European Accounting Review Vol. 17, No.

3, 447 469, 2008

Earnings Management and Audit Quality in Europe: Evidence from the Private Client Segment Market
BRENDA VAN TENDELOO and ANN VANSTRAELEN ,

Universiteit Maastricht, The Netherlands,

Universiteit Antwerpen, Belgium

ABSTRACT This paper contributes to the recent literature on nancial reporting quality in private (i.e. non-listed) companies (Ball and Shivakumar, 2005; Burgstahler et al., 2006) by examining whether in these types of companies Big 4 audit rms, as high quality auditors, provide a constraint on earnings management. Considering incentives of auditors to supply a high audit quality in private rms, we expect that Big 4 auditors have an incentive to constrain earnings management only in high tax alignment countries, where nancial statements are more scrutinized by tax authorities and the probability that an audit failure is detected is higher. Using data on private rms in European countries, this study provides evidence consistent with this expectation.

1.

Introduction

Some recent studies have focused on the demand and supply of nancial reporting quality in private (i.e. non-listed) rms, as opposed to the extensively researched nancial reporting quality in public (i.e. listed) rms. For example, Burgstahler et al. (2006) nd that private rms engage more in earnings management compared to public rms, and Ball and Shivakumar (2005) nd that private rms incorporate losses less timely than public rms. This study contributes to this recent literature by examining audit quality in private rms, and by questioning whether audit rm quality enhances nancial reporting quality in private rms. In particular, this study examines (1) whether Big 41 audit rms provide a

Corresponding Author: Brenda Van Tendeloo, Universiteit Maastricht, Faculty of Economics and Business Administration, Department of Accounting and Information Management, PO Box 616, 6200 MD Maastricht, the Netherlands. E-mail: b.vantendeloo@aim.unimaas.nl 0963-8180 Print/1468-4497 Online/08/03044723 # 2008 European Accounting Association DOI: 10.1080/09638180802016684 Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA.

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constraint on earnings management in private rms and (2) to what extent Big 4 audit rms provide a uniform level of audit quality for private companies across countries. Given that private companies constitute the majority of the EU economy and the EU market for audit services, this research seems warranted. Furthermore, although audit quality is mainly considered to be important for listed rms and derived from the agency theory, high quality auditing can also be functional in private rms. For example, it can help to alleviate agency conicts between owners, managers and banks, and it can be useful for evaluation of managerial performance or for convincing various stakeholders of the credibility of the nancial statements. As earnings management in private rms deprives the users of nancial statements of obtaining reliable information, the task of the auditor is to protect stakeholders interests. The incentives of (especially large) audit rms to supply a high quality audit are expected to depend upon the probability that an audit failure is detected and the risk of litigation, hereby damaging their reputation. However, since nancial statements of private rms, compared to public rms, are not scrutinized as much by investors, nancial analysts or regulating authorities of stock exchanges, the probability that an audit failure is detected and the risk of litigation is much lower in privately held companies, even in countries generally considered as stronger in terms of investor protection or legal enforcement (Chaney et al., 2004; Vander Bauwhede and Willekens, 2004). We argue that for private rms in countries with a high alignment between nancial reporting and tax accounting, tax authorities are expected to (partly) take on the role that investors, nancial analysts or regulating authorities of stock exchanges have in public rms. In particular we argue that tax authorities in countries with a high tax alignment will scrutinize nancial statements more compared to countries with a low tax alignment because the nancial statements are taken as the basis for taxation. This results in a higher probability of audit failure detection, which will negatively affect auditor reputation. In low tax alignment countries, nancial statements and tax returns are more considered to be two separate items, with the auditor only being responsible for the former. Because nancial statements are less scrutinized, lowering the probability of audit failure detection, one could expect that Big 4 auditors have weaker incentives to supply a high audit quality to their private clients in these countries.2 Therefore, we expect to observe a Big 4 audit quality effect only in high tax alignment countries, where nancial statements are more scrutinized and the probability that an audit failure is detected is higher. Our sample consists of all private rms in six EU countries (Belgium, Finland, France, the Netherlands, Spain and the UK) during the period 1998 2002 that are required by law to have their nancial statements audited and for which both nancial data and audit rm data were available in the Amadeus database.3 Belgium, Finland, France and Spain are considered as high tax alignment countries. The Netherlands and the UK are considered as low tax alignment countries. Consistent with our hypothesis, we nd that a Big 4 audit rm constrains earnings

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management more compared to a non-Big 4 audit rm only in countries with high tax alignment. Furthermore, consistent with Burgstahler et al. (2006), we nd that private companies domiciled in countries with stronger legal systems engage less in earnings management. As expected, audit quality differentiation in private rms is not enhanced in strong legal environments. Further, we show that subdividing non-Big 4 audit rms into second-tier and small audit rms does not support audit quality differentiation between these two types of audit rms. Our results are robust to a number of sensitivity tests. The remainder of this paper is organized as follows. In Section 2, we review the relevant literature, provide the theoretical background and formulate the research hypotheses. Section 3 describes the research design. The results of the study and sensitivity analyses are presented in Section 4. We conclude in Section 5 with summarizing our results and discussing the implications of our analysis.

2.

Previous Literature and Hypothesis Development

2.1. Earnings Management in Private Firms While numerous studies have investigated earnings quality and its determinants among public rms, only a few studies have considered earnings management in private rms (see Beatty and Harris, 1998; Beatty et al., 2002; Coppens and Peek, 2005; Burgstahler et al., 2006). Private companies are more closely held, have greater managerial ownership, major capital providers often have insider access to corporate information and capital providers take a more active role in management. Moreover, their nancial statements are not widely distributed to the public and are more likely to be inuenced by tax objectives (Ball and Shivakumar, 2005). Given these unique attributes of private rms as opposed to public rms and the fact that private rms constitute the majority of the EU economy and of the EU market for audit services, studying earnings management and the role of the auditor in private rms is relevant. The main users of private rms nancial statements are stakeholders other than equity investors, such as employees, bankers, customers, suppliers and the government. To protect the interests of these stakeholders, private European companies that exceed certain size criteria4 are required to have their nancial statements audited. To the extent that managers want to mislead some stakeholders about the underlying economic performance of the company or to inuence contractual outcomes that depend on reported accounting numbers (Healy and Wahlen, 1999, p. 368) earnings will also be managed in private rms.5 For example, bank nancing is usually a major source of nance in privately held companies, resulting in agency conicts between bankers and owners, and between bankers and management (Vander Bauwhede and Willekens, 2004), which could also create earnings management incentives. Typical explanations of why private

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rms would potentially engage in earnings management are tax minimization and obtaining better terms of trade with banks, suppliers, customers, employees and government (Coppens and Peek, 2005). Similar to public rms, earnings management in private rms deprives the users of nancial statements of obtaining reliable information. As it is the task of the statutory auditor to protect stakeholders interests, we question to what extent audit quality constitutes a constraint on earnings management in private rms. 2.2. Audit Quality in Private Firms All European private companies that meet certain size criteria6 are required to have their nancial statements audited. The statutory auditor is expected to provide different stakeholders of the company assurance concerning the accuracy of the nancial statements, the non-existence of nancial statement fraud and the going concern status. It could be argued that agency conicts may be weaker in private rms compared to public rms, because ownership and control are less separated, possibly reducing the demand for nancial statements for monitoring managers (Fama and Jensen, 1983) and a high quality audit. However, high quality auditing is also called for in private rms for the following reasons. First, many private rms are subject to agency conicts when they are not entirely run by owner-managers (Ang et al., 2000) and agency conicts possibly exist between bankers and owners and bankers and management (Vander Bauwhede and Willekens, 2004). In the absence of market-based measures of rm-value, high quality reporting becomes particularly relevant for evaluation of managerial performance and to support personnel and compensation decisions, resulting in a demand for high quality audits (Chaney et al., 2004). Further, having a Big 4 auditor could also in private rms be used to signal high nancial reporting quality. For instance, private rms may choose a Big 4 auditor in order to obtain nancing at the lowest possible cost (Beatty, 1989), or in view of the possibility of going public in the future or of being targeted for acquisition (Chaney et al., 2004). Moreover, tax authorities rely on nancial statements to determine taxable income especially in countries with a high alignment between nancial reporting and tax accounting. Having a high quality auditor could signal nancial reporting quality and perhaps deter a rigorous tax audit. And nally, private rms may also want to convince suppliers, clients or employees of the credibility of their nancial statements. From an audit market perspective, audit quality depends on (1) the probability that material misstatements and signals of nancial distress are discovered and (2) the probability that the auditor will report these misstatements and signals (DeAngelo, 1981). While the technical capability of auditors or the probability that the auditor will discover material misstatements and going concern breaches is often assumed to be constant across different auditors, audit quality is assumed to be a function of auditor independence. Litigation and disciplinary sanctions are

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supposed to prevent auditors from compromising their independence and as such, provide incentives to the auditor to constrain earnings management or issue a qualied opinion when necessary. Apart from the sanctions themselves, litigious actions or disciplinary sanctions damage the auditors reputation. In this respect, larger audit rms are expected to be less likely to perform low quality audits because these rms have more to lose in terms of clients and audit fees in case of an audit failure. Auditor independence is thus considered to relate to the auditors reputational capital (DeAngelo, 1981). However, this reputation rational is only expected to hold when the probability that an audit failure is detected and the risk of litigation is high, hereby damaging the auditors reputation. When the risk of audit failure detection and litigation is low, litigation and reputation costs of providing a low quality audit are expected to be reduced, hereby lowering the incentives of large audit rms to supply a high quality audit. As documented in different empirical studies (e.g. Maijoor and Vanstraelen, 2006; Francis and Wang, 2008), Big 4 audit rms are less inclined to supply public client rms with high quality audits in countries with weaker investor protection,7 lower level of enforcement and lower risk of litigation. In privately held companies, litigation and reputation costs are likely much lower, even in countries generally considered as stronger in terms of investor protection or legal enforcement since nancial statements of private rms are not scrutinized as much by investors, nancial analysts or regulating authorities of stock exchanges (Chaney et al., 2004; Vander Bauwhede and Willekens, 2004). As a consequence, we do not expect investor protection or legal enforcement to enhance audit quality differentiation between Big 4 and non-Big 4 auditors with respect to private client rms. Previous studies concerning audit quality and earnings management in private rms have, to our knowledge, only been performed for the Belgian audit market and provide somewhat mixed results (Vander Bauwhede et al., 2003; Vander Bauwhede and Willekens, 2004). Drawing on DeAngelos reputation rational (1981) and the expectation that the incentives of (especially large) auditors to supply a high quality audit depend upon the probability that an audit failure is detected and the risk of litigation, we argue that tax enforcement8 could enhance audit quality in private rms, in countries with a high alignment between nancial reporting and tax accounting. Since in high tax alignment countries nancial statements are taken as the basis for taxation and are in fact part of the tax statement, tax authorities are expected to rigorously examine nancial statements. In particular, we argue that tax authorities in private rms (partly) take on the role that investors, nancial analysts or regulating authorities of stock exchanges have in public rms, in scrutinizing nancial statements. Given that nancial statements are more likely to be scrutinized, the probability that an audit failure is detected is higher in high tax alignment countries.9 The auditor, who has to assess the fairness of the nancial statements, has as such a direct responsibility to constrain aggressive (tax) accounting practices. As the detection of aggressive tax accounting practices will lead to additional tax expenses, due to

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tax income restatements and sanctions of tax authorities, and possibly even court cases,10 Big 4 auditors, who want to protect their reputation as high quality auditors, are therefore encouraged to constrain earnings management. In low tax alignment countries, nancial statements and tax returns are more considered to be two separate items, with the auditor only being responsible for the nancial statements. Tax authorities are expected to focus their attention on tax returns. Hence, nancial statements are less scrutinized, lowering the probability of audit failure detection. Hence, one could expect Big 4 auditors to have weaker incentives to supply a high audit quality to their private clients in these countries. Thus, in order to protect their internationally recognized reputation, we expect that Big 4 auditors have an incentive to provide a high quality audit to their private client rms only in high tax alignment countries, where nancial statements are more scrutinized by tax authorities and the probability that an audit failure is detected is higher. This is reected in the following hypothesis, stated in alternative form: Hypothesis: Private rms engage signicantly less in earnings management when audited by a Big 4 auditor compared to a non-Big 4 auditor, only when domiciled in a country with a high alignment between nancial reporting and tax accounting.

3.

Research Design

3.1. Sample We use the August 2003 version of the Amadeus Top 250,000 database to collect our data.11 Amadeus is a relatively new database which provides standardized nancial statement data. We focus our analysis on a ve-year period from 1998 to 2002. The initial sample consists of all privately held companies that have their domicile in one of the at that time 15 member states of the European Union, that are required by law to have their nancial statements audited and for which nancial data and audit rm data are available in the Amadeus database. Observations of Austria, Germany, Greece, Italy and Sweden had to be excluded because of unavailability of audit rm data. In addition, Portugal is excluded due to insufcient observations for companies with Big 4 auditors. Finally, three countries were excluded because of missing accounting and institutional data. In particular, Ireland and Denmark are excluded because Amadeus does not provide data on depreciation and operating income for Irish companies and cash and short-term debt for Danish companies, and Luxembourg is excluded because of missing institutional data in La Porta et al. (1998, 2006). Hence, the remaining countries are Belgium, Finland, France, the Netherlands, Spain and the UK. Consistent with previous research, we exclude banks, insurance companies and other nancial holdings (SIC codes between 6000 and 6799), public

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administrative institutions (SIC code 43 and SIC codes above 9000) as well as privately held subsidiaries of quoted companies as indicated in Amadeus.12 Further, to eliminate extreme outliers, all accounting items needed to construct the earnings management measures are truncated at the 0.5th and 99.5th percentile. For our industry country analysis (see Section 3.2), the above selection criteria result in 64,831 rm-year observations, constituting 144 industry country observations (6 countries 12 industry groups 2 audit rm types). However, we further require a minimum of 10 observations per unit of analysis, resulting in 129 industry country observations. This number is further reduced to 113 observations due to zero small losses in these eliminated subgroups.13 3.2. Earnings Management Proxies Discretionary accruals and earnings distributions have been heavily criticized as earnings management measures (e.g. Young, 1999; McNichols, 2000; Dechow et al., 2003; Beaver et al., 2004; Durtschi and Easton, 2005). Especially in cross-country studies, accruals models exhibit considerable variation in performance, caused by the international variation in model misspecication problems as well as sample size (Meuwissen et al., 2007). In response to the criticisms, a growing number of studies are relying on an aggregate measure of earnings management behaviour, as developed by Leuz et al. (2003) (e.g. Lang et al., 2003, 2006; Wysocki, 2004; Burgstahler et al., 2006). This measure is constituted of four different proxies capturing a wide range of earnings management activities: the magnitude of total accruals14 scaled by operational cash ow; the tendency of rms to avoid small losses; the smoothness of earnings relative to cash ows; and the correlation of accounting accruals and operating cash ow. Averaging various earnings management proxies is expected to mitigate potential measurement error (Leuz et al., 2003). We draw on Burgstahler et al. (2006), to compute the earnings management proxies, which are calculated at the industry country level for rms with a high quality auditor vs. rms with a low quality auditor. The magnitude of total accruals relative to operational cash ow (EM1) is computed as the median absolute value of total accruals scaled by the corresponding median absolute value of operational cash ow for each industry country audit quality subgroup. The scaling by operating cash ow controls for differences in rm size and performance. To measure the extent in which rms avoid reporting small losses (EM2), we calculate the ratio of small prots to small losses at the industry country level for rms with a high quality auditor vs. rms with a low quality auditor. A rm-year observation is classied as a small prot (small loss) if positive (negative) earnings fall within the range of 1% of lagged total assets. The smoothness of earnings relative to cash ows (EM3) is calculated as the standard deviation of operating income scaled by the standard deviation of

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operational cash ow to control for differences in the variability of the rms economic performance. The resulting ratio is multiplied by 2 1 so that higher values correspond to more earnings smoothing. As a second measure of earnings smoothing (EM4), we consider the contemporaneous Spearman correlation between the changes in total accruals and the changes in operational cash ow for each industry country audit quality subgroup, multiplied by 2 1, so that higher values again correspond to more earnings smoothing.15 Finally, the individual earnings management scores are transformed into percentage ranks (ranging from 0 to 100). The average percentage rank per industry country audit quality subgroup constitutes the aggregate earnings management measure (EMAgg). 3.3. Empirical Model The dependent variable in our empirical model is the aggregate earnings management measure, described above. Our independent variables of interest are the following. For audit quality differentiation, a dichotomous variable is used indicating whether the company has a Big 4 auditor (B4) or not. To take the extent of tax alignment into account, we include a dichotomous variable TAX. The TAX variable takes on a value of one when nancial reporting and tax rules are highly aligned (Belgium, Finland, France and Spain16) and zero otherwise (the Netherlands and the UK). To examine whether tax alignment has an inuence on audit quality, we include an interaction term B4 TAX. As we expect private rms to engage signicantly less in earnings management when audited by a Big 4 auditor compared to a non-Big 4 auditor only in high tax alignment countries, we expect the coefcient on B4 to be insignicant when including this interaction term, while the interaction effect is expected to be negative. The expected sign of the coefcient on TAX is positive, as prior research has shown that earnings management is more pervasive in high tax alignment countries (Burgstahler et al., 2006). In addition, a number of control variables are included that are expected to inuence our earnings management measure. Previous research has shown that private rms engage more in earnings management in countries with weak legal enforcement (Burgstahler et al., 2006). To control for the inuence of legal enforcement on earnings management, we include a variable LEGAL. This variable is computed as the mean of three legal variables from La Porta et al. (1998), which measure the quality of the legal system or enforcement: efciency of the judicial system, rule of law and a corruption index.17 LEGAL ranges from 0 to 10, and higher values correspond to stronger legal enforcement. Since private rms are expected to engage less in earning management in strong legal protection environments, we expect the coefcient on LEGAL to be negative. To control for the potential inuence of legal enforcement on audit quality, and hence mitigate potential alternative explanations regarding the cross-country

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variation in audit quality differentiation in private rms, we additionally include an interaction term B4 LEGAL. However, we do not expect investor protection or legal enforcement to enhance audit quality differentiation between Big 4 and non-Big 4 auditors for private client rms. We therefore expect the coefcient on this interaction term to be insignicant. In addition, in our sensitivity analysis, we replace LEGAL by a number of other institutional variables which could potentially inuence earnings management or audit quality. To control for differences in earnings management incentives and rm characteristics that are systematically associated with accruals, we include the following variables. First, we include the natural logarithm of total assets (LNASSETS) to proxy for the size of a company, as prior research suggests an association with the level of accruals or earnings management (e.g. Watts and Zimmerman, 1990; Young, 1999). Second, we include a leverage variable (LEV), calculated as the ratio of total liabilities to total assets, which can have an impact on earnings management in two directions. While highly leveraged rms could be expected to engage more in upward earnings management to avoid debt covenant violations (Watts and Zimmerman, 1990; DeFond and Jiambalvo, 1994; Young, 1999), alternatively, high leverage may induce income-decreasing earnings management in nancially distressed rms in view of contractual renegotiations (Becker et al., 1998). Third, to control for differences in performance, we include the yearly percentage change in sales (GROWTH) and the yearly return on assets as measured by earnings divided by lagged total assets (ROA) (Dechow et al., 1995; Young, 1999). All control variables are computed as industry-level medians.18 Finally, we include industry dummies (IND) to control for industry effects on earnings management. The industry classication is based on Campbell (1996) and is illustrated in Table 1. Hence, our empirical model looks as follows: EMAgg b0 b1 B4 b2 TAX b3 B4 TAX b4 LEGAL b5 B4 LEGAL b6 LNASSETSt b7 LEVt b8 GROWTHt b9 ROAt b10 IND 1 where: Dependent variable EMAgg aggregate earnings management measure (EMAgg) Independent variables B4 dummy variable (company has a Big 4 auditor 1, else 0) TAX dummy variable (high tax alignment 1, else 0) LEGAL legal enforcement computed as the mean of three legal variables which measure the quality of the legal system or

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Table 1. Industry classication

No. 1 2 3 4 5 6 7 8 9 10 11 12

Industry group Agriculture and forestry Petroleum industry Consumer durables Basic industry Food/tobacco Construction Capital goods Transportation Utilities Textiles/trade Service Leisure

SIC code 2, 7 9 13, 29 25, 30, 36 37, 39, 50, 55, 57 10, 12, 14, 24, 26, 28, 33 1, 20, 21, 54 15 17, 32, 52 34 35, 38 40 42, 44, 45, 47 46, 48, 49 22 23, 31, 51, 53, 56, 59 72 73, 75, 76, 80, 81, 82, 83, 84, 86 88, 89 27, 58, 70, 78 79

enforcement, for instance, efciency of the judicial system, rule of law and corruption index (La Porta et al., 1998) LNASSETSt natural logarithm of total assets in year t LEVt ratio of total liabilities to total assets in year t GROWTHt yearly percentage change in sales ROAt yearly return on assets as measured by earnings divided by lagged total assets IND vector of industry dummies based on Campbell (1996), as illustrated in Table 1. It is noted that Campbell industry group No. 1 (Agriculture and Forestry) is the industry of reference. 4. Results

4.1. Descriptive Statistics Table 2 illustrates our sample composition, mean values of the four individual earnings management measures (EM1 to EM4) and the aggregate earnings management measure (EMAgg) for the different industry country groups. As illustrated in Table 2, a large percentage of European private rms are audited by non-Big 4 audit rms. Contrary to prior research on audit quality using US data, our study does not suffer from poor variation in the audit variable. Table 2 further indicates that, overall, industry groups with a Big 4 auditor have a lower aggregate earnings management measure compared to non-Big 4 auditors. This result is also observed at country level, except for the Netherlands and the UK. For the individual earnings management scores, we observe a similar pattern except for EM1. Table 3 presents the descriptive statistics for the institutional variables by country. The institutional variables that we consider in our main analysis are tax alignment (TAX) and legal enforcement (LEGAL), which is a control

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Table 2. Sample composition and descriptive statistics for the earnings management measures by country and auditor Country Belgium Finland France Netherlands Spain UK Total Mean Median Standard Deviation Auditor B4 NB4 B4 NB4 B4 NB4 B4 NB4 B4 NB4 B4 NB4 B4 NB4 B4 NB4 B4 NB4 Industry obs. 10 11 10 5 11 10 9 4 11 10 12 10 63 50 Firm-years EM1 3,478 5,762 1,427 155 2,653 15,829 868 154 5,701 14,886 6,126 7,314 20,253 44,100 0.712 0.689 0.513 0.685 0.683 0.626 0.661 0.598 0.63 0.587 0.684 0.631 0.649 0.637 0.655 0.632 0.114 0.101 EM2 2.165 3.295 4.926 2.017 2.184 3.941 2.299 0.875 3.779 6.642 2.292 1.961 2.932 3.506 2.35 3.086 2.012 2.333 EM3 2 0.618 2 0.584 2 0.761 2 0.628 2 0.637 2 0.616 2 0.631 2 0.522 2 0.684 2 0.604 2 0.614 2 0.684 2 0.657 2 0.614 2 0.650 2 0.603 0.102 0.104 EM4 EMAgg 0.896 0.928 0.798 0.84 0.878 0.91 0.865 0.853 0.878 0.898 0.876 0.866 0.866 0.891 0.88 0.9 0.062 0.051 54.082 68.152 28.839 40.487 48.029 61.814 46.079 40.044 51.659 62.544 50.95 39.226 46.855 54.962 47.788 52.434 15.397 20.033

All rms included in the sample are required by law to have their nancial statements audited. Audit quality is captured by auditor size. Either a rm has a Big 4 auditor (B4) or not (non-B4). Companies with a Big 4 auditor and companies with a non-Big 4 auditor, in a particular industry and country, form separate subgroups. The industry classication is based on Campbell (1996). EM1, EM2, EM3 and EM4 are earnings management scores measured for each industrycountry auditor subgroup. The table presents mean values by country and auditor size. EM1 measures the magnitude of total accruals relative to operational cash ow and is computed as the median absolute value of total accruals scaled by the corresponding median absolute value of operational cash ow. EM2 measures the avoidance of small losses and is computed as the ratio of small prots to small losses. A rm-year observation is classied as a small prot (small loss) if positive (negative) earnings fall within the range of 1% of lagged total assets. EM3 measures smoothing of operating income and is computed as the standard deviation of operating income divided by the standard deviation of cash ow from operations. EM4 also measures the degree of income smoothing and is calculated as the Spearman correlation between the changes in total accruals and the changes in operational cash ow. Both EM3 and EM4 are multiplied by 2 1, so that higher values correspond to more earnings smoothing. EMAgg is an aggregate earnings management measure, obtained by transforming the individual earnings management scores into percentage ranks and averaging these percentage ranks.

variable. In our sensitivity analysis, we consider the litigation index from La Porta et al. (2006) and the accruals index from Hung (2001). Table 4 presents descriptive statistics of the control variables used in the multivariate analysis. Table 4 indicates that, overall, companies with a Big 4 auditor are larger and are less growing. With respect to leverage and return on assets, no clear pattern arises.

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Table 3. Descriptive statistics for institutional variables by country

Country Belgium Finland France Netherlands Spain UK

TAX 1 1 1 0 1 0

LEGAL 9.44 10.00 8.68 10.00 7.14 9.22

LITIGATION 0.44 0.66 0.22 0.89 0.66 0.66

ACCRUAL 0.64 0.77 0.64 0.77 0.77 0.86

TAX takes on a value of one when nancial reporting and tax rules are highly aligned (Belgium, Finland, France and Spain) and zero otherwise (the Netherlands and the UK). LEGAL is the mean of three variables which measures the quality of the legal system or enforcement: efciency of the judicial system, rule of law and corruption index (La Porta et al., 1998). LITIGATION is the litigation index from La Porta et al. (2006), which measures the liability standard for investors to recover damages from companies, directors and auditors when misleading information is disclosed. ACCRUAL is the accrual index from Hung (2001), updated for European countries by Comprix et al. (2003) and captures differences in accrual accounting rules.

Table 5 provides Pearson and Spearman correlation coefcients of the different earnings management measures, audit quality, legal enforcement and tax alignment. All earnings management scores seem to be signicantly correlated with each other, except for EM2 (loss avoidance), which is only signicantly correlated with EMAgg. Because reliably measuring loss avoidance requires a substantial amount of rm-years, it is possible that we failed to measure this proxy consistently. Hence, we use EMAgg as dependent variable for the multivariate analyses, which is expected to mitigate potential measurement error.19 Audit quality is signicantly negatively correlated with EMAgg. While legal enforcement (LEGAL) is strongly negatively correlated with EMAgg, TAX is positively correlated with EMAgg. TAX and LEGAL are also signicantly negatively correlated. 4.2. Univariate Results The univariate results are presented in Table 6. Table 6 indicates that, for the sample as a whole, companies with a Big 4 auditor engage less in earnings management compared to companies with a non-Big 4 auditor. When considering the institutional variable of interest, it appears that this audit quality difference is signicant for companies domiciled in countries with high tax alignment. In low tax alignment countries (i.e. the UK and the Netherlands) having a Big 4 auditor even seems to be associated with more earnings management. Tax alignment increases earnings management for the sample as a whole and for companies with a nonBig 4 auditor. 4.3. Multivariate Results The multivariate results are presented in Table 7. In column 1, we study audit quality differentiation in the sample as a whole, without differentiating on

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Table 4. Descriptive statistics for control variables Country Belgium Auditor Industry obs. 10 11 10 5 11 10 9 4 11 10 12 10 63 50 Firm-years LNASSETS GROWTH LEV 3,478 5,762 1,427 155 2,653 15,829 868 154 5,701 14,886 6,126 7,314 20,253 44,100 9.583 9.239 9.339 8.919 9.826 9.412 10.018 9.799 9.884 9.215 9.959 9.323 9.898 9.339 9.861 9.288 0.536 0.482 0.037 0.052 0.03 0.062 0 0.004 2 0.022 2 0.027 0.015 0.02 0.026 0.078 0.01 0.037 0.015 0.034 0.032 0.043 0.751 0.756 0.599 0.66 0.725 0.742 0.718 0.726 0.687 0.679 0.698 0.691 0.694 0.712 0.703 0.728 0.08 0.017

459

ROA 0.025 0.015 0.05 0.013 0.027 0.032 0.039 0.048 0.039 0.036 0.041 0.042 0.035 0.035 0.033 0.034 0.017 0.017

B4 NB4 Finland B4 NB4 France B4 NB4 Netherlands B4 NB4 Spain B4 NB4 UK B4 NB4 Total Mean Median Standard Deviation B4 NB4 B4 NB4 B4 NB4

All rms included in the sample are required by law to have their nancial statements audited. Audit quality is captured by auditor size. Either a rm has a Big 4 auditor (B4) or not (non-B4). Companies with a Big 4 auditor and companies with a non-Big 4 auditor, in a particular industry and country, form separate subgroups. The industry classication is based on Campbell (1996). Control variables are medians of rm-level realizations within each industrycountryauditor subgroup. We truncate rm-level realizations at the 0.5 and 99.5 percentile before computing subgroup medians. The table presents medians for the control variables by country and auditor size. LNASSETSt is the natural logarithm of total assets in year t. GROWTHt is the yearly percentage change in sales. LEVt is the ratio of total liabilities to total assets in year t. ROAt is the yearly return on assets as measured by earnings divided by lagged total assets.

institutional features. The results in column 1 show that overall, private rms engage signicantly less in earnings management when audited by a Big 4 auditor compared to a non-Big 4 auditor. In column 2, we include tax alignment (TAX) and the interaction between having a Big 4 auditor and tax alignment. Including these variables increases the explanatory power of the model. The results show that the coefcient of the Big 4 dummy is no longer signicant, indicating that in low tax alignment countries, private clients of Big 4 auditors are not signicantly associated with less earnings management than private clients of non-Big 4 auditors. To assess the difference in the magnitude of earnings management between clients of a Big 4 and a non-Big 4 audit rm in a high tax alignment country, we compare the coefcient of the tax variable (capturing the non-Big 4 audit rm effect) with the sum of the coefcients of the Big 4 variable and the interaction term

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Table 5. Earnings management measures: correlation coefcients (Pearson above Spearman below the diagonal) Variable EM1 EM2 EM3 EM4 EMAgg B4 LEGAL TAX

EM1 1 2 0.212 0.242 0.108 0.472 0.055 0.060 2 0.061 EM2 2 0.143 1 2 0.016 0.157 0.370 2 0.132 2 0.378 0.356 EM3 0.279 2 0.87 1 0.488 0.662 2 0.204 2 0.009 2 0.063 EM4 0.234 0.271 0.523 1 0.714 2 0.217 2 0.217 0.108 EMAgg 0.550 0.397 0.688 0.826 1 2 0.225 2 0.276 0.200 B4 0.066 2 0.161 2 0.221 2 0.242 2 0.216 1 0.075 2 0.057 LEGAL 2 0.049 2 0.326 2 0.030 2 0.309 2 0.278 0.092 1 2 0.372 TAX 2 0.090 0.420 2 0.037 0.203 0.198 2 0.057 2 0.285 1
The table reports Pearson and Spearman correlation coefcients. , indicate statistical signicance at the 0.05 and 0.01 level, respectively (two-tailed). EM1, EM2, EM3 and EM4 are earnings management scores measured for each industrycountry auditor subgroup. The table presents mean values by country and auditor size. EM1 measures the magnitude of total accruals relative to operational cash ow and is computed as the median absolute value of total accruals scaled by the corresponding median absolute value of operational cash ow. EM2 measures the avoidance of small losses and is computed as the ratio of small prots to small losses. A rm-year observation is classied as a small prot (small loss) if positive (negative) earnings fall within the range of 1% of lagged total assets. EM3 measures smoothing of operating income and is computed as the standard deviation of operating income divided by the standard deviation of cash ow from operations. EM4 also measures the degree of income smoothing and is calculated as the Spearman correlation between the changes in total accruals and the changes in operational cash ow. Both EM3 and EM4 are multiplied by 2 1, so that higher values correspond to more earnings smoothing. EMAgg is an aggregate earnings management measure, obtained by transforming the individual earnings management scores into percentage ranks and averaging these percentage ranks. B4 takes on a value of one when a rm has a Big 4 auditor and zero otherwise. LEGAL is the mean of three variables which measure the quality of the legal system or enforcement: efciency of the judicial system, rule of law and corruption index (La Porta et al., 1998). TAX takes on a value of one when nancial reporting and tax rules are highly aligned (Belgium, Finland, France and Spain) and zero otherwise (the Netherlands and the UK).

between the B4 and TAX dummies (capturing the Big 4 audit rm effect). The coefcient for the interaction variable is signicantly negative, indicating that in high tax alignment countries, a Big 4 audit rm constrains earnings management more compared to a non-Big 4 audit rm. These results show that the negative association between the magnitude of earnings management and having a Big 4 auditor only exists in countries with high tax alignment. Hence, our results suggest that tax authorities help in enforcing audit quality in private rms in high tax alignment countries. Further, the coefcient on tax alignment is signicantly positive, indicating that private rms with a non-Big 4 auditor engage more in earnings management when they are domiciled in countries with a high tax alignment. As explained above, this result is consistent with expectations because of increased incentives to manage earnings in order to lower taxation. In column 3, we additionally include the institutional variable on legal enforcement (LEGAL) as well as the interaction variable between Big 4 auditor and degree of legal enforcement. Introducing these variables further increases the

Earnings Management and Audit Quality in Europe

Table 6. Univariate analysis EMAgg Big 4 Mean Median (N) 46.855 47.788 (63) 45.852 45.243 (42) 48.862 55.642 (21) 2 0.729 2 0.700 Non-Big 4 Mean Median (N) 54.962 52.434 (50) 60.991 64.712 (36) 39.46 33.85 (14) 3.868 2 3.446 Total sample Mean Median (N) 50.442 50.332 (113) 52.839 52.102 (78) 45.101 45.133 (35) 2.150 2 2.099

461

t-Statistic Z-Statistic Wilcoxon Mann Whitney 2 2.433 2 2.286 2 3.992 2 3.759 1.711 2 1.886

Total sample High tax alignment Low tax alignment

t-Statistic Z-Statistic Wilcoxon Mann Whitney

The table reports mean and median values of the aggregate earnings management index, EMAgg. EMAgg is constructed such that higher values correspond to higher levels of earnings management. Further, test statistics on differences in mean and median values of EMAgg are reported. , , indicate statistical signicance at the 0.10, 0.05 and 0.01 level, respectively (two-tailed). Companies either have a Big 4 auditor or a non-Big 4 auditor. Belgium, Finland, France and Spain are classied as high

explanatory power of the model. The results presented in column 3 show a signicant negative coefcient for legal enforcement implying that legal enforcement provides a constraint on earnings management in private rms. This nding is consistent with the results of Burgstahler et al. (2006). The interaction variable between Big 4 auditor and legal enforcement is, however, not signicant. This implies that legal enforcement does not signicantly increase audit quality differentiation. This result is consistent with our expectation that litigation risk for auditors in the private client segment market is not necessarily higher in countries with stronger investor protection or legal enforcement. The regression results further show that leverage and return on assets are signicant control variables in all three models. 4.4. Sensitivity Analyses As a rst sensitivity analysis, we replace LEGAL by other institutional variables which could potentially inuence earnings management or audit quality differentiation. In this way, we further mitigate potential alternative explanations regarding the cross-country variation in audit quality differentiation in private rms. In this respect, we include the litigation index from La Porta et al. (2006), LITIGATION, which measures the effectiveness with which investors can

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Table 7. Earnings management and audit quality in private rms

EMAgg b0 b1 B4 b2 TAX b3 B4 TAX b4 LEGAL b5 B4 LEGAL b6 LNASSETSt b7 LEVt b8 GROWTHt b9 ROAt b10 IND 1 Variables Intercept B4 TAX B4

1 37.020 (0.746) 2 7.680 (2 2.364)

2 2 3.713 (2 0.064) 6.694 (1.403) 17.347 (3.743) 2 20.861 (2 3.780)

3 82.867 (1.270) 14.222 (0.501) 11.822 (2.262) 2 22.038 (2 3.561) 2 5.286 (2 2.249) 2 0.474 (2 0.166) 2 1.757 (2 0.365) 2 10.029 (2 0.175) 41.237 (1.863) 2 381.437 (2 3.676) Included 113 0.510 6.830

TAX

LEGAL B4

LEGAL 2 0.177 (2 0.041) 2 50.573 (2 0.891) 44.098 (1.849) 2 406.245 (2 3.751) Included 113 0.360 4.932 2.119 (0.467) 2 9.043 (2 0.157) 43.086 (2.026) 2 309.607 (2 3.230) Included 113 0.413 5.376

LNASSETSt GROWTHt LEVt ROAt IND N R 2 (Adjusted) F

The table reports OLS coefcients and t-statistics are based on heteroscedastic-consistent standard errors. , , indicate statistical signicance at the 0.10, 0.05 and 0.01 level, respectively (twotailed). EMAgg is an aggregate earnings management measure, constructed such that higher values correspond to higher levels of earnings management. B4 takes on a value of one when a rm has a Big 4 auditor and zero otherwise. LEGAL is a measure of legal enforcement, computed as the mean of three legal variables which measure the quality of the legal system or enforcement: efciency of the judicial system, rule of law and corruption index (La Porta et al., 1998). TAX takes on a value of one when nancial reporting and tax rules are highly aligned (Belgium, Finland, France and Spain) and zero otherwise (the Netherlands and the UK). Control variables are subgroup medians. We truncate rm-level realizations at the 0.5 and 99.5 percentile before computing subgroup medians. LNASSETSt is the natural logarithm of total assets in year t. GROWTHt is the yearly percentage change in sales. LEVt is the ratio of total liabilities to total assets in year t. ROAt is the yearly return on assets as measured by earnings divided by lagged total assets. IND, a vector of industry dummies with Campbell industry group No. 1 as industry of reference, are included but not reported.

recover damages from companies, directors and auditors when misleading information is disclosed, and the accruals index from Hung (2001), ACCRUAL, to control for differences in accounting regulation. These variables (results not reported) are not signicant. Also their interactions with auditor quality are not

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signicant and including these variables does not alter our results. Hence, neither the litigation variable nor the accounting regulation variable has incremental explanatory power with regard to audit quality differentiation in private rms across European countries. As a second sensitivity analysis, we further subdivide the non-Big 4 audit rms into the so-called second-tier audit rms and small audit rms. Since Big 4 audit rm concentration of the European private client audit market is much lower compared to the public client market, the traditional distinction between Big 4 and non-Big 4 audit rms might not be adequate in these less concentrated markets. We expect a large auditor to provide a higher audit quality compared to a small auditor. In particular, Big 4 auditors are expected to provide a higher audit quality compared to non-Big 4 (both second-tier and small) auditors, while second-tier auditors are considered to provide a higher audit quality compared to small auditors. To examine this, we include in our regression analysis, a vector of audit dummies (AUD) indicating whether the company has a Big 4 auditor (B4) or not and whether the company has a second-tier auditor (ST) or not. The auditor of reference is the small auditor. Second-tier audit rms are identied as member rms of the Top 20 International Accounting Firms and Networks, excluding Big 4 audit rms (Broom, 2002).20 Subdividing the nonBig 4 audit rms into the so-called second-tier audit rms and small audit rms does not show signicant differences in audit quality between these two types of audit rms (results not reported). In addition, the following sensitivity checks (results not reported) were performed to verify the robustness of our results. First, we attempt to control for self-selection bias. The results of Chaney et al. (2004) indicate that certain private rm-specic characteristics that inuence nancial reporting, and more specically earnings management behaviour, might also inuence auditor choice. When certain variables that both affect earnings management and auditor choice have not been adequately controlled for in our regression analysis, auditor choice (Big 4/non-Big 4) would be endogenous in our analysis, hereby possibly confounding our results (e.g. Heckman, 1978). The existence of an endogeneity problem can be tested by performing the extended regression version of the Hausman specication test (Maddala, 2001, p. 498; Wooldridge, 2003, p. 506). Hence, in a rst stage, auditor choice is explained by all the exogenous variables of the earnings management model. Including the rst stage residual does not inuence results nor is the coefcient on the rst stage residuals signicant, which would indicate that the model does not suffer from an endogeneity bias. Furthermore, to address the concern that, in some instances, there is no head-to-head comparison possible between companies with a Big 4 auditor and companies with a non-Big 4 auditor, we construct a balanced sample, in which each industry country subgroup with a Big 4 auditor has a non-Big 4 counterpart and vice versa. This reduced sample results in 98 industry country observations and provides similar results as our initial sample.

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Finally, as companies with a Big 4 auditor are on average larger than companies with a non-Big 4 auditor, we also perform our regressions using only the largest quartile of companies with a non-Big 4 auditor. Hereby, we improve the size comparability between the two groups. As we require a minimum of 10 observations per industry country auditor subgroup, this results in 109 industry country observations. Results are qualitatively similar. 5. Conclusion

Previous studies have documented that Big 4 audit rms, compared to non-Big 4 audit rms, do a better job in constraining earnings management in public rms domiciled in strong investor protection countries. This study examines (1) whether Big 4 audit rms provide a constraint on earnings management in private rms and (2) to what extent this audit quality differentiation is uniform across countries. Using data on private rms in European countries, this study provides evidence that privately held companies engage less in earnings management when they have a Big 4 auditor compared to a non-Big 4 auditor. However, consistent with our hypothesis, we nd that this association only exists in countries with a high tax alignment. We attribute this result to the increased enforcement of tax authorities with respect to nancial statements in these countries. In high tax alignment countries, tax authorities rely on nancial statements to determine taxable income and are as such considered a direct stakeholder and user of the nancial statements. Hence, nancial statements are likely to be more scrutinized, which increases the probability of audit failure detection, which will negatively affect auditor reputation. In addition, we nd consistent with Burgstahler et al. (2006), that private companies domiciled in countries with a stronger legal environment engage less in earnings management. As expected, we do not nd audit quality differentiation to be larger in countries with stronger legal systems. This is consistent with the argument that the probability of audit failure detection and the risk of litigation or disciplinary sanctions is much lower in private rms because nancial statements of private rms are not scrutinized as much, even in countries generally considered as having a strong legal enforcement. Other institutional variables such as litigation or accrual accounting do not provide incremental explanatory power above tax alignment in explaining cross-country variation in audit quality differentiation. Although the private client audit market in Europe is less concentrated compared to the public client audit market, subdividing non-Big 4 audit rms into second-tier and small audit rms does not provide support for an audit quality difference between second-tier audit rms and small audit rms with regard to earnings management. Further, our results are robust to a number of other sensitivity tests. These ndings contribute to the literature on audit quality differentiation between Big 4 and non-Big 4 auditors. While various Anglo-American studies

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on public rms use DeAngelos auditor reputation theory (1981) to explain the observed audit quality differentiation (e.g. Francis et al., 1999; Gore et al., 2001), other studies have shown that audit quality differentiation is weak or absent for public companies in countries with weak investor protection, as the probability of reputational damage due to a low quality audit is much lower in these countries (e.g. Maijoor and Vanstraelen, 2006; Francis and Wang, 2008). These studies indicate that DeAngelos reputation rational (1981) is conditional upon a high probability of audit failure detection and litigation, damaging the auditors reputation. Our results contribute to this viewpoint by showing that a negative association between earnings management in private rms and having a Big 4 auditor only exists in high tax alignment countries. In addition, this study contributes to the recent literature on demand and supply of nancial reporting quality in private rms, constituting the majority of the EU economy and the EU audit services market. Our results are subject to the following limitations. First, while we use an aggregate earnings management measure that is expected to mitigate potential measurement error (Leuz et al., 2003), we acknowledge that earnings management remains difcult to measure. Second, although we have controlled for various earnings management incentives, there may be other incentives that we have not controlled for. Third, as every cross-country study, our research is subject to the inuence of different institutional factors which are difcult to disentangle, making it difcult to control for the potential impact of other institutional differences than those investigated in the study. Finally, our study is focused on earnings management which is only one indirect measure of audit quality. Future research is encouraged to consider other measures of audit quality and to further examine factors inuencing audit quality in private client rms and to assess to what extent agency theory provides an explanation for auditor choice and audit quality in the private client segment market. In this respect, it seems warranted to make a distinction between private companies with separation of ownership and management, and private companies that are run by owners. Acknowledgements The authors are grateful for the comments received from Walter Aerts, Christof Beuselinck, Willem Buijink, Marc Deloof, Rajib Doogar, Jere Francis, Ann Jorissen, Steven Maijoor, Jeffrey Pittman, Carl Reyns, Srinivasan Sankaraguruswamy, Stuart Turley and the participants of the 2005 Annual teborg, the 2005 Congress of the European Accounting Association in Go Belgian Financial Research Forum in Antwerp, the 2005 Annual Conference of the American Accounting Association in San Francisco, the 2005 Symposium of the European Auditing Research Network in Amsterdam, the workshop at Tilburg University and the 2007 Annual Congress of the European Accounting Association in Lisbon.

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For convenience we use the term Big 4 auditor to identify the large international audit rm networks (Big 6/5/4). Some of the studies we refer to were conducted before the mergers resulted in a reduction to four international audit networks. Up to 2002, Big 5 audit rms included PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young, KPMG and Arthur Andersen. In 2002, Arthur Andersen disappeared after the high prole nancial scandal in its client rm Enron. 2 It can be argued that in low tax alignment countries with a higher litigation risk (such as the UK), Big 4 auditors will also have an incentive to constrain earnings management to avoid private litigation (for example, bank lawsuits). To control for this, we perform a sensitivity analysis (see Section 4) with a litigation index as control variable. From this analysis, it appears that litigation does not provide incremental explanatory power above tax alignment in explaining cross-country variation in audit quality differentiation. 3 Amadeus is a database containing nancial data of public and private rms in Europe. Due to data limitations (see Section 3.1), we could only include 6 out of the 15 EU member states in 2002. 4 In accordance with the Fourth Council Directive (78/660/EEC) of 25 July 1978 only small companies are exempted from a statutory audit. During our sample period 1998 2002, small companies are companies that do not exceed more than one of following criteria: (a) average number of employees: 50; (b) balance sheet total: 3,125,000 EUR; (c) annual net turnover: 6,250,000 EUR. Companies with more than 100 employees are always considered as large companies. These exemption criteria have, however, been revised over time. Since 2005, small companies are dened as companies with less than 50 employees and whose annual turnover or annual balance sheet total does not exceed 10 million EUR. 5 While the exercised discretion in reporting earnings can also be used to signal private information and reduce information asymmetry (e.g. Subramanyam, 1996), we assume earnings are managed for opportunistic reasons to mislead some stakeholders or inuence contractual outcomes, following the denition of Healy and Wahlen (1999). 6 See note 4. 7 Similar to DeFond and Hung (2004) we dene investor protection as the extent of laws that protect investors rights and the strength of the legal institutions that facilitate law enforcement. 8 Tax enforcement is considered to be stronger in high tax alignment countries with respect to nancial statements and with respect to the auditors, which are considered to provide assurance over the accuracy of these nancial statements. We hereby do not claim that tax authorities are better at enforcing tax law in these countries compared to low tax alignment countries. 9 However, increased enforcement due to the increased scrutiny of nancial statements by tax authorities does not appear to lead to less earnings management in countries with a strong tax alignment, as indicated by the results of Burgstahler et al. (2006). They argue that stronger tax alignment is associated with more earnings management, since companies have more direct incentives to inuence nancial reporting income to minimize their tax expense when this income gure is taken as the basis for taxation. 10 For example, KPMG tax shelter fraud in 2005. 11 Listing status and audit rm data is provided in Amadeus only for the nal year. Therefore, previous versions of the Amadeus database were used to verify the listing status and audit rm data. 12 Financial institutions are excluded because of their specic accounting requirements, which differ substantially from those of industrial and commercial companies. Public administrative institutions are excluded because of their specic nature. Similar to Fenn (2000) we exclude subsidiaries of quoted companies as their management and nancial reporting decisions are likely to be inuenced by public parent companies. 13 This makes the calculation of EM2, described in Section 3.2, impossible.

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Following Dechow et al. (1995), we compute total accruals as (Dtotal current assets 2 Dcash) 2 (Dtotal current liabilities 2 Dshort-term debt) 2 depreciation expense, where D denotes the change over the scal year. 15 While a negative correlation between accruals and operating cash ow is inherent to accrual accounting, differences in the magnitudes of this correlation indicate, ceteris paribus, variation in the extent of earnings smoothing. Moreover, because accounting systems likely underreact to economic shocks, using accruals to signal rm performance results on average in a less negative (and in specic cases even positive) correlation with cash ows (Leuz et al., 2003). 16 While Spain theoretically experienced a great reduction in tax alignment in the early 1990s, in practice a strong tax link still exists in Spanish individual nancial statements (Oliveiras and Puig, 2005). 17 This variable is the same as the institutional variable used by Burgstahler et al. (2006). 18 We truncate rm-level realizations at the 0.5 and 99.5 percentile before computing subgroup medians. 19 We have also performed our analyses with EM2 excluded from the aggregate earnings measure. Our conclusions with respect to audit quality differentiation and tax alignment remain qualitatively similar. 20 Comparison of this list with the 1999 list revealed only one difference. In 2002 one rm had been replaced by number 23 of 1999.

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