The Effect of the Private Securities Litigation Reform Act of 1995 on Accounting Discretion of Client Managers of Big 6 and Non-Big 6 Auditors

Abstract

This study examines how the Private Securities Litigation Reform Act of 1995 (PSLRA) affects auditors' incentives to curtail earnings management by client managers. The most significant reform of PSLRA was the elimination of joint and several liability under which auditors and other parties could be named to lawsuits because of ‘deep pockets’ rather than culpability. While the elimination of joint and several liability provides significant relief to auditors from litigation, opponents of PSLRA argue that it discourages meritorious lawsuits and lowers audit quality, reducing investor confidence in markets. The potential benefit would be greatest for Big 6 firms, who have the highest exposure (largest clients) and significant resources to pay damages. In this paper we argue that if PSLRA induces decreases in audit quality, then we should expect increases in the prevalence of accruals after this Act. To investigate this issue we examine the discretionary accruals of a sample of 2,600 companies three years before and after the act. Our results support this hypothesis. Specifically, we find that after PSLRA income-increasing discretionary accruals rise for auditees of Big 6 firms but not for auditees of non-Big 6 firms.