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

This study investigates whether and how a firm’s real earnings management (REM) activities are influenced by the strength of a country’s legal regime, and then examines whether the role of Big 4 auditors to constrain REM is different between countries with strong and weak legal regimes. Using 36,927 firm-year observations from 25 countries across the world, we find that the intensity of REM increases as a country’s legal regime strengthens because more firms switch from accrual-based earnings management (AEM) to REM, suggesting a substitutive relation between AEM and REM. We find, however, that this increased use of REM in countries with stronger legal regimes is less pronounced for the clients of Big 4 auditors than for those of non-Big 4 auditors. These findings suggest that the high-quality audit service provided by Big 4 auditors reduces the client firms’ tendency to use REM, especially in countries with a strong legal regime.