Earnings management: the effects of national audit environment, audit quality and international capital markets

Abstract

This paper studies earnings management in an international context. More specifically, the effects of three factors on earnings management are studied: national audit environment, audit firm quality and reliance on international capital markets. National audit environments vary strongly in terms of independence rules, auditor education and auditor liability. Hence, it can be expected that the restrictions imposed by national audit environments on earnings management vary. However, there are two factors that can mitigate the national audit environment effect. First, there is strong evidence that audit firm quality, as indicated by the Big 5 and non-Big 5 dichotomy, affects earnings management opportunities for clients. In the context of this study an important issue is to what extent this quality effect overrides national differences. In other words, to what extent do the international audit firms provide a standardized high quality audit across different jurisdictions? Second, the reliance on international capital markets might reduce companies’ earnings management, irrespective of the opportunities provided by the national environment. The study uses data for the period 1991 1999 from listed firms in four jurisdictions: France, UK, the Netherlands and Germany. The total number of firm year observations is 17,838. The results of the study suggest that national differences in audit environments are strongly affecting earnings management. While earnings management is also affected by the audit quality of the audit firm and the reliance on international capital markets, the effect is rather small. The evidence provided in this study is relevant for the current worldwide integration of capital markets and the acceptance of international accounting standards. For the international comparability of earnings, not only the standardization of financial reporting is important but also the standardization of enforcement across jurisdictions. The results of this study suggest that the enforcement of financial reporting still varies strongly across countries.