Unintended Consequences from Downward Audit Adjustments : Evidence from China

Prior studies suggest that financial accounting audits improve earnings quality and exert positive effects on a firm’s cost of capital/investments. We argue, however, that managers who have experienced prior downward audit adjustments, will react myopically by increasing future real earnings management activities, potentially leading to subsequent poor operating performance. Using a unique audit adjustment data from China, we document a significant increase of real earnings management activities and a simultaneous decrease of accrual-based earnings management post downward audit adjustments. More importantly, we show that this behavior change is attributed to the potential loss of the CEO’s cash compensation caused by the downward audit adjustments. Finally, we find that firm’s future operating performance deteriorates due to this observed myopic behavior. Overall, our results suggest that there are unintended consequences associated with financial accounting audits in China, especially for those firms which had experienced a downward audit adjustment