International Differences Between Big Four Auditors and Their Smaller Counterparts in Monitoring Earnings Management

Abstract

Earnings management that misrepresents the firm’s financial picture and misleads investors is a persistent problem. One role of the auditor is to efficiently monitor the accounting reports so as to better inform investors as to the true status of the firm and help close the asymmetric information gap between owners and management. Auditors, however, operate within the constraints of social and legal environments that often display vast international differences. Using sample data from around 50,000 firm-year observations in 42 countries, the paper shows that in the United States the Big Four auditors more effectively monitor overstated earnings than their smaller counterparts, while elsewhere they tend to be more effective in monitoring both overstated and understated earnings. An important policy implication of the results is that uniform worldwide audit and financial reporting standards may not be as effective as might be hoped, because international differences in ownership structures and the resultant agency issues create different reporting incentives.