The Joint Effect of Audit Quality and Legal Regime on the Use of Real versus Accrual Based Earnings Management : International Evidence

This study investigates whether and how firms’ real earnings management (REM) activities are influenced by the strength of country-level legal regime, and examines whether the role of Big 4 auditors on mitigating REM is different between countries with strong and weak legal regimes. We find that the intensity of REM increases as legal regime strengthens because more firms switch from the accrual-based earnings management (AEM) to REM, suggesting substitutive relationship between AEM and REM. However, this increased use of REM is mitigated by monitoring role of Big 4 auditors, especially in strong legal regime countries due to their increasing concerns about litigation risk and reputations in those countries. As a result, the magnitude of REM of the clients of non-Big 4 is much greater than that of the clients of Big 4 in strong legal regime countries. In contrast, there is only a marginal difference in the magnitude between the clients of Big 4 and those of non-Big 4 in weak legal regime countries. These findings are robust to a battery of sensitivity tests.