securities and
Futures Commission[2] (SFC, the SEC counterpart in Taiwan). If it meets the listing
requirements of the Taiwan Stock Exchange, it will be listed there. Second, there are
also regulation differences with regard to the audited financial statements in the
Audit quality for
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firms
87
registration statements. The auditor report in the registration statements to SFC in
Taiwan is signed by two audit partners in addition to a signature representative of the
audit firm, whereas only a signature representative of the audit firm is required in US.
Third, prior studies suggest that in well-developed capital markets such as the US,
there is information asymmetry between management and investors (Leland and Pyle,
1977), and between informed and uninformed investors (e.g. Rock, 1986; Beatty and
Ritter, 1986), and such information asymmetry is a necessary condition for earnings
management. The capital market is less developed and the average listed company size
is much smaller in Taiwan than in the US major stock exchanges, so the information
intermediary role played by the auditor is maybe even more important in Taiwan. The
three areas of differences between the US and Taiwan make it interesting to examine
whether audit quality constrains earnings management in Taiwan.
Earnings management in the IPO process is of particular concern for several
reasons. First, management has incentives to engage in income increasing earnings
management to ensure that the issue is fully subscribed and/or priced higher to garner
greater proceeds, because their compensation and/or reputation depend on the success
of the IPO. Second, at the issuing stage, earnings management is found to be negatively

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.

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Our study differs from Becker et al. (1998) in several respects. First, we use an industry
specialist variable in addition to a big five/non-big five measure. Previous literature finds
that audit firms devote significant resources to the development of industry expertise
(Craswell et al., 1995) and audit firms promote themselves as industry specialists. Second,
we focus on a setting where the direction of earnings management is clear, specifically,
IPO companies have incentives to engage in income increasing behavior. In contrast,
non-IPO companies may not always engage in income increasing behavior. For example,
DeFond and Park (1997) find that firms engage in income smoothing behavior because of
managers’ job security concerns[6]. Third, there are significant resource allocation
concerns in the IPO process. Managers/owners can benefit from higher IPO proceeds;
however investors may make incorrect decisions based on reported earnings. Fourth,
unexpected accruals have been found on average to be opportunistic for IPO companies.
Teoh et al. (1998b) find that earnings at the time of the IPO are high because of high
unexpected accruals, and earnings after the issue are low because the earlier high
unexpected accruals are not sustained. Teoh et al. (1998a) find that at-issue earnings
management is significantly negatively related to post-issue stock returns.
Using a sample of IPO firms from 1996-1998 from the December 1998 Compact D
New Issue database, Zhou and Elder (2003) find that unexpected accruals for IPO firms
are lower when big five auditors are used, suggesting that the big five auditors are
associated with reduced management discretion over earnings. They also find that
firms audited by industry specialist auditors engage in less earnings management.
Similar to Zhou and Elder (2003), we seek to address these two research questions:
(1) Do big five auditors constrain earnings management in the IPO process?
(2) Do industry specialist auditors provide higher quality of audits in the IPO
process as evidenced by less earnings management?
Using 367 IPO observations satisfying all the data requirements from 1999-2002, we
find that unexpected accruals for IPO firms are lower when big five auditors are used,

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

prospects in an environment in which they have less information than management. In
such an environment, management can use its flexibility to manage reported earnings.
Furthermore, management’s discretionary ability to manage earnings increases as the
information asymmetry between management and shareholders increases. Richardson
(2000) provides empirical evidence consistent with this line of reasoning. He finds that
the extent of information asymmetry, as measured by the bid-ask spread and the
dispersion in analysts’ forecasts, is positively related to the degree of earnings
management. The information asymmetry in the IPO environment creates an
opportunity for management to engage in earnings management because it is difficult
for related stakeholders (especially shareholders) to undo this behavior.
Teoh et al. (1998b) evaluate whether accounting accrual choices during an IPO are
informative to investors or opportunistic. They find evidence consistent with
opportunism. They find that the net income of IPO firms are significantly higher
during the issuing year relative to subsequent years, and to non-issuing industry peers.
IPO firms are able to report high earnings during the IPO by reporting unexpected
accruals aggressively. The IPO firms’ earnings under-perform relative to their matched
firms and non-issuing industry peers when high unexpected accruals at issue cannot
be sustained in the following periods. More importantly, they find that unexpected
accruals explain the post-issue underperformance in earnings.
In a related paper, Teoh et al. (1998a) find that at issue earnings management is
negatively related to post issue stock returns. A possible interpretation of their
findings is that at issue earnings management helps the company receive a higher
issuing price. When at issue earnings performance attributable to earnings
management cannot be sustained in the following periods, this is negatively
reflected in the stock price.
Audit quality and earnings management
Auditor firm size. In Taiwan, the big five audit firms are T.N. Soong & Co. (member of
Arthur Andersen), PricewaterhouseCoopers, KPMG, Deloitte and Touche, and Diwan
Ernst & Young. Due to the Enron scandal and ceased operation of Andersen on August
31, 2002, T.N. Soong & Co. merged into Deloitte and Touche and became Deloitte 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
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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

about earnings, which makes it easier for the investment banker to price the issue
correctly and preserve reputation quality. This information argument is consistent
with the model in Titman and Trueman (1986), in which the price of the shares in an
IPO is increasing with the quality of the information provided by the offering
company, which they argue is partially determined by the quality of the auditor.
Evidence that big five auditors are associated with lower unexpected accruals for IPO
firms would further support the information hypothesis. Zhou and Elder (2003) provide
evidence supporting the information hypothesis that audit quality provided by big five
audit firms is an important constraint in earnings management in the IPO process in
the US. Therefore, we expect that IPO companies in Taiwan that use big five audit
firms will engage in less earnings management than IPO companies with non-big five
auditors:
H1. IPO firms in Taiwan audited by big five audit firms engage less in earnings
management than firms audited by non-big five auditors.
Auditor industry specialization. Recent audit quality research has focused on the role of
auditor industry specialization. Hogan and Jeter (1999) find that measures of
specialization have increased in both regulated and unregulated industries, consistent
with returns to specialization. Craswell et al. (1995) argue that audit firms market
themselves in terms of both a general reputation and industry expertise. In a test of
audit fees in the Australian audit market, they find that industry specialists receive a
significant fee premium, and that this fee premium is a significant component of the fee
premium received by big five firms.
Industry specialization is acknowledged in DeAngelo (1981) as one possible reason
for the selection of big five auditors by IPO companies. In the Titman and Trueman
(1986) model, in which the pricing of an IPO is increasing with the quality of
information associated with the expertise of the auditor, they suggest that industry
knowledge is one element of auditor expertise. Elder (1999) finds that IPO
Audit quality for
Taiwan IPO
firms

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

Þ=TA
it21
TACC
it
¼ a
1
ð1=TA
it2 1
Þþa
2
ðDREV
it
2 DREC
it
Þ=TA
it21
þ a
3
PPE
it
=TA
it2 1
þ 1
it
where:
TACC
it
¼ total accruals for firm i in year t, defined as above.
D
CA

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

¼ total assets for firm i in year t-1.
This equation is estimated cross-sectionally each year for each two-digit Taiwan
Economic Journal (TEJ) code industry using all available firms. At least ten firm year
observations are required in a two-digit TEJ code. The residual from the regression is
the unexpected accruals. Normal levels of working capital accruals related to sales are
controlled through the changes in revenue adjusted for changes in accounts receivable.
Normal levels of depreciation expense and related deferred tax accruals are controlled
through the gross property, plant and equipment. In addition the total assets of the
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previous period are used as a deflator to control for potential scale bias. The
cross-sectional model reflects common industry factors applied to unexpected accruals.
As a result, estimated unexpected accruals are more likely to reflect management’s
choice rather than industry factors. Also, since the model is estimated year-by-year,
changes in industry conditions are also factored in the model.
Auditor industry specialization
Craswell et al. (1995), and Ferguson and Stokes (2002) use the percentage of the audit
firm’s share of total industry audit fees as an industry specialist measure. This
measure incorporates size weighting into market share (weighted by audit fees). They
define an auditor to be an industry specialist if the auditor attains a 10 percent market
share from either or both of these two measures. Since the audit fee data is not
available to us, we cannot use this procedure and instead use a sales-based industry
specialist measure. Since the Taiwan market is comparatively smaller than the US
market, we require there to be at least ten firms in a two-digit TEJ code industry for an
auditor to qualify as an industry specialist, rather than the 30 US firms used in Zhou
and Elder (2003). Audit firm industry specialization is defined as follows:
MS
ik
¼

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.

J
ik
¼ the number of clients served by audit firm i in industry k.
Industry specialists are calculated yearly based on the firm-year observations from the
TEJ database. When auditor j’s market share is greater than 15 percent in a two-digit
TEJ code industry, the auditor j is treated as an industry specialist.
Approach to testing
Our hypotheses relate earnings management as measured by unexpected accruals to
audit quality as measured by auditor type and industry specialization. Many other
variables may play a role in management’s unexpected accruals decision in the IPO
process. Becker et al. (1998) find that operating cash flows are significantly different for
firms audited by big five versus firms audited by non-big five firms. The absolute
value of total accruals is used as a control variable because Becker et al. (1998) provide
evidence that this is significantly negatively related to unexpected accruals. Also
Audit quality for
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93
Francis et al. (1999) find that the likelihood of using a big five auditor is increasing in
firms’ endogenous propensity for accruals.
Burgstahler and Dichev (1997) find that firms manage reported earnings to avoid
reporting earnings decreases and losses. Accordingly, loss and income change
indicator are added as control variables to account for managers’ incentive to avoid
earnings decreases and losses. Market-to-book value at the end of the IPO offering year
is used as a surrogate for growth opportunity because information communication
might play a role in some managers’ earnings management decisions, even though
Teoh et al. (1998b) find that managers use unexpected accruals opportunistically in the
IPO process. Managers may try to signal the firm’s future prospects through
unexpected accruals.
The log of sales is used as an independent variable to control for the possible effect

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
4
ABSTA
it
þ
b
5
LOSS
it
þ
b
6
INCCHG
it
þ
b
7
MTB
it
þ
b
8
SIZE
it
þ
b
9
LEV
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;

0 otherwise.
MTB
it
¼ market to book ratio.
SIZE
it
¼ log of total sales.
LEV
it
¼ leverage, defined as total liabilities over total assets.
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ELEC
it
¼ 1 if the firm is member of electronic industry; 0 otherwise.
TSE
it
¼ 1 if the firm is member of TSE; 0 otherwise.
The model is estimated using unexpected accruals (DAC) as the dependent variable.
The main research variables of interest are BIG5 and SPEC. Consistent with the two
research hypotheses, the coefficients on these two variables are predicted to be
negative because firms audited by big five auditors and industry specialists are
expected to engage in less earnings management in the IPO process.
IV. Sample selection and results
The sample consists of 367 observations of new issues between 1999 and 2002 from the
Taiwan Economic Journal (TEJ) database satisfying the following criteria:
.
IPO date, and the auditor for the IPO are available from the database; and
.

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

and by auditor
Audit quality for
Taiwan IPO
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95
TEJ industry codes; no other TEJ industry code contains more than 6 percent of the
sample firms.
Table IV presents the distributions of auditors operating in different industries. As
evident from Table IV, not every big five auditors are industry specialist auditors. For
example, all the big five audit IPO firms in the electronics industry, Deloitte & Touche
is not an industry specialist auditor.
Table V provides descriptive statistics for the sample. The average total accruals
are 0.047. The average unexpected accruals are 0.083 and the median of unexpected
accruals is 0.062. Big five auditors are used by 81.7 percent of the sample firms, and
around 53 percent of firms use industry specialist as auditors. The mean and median
operating cash flows are 0.046 and 0.058. The mean and median of absolute value of
total accruals are 0.294 and 0.153 respectively. The median firm has positive net
income and positive income change in the IPO year. The average market-to-book ratio
at the end of the offering year is 2.251, and the average log of sales is 14.126. The mean
and median leverage are 0.393 and 0.384, respectively. The sample companies from the
electronics industry are 66.8 percentage of the sample, and there are 30 percentage of
the sample companies listed in the Taiwan Stock Exchange.
Industry B5 (Freq.) NB5 (Freq) SPEC (Freq)
Food PWC, DT Other PWC, DT
Plastics AA, KPMG, PWC, EY, DT MRI AA, KPMG
Textiles AA, KPMG, PWC, EY, DT MRI, CH, other AA, KPMG, DT
Electrical and
machinery AA, KPMG, PWC, EY BDO, other
KPMG, PWC
Chemicals AA, KPMG, PWC, EY, DT BDO, other

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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Table VI shows the correlation among the dependent and independent variables. Total
accruals and unexpected accruals are significantly positively correlated with each

other. The big five variable is negatively related to total accruals and unexpected
accruals. Industry specialist is insignificantly and negatively related to total accruals
and unexpected accruals. This suggests that big five auditors constrain earnings
management in the IPO process, although the formal analyses are based on
multivariate analyses. As expected, there is a positive correlation (0.50) between the big
5 and industry specialist variables. As described in Table V, 81.7 percent of the sample
firms (300/367) audited by big five firms, and around 53 percent of firms (193/367) use
industry specialist as auditors. That is, there are 107 firms out of 300 big five audited
firms are not industry specialists.
Tests of the research hypotheses using unexpected accruals in the fiscal year of IPO
offering as the dependent variable are reported in Table VII. The first two columns
report the results using separate big five and industry specialist auditor reputation
measures, and the last column reports the results using both measures. The big five
measure is associated with lower unexpected accruals at the 5 percent level or better in
both model specifications. These results suggest that big five auditors are associated
with lower unexpected accruals in the fiscal year of IPO offering, and audit quality
plays an important role in reducing earnings management.
The coefficient on the industry specialist variable is insignificantly negative when
the big five variable is excluded, and is insignificantly positive when both big five and
SPEC variables are included. This is not consistent with the findings in Zhou and Elder
(2003) and Craswell et al. (1995) that industry specialization is an important element in
auditor quality. The possible explanation is that the Taiwan audit market is
comparatively smaller than the US, or the industry specialization is not well recognized
Var Mean STD Lower quartile Median Upper quartile
TAC 0.047 0.503 2 0.113 0.036 0.193
DAC 0.083 0.504 2 0.084 0.062 0.238
BIG5 0.817 0.387 1 1 1
SPEC 0.526 0.500 0 1 1
OCF 0.046 0.170 2 0.023 0.058 0.125
ABSTA 0.294 0.410 0.064 0.153 0.344

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

Taiwan IPO
firms
97
TAC DAC BIG5 SPEC OCF ABSTA LOSS INCCHG MTB SIZE LEV ELEC TSE
TAC 1
DAC 0.97 0.00 1
BIG5 2 0.09 0.10 2 0.09 0.08 1
SPEC 2 0.03 0.54 2 0.04 0.42 0.50 0.00 1
OCF 20.07 0.17 2 0.06 0.22 2 0.02 0.77 0.10 0.06 1
ABSTA 0.18 0.00 0.20 0.00 0.05 0.38 0.03 0.53 2 0.03 0.55 1
LOSS 2 0.11 0.03 2 0.11 0.03 0.07 0.15 0.12 0.02 2 0.14 0.01 2 0.05 0.33 1
INCCHG 0.11 0.04 0.11 0.04 0.03 0.63 2 0.08 0.15 0.13 0.01 0.09 0.09 2 0.38 0.00 1
MTB 0.17 0.00 0.16 0.00 0.14 0.01 0.08 0.11 0.23 0.00 0.09 0.09 2 0.12 0.02 0.30 0.00 1
SIZE 0.06 0.26 0.03 0.51 0.06 0.26 0.12 0.02 0.04 0.40 2 0.06 0.24 2 0.21 0.00 0.23 0.00 0.06 0.29 1
LEV 2 0.07 0.20 2 0.06 0.24 2 0.03 0.58 2 0.02 0.72 2 0.26 0.00 0.01 0.86 0.05 0.34 0.04 0.40 2 0.18 0.00 0.35 0.00 1
ELEC 2 0.03 0.50 2 0.06 0.24 0.27 0.00 0.35 0.00 2 0.04 0.47 0.01 0.81 0.10 0.06 0.16 0.00 0.26 0.00 0.17 0.00 2 0.06 0.27 1
TSE 0.02 0.74 0.03 0.62 0.05 0.36 2 0.01 0.85 0.05 0.37 2 0.24 0.00 2 0.11 0.03 0.17 0.00 0.27 0.00 0.20 0.00 2 0.16 0.00 0.05 0.39 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:
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

reduce earnings management for IPO firms in the offering year. Interestingly, we find
that industry specialists for big five clients is significantly different from those of
non-big five clients, which indicates that industry specialist firms are highly
recognized by big five clients.
DAC DAC DAC
INTERCEPT (t-statistic) 2 0.225 2 0.754 2 0.293 2 0.982 2 0.191 2 0.634
BIG5 2 0.134 2 1.966** 2 0.167 2 2.186**
SPEC 2 0.002 2 0.039 0.060 0.959
OCF 2 0.447 2 2.772*** 2 0.441 2 2.692*** 2 0.473 2 2.892***
ABSTA 0.222 3.429*** 0.216 3.314*** 0.220 3.389***
LOSS 2 0.066 2 0.722 2 0.076 2 0.829 2 0.071 2 0.770
INCCHG 0.050 0.842 0.052 0.869 0.058 0.975
MTB 0.038 3.044*** 0.036 2.896*** 0.039 3.071***
SIZE 0.035 1.506* 0.034 1.432* 0.033 1.404*
LEV 2 0.365 2 1.896** 2 0.360 2 1.859** 2 0.367 2 1.905**
ELEC 2 0.121 2 2.021** 2 0.146 2 2.340*** 2 0.137 2 2.203**
TSE 2 0.011 2 0.171 2 0.014 2 0.226 2 0.009 2 0.148
Adj. R-sq. 8.4 7.4 8.4
Notes: Significant at the *0.10, **0.05, 0.01 level based on a one-tail test; 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: 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 VII.
Regression of unexpected
accruals on auditor size
and industry
specialization (using 15

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

LOSS 1 300 0.120 0.326 1.432
0 67 0.060 0.239
INCCHG 1 300 0.570 0.496 0.487
0 67 0.537 0.502
MTB 1 300 2.401 2.494 2.630***
0 67 1.582 1.075
SIZE 1 300 14.162 1.381 1.117
0 67 13.967 0.793
LEV 1 300 0.391 0.159 2 0.552
0 67 0.403 0.139
ELEC 1 300 0.727 0.446 5.260***
0 67 0.403 0.494
TSE 1 300 0.310 0.463 0.907
0 67 0.254 0.438
Notes: Significant at the *0.10, **0.05, 0.01 level based on a two-tail test; 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; SPEC:1if
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: 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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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,

Executive Yuan. Self-regulated bodies of the accounting profession include National
Federation of Certified Public Accounts Association of the ROC, which govern the
DAC DAC DAC
INTERCEPT 2 0.286 2 0.943 2 0.195 2 0.628 2 0.198 2 0.636
SPEC 0.065 1.048 0.015 0.181
AA 2 0.073 2 0.828 2 0.074 2 0.835
DT 2 0.077 2 0.892 2 0.067 2 0.655
EY 2 0.112 2 1.236 2 0.106 2 1.109
KPMG 0.033 0.393 0.030 0.360
OCF 2 0.606 2 3.591*** 2 0.571 2 3.415*** 2 0.577 2 3.388***
ABSTA 2 0.072 2 0.960 2 0.079 2 1.041 2 0.079 2 1.038
LOSS 2 0.086 2 0.895 2 0.072 2 0.744 2 0.073 2 0.752
INCCHG 0.088 1.339* 0.085 1.314* 0.088 1.323*
MTB 0.038 2.993*** 0.037 2.869** 0.037 2.868***
SIZE 0.037 1.557* 0.036 1.524* 0.036 1.495*
LEV 2 0.510 2 2.458*** 2 0.544 2 2.594*** 2 0.544 2 2.590***
ELEC 2 0.118 2 1.685* 2 0.098 2 1.452* 2 0.103 2 1.408*
TSE 2 0.058 2 0.840 2 0.046 2 0.664 2 0.046 2 0.663
Adj. R-sq. (%) 5.8 5.7 5.4
Notes: Significant at the *0.10, **0.05, 0.01 level based on a one-tail test; DAC: unexpected accruals;
SPEC: 1 if the auditor is an industry specialist; 0 otherwise; AA: 1 if the auditor is AA; 0 otherwise; DT:
1 if the auditor is DT; 0 otherwise; EY: 1 if the auditor is EY; 0 otherwise; KPMG: 1 if the auditor is
KPMG; 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 IX.
Regression of unexpected
accruals on industry

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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Audit quality for
Taiwan IPO
firms
103
Further reading
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the role of accounting accruals”, Journal of Accounting and Economics, Vol. 18 No. 1,
pp. 3-42.
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