Earnings management and the role of the external auditor

The academic and the professional literature report the central role that an auditor should play in promoting financial reporting quality. High quality external audit can have an influential role in reducing earnings management practices. Of course the external auditor’s effectiveness may be affected by knowledge, experience, conflicts of interest (fees, tenure) and audit procedures and sampling. This paper examines the perceptions of Libyan Commercial Banks' (LCBs) stakeholders regarding the role of the external auditor in relation to earnings management. In the Libyan Commercial banks context, the length of an auditor-bank relationship is restricted to only two years and only specially listed auditors are allowed to perform a bank’s audit. The Central Bank of Libya requires an external auditor to prove relevant experience before being listed and, therefore, it could be argued that all such listed auditors are industry specialists. The paper adopts a qualitative approach in order to investigate the topic using two methods; interviews and questionnaire. First, the paper reports on semi-structured interviews with a range of stakeholders of LCBs; a key and widely held perception is that the auditor has the ability to detect earnings management practices but may not be able to prevent it. However, the questionnaire results regarding the role of the external auditor in relation to earnings management detection and prevention were, in this regard, inconsistent with interview findings. Respondents showed, on balance, agreement that listed auditors are qualified and capable of doing the job of a bank’s audit. Moreover, listed auditors are seen, on balance, to be able to detect and deter earnings management practices. The power the external auditor can rely on was thought to derive from the importance of the auditor’s opinion on a bank’s financial position