The Effect of Audit Quality on Earnings Management*

TLDR

Audit quality is treated as a dichotomous variable with Big Six auditors considered higher quality, and prior research indicates auditors are more likely to challenge earnings‑increasing accounting choices and face litigation when financial statements overstate earnings. The study investigates whether clients of non‑Big Six auditors exhibit higher discretionary accruals that increase earnings compared to clients of Big Six auditors. Discretionary accruals were estimated with a cross‑sectional Jones 1991 model to capture earnings management. Evidence from 10,379 Big Six and 2,179 non‑Big Six firm years shows that non‑Big Six clients report discretionary accruals 1.5‑2.1 % of total assets higher, with larger mean and median absolute values, indicating greater accounting flexibility.

Abstract

Abstract This study examines the relation between audit quality and earnings management. Consistent with prior research, we treat audit quality as a dichotomous variable and assume that Big Six auditors are of higher quality than non‐Big Six auditors. Earnings management is captured by discretionary accruals that are estimated using a cross‐sectional version of the Jones 1991 model. Prior literature suggests that auditors are more likely to object to management's accounting choices that increase earnings (as opposed to decrease earnings) and that auditors are more likely to be sued when they are associated with financial statements that overstate earnings (as compared to understate earnings). Therefore, we hypothesize that clients of non‐Big Six auditors report discretionary accruals that increase income relatively more than the discretionary accruals reported by clients of Big Six auditors. This hypothesis is supported by evidence from a sample of 10,379 Big Six and 2,179 non‐Big Six firm years. Specifically, clients of non‐Big Six auditors report discretionary accruals that are, on average, 1.5‐2.1 percent of total assets higher than the discretionary accruals reported by clients of Big Six auditors. Also, consistent with earnings management, we find that the mean and median of the absolute value of discretionary accruals are greater for firms with non‐Big Six auditors. This result also indicates that lower audit quality is associated with more “accounting flexibility”.