Earnings management and audit quality in Europe: Evidence from the private client segment market

This paper examines audit quality in private firms across different European countries. Prior research (e.g. Becker et al., 1998; Francis et al., 1999) has shown that audit quality provides a constraint on earnings management for public firms. We investigate whether audit quality differentiation also holds in private firms, constituting the majority of the EU economy and the EU market for audit services. This is an empirical question given that opposing arguments for (and against) the existence of a Big 4 audit quality difference between public and private firms can be given. Moreover, we question whether this audit quality difference, if any, is influenced by institutional factors. Using data on private firms of six European countries, this study provides evidence that, after controlling for self-selection, audit quality differentiation between Big 4 and non-Big 4 audit firms also exists in the private client segment market. However, we do not find support for an audit quality difference between second-tier and small audit firms. Consistent with prior research, we find that private companies domiciled in countries with a stronger investor protection engage less in earnings management. In addition, our results suggest that audit quality and investor protection are substitutes in constraining earnings management in private firms, in the sense that the Big 4 audit quality effect attenuates when investor protection is stronger.