Content area
Full text
SUMMARY
This study investigates if the use of a Big 6 auditor is increasing in the firm's endogenous propensity to generate accruals. High-accrual firms have greater scope for aggressive and/or opportunistic earnings management and therefore have an incentive to hire a Big 6 auditor to provide assurance that reported earnings are credible. For a large sample of NASDAQ firms over the period 1975-1994 we find that the likelihood of using a Big 6 auditor is increasing in firms' endogenous propensity for accruals. Even though Big-6-audited firms have higher levels of total accruals, we also find they have lower amounts of estimated discretionary accruals. This finding is consistent with Big 6 auditors constraining aggressive and potentially opportunistic reporting of accruals. Key Words: Accruals, Earnings management, Auditor choice, Big 6 firms.
Data Availability: Data are available from public sources.
INTRODUCTION
The international Big 6 accounting firms have brand-name reputations and are widely viewed as producing higher quality audits than non-Big 6 firms.1 We argue that the demand for Big 6 audits is based, in part, on mitigating the potential for opportunistic management of accruals-based earnings. Accruals-based earnings are used for contracting with the firm and by investors for valuing the firm. The possibility of earnings management undertaken for private gain (e.g., executive compensation contracts) creates uncertainty for outsiders with respect to the firm's reported earnings and whether they have been prepared under a reasonable and unbiased application of generally accepted accounting principles (GAAP). Absent the ability to directly observe earnings, outsiders may expect some managers to engage in earnings management opportunism. Investors and contracting parties will rationally price protect in response. This creates an incentive for managers of "high accrual" firms to convey the credibility of their reported earnings by hiring a higher quality auditor as external monitor.2 We investigate if the choice of a Big 6 auditor serves as such a monitor and argue that Big 6 auditors have greater ability to constrain aggressive and questionable accounting accruals, thus reducing uncertainty about reported earnings for high-accrual Firms.
We investigate two empirical associations between accruals and Big 6 auditors. First, we examine if the use of a Big 6 auditor is increasing in the firm's opportunities for earnings management, as reflected by accruals endogeneity. Two...