Auditor Conservatism, Asymmetric Monitoring, and Earnings Management*

TLDR

The study examines how audit effectiveness differences between Big 6 and non‑Big 6 auditors are affected by conflicts or convergence of reporting incentives between managers and auditors. The authors use a two‑stage treatment‑effects model to account for manager self‑selection of auditors and discretionary accruals. Results indicate that Big 6 auditors are more effective than non‑Big 6 auditors only when managers favor income‑increasing accruals, but less effective when both parties favor income‑decreasing accruals, and these findings are robust to alternative proxies.

Abstract

Abstract In this paper, we investigate whether, and how, audit effectiveness differentiation between Big 6 and non‐Big 6 auditors is influenced by a conflict or convergence of reporting incentives faced by corporate managers and external auditors. In so doing, we incorporate into our analysis the possibility that managers self‐select both external auditors and discretionary accruals, using the two stage “treatment effects” model. Our results show that only when managers have incentives to prefer income‐increasing accrual choices are Big 6 auditors more effective than non‐Big 6 auditors in deterring/monitoring opportunistic earnings management. Contrary to conventional wisdom, we find Big 6 auditors are less effective than non‐Big 6 auditors when both managers and auditors have incentives to prefer income‐decreasing accrual choices and thus no conflict of reporting incentives exists between the two parties. The above findings are robust to different proxies for opportunistic earnings management and different proxies for the direction of earnings management incentives.