Do Earnings Management and Audit Quality Influence Over-Investment by Chinese Companies?

This paper examines how earnings quality affects the investment decisions of Chinese companies who employ non-Big 4 auditors. We measure earnings quality through the companies’ use of discretionary accruals to manage earnings, and by the quality of the companies’ auditors. We then seek to determine whether the quality of the earnings and the quality of the audit relate to overconfidence in internal decision making and lead to excess investment. We use two models for our study, adapted from the model used by McNichols and Stubben (2008). The first model measures the impact of earnings management on investment. Our second model employs a logistic regression model to measure the significant variables in companies that over-invest. We find that more important clients have significantly higher investment than less important clients, and that discretionary accruals are significant indicators of over-investment. Less important clients are more conservative in their investments, although they have more investment opportunities. We also observe that the proportion of over-investment drops for clients, regardless of their importance, whose auditors have a long tenure.