Relationship among Audit Quality, Earnings

Management and Financial Performance of

listed companies: Case of Bahrain
CURRENT ISSUES IN ACCOUNTING (ACC 491) RESEARCH
PAPER

SUBMITTED TO: DR. OMAR JUHMANI

GROUP 6 SEC 02
SHAMEEM EBRAHIM
AHMED KHALIL
NAVEED KARIM BAKSH
ABDULLA AHMED KHALAF
MUBARAK A.RAHMAN
YUSUF SAEED AHMED ALSAEGH

20126301
20120504
20124656
20110014
20125424
20112536

Table of Contents
Abstract ................................................................................................................... 2
1. Introduction ............................................................................................................. 3
2. Literature Review ..................................................................................................... 5
3. Research Hypothesis ................................................................................................ 9
4. Research Methodology .......................................................................................... 10
5. Model Development .............................................................................................. 11
6. Findings and Discussions ........................................................................................ 12
7. Conclusion and Recommendations ......................................................................... 23
References ............................................................................................................. 24
Appendix ............................................................................................................... 25

1|Page

Topic: Relationship between Audit Quality, Earnings Management and

Financial Performance of listed companies in Bahrain
Abstract:
The aim of this study to identify the relationship among audit quality, earnings management
and financial performance of listed companies in Bahrain. Our sample included listed firms in
Bahrain Bourse during the period 2009 to 2011. Total of 45 companies were selected.
Analysis was carried out using SPSS and Microsoft excel. It was concluded that audit quality
does not really affect earnings management practices in Bahraini listed companies. Whereas,
audit quality has an impact on financial performance as companies audited by Big 4 tend to
improve companies audit quality and enhance confidence of investors. It was also concluded
that earnings management practices have a low significant impact on companys financial
performance. Certain limitations existed such as lack of information related to audit quality,
small sample, etc.
Keywords: Earnings Management, Audit Quality, Financial Performance

2|Page

1. Introduction:
Earnings or Net Income is the most important item of a statement of profit or loss and other
comprehensive income or simply, an income statement. It indicates a companys value. An
increase in earning indicates an increase in companys value and vice versa. Importance of
earnings is due to its informative and stewardship roles. Earnings helps in determining the
attractiveness of a companys stock. The ability of a company to generate profits is vital in
determining value of a companys stock. This represents the informative role of earnings.
Stewardship role is due to the separation of company ownership from its management, where
the managers act as stewards of shareholders investment.
Due to its importance, companys management is interest on how earnings of a company are
reported in their financial statements. This puts a pressure on the management to need to
understand the accounting choices that are available so as to make it useful for decision making.
Earnings management refers to the strategy used by the companys management to deliberately
manipulate the earnings so as to match their predetermined target. Ronen and Yaari (2008)
suggested three definitions for earnings management

A tool used by managers for accounting information flexibility.

Utilization of accounting tools by the management in such a way that it can be applied
to optimistic and opportunistic managerial goals.
Manipulating the accounting data which could mislead shareholders and potential
investors.

According to Healy and Wahlen (1999), earning management occurs when managers use their
judgements to report and structure transactions to manipulate information either to mislead
stakeholders or to attract contractual outcomes depending on the information. According to
them, it was discretionary adjustments of management which led to manipulating the numbers.
Brown (1999) states earnings management as an expression of financial fraud.
A study by Watts and Zimmerman (1986) concluded that capital market, contractual
arrangements and regulatory considerations motivates the managers to manage earnings. They
used Positive Accounting theory to shows how the managers choose a method to manage
earnings to reach to their predetermined numbers and to influence various stakeholders
including potential investors and shareholders.
Excessive earnings management often results in fraud. The 2007 scandal is one such instance
which pushed the world into financial crisis. As a result, companies such as Lehman Brothers
and Merryl Lynch either went bankrupt or were taken over by the government. Corruption is
considered to be high in developing countries with weak rules of law. For instance,
Transparency International (2012) stated that rate of corruption has increased over the past five
years in India.
As per Dyreng, Hanlon and Maydew (2011), earnings management is a common practice in
countries with weak rules of law. They also concluded that firms with high tax havens practice

3|Page

earnings management than any other firms and it takes place in their domestic income instead
of their foreign income.
Various scandals such as Enron and WorldCom eroded public confidence in the US. This led
to the formation of Sarbanes Oxley Act in 2002 to improve integrity, reliability and accuracy
of corporate disclosure and thereby to boost investors confidence. Earnings Management were
given more importance in the Act (Nting, 2008).
Most of the empirical researches regarding the relationship between firm performance and
earnings management were conducted before the implementation of Sarbanes Oxley Act in
2002. Since managers compensations are based on firms earning, managers are motivated to
use their judgement to manipulate financial reporting (Degeorge, Patel and Zeckhauser, 1999)
Audit quality is considered to be one of the most discussed topics of current audit practices.
Various internal and external groups have interest in audited financial statements quality (Heil,
2012). It is a monitoring mechanism which helps to reduce asymmetry of information and
protect interests of various user groups. Auditors are required to reduce risks of material
misstatements and also evaluate the internal controls of the organization.
Audit Quality has a vital role in maintaining the efficiency of markets by improving confidence
and integrity of financial statements. Confidence is improved as auditors provide objective and
unbiased opinion on financial statements.
The study examines the relationship among Audit Quality (AQ), Earnings Management (EM)
and Financial Performance (FM) of listed companies in Bahrain.
The objectives of our study are as follows:

Examine the relationship between earnings management and audit quality

Identify the relationship between earnings management and financial performance
Determine the relationship between audit quality and financial performance
Examine relationship among audit quality, earning management and financial
performance

The remainder of the article is structured as follows. Section 2 reviews the literature on
relationship between audit quality, earnings management and financial performance.
Hypothesis are developed in section 3. Section 4 describes models that are used for our study.
It is followed by research methodology that explains the variables and sample we have used.
Section 6 explains the findings of our study and conclusions are drawn and recommendations
provided in the last section.

4|Page

2. Literature Review:
Agency theory explains the relationship between principles and their agents. Agents are those
who act on behalf of their principle. Potential conflicts of interests could arise as a result of
separation of ownership and control. This is because each party has their own goal which could
result in managers not acting in their best interest on behalf of their owners (Br Bukit and
Iskandar, 2009). As a result, it can result in demand for external auditor (Gerayli, Yanesari and
Maatoofi, 2011).
Methods of earnings manipulation is important to understand because firm performance is
assessed based on net income, which the managers can manipulate using current assets. For
instance, manipulating cost of sales by overstating ending inventory.
Various tools are used by the managers for earnings management. According to Ayres (1994),
Bruns Jr and Merchant (2005) and Francis (2001), four categories to manage earnings are:

Discretionary Accruals and estimation of liabilities

Revenue Recognition
Excessive provisions and generous reserve accounting
Minor breaches of reporting requirements, that could be material when aggregated.

We have focused on discretionary accruals (Modified Jones Model) as measure of earnings

management in our research. The first model for total discretionary accruals that was used
widely by researchers and analysts was introduced by Jones in 1991. It was used to determine
the extent to which financial data was manipulated and a milestone for accruals approach.
Before the introduction of Jones model, other researchers including Deangelo (1986, 1988),
Dechow and Sloan (1991), Healy (1985) and Ronen and Sadan (!981) tried to develop a model
for accruals.
Ronen and Sadan (1981) introduced expense model which was based on income statement
classification and use of two step regression analysis to examine income smoothing. Healy
(1985) was focused on use of management incentives that was used to manipulate earnings
downwards. He defined accruals as deflated long term accruals. The model developed by
Deangelo considered accrual as the prior accruals which were deflated by lagged assets.
Research and Development expenditure were compared with previous CEOs spending by
Dechow and Sloan (1991), who developed three hypotheses for reduction in research and
development expenditure.
Total accruals and discretionary accruals are affected by earnings management. Richardson et
al. (2006) suggested that there exist an association between accruals and earnings
manipulation.

5|Page

Earnings Management (EM)

Audit Quality (AQ)

Financial Performance (FP)

Figure 1 Relationship between audit quality, earnings management and financial performance

Deangelo (1981) defined audit quality as auditors competency and independence in detecting
and reporting material misstatements. As the audit quality improves, the more likely it is to
discover accounting practices that are questionable by clients and report material misstatements
(Shabou 2011). As a result, high audit quality should help in detecting earnings management.
It also enhances the quality of financial statements. Okolie (2014), Soliman and Ragab (2014),
Gerayli, Yanesari and Maatoofi (2011) are some of other researches that have proved that high
audit quality eliminates earnings managements. Our study used audit firm size as an indicator
of audit quality.
Companies that are audited by Big 4 are involved in low earnings management compared to
companies that are audited by other auditors. As per Solimna and Ragab (2014) and Zgarni,
Hlioui and Zehri (2012), there is a significant negative relationship between earnings
management and audit quality. Therefore, it can be concluded that when companies are audited
by Big 4 audit firms, the chances of earnings management are less.
Audit Fees is another factor of audit quality. As the discretionary accruals increases, the audit
fees increases to improve quality of earnings and to reduce earnings management practices
(Alali, 2011). On the other hand, high audit fees can be considered as a threat to auditors
independence that can result in low audit quality and support greater earnings management
practices. (Okolie, 2014). Audit fees should be based on the number of hours worked. High
working hours and efforts could lead to clients paying high bill to the auditors and thereby,
enhancing the audit quality.
Audit Tenure refers to the length of auditors relationship with their clients. Long relationships
can be considered as threat of independence as the auditors will be more familiar with the
company management. This could reduce auditors alertness to threats and potential material
misstatements. As the auditor get more familiarized with the company management, they put
in less efforts to detect material misstatements and internal control weaknesses (Piot and Janin,
2007). According to Chi and Huang (2005), familiarity, due to audit tenure, increases earnings
quality but, could affect audit quality due to excessive familiarity.
As per Becker et al. (1998), high quality auditors, as compared to low quality auditors, are
more likely to detect accounting practices that are questionable which could lead to
qualification of audit opinion.

6|Page

Various government regulations are present whose objective is to reduce familiarity threat. For
instance, as per provision under Malaysian Institute of Accountants (MIA), audit partners
should be rotated after a period of not more than 5 years.
Various measures are present that helps in assessing financial performance of an entity.
Different studies used different measures as an indicator of financial performance. For instance,
Klein (1998) used return on assets (ROA) whereas Lo (2003) depended on return on equity
(ROE) to assess the financial performance. Both ROE and ROA were used by Brown and
Caylor (2005) to measure financial performance of entities.
We used ROA to indicate firms financial performance.
Very few studies have been conducted that examines relationship between firm performance
and audit quality. Audit Quality has both a direct effect and a mediate effect as they contribute
to financial performance (Miettinen, 2011). As per Anderson and Verma (2012), Big 4 audit
firms are regarded more conservative than the other audit firms. They also concluded that audit
rotation helps in improving audit quality.
According to Hassan and Farouk (2014), there exist a positive relationship between audit
quality and performance organization. As the audit fees increases, the commitment to work
also improves which reduces the risk of material misstatements and internal control weaknesses
being unnoticed. Audit firms also ensure that they provide the best services for the fees they
get, thereby increasing value for money. Non-Big 4 audit firms can be easily arm twisted by
the firms as compared to Big 4 audit firms.
Due to the perception of investors, audit quality enhances firm performance (Afza and Nasir,
2014). Firms disclose reliable and reasonable financial statements when they are audited by
one of Big 4 auditors. This improves investors confidence. It also reduces agency costs by
highlighting the credibility and integrity of companys financial statements thereby reducing
monitoring costs and enhancing firm performance (Jusoh, Ahmed and Omar, 2013).
Various studies have shown that there exist a negative relationship between earnings
management and firm performance. According to Hassan and Ahmed (2012), in order to
increase or decrease reported income, accruals are the most common form of manipulating
earnings, which indicates that financial performance of a firm is negatively affect by accruals
based earnings management.
Companys performance and earnings management vary according to the way company is
governed (Tang and Chang, 2014). Shareholders access to true financial performance in also
negatively affected due to earnings management (Kang and Kim, 2011). This could result in
affecting companys long term performance.
A study on relationship between earnings management and firm performance in acquiring firms
in Malaysia showed that stocks of those firms that acquired other firms via share swap have
underperformed, right after the acquisition date.
7|Page

As per Beidleman, earnings are widely used to evaluate the past performance, as a basis for
preparing budgets and forecasts and to help in making acquisition decision. It will be difficult
to plan and budget for future periods if reported income is considered to be highly variable. A
repeat performance showing sharp increase in income will be unattainable. Due to this,
management is forced to smooth income and sustain recent performance.
According to Fairfield et al. (2003), there is a negative relationship between working capital
accruals and future profitability. Current assets and current liabilities are included in working
capital.
Verma (2012) suggested some of the allowable management techniques which includes
inventory valuation methods, expenses that are accrued for a future period, revenue and
expense recognition techniques, usage of derivatives, increasing or decreasing the profits of
selling or buying goods, unexpected gains or losses from long term assets valued at cost.
Managing earnings by depositing current years checks in the next year can lead to abnormal
cash flows from operations that can affect future profits of the firm. According to Gill, Biger
and Mand (2013), who conducted a study on relationship between financial performance and
earnings management in India, there exist a positive relationship between financial
performance and earnings management.
Firm Size is used as control variable in our research. Studies have shown that companys
financial performance can be affected by its size (Glancey 1998; Lang and Stulz ,1994; Sarkar
and Sarkar, 2000). Research by Himmelberg et al. (1999) concluded that smaller companies
are more efficient since the management has control over their operations and strategic
activities as compared to larger firms. Whereas, according to Short and Keasay (1999), due to
the economies of scale factor, large firms are more efficient than small firms. Therefore, we
expect a positive relation between firm size and financial performance.
Kang and Kim (2011) concluded in their study that earnings management act as a mediator
between financial performance and audit quality. They also concluded that earnings
management strengthens the link between audit quality and financial performance.
Another study by Fang concluded that earnings management increases as the firm performance
increases. This may be due to management having incentives to reduce losses. There is also a
stable relationship between them which could be due to managers wanting to sustain the recent
performance. Once the firm reaches a particular level of performance, earnings management
magnitude gradually decreases which could be due to managers having fewer incentives to
manage earnings.

8|Page

3. Research Hypothesis
The study aims to examine the mediating relationship that earnings management has on audit
quality and firm performance. We also have examined other relationships as shown in the
following:
NULL HYPOTHESIS
Ho1: There is a significant negative relationship between audit quality and earnings
management
Ho2: There is a significant positive relationship between audit quality and financial
performance
Ho3: There is a negative relationship between earnings management and financial performance
Ho4: earnings management mediates the association between audit quality and financial
performance
Ho5: earning management level in small sized firms are greater than large sized companies
ALTERNATIVE HYPOTHESIS
Ha1: There is no significant negative relationship between audit quality and earnings
management
Ha2: There is no significant positive relationship between audit quality and financial
performance
Ha3: There is no negative relationship between earnings management and financial
performance
Ha4: earnings management does not mediate the association between audit quality and
financial performance
Ha5: earning management level in small sized firms are not greater than large sized companies
The relationship between variables exist if the coefficient is positive or negative and at 95%
confidence level for significance. We have used the following models to examine the
relationship between audit quality, earnings management and financial performance variables.

9|Page

4. Research Methodology
Sample
Our study is based on listed companies in Bahrain Bourse during the period 2009 to 2011. A
total of 45 companies, that are listed on Bahrain bourse, have been selected for our research.
In order to analyze, we used IBM SPSS (version 22) for descriptive analysis and multiple
regression. To ensure accuracy, Microsoft Excel was also used
Determinants of Variables
The variables that we have used in our research are shown in Table 1
Table 1 Definition and measurement of variables

Variable

Proxies

Measurement

Audit quality (AQ

Independent variables)

Audit firm size

(AudSIZE)

A dummy variable; 1 is given to

the company that is audited by a
Big Four audit firm; 0 otherwise.
Natural log of audit fees paid to
an audit firm in a year.

Audit Fees (AudFEE)

Audit Partner tenure
(TENURE)

Length of relationship between

audit partner and client company

Earnings
management
(EM Mediating variables)

Discretionary Accruals
(DA)

Modified Jones Model

Absolute discretionary
accruals |DA|

Absolute value of DA.

Financial performance
(FP Dependent variables)

Return on assets (ROA)

Earnings before Interest and Tax

divided by previous year Total
Assets
ROA minus DA

Control variable

True return on Assets

(TROA)
Company size

Natural log of companys total

average assets

10 | P a g e

5. Model Development
The purpose of our study was to examine the effect of earnings management on audit quality
and financial performance in listed companies in Bahrain. To investigate the relationship
among the above mentioned variables, following models were developed:
Model 1: EMi,t = 0 + 1AQi,t + 2SIZEi,t+ i,t
Model 2: FPi,t = 0 + 1AQi,t + 2SIZEi,t+ i,t
Model 3: FPi,t = 0 + 1EMi,t + 2SIZEi,t+ i,t
Model 4: FPi,t = 0 + 1AQi,t + 2EMi,t + 3SIZEi,t+ i,t
Earnings Management Measurement: Modified Jones Model (1991)
Discretionary Accruals is used as a proxy to determine earnings management. It was
determined using Modified Jones Model (1991) as follow:

Where:
TAt = total accruals of year t;
IBEIt = income before extraordinary items of year t;
OCFt = net cash flows in operating activities of year t;
0, 1, 2 = estimated coefficients of Modified Jones Model (1991);
TAi,t = total accruals for sample company i in year t;
Ai,t1 = total assets for sample company i in year t-1;
REVi,t = change in net revenues for sample company i in year t;
ARi,t = change in account receivables for sample company i in year t;
PPEi,t = gross value of property, plant and equipment for sample company i
in year t;
i,t = discretionary accruals (error term) for sample company i in year t;
NDAi,t = non-discretionary accruals for sample company i in year t

11 | P a g e

6. Findings and Discussions

Descriptive Results
2009
N

Minimum

Maximum

Mean

Std. Deviation

AQ

27

.93

.267

EM

28

.00300

.86200

.1594286

.18086836

FP

28

-.68500

.95800

.1230714

.28809951

SIZE

28

7.63800

22.15700

16.0723214

3.44439513

Valid N (list wise)

27
Table 2 Descriptive Analysis for 2009

2010
N

Minimum

Maximum

Mean

Std. Deviation

AQ

30

.90

.305

EM

30

.002

.992

.17833

.235047

FP

30

-.606

15.280

.60788

2.787238

SIZE

31

7.694

21.981

16.09098

3.029812

Valid N (list wise)

29
Table 2 Descriptive Analysis for 2010

2011
N

Minimum

Maximum

Mean

Std. Deviation

AQ

28

.89

.315

EM

28

.005

.920

.16686

.221956

FP

28

-.582

2.646

.21391

.549390

SIZE

29

7.754

21.867

15.87156

3.215315

Valid N (list wise)

27
Table 3 Descriptive Analysis for 2011

The descriptive analysis for the variables of this report are presented in above tables (table 3,4
and 5). Variables such as audit quality (audit size), earnings management, financial
performance and size of the company are shown in the tables. The results show that earnings
management have the lowest mean in all the three years with a mean of 0.16686 in year 2011
& standard deviation of 0.221956 and with range from a minimum of 0.005 to maximum of
0.920. While the mean for 2013 is 0.17833 and for 2012 its 0.1594286.
12 | P a g e

Multiple Linear Regression

Model 1

2009
Model Summary

Model

Std. Error of the

Square

Estimate

R Square
.290a

Adjusted R

.084

.008

.18319

ANOVAa
Model
1

Sum of Squares

df

Mean Square

Regression

.074

.037

Residual

.805

24

.034

Total

.879

26

Sig.

1.101

.349b

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

B
(Constant)

Coefficients

Std. Error

Beta

-.119

.235

AQ

.033

.138

SIZE

.016

.010

Sig.
-.506

.618

.048

.240

.813

.296

1.482

.151

2010
Model Summary

Model

Std. Error of the

Square

Estimate

R Square
.094a

Adjusted R

.009

-.067

.246461

ANOVAa
Model
1

Sum of Squares
Regression

df

Mean Square

.014

.007

Residual

1.579

26

.061

Total

1.593

28

Sig.
.115

.891b

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Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

Coefficients

Std. Error

Beta

(Constant)

.047

.333

AQ

.018

.185

SIZE

.007

.015

Sig.
.141

.889

.020

.097

.923

.096

.480

.635

2011
Model Summary

Model

Std. Error of the

Square

Estimate

R Square
.056a

Adjusted R

.003

-.080

.234525

ANOVAa
Model
1

Sum of Squares
Regression

df

Mean Square

.004

.002

Residual

1.320

24

.055

Total

1.324

26

Sig.
.037

.963b

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

Std. Error

(Constant)

.090

.311

AQ

.021

.177

SIZE

.004

.014

Coefficients
Beta

Sig.
.290

.774

.025

.118

.907

.056

.268

.791

According to results of SPSS analysis of multiple regressions analysis. Model 1 examines the
relationship between audit quality and earnings management. The results of earnings
management mean shows that there is statistically no significant dependence between them in
all the three years (2009-2011). This point out that audit size does not actually affect the
14 | P a g e

earnings management that is practiced in Bahrain public listed companies. Due to no variation
in audit quality aspect between being audited by the Big Four audit companies and non-Big
four audit companies, as well as there might be different audit environment in Bahrain
comparing to other countries in the world.
And this is in consistent with studies of Solimna and Ragab (2014) and Zgarni, Hlioui and
Zehri (2012). Like taking the case of 2009 as F:P=0.349>=0.05 along with taking the cases of
2010 and 2011 similarly, we can conclude that H01 is rejected for all the three years, as there is a
positive relationship but its not significant so it wont affect earnings management.

Model 2
2009
Model Summary

Model

Std. Error of the

Square

Estimate

R Square
.110a

Adjusted R

.012

-.070

.30371

ANOVAa
Model
1

Sum of Squares
Regression

df

Mean Square

.027

.014

Residual

2.214

24

.092

Total

2.241

26

Sig.
.147

.864b

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

B
(Constant)

Std. Error
.327

.389

AQ

-.103

.228

SIZE

-.007

.017

Coefficients
Beta

Sig.
.840

.409

-.093

-.450

.657

-.081

-.392

.699

15 | P a g e

2010
Model Summary

Model

Std. Error of the

Square

Estimate

R Square
.252a

Adjusted R

.064

-.008

2.846932

ANOVAa
Model
1

Sum of Squares
Regression

df

Mean Square

14.333

7.167

Residual

210.731

26

8.105

Total

225.064

28

Sig.
.884

.425b

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

B
(Constant)

Coefficients

Std. Error

Beta

-4.079

3.843

1.055

2.139

.231

.176

AQ
SIZE

Sig.

-1.062

.298

.096

.493

.626

.256

1.313

.201

2011
Model Summary

Model

Std. Error of the

Square

Estimate

R Square
.296a

Adjusted R

.088

.012

.556434

ANOVAa
Model
1

Sum of Squares
Regression

df

Mean Square

.714

.357

Residual

7.431

24

.310

Total

8.145

26

F
1.154

Sig.
.332b

16 | P a g e

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

B
(Constant)

Coefficients

Std. Error

Beta

-.755

.737

AQ

.174

.420

SIZE

.051

.034

Sig.

-1.024

.316

.083

.415

.682

.304

1.518

.142

In Model 2, it tests the relationship between financial performance and audit quality. As shown
in the results above the audit quality is consider statistically significant for the year 2009 with
(p-value = 0.657) and there is a negative correlation with TROA, with a t-value of -0.450.
While for 2010 and 2011 the audit quality is considered to be statistically positively significant
with p-values of 0.626 and 0.682 respectively and t-values of 0.493 and 0.415 respectively.
The results for 2009 is completely the opposite of what is found for 2010 and 2011. The results
for 2010 and 2011 indicate that being audited by the Big Four audit companies give more audit
quality, and that results to more effective financial performance comparing to other non-Big
four auditing companies, while the results for 2009 show a that being audited by a big four
audit firm decreases the financial performance of the firms. Similarly, for 2010 and 2011, we
can say that Companies who are audited by these Big Four are discern to have better audit
quality which leads to improvement to those companies and the opposite is true for. As well
as, external auditing (Big Four) makes the investors more confidence of the outcome of these
reports, and enhance the credibility and integrity of the annual financial reports. Consequently,
this may evolve to better financial performance and the opposite is true for 2009.
The results for 2010 and 2011 is similar to Farouk (2014), Afza and Nasir (2014) work and
opinion. And its support Ho2 that there is a significant positive relationship between audit
quality and financial performance. While the results found for 2009 we can interpret that Ho2
is rejected as there is a significant negative relationship between audit quality and financial
performance.
Model 3
2009
Model Summary

Model
1

R Square
.687a

.471

Adjusted R

Std. Error of the

Square

Estimate
.429

.21769

17 | P a g e

ANOVAa
Model
1

Sum of Squares

df

Mean Square

Regression

1.056

.528

Residual

1.185

25

.047

Total

2.241

27

Sig.

11.146

.000b

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

Coefficients

Std. Error

(Constant)

Beta

.300

.201

EM

1.137

.242

SIZE

-.022

.013

Sig.
1.495

.147

.714

4.702

.000

-.267

-1.756

.091

2010
Model Summary

Model

Std. Error of the

Square

Estimate

R Square
.250a

Adjusted R

.063

-.007

2.796847

ANOVAa
Model
1

Sum of Squares
Regression

df

Mean Square

14.089

7.044

Residual

211.204

27

7.822

Total

225.292

29

Sig.
.901

.418b

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

B
(Constant)
SIZE

Std. Error
-2.877

2.762

.205

.169

Coefficients
Beta

.227

Sig.

-1.042

.307

1.213

.235

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EM

1.014

2.219

.086

.457

.651

2011
Model Summary

Model

Std. Error of the

Square

Estimate

R Square
.367a

Adjusted R

.135

.066

.531050

ANOVAa
Model
1

Sum of Squares

df

Mean Square

Regression

1.099

.550

Residual

7.050

25

.282

Total

8.149

27

Sig.

1.949

.164b

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

B
(Constant)

Std. Error
-.609

.508

SIZE

.046

.031

EM

.574

.461

Coefficients
Beta

Sig.

-1.199

.242

.273

1.467

.155

.232

1.245

.225

In Model 3, it examines the relationship between financial performance and earnings

management. From 2009 and 2011 results it has been detected that the mean of financial
performance has statistically significant linear dependence on absolute discretionary accruals
with p-values of 0.000 and 0.225 respectively and a positive correlation with a t-values of 4.702
and 1.245 respectively. While for 2010 we found an insignificant association between financial
performance and earnings management. The 2009 and 2011 results indicate that there is a
significant impact of earnings management on financial performance, though which when
companies go with exercising income-increasing accruals, their financial performance will
look better, and vice versa. While there is no impact of earnings management practices on
financial performance in 2010.
In 2009 and 2011, cases such as maximizing the value of the company by advance recognition
of revenues in order to make the overall revenues more and to improve the financial
performance of the company. While, managers tend to exercise income-decreasing accruals. In
cases such as of the company for instance, when the managers goal is to maximize the
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companys value, he or she tends to exercise income-increasing accruals (increasing expenses)

to show that their financial performance low and prevent any acquisition or takeover situations.
In addition, the results for 2009 and 2011 are in contrary with Hassan and Ahmed (2012) but
in favour with Fang, Gill, Biger and Mand (2013) who sees a positive relationship between
these two factors. Which rejects the Ho3 hypothesis as (F:P=0.164>=0.05). While for 2010
results we can conclude that Ho3 hypothesis is also rejected.
Model 4
2009
Model Summary

Model

Std. Error of the

Square

Estimate

R Square
.700a

Adjusted R

.489

.423

.22305

ANOVAa
Model
1

Sum of Squares

df

Mean Square

Regression

1.097

.366

Residual

1.144

23

.050

Total

2.241

26

Sig.

7.347

.001b

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

Std. Error

(Constant)

.464

.287

AQ

-.141

.168

EM

1.152

SIZE

-.025

Coefficients
Beta

Sig.
1.614

.120

-.128

-.838

.411

.249

.722

4.636

.000

.013

-.295

-1.853

.077

2010
Model Summary

Model
1

R Square
.265a

.070

Adjusted R

Std. Error of the

Square

Estimate
-.041

2.892901

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ANOVAa
Model
1

Sum of Squares
Regression

df

Mean Square

15.842

5.281

Residual

209.222

25

8.369

Total

225.064

28

Sig.
.631

.602b

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

B
(Constant)

Coefficients

Std. Error

Beta

-4.125

3.906

SIZE

.224

.180

EM

.977

AQ

1.037

Sig.

-1.056

.301

.248

1.247

.224

2.302

.082

.425

.675

2.174

.094

.477

.638

2011
Model Summary

Model

Std. Error of the

Square

Estimate

R Square
.374a

Adjusted R

.140

.028

.551835

ANOVAa
Model
1

Sum of Squares

df

Mean Square

Regression

1.141

.380

Residual

7.004

23

.305

Total

8.145

26

Sig.

1.249

.315b

Coefficientsa
Standardized
Unstandardized Coefficients
Model
1

B
(Constant)

Std. Error
-.806

.732

Coefficients
Beta

t
-1.100

Sig.
.283

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SIZE

.049

.033

.291

1.463

.157

EM

.569

.480

.229

1.184

.249

AQ

.162

.417

.077

.390

.700

In Model 4, it investigates the relationship between earnings management, audit quality and
the financial performance. The results are comprehensive and composed with the previous
models 1, 2, and 3. The Relationship between these variables that was produced from the Sobel
test present a significant results in mediation effect aspect. The results for all the three years
show an insignificant association between audit quality and financial performance of the firms.
However for 2009 and 2011 when accrual based earnings management are added as mediating
accrual variable, we get a significant association between audit quality and financial
performance. This shows that in 2009 and 2011 audit quality affects the financial performance
of a firm when accruals based earnings management has been controlled by it. Therefor
resulting in clearly showing the affects the audit quality has when audited by a big four audit
firm as compared to non-big four audit firm. Thus indicating that accrual based earnings
management practices in Bahrain somewhat significant impact on financial performances of
the firms.
Thus for 2009 and 2011 Ho4 is supported, which shows that accruals based earnings
management mediates the relationship between financial performance and audit quality. Thats
similar to Kang and Kim (2011) studies as earnings management act as a mediator between
audit quality and financial performance. While for 2010 we can conclude that Ho4 is rejected
as accrual based earnings does not mediate the relationship between audit quality and financial
performance.

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7. Conclusions and Recommendation

The aim of our study was to investigate the mediating effect of earnings management on
relationship between audit quality and financial performance. Our study also examined other
relationships between variables such as relationship between financial performance and audit
quality, between financial performance and earnings management, etc. Our sample included
45 companies that are listed in Bahrain Bourse during the year 2009, 2010 and 2011.
Audit quality was measured using only audit size and couldnt use other proxies such as audit
fees and audit tenure as they were not disclosed by any of those sample companies.
Discretionary accruals were used as a proxy for earnings management while total assets were
used to indicate the size of the firm. Return on assets was used to indicate the financial
performance of a company in a year.
Analysis were done using SPSS and Microsoft excel. Using SPSS, descriptive statistics and
multi-liner regression were generated to conduct the research. For analysis purpose and to
ensure accuracy, TROA and absolute DA were used as a measure for Financial performance
and accruals based earnings management respectively.
It was found that audit quality does not consider a significant force on earnings management
in the companies due to some differences in environmental aspects. Therefore, the assumption
of audit quality lessens earnings management does not always be logical in developing
countries. Although those companies that been audited by the big four companies tend to have
the investors confidence in the financial reports as they realize that big audit firms have more
audit quality.
In addition, it was indicated that with earning management is involved financial performance
could increase when there is manipulation from the management to show and report average
annual reports so no questions asked by the investors or the stakeholders about their hand
involvement to undervalue/overvalue the actual financial performance. However, an addition
of earnings management as a mediate variable between financial performance and audit quality,
will make audit quality have no true effect on improvement of financial performance.
Further research should contain bigger sample size and more information gathered about the
listed companies in Bahrain, as some sites dont provide all the information needed to conduct
a research, such in this report audit fees and audit tenure were a limitation to run a full analysis
for the Sobel test. In addition, using different approaches to analyse the data collected and
considering other related variables that may be useful to conduct a sufficient report and
findings.

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References
Ching, C. P. Teh, B. H. San, O. T. Hoe, H.Y. (2015). The Relationship among Audit Quality,
Earnings Management, and Financial Performance of Malaysian Public Listed Companies.
International Journal of Economics and Management. 9(1), 211-229.
Farouk, M.A. Hassan, S.U. (2014). Impact of Audit Quality and Financial Performance of
Quoted Cement Firms in Nigeria. International Journal of Accounting and Taxation. 2(2),
01-22.
Becker, C. L., Defond, M. L., Jiambalvo, J., & Subramanyam, K. (1998). The Effect of Audit
Quality on Earnings Management. Contemporary Accounting Research, 15(1), 1-24.
Gong, G., Louis, H., & Sun, A. X. (2008). Earnings Management and Firm Performance
Following Open-Market Repurchases. THE JOURNAL OF FINANCE, 63(2), 947-986.
Fang, D. Research on the Relationship between Firm Performance and Earnings
Management. Working paper, Universiteit van Amsterdam
Ardekani,, A. M., Younesi, N., & Hashemijoo, M. (2012). Acquisition, Earnings
Management and Firms Performance: Evidence from Malaysia. Journal of Business Studies
Quarterly, 4(1), 91-110.
Gill, A., Biger, N., & Mand, H. S. (2013). Earnings Management, Firm Performance, and the
Value of Indian Manufacturing Firms. International Research Journal of Finance and
Economics, (116), 120-132.
Lin, F., & Wu, S. (2015). Applying Digital Analysis to Investigate the Relationship between
Corporate Governance and Earnings Management: An Empirical Analysis of Publicly Listed
Companies in Taiwan. Contemporary Management Research CMR, 11(3), 209-222.

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Appendix A
S.No
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45

Listed Companies in Bahrain (source: Bahrain Bourse)

Name of the Company

Al Salam Bank - Bahrain B.S.C.
Al-Ahli United Bank
Bahrain Islamic Bank
BBK
Ithmaar Bank B.S.C.
Khaleeji Commercial Bank B.S.C
National Bank of Bahrain
Al Baraka Banking Group B.S.C.
Arab Banking Corporation
Bahrain Commercial Facilities Company
Bahrain Middle East Bank
ESTERAD INVESTMENT COMPANY B.S.C
GFH Financial Group B.S.C
Gulf Monetary Agency(Suspended)
INOVEST B.S.C
Investcorp Bank
Taib Bank (Suspended)
United Gulf Bank
UNITED GULF INVESTMENT CORPORATION B.S.C
Securities & Investment Company
United Paper Industries B.S.C.(c)
Al Ahlia Insurance Company
Arab Insurance Group
Bahrain & Kuwait Insurance Company
Bahrain National Holding Company
Takaful International Company
Bahrain CarPark Company
Bahrain Cinema Company
Bahrain Duty Free Complex
Bahrain Shipping Repairing & Engineering
Bahrain Telecommunication Company
BMMI B.S.C
Nass Corporation BSC
Seef Properties
TRAFCO GROUP B.S.C
Zain Bahrain B.S.C
Bahrain Family Leisure
Bahrain Tourism Company(Suspended)
Banader Hotels Company BSC
GULF HOTEL GROUP B.S.C
National Hotels Company
Aluminium Bahrain B.S.C.
Bahrain Flour Milles Company
Delmon Poultry Company
Bank Muscat

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