An Interplay of Audit Quality and Default Risk on Earnings Management: A Comprehensive Analysis from the non-financial sector of Pakistan

Abstract

The purpose of this study is to investigate the relationship between audit quality and default risk in earnings management. The auditors have a key role in mitigating earnings management and improving the quality of financial statements. It is also necessary for the regulatory authorities to increase transparency through reliable financial information disclosures. The data employed in this study is based on 200 non-financial firms listed on the Pakistan Stock Exchange (PSX) from 2011 to 2020. The modified Jones model is used to determine discretionary accruals and detect earnings management. Audit procedures executed by the Big Four audit firms are analyzed and operationalized as a measure of audit quality. The results of this study highlight the requirement for appropriate accounting and auditing procedures to mitigate the risk of earnings management. Based on the key findings of this study, authorities should foster a regulatory environment that should be transparent as well as accommodating to monitoring institutions, as audits executed by Big Four firms not only reduce the default risk but also mitigate the detrimental effects of counterfeit financial disclosures by increasing the transparency of information and reducing information asymmetry to protect the right of shareholders.