Impact of regulation change on earnings quality in India

Abstract

The primary objective of this thesis is to examine the impact of regulation change on earnings quality. This work is organized into two distinct chapters. The first chapter examines the impact of auditor appointment regulation change on the earnings quality. This study examines the impact of regulation change with respect to auditor appointment on banks’ earnings quality in India. Since top management makes all decisions related to auditor appointment, it creates an economic bond between top management and auditors which could impair auditor independence. Effectively the appointment of auditors is controlled by the same entity whose decisions they are supposed to evaluate and audit. Prior research argues that such an arrangement allows management greater discretion in reporting their earnings. In recent times, the Indian government over certain periods has allowed public sector banks to appoint their own auditors, and over certain periods the government has appointed auditors on the bank’s behalf. This context creates a natural experiment where the economic bond between top management and auditors is weakened or strengthened. This allows us to perform a comparative analysis to examine if the vesting of auditor appointment authority in the top management results in greater discretion on the reported earnings. The results of our analysis indicate that autonomy in bank auditor appointment results in greater earnings management. More specifically we argue that auditor’s oversight capabilities are negatively impacted by the existence of an economic bond stemming from their appointment by top management. The second chapter examines the impact of Related Party Transactions (RPT) on earnings quality and the subsequent market reactions. Prior research indicates that RPT tends to adversely impact shareholders’ interests (Gordon & Henry, 2005) particularly by tunnelling profits to controlling shareholders (Lo & Wong, 2011), thus destroying firm value (Kang et al., 2014; Kohlbeck & Mayhew, 2010). In India, the magnitude of RPT has been increasing over time, and as a result, new regulations have been introduced for RPT approvals. These new regulations involve getting approval for RPTs from the shareholders as well as the board of directors and audit committee. This study finds that the mere presence of RPTs is not essentially an indication that a firm is likely to engage in greater earnings management, which is in contrast to theoretical arguments proposed in Aharony et al. (2010). However, more importantly, the results indicate that markets respond positively to the RPT related regulation change which requires greater scrutiny from the stakeholders of the company. The study also supports the above arguments using an experimental design and observes that the recent change in RPT approval regulation improves investor perceptions of firms engaging in RPTs.