The need to avoid future audit and governance failures such as Enron, Tyco and World-Com has renewed the interest of, regulators, executives, auditors, investors and academicians in understanding the role of auditing in improving transparent reporting and reducing expropriations by managers. Managers can expropriate investor wealth in at least two ways. First, by understating the true performance of the firm, managers can expropriate the difference between the “achievable” and “achieved” performance. For example, in a study spanning 31 countries, Leuz et al. (2003) argue that if the governance and/auditing is weak, managers of the firm engage in the consumption of private control benefits such as related party transactions, empire building and other “hidden” transactions that effectively transfer wealth from investors to managers.

The second way in which managers transfer wealth from investors to themselves is by earnings management, a notion that is supported by extensive empirical literature (Healy and Wahlen, 1999; Bruns Jr. and Merchant, 1990; Burgstahler and Dichev, 1997; Burgstahler and Eames, 2003; Christie and Zimmerman, 1994; Dechow et al., 1996; DuCharme et al., 2004; Richardson, 2000). Numerous empirical studies have examined the effectiveness of audit and internal governance mechanisms in restraining such expropriation and opportunistic earnings management behavior of managers. These studies have ranged, from the studies on auditor independence (Frankel et al., 2002; Ashbaugh et al., 2003; DeFond et al., 2002; Larcker and Richardson, 2004), to the effect of the internal corporate governance mechanism such as board independence and audit committee structure on managerial reporting behavior (Klein, 2002a; Klein, 2002b; Becker et al., 1998). Srinidhi and Sen (2007b) show that weakening of the market-based corporate control mechanisms in the form of adopting poison pills increases earnings management and decreases the value-relevance of earnings. Further, there is evidence that managers increase their compensation after poison pill adoption (Srinidhi and Sen, 2007a; Bebchuk et al., 2002). The overall findings of these studies support the contention that audit quality and strong governance mechanisms restrain earnings management and other expropriating behaviors of managers but managers try to weaken these mechanisms by creating economic bonds with the auditors and by adopting poison pills (Gompers et al., 2003; Srinidhi and Sen, 2007b).