tendeloo et al - 2008 - earnings management and audit quality in europe

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European Accounting Review
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/>Earnings Management and Audit
Quality in Europe: Evidence
from the Private Client Segment
Market
Brenda Van Tendeloo
a
& Ann Vanstraelen
a

b
a
Universiteit Maastricht, The Netherlands
b
Universiteit Antwerpen, Belgium
Published online: 11 Oct 2011.
To cite this article: Brenda Van Tendeloo & Ann Vanstraelen (2008): Earnings
Management and Audit Quality in Europe: Evidence from the Private Client Segment
Market, European Accounting Review, 17:3, 447-469
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Earnings Management and Audit
Quality in Europe: Evidence from
the Private Client Segment Market
BRENDA VAN TENDELOO
Ã
and ANN VANSTRAELEN
Ã
,
ÃÃ
Ã
Universiteit Maastricht, The Netherlands,
ÃÃ
Universiteit Antwerpen, Belgium
ABSTRACT This paper contributes to the recent literature on financial reporting quality
in private (i.e. non-listed) companies (Ball and Shivakumar, 2005; Burgstahler et al.,
2006) by examining whether in these types of companies Big 4 audit firms, as high
quality auditors, provide a constraint on earnings management. Considering incentives
of auditors to supply a high audit quality in private firms, we expect that Big 4 auditors
have an incentive to constrain earnings management only in high tax alignment
countries, where financial statements are more scrutinized by tax authorities and the

probability that an audit failure is detected is higher. Using data on private firms in
European countries, this study provides evidence consistent with this expectation.
1. Introduction
Some recent studies have focused on the demand and supply of financial report-
ing quality in private (i.e. non-listed) firms, as opposed to the extensively
researched financial reporting quality in public (i.e. listed) firms. For example,
Burgstahler et al. (2006) find that private firms engage more in earnings manage-
ment compared to public firms, and Ball and Shiva kumar (2005) find that privat e
firms incorporate losses less timely than public firms. This study contributes
to this recent literature by examining audit quality in private firms, and by ques-
tioning whether audit firm quality enhances financial repor ting quality in private
firms. In particular, this study examines (1) whether Big 4
1
audit firms provide a
European Accounting Review
Vol. 17, No. 3, 447–469, 2008
Corresponding Author: Brenda Van Tendeloo, Universiteit Maastricht, Faculty of Economics and
Business Administration, Department of Accounting and Information Management, PO Box 616,
6200 MD Maastricht, the Netherlands. E-mail:
0963-8180 Print/1468-4497 Online/08/030447–23 # 2008 European Accounting Association
DOI: 10.1080/09638180802016684
Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA.
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constraint on earnings management in private firms and (2) to what extent Big 4
audit firms provide a uniform level of audit quality for private companies across
countries. Given that private companies constitute the majority of the EU
economy and the EU market for audit services, this research seems warranted.
Furthermore, although audit quality is mainly considered to be important for
listed firms and derived from the agency theory, high quality auditing can also
be functional in private firms. For example, it can help to alleviate agency con-

flicts between owners, managers and banks, and it can be useful for evaluation of
managerial performance or for convincing various stakeholders of the credibility
of the fin ancial statements.
As earnings management in private firms deprives the users of financial state-
ments of obtaining reliable information, the task of the auditor is to protect
stakeholders’ interests. The incentives of (especially large) audit firms to
supply a high quality audit are expected to depend upon the probability that an
audit failure is detected and the risk of litigation, hereby damaging their repu-
tation. However, since financial statements of privat e firms, compared to public
firms, are not scrutinized as much by investors, financial analysts or regulating
authorities of stock exchanges, the probability that an audit failure is detected
and the risk of litigation is much lower in privately held companies, even in
countries generally considered as stronger in terms of investor protection or
legal enforcement (Chaney et al., 2004; Vander Bauwhede and Willekens, 2004).
We argue that for private firms in countries with a high alignment between
financial reporting and tax accounting, tax authorities are expected to (partly)
take on the role that investors, financial analysts or regulating authorities of
stock exchanges have in public firms. In particular we argue that tax authorities
in countries with a high tax alignment will scrutinize financial statements more
compared to countries with a low tax alignment because the financial statements
are take n as the basis for taxation. This results in a higher probability of audit
failure detection, which will negatively affect auditor reputation. In low tax align-
ment countries, financial statements and tax returns are more considered to be
two separate items, with the auditor only being responsible for the former.
Because financial statements are less scrutinized, lowering the probability of
audit failure detection, one could expect that Big 4 auditors have weaker incen-
tives to supply a high audit quality to their private clients in these countries.
2
Therefore, we expec t to observe a Big 4 audit quality effect only in high tax align-
ment countries, where financial statements are more scrutinized and the prob-

ability that an audit failure is detected is higher.
Our sample consists of all private firms in six EU countries (Belgium, Finland,
France, the Nether lands, Spain and the UK) during the period 1998–2002 that are
required by law to have their financial statements audited and for which both finan-
cial data and audit firm data were available in the Amadeus database.
3
Belgium,
Finland, France and Spain are considered as high tax alignment countries. The
Netherlands and the UK are considered as low tax alignment countries. Consistent
with our hypothesis, we find that a Big 4 audit firm constrains earnings
448 Brenda Van Tendeloo & Ann Vanstraelen
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management more compared to a non-Big 4 audit firm only in countries with high
tax alignment. Furthermore, consistent with Burgstahler et al. (2006), we find that
private companies domiciled in countries with stronger legal syst ems engage less
in earnings management. As expected, audit quality differentiation in private firms
is not enhanced in strong legal environments. Further, we show that subdividing
non-Big 4 audit firms into second-tier and small audit firms does not support
audit quality differentiation between these two types of audit firms. Our results
are robust to a number of sensitivity tests.
The remainder of this paper is organized as follows. In Section 2, we review
the relevant literature, provide the theoretical background and formulate the
research hypotheses. Section 3 describes the research design. The results of the
study and sensitivity analyses are presented in Section 4. We conclude in
Section 5 with summarizing our results and discussing the implications of our
analysis.
2. Previous Literature and Hypothesis Development
2.1. Earnings Management in Private Firms
While numerous studies have investigated earnings quality and its determinants
among public firms, only a few studies have considered earnings management in

private firms (see Beatty and Harris, 1998; Beatty et al. , 2002; Coppens and Peek,
2005; Burgstahler et al., 2006). Private companies are more closely held, have
greater managerial ownership, major capital providers often have insider
access to corporate information and capital providers take a more active role in
management. Moreover, their financial statements are not widely distributed to
the public and are more likel y to be influenced by tax objectives (Ball and
Shivakumar, 2005). Given these unique attributes of private firms as opposed
to public firms and the fact that private firms constitute the majority of the EU
economy and of the EU market for audit services, studying earnings management
and the role of the auditor in private firms is relevant.
The main users of private firms’ financial statements are stakeholders other
than equity investors, such as employees, bankers, customers, suppliers and the
government. To protect the interests of these stakeholders, private European
companies that exceed certain size criteria
4
are required to have their financial
statements audited.
To the extent that managers want to ‘mislead some stakeholders about the
underlying economic performance of the company or to influence contractual
outcomes that depend on reported accounting numbers’ (Healy and Wahlen,
1999, p. 368) earnings will also be managed in private firms.
5
For example,
bank financing is usually a major source of finance in privately held companies,
resulting in agency conflicts between bankers and owners, and between bankers
and management (Vander Bauwhede and Willekens, 2004), which could also
create earnings management incentives. Typical explanations of why private
Earnings Management and Audit Quality in Europe 449
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firms would potential ly engage in earnings management are tax minimization and

obtaining better terms of trade with banks, suppliers, cust omers, employees and
government (Coppens and Peek, 2005).
Similar to public firms, earnings management in private firms deprives the
users of financial statements of obtaining reliable information. As it is the task
of the statutory auditor to protect stakeholders’ interests, we question to what
extent audit quality constitutes a constraint on earnings management in private
firms.
2.2. Audit Quality in Private Firms
All European private companies that meet certain size crite ria
6
are required
to have their financial statements audited. The statutory auditor is expected to
provide different stakeholders of the company assurance concerning the accuracy
of the financial statements, the non-existence of financial statement fraud and the
going concern status. It could be argued that agency conflicts may be weaker in
private firms compared to public firms, because ownership and control are less
separated, possibly reducing the demand for financial statements for monitoring
managers (Fama and Jensen, 1983) and a high quality audit. However, high
quality auditing is also called for in private firms for the following reasons.
First, many private firms are subject to agency conflicts when they are not entirely
run by owner-managers (Ang et al., 2000) and agency conflicts possibly exist
between bankers and owners and bankers and management (Vander Bauwhede
and Willekens, 2004). In the absence of market-based measures of firm-value,
high quality reporting becomes particularly relevant for evaluation of managerial
performance and to support personnel and compensation decisions, resu lting in a
demand for high quality audits (Chaney et al., 2004). Further, having a Big 4
auditor could also in private firms be used to signal high financial reporting
quality. For instance, private firms may choose a Big 4 auditor in order to
obtain financing at the lowest possible cost (Beatty, 1989), or in view of the possi-
bility of going public in the future or of being targeted for acquisition (Chaney

et al., 2004). Moreover, tax authorities rely on financial statements to determine
taxable income especially in countries with a high alignment between financial
reporting and tax accounting. Having a high quality auditor could signal financial
reporting quality and perhaps deter a rigorous tax audit. And finally, private firms
may also want to convince suppliers, clients or employees of the credibility of
their financial statements.
From an audit market perspective, audit quality depends on (1) the probability
that material misstatements and signals of financial distress are discovered and
(2) the probability that the auditor will report these misstatements and signals
(DeAngelo, 1981). While the technical capability of auditors or the probability
that the auditor will discover material misstatements and going concern breaches
is often assumed to be constant across different auditors, audit quality is assumed
to be a function of auditor independence. Litigation and disciplinary sanctions are
450 Brenda Van Tendeloo & Ann Vanstraelen
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supposed to prevent auditors from compromising their independence and as such,
provide incentives to the auditor to constrain earnings management or issue a
qualified opinion when necessary. Apart from the sanctions themselves, litigious
actions or disciplinary sanctions damage the auditor’s reputation. In this respect,
larger audit firms are expected to be less likely to perform low quality audits
because these firms have more to lose in terms of clients and audit fees in case
of an audit failure. Auditor independence is thus considered to relate to the audi-
tor’s reputational capital (DeAngelo, 1981).
However, this reputation rational is only expected to hold when the probability
that an audit failure is detected and the risk of litigation is high, hereby damaging
the auditor’s reputation. When the risk of audit failure detection and litigation is
low, litigation and reputation costs of providing a low quality audit are expected
to be reduced, hereby lowering the incentives of large audit firms to supply a high
quality audit. As documented in different empirical studies (e.g. Maijoor and
Vanstraelen, 2006; Francis and Wang, 2008), Big 4 audit firms are less inclined

to supply public client firms with high quality audits in countries with weaker
investor protection,
7
lower level of enforcement and lower risk of litigation.
In privately held companies, litigation and reputation costs are likely much
lower, even in countries generally considered as stronger in terms of investor pro-
tection or legal enforcement since financial statements of private firms are not
scrutinized as much by investors, financial analysts or regulating authorities of
stock exchanges (Chaney et al., 2004; Vander Bauwhede and Willekens,
2004). As a consequence, we do not expect investor protection or legal enforce-
ment to enhance audit quality differentiation between Big 4 and non-Big 4 audi-
tors with respect to private client firms.
Previous studies concerning audit quality and earnings management in private
firms have, to our knowledge, only been performed for the Belgian audit market
and provide somewhat mixed results (Vander Bauwhede et al., 2003; Vander
Bauwhede and Willekens, 2004). Drawing on DeAngelo’s reputation rational
(1981) and the expectation that the incentives of (especially large) auditors to
supply a high quality audit depend upon the probability that an audit failure is
detected and the risk of litigation, we argue that tax enforcement
8
could
enhance audit quality in private firms, in countries with a high alignment
between financial reporting and tax accounting. Since in high tax alignment
countries financial statements are taken as the basis for taxation and are in fact
part of the tax statement, tax authorities are expected to rigorously examine finan-
cial statements. In particular, we argue that tax authorities in private firms (partly)
take on the role that investors, financial analysts or regulating authorities of stock
exchanges have in public firms, in scrutinizing financial statements. Given that
financial statements are more likely to b e scrutinized, the probability that an
audit failure is detected is higher in high tax alignment countries.

9
The auditor,
who has to assess the fairness of the financial statements, has as such a direct
responsibility to constrain aggressive (tax) accounting practices. As the detection
of aggressive tax accounting practices will lead to additional tax expenses, due to
Earnings Management and Audit Quality in Europe 451
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tax income restatements and sanctions of tax authorities, and possibly even court
cases,
10
Big 4 auditors, who want to protect their reputation as high quality audi-
tors, are therefore encouraged to constrain earnings management.
In low tax alignment countries, financial statements and tax returns are more
considered to be two separate items, with the auditor only being responsible
for the financial statements. Tax authorities are expected to focus their attention
on tax returns. Hence, financial statements are less scrutinized, lowering the prob-
ability of audit failure detection. Hence, one could expect Big 4 auditors to have
weaker incentives to supply a high audit quality to their private clients in these
countries.
Thus, in order to protect their internationally recognized reputation, we expect
that Big 4 auditors have an incentive to provide a high quality audit to their
private client firms only in high tax alignment countries, where financial state-
ments are more scrutinized by tax authorities and the probability that an audit
failure is detected is higher. This is reflected in the following hypothesis,
stated in alternative form:
Hypothesis: Private firms engage significantly less in earnings management
when audited by a Big 4 auditor compared to a non-Big 4 auditor, only when
domiciled in a country with a high alignment between financial reporting and
tax accounting.
3. Research Design

3.1. Sample
We use the August 2003 version of the Amadeus Top 250,000 database to collect
our data.
11
Amadeus is a relatively new database which provides standardized
financial statement data. We focus our analysis on a five-year period from
1998 to 2002. The initial sample consists of all privat ely held compani es that
have their domicile in one of the – at that time – 15 member states of the Euro-
pean Union, that are required by law to have their financial statements audited
and for which financial data and audit firm data are available in the Amadeus
database. Observations of Austria, Germany, Greece, Italy and Sweden had to
be excluded because of unavailability of audit firm data. In addition, Portugal
is excluded due to insufficient observations for companies with Big 4 auditors.
Finally, three countries were excluded because of missing accounting and insti-
tutional data. In particular, Ireland and Denmark are excluded because Amadeus
does not provide data on depreciation and operating income for Irish companies
and cash and short-term debt for Danish companies, and Luxembourg is excluded
because of missing institutional data in La Porta et al. (1998, 2006). Hence, the
remaining countries are Belgium, Finland, France, the Netherlands, Spain and
the UK.
Consistent with previous research, we exclude banks, insurance companies
and other financial holdings (SIC codes between 6000 and 6799), public
452 Brenda Van Tendeloo & Ann Vanstraelen
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administrative institutions (SIC code 43 and SIC codes above 9000) as well as
privately held subsidiaries of quoted companies as indicated in Amadeus.
12
Further, to eliminate extreme outliers, all accounting items needed to construct
the earnings management measures are truncated at the 0.5th and 99.5th
percentile.

For our industry –country analysis (see Section 3.2), the above selection criteria
result in 64,831 firm-year observations, constituting 144 industry– country
observations (6 countries  12 industry groups  2 audit firm types). However,
we further require a minimum of 10 observations per unit of analysis, resulting
in 129 industry –country observations. This number is further reduced to 113
observations due to zero small losses in these eliminated subgroups.
13
3.2. Earnings Management Proxies
Discretionary accruals and earnings distributions have been heavily criticized as
earnings management measures (e.g. Young, 1999; McNichols, 2000; Dechow
et al., 2003; Beaver et al., 2004; Durtschi and Easton, 2005). Especially in
cross-country studies, accruals models exhibit considerable variation in perform-
ance, caused by the international variation in model misspecification problems as
well as sample size (Meuwissen et al., 2007). In response to the criticisms, a
growing number of studies are relying on an aggregate measure of earnings man-
agement behaviour, as developed by Leuz et al. (2003) (e.g. Lang et al., 2003,
2006; Wysocki, 2004; Burgstahler et al., 2006).
This measure is constituted of four different proxies capturing a wide range of
earnings management activities: the magnitude of total accruals
14
scaled by oper-
ational cash flow; the tendency of firms to avoid small losses; the smoothness of
earnings relative to cash flows; and the correlation of accounting accruals and
operating cash flow. Averaging various earnings management proxies is expected
to mitigate potential measurement error (Leuz et al., 2003).
We draw on Burgstahler et al. (2006), to compute the earnings management
proxies, which are calculated at the industry –country level for firms with a
high quality auditor vs. firms with a low quality auditor. The magnitude of total
accruals relative to operational cash flow (EM1) is computed as the median
absolute value of total accruals scaled by the corresponding median absolute

value of operational cash flow for each industry– country– audit quality subgroup.
The scaling by operating cash flow controls for differences in firm size and
performance.
To measure the extent in which firms avoid reporting small losses (EM2), we
calculate the ratio of small profits to small losses at the industry–country level for
firms with a high quality auditor vs. firms with a low quality auditor. A firm-year
observation is classified as a small profit (small loss) if positive (negative)
earnings fall within the range of 1% of lagged total assets.
The smoothness of earnings relative to cash flows (EM3) is calculated as the
standard deviation of operating income scaled by the standard deviation of
Earnings Management and Audit Quality in Europe 453
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operational cash flow to control for differences in the variability of the firms’
economic performance. The resulting ratio is multiplied by 2 1 so that higher
values correspond to more earnings smoothing. As a second measure of earnings
smoothing (EM4), we consider the contemporaneous Spearman correlation
between the changes in total accruals and the changes in operational cash flow
for each industry– country–audit quality subgroup, multiplied by 2 1, so that
higher values again correspond to more earnings smoothing.
15
Finally, the individual earn ings management scores are transformed into
percentage ranks (ranging from 0 to 100). The average percentage rank per
industry–country –audit quality subgroup constitutes the aggregate earnings
management measure (EM
Agg
).
3.3. Empirical Model
The dependent variable in our empirical model is the aggregate earnings manage-
ment measure, described above. Our independent variables of interest are the
following. For audit quality differentiation, a dichotomous variable is used

indicating whether the company has a Big 4 auditor (B4) or not. To take the
extent of tax alignment into account, we include a dichotomous variable TAX.
The TAX variable takes on a value of one when financial reporting and tax
rules are highly aligned (Belgium, Finland, France and Spain
16
) and zero other-
wise (the Netherlands and the UK). To examine whether tax alignment has an
influence on audit quality, we include an interaction term B4
Ã
TAX. As we
expect private firms to engage significantly less in earnings management when
audited by a Big 4 auditor compared to a non-Big 4 auditor only in high tax
alignment countries, we expect the coefficient on B4 to be insignificant when
including this interaction term, while the interaction effect is expected to be nega-
tive. The expec ted sign of the coefficient on TAX is positive, as prior research has
shown that earnings management is more pervasive in high tax alignment
countries (Burgstahler et al., 2006).
In addition, a number of control variables are included that are expected to
influence our earnings management measure. Previous research has shown that
private firms engage more in earnings management in countries with weak
legal enforcement (Burgstahler et al., 2006). To control for the influence of
legal enforcement on earnings management, we include a variable LEGAL.
This variable is computed as the mean of three legal variables from La Porta
et al. (1998), which measure the quality of the legal system or enforcement:
efficiency of the judicial system, rule of law and a corruption index.
17
LEGAL
ranges from 0 to 10, and higher values correspond to stronger legal enforcement.
Since private firms are expected to engage less in earning management in strong
legal protection environments, we expect the coefficient on LEGAL to be

negative.
To control for the potential influence of legal enforcement on audit quality, and
hence mitigate potential alternative explanations regarding the cross-country
454 Brenda Van Tendeloo & Ann Vanstraelen
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variation in audit quality differentiation in private firms, we additionally include
an interaction term B4
Ã
LEGAL. However, we do not expect investor protection
or legal enforcement to enhance audit quality differentiation between Big 4 and
non-Big 4 auditors for private client firms. We therefore expect the coefficient on
this interaction term to be insignificant. In addition, in our sensitivity analysis, we
replace LEGAL by a number of other institutional variables which could poten-
tially influence earnings management or audit quality.
To control for differences in earnings management incentives and firm charac-
teristics that are systematically associated with accruals, we include the following
variables. First, we include the natural logarithm of total assets (LNASSETS) to
proxy for the size of a company, as prior research suggests an association with the
level of accruals or earnings management (e.g. Watts and Zimmerman, 1990;
Young, 1999).
Second, we include a leverage variable (LEV), calculated as the ratio of total
liabilities to total assets, which can have an impact on earnings management in
two directions. While highly leveraged firms could be expected to engage
more in upward earnings management to avoid debt covenant violations
(Watts and Zimmerman, 1990; DeFond and Jiambalvo, 1994; Young, 1999),
alternatively, high leverage may induce inco me-decreasing earnings manage-
ment in financially distressed firms in view of contractual renegotiations
(Becker et al., 1998).
Third, to control for differences in performance, we include the yearly percen-
tage change in sales (GROWTH) and the yearly return on assets as measured by

earnings divided by lagged total assets (ROA) (Dechow et al., 1995; Young,
1999). All control variables are computed as industry-level medians.
18
Finally, we include industry dummies (IND) to control for industry effects on
earnings management. The industry classification is based on Campbell (1996)
and is illustrated in Table 1.
Hence, our empirical model looks as follows:
EM
Agg
¼
b
0
þ
b
1
B4 þ
b
2
TAX þ
b
3
B4 Ã TAX þ
b
4
LEGAL
þ
b
5
B4 Ã LEGAL þ
b

6
LNASSETS
t
þ
b
7
LEV
t
þ
b
8
GROWTH
t
þ
b
9
ROA
t
þ
b
10
IND þ 1
where:
Dependent variable
EM
Agg
¼ aggre gate earnings management measure (EM
Agg
)
Independent variables

B4 ¼ dummy variable (company has a Big 4 auditor ¼ 1, else ¼ 0)
TAX ¼ dummy variable (high tax alignment ¼ 1, else ¼ 0)
LEGAL ¼ legal enforcement computed as the mean of three legal vari-
ables which measure the quality of the legal system or
Earnings Management and Audit Quality in Europe 455
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enforcement, for instance, efficiency of the judicial system,
rule of law and corruption index (La Porta et al., 1998)
LNASSETS
t
¼ natural logarithm of total assets in year t
LEV
t
¼ ratio of total liabilities to total assets in year t
GROWTH
t
¼ yearly percentage change in sales
ROA
t
¼ yearly return on assets as measured by earnings divided by
lagged total assets
IND ¼ vector of industry dummies based on Campbell (1996), as illus-
trated in Table 1. It is noted that Campbell industry group No. 1
(Agriculture and Forestry) is the industry of reference.
4. Results
4.1. Descriptive Statistics
Table 2 illustrates our sample composition, mean values of the four individual
earnings management measures (EM1 to EM4) and the aggregate earnings man-
agement measure (EM
Agg

) for the different industry–country groups. As illus-
trated in Table 2, a large percentage of European private firms are audited by
non-Big 4 audi t firms. Contrary to prior research on audit quality using US
data, our study does not suffer from poor variation in the audit variable.
Table 2 further indicates that, overall, industry groups with a Big 4 auditor
have a lower aggregate earnings management measure compared to non-Big 4
auditors. This result is also observed at country level, except for the Netherlands
and the UK. For the individual earnings management scores, we observe a similar
pattern except for EM1.
Table 3 pres ents the descriptive statistics for the institutional variables by
country. The institutional variables that we consider in our main analysis are
tax alignment (TAX) and legal enforcement (LEGAL), which is a control
Table 1. Industry classification
No. Industry group SIC code
1 Agriculture and forestry 2, 7 –9
2 Petroleum industry 13, 29
3 Consumer durables 25, 30, 36–37, 39, 50, 55, 57
4 Basic industry 10, 12, 14, 24, 26, 28, 33
5 Food/tobacco 1, 20, 21, 54
6 Construction 15– 17, 32, 52
7 Capital goods 34– 35, 38
8 Transportation 40– 42, 44, 45, 47
9 Utilities 46, 48, 49
10 Textiles/trade 22– 23, 31, 51, 53, 56, 59
11 Service 72– 73, 75, 76, 80, 81, 82, 83, 84, 86 –88, 89
12 Leisure 27, 58, 70, 78–79
456 Brenda Van Tendeloo & Ann Vanstraelen
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variable. In our sensitivity analysis, we consider the litigat ion index from La
Porta et al. (2006) and the accruals index from Hung (2001).

Table 4 presents descriptive statistics of the control variables used in the multi-
variate analysis. Table 4 indicates that, overall, companies with a Big 4 auditor
are larger and are less growing. With respect to leverage and return on assets,
no clear pattern arises.
Table 2. Sample composition and descriptive statistics for the earnings management
measures by country and auditor
Country Auditor Industry
obs.
Firm-years EM1 EM2 EM3 EM4 EM
Agg
Belgium B4 10 3,478 0.712 2.165 2 0.618 0.896 54.082
NB4 11 5,762 0.689 3.295 2 0.584 0.928 68.152
Finland B4 10 1,427 0.513 4.926 2 0.761 0.798 28.839
NB4 5 155 0.685 2.017 2 0.628 0.84 40.487
France B4 11 2,653 0.683 2.184 2 0.637 0.878 48.029
NB4 10 15,829 0.626 3.941 20.616 0.91 61.814
Netherlands B4 9 868 0.661 2.299 2 0.631 0.865 46.079
NB4 4 154 0.598 0.875 2 0.522 0.853 40.044
Spain B4 11 5,701 0.63 3.779 2 0.684 0.878 51.659
NB4 10 14,886 0.587 6.642 20.604 0.898 62.544
UK B4 12 6,126 0.684 2.292 2 0.614 0.876 50.95
NB4 10 7,314 0.631 1.961 2 0.684 0.866 39.226
Total
Mean B4 63 20,253 0.649 2.932 20.657 0.866 46.855
NB4 50 44,100 0.637 3.506 20.614 0.891 54.962
Median B4 0.655 2.35 2 0.650 0.88 47.788
NB4 0.632 3.086 2 0.603 0.9 52.434
Standard B4 0.114 2.012 0.102 0.062 15.397
Deviation NB4 0.101 2.333 0.104 0.051 20.033
All firms included in the sample are required by law to have their financial statements audited. Audit

quality is captured by auditor size. Either a firm has a Big 4 auditor (B4) or not (non-B4). Companies
with a Big 4 auditor and companies with a non-Big 4 auditor, in a particular industry and country, form
separate subgroups. The industry classification is based on Campbell (1996). EM1, EM2, EM3 and
EM4 are earnings management scores measured for each industry–country– auditor subgroup. The
table presents mean values by country and auditor size. EM1 measures the magnitude of total accruals
relative to operational cash flow and is computed as the median absolute value of total accruals scaled
by the corresponding median absolute value of operational cash flow. EM2 measures the avoidance of
small losses and is computed as the ratio of small profits to small losses. A firm-year observation is
classified as a small profit (small loss) if positive (negative) earnings fall within the range of 1% of
lagged total assets. EM3 measures smoothing of operating income and is computed as the standard
deviation of operating income divided by the standard deviation of cash flow from operations.
EM4 also measures the degree of income smoothing and is calculated as the Spearman correlation
between the changes in total accruals and the changes in operational cash flow. Both EM3 and
EM4 are multiplied by 2 1, so that higher values correspond to more earnings smoothing. EM
Agg
is an aggregate earnings management measure, obtained by transforming the individual earnings man-
agement scores into percentage ranks and averaging these percentage ranks.
Earnings Management and Audit Quality in Europe 457
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Table 5 provides Pearson and Spearman correlation coefficients of the different
earnings management measures, audit quality, legal enforcement and tax align-
ment. All earnings management scores seem to be significantly correl ated with
each other, except for EM2 (loss avoidance), which is only significantly correlated
with EM
Agg
. Because reliably measuring loss avoidance requires a substantial
amount of firm-years, it is possible that we failed to measure this proxy consist-
ently. Hence, we use EM
Agg
as dependent variable for the multivariate analyses,

which is expected to mitigate potential measurement error.
19
Audit quality is sig-
nificantly negatively correlated with EM
Agg
. While legal enforcement (LEGAL) is
strongly negatively correlated with EM
Agg
, TAX is positively correlated with
EM
Agg
. TAX and LEGAL are also significantly negatively correlated.
4.2. Univariate Results
The univariate results are presented in Table 6. Table 6 indicates that, for the
sample as a whole, companies with a Big 4 auditor engage less in earnings man-
agement compared to companies with a non-Big 4 auditor. When considering the
institutional variable of interest, it appears that this audit quality difference is sig-
nificant for companies domiciled in countries with high tax alignment. In low tax
alignment countries (i.e. the UK and the Netherlands) having a Big 4 auditor even
seems to be associated with more earnings management. Tax alignment increases
earnings management for the sample as a whole and for companies with a non-
Big 4 auditor.
4.3. Multivariate Results
The multivariate results are presented in Table 7. In column 1, we study audit
quality differentiation in the sample as a whole, without differentiating on
Table 3. Descriptive statistics for institutional variables by country
Country TAX LEGAL LITIGATION ACCRUAL
Belgium 1 9.44 0.44 0.64
Finland 1 10.00 0.66 0.77
France 1 8.68 0.22 0.64

Netherlands 0 10.00 0.89 0.77
Spain 1 7.14 0.66 0.77
UK 0 9.22 0.66 0.86
TAX takes on a value of one when financial reporting and tax rules are highly aligned (Belgium,
Finland, France and Spain) and zero otherwise (the Netherlands and the UK). LEGAL is the mean
of three variables which measures the quality of the legal system or enforcement: efficiency of the
judicial system, rule of law and corruption index (La Porta et al., 1998). LITIGATION is the litigation
index from La Porta et al. (2006), which measures the liability standard for investors to recover
damages from companies, directors and auditors when misleading information is disclosed.
ACCRUAL is the accrual index from Hung (2001), updated for European countries by Comprix
et al. (2003) and captures differences in accrual accounting rules.
458 Brenda Van Tendeloo & Ann Vanstraelen
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institutional features. The results in column 1 show that overall, private firms
engage significantly less in earnings management when audited by a Big 4
auditor compared to a non-Big 4 auditor.
In column 2, we include tax alignment (TAX) and the interaction between
having a Big 4 auditor and tax alignment. Including these variables increases
the explanatory power of the model. The results show that the coefficient of
the Big 4 dummy is no longer significant, indicating that in low tax alignment
countries, private clients of Big 4 auditors are not significantly associated with
less earnings management than private clients of non-Big 4 auditors. To assess
the difference in the magnitude of earnings management between clients of a
Big 4 and a non-Big 4 audit firm in a high tax alignment country, we compare
the coefficient of the tax variable (capturing the non-Big 4 audit firm effect)
with the sum of the coefficients of the Big 4 variable and the interaction term
Table 4. Descriptive statistics for control variables
Country Auditor Industry
obs.
Firm-years LNASSETS GROWTH LEV ROA

Belgium B4 10 3,478 9.583 0.037 0.751 0.025
NB4 11 5,762 9.239 0.052 0.756 0.015
Finland B4 10 1,427 9.339 0.03 0.599 0.05
NB4 5 155 8.919 0.062 0.66 0.013
France B4 11 2,653 9.826 0 0.725 0.027
NB4 10 15,829 9.412 0.004 0.742 0.032
Netherlands B4 9 868 10.018 2 0.022 0.718 0.039
NB4 4 154 9.799 20.027 0.726 0.048
Spain B4 11 5,701 9.884 0.015 0.687 0.039
NB4 10 14,886 9.215 0.02 0.679 0.036
UK B4 12 6,126 9.959 0.026 0.698 0.041
NB4 10 7,314 9.323 0.078 0.691 0.042
Total
Mean B4 63 20,253 9.898 0.01 0.694 0.035
NB4 50 44,100 9.339 0.037 0.712 0.035
Median B4 9.861 0.015 0.703 0.033
NB4 9.288 0.034 0.728 0.034
Standard B4 0.536 0.032 0.08 0.017
Deviation NB4 0.482 0.043 0.017 0.017
All firms included in the sample are required by law to have their financial statements audited. Audit
quality is captured by auditor size. Either a firm has a Big 4 auditor (B4) or not (non-B4). Companies
with a Big 4 auditor and companies with a non-Big 4 auditor, in a particular industry and country, form
separate subgroups. The industry classification is based on Campbell (1996). Control variables are
medians of firm-level realizations within each industry–country– auditor subgroup. We truncate
firm-level realizations at the 0.5 and 99.5 percentile before computing subgroup medians. The table
presents medians for the control variables by country and auditor size. LNASSETS
t
is the natural log-
arithm of total assets in year t. GROWTH
t

is the yearly percentage change in sales. LEV
t
is the ratio of
total liabilities to total assets in year t. ROA
t
is the yearly return on assets as measured by earnings
divided by lagged total assets.
Earnings Management and Audit Quality in Europe 459
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between the B4 and TAX dummies (capturing the Big 4 audit firm effect). The
coefficient for the interaction variable is significantly negative, indicating that
in high tax alignment countries, a Big 4 audit firm constrains earnings manage-
ment more compared to a non-Big 4 audit firm. These results show that the nega-
tive association between the magnitude of earnings management and having a
Big 4 auditor only exists in countries with high tax alignment. Hence, our
results suggest that tax authorities help in enforcing audit quality in private firms
in high tax alignment countries. Further, the coefficient on tax alignment is signifi-
cantly positive, indicating that private firms with a non-Big 4 auditor engage more
in earnings management when they are domiciled in countries with a high tax
alignment. As explained above, this result is consistent with expectations
because of increased incentives to manage earnings in order to lower taxation.
In column 3, we additionally include the institutional variable on legal enfor -
cement (LEGAL) as well as the interaction variable between Big 4 auditor and
degree of legal enforcement. Introducing these variables further increases the
Table 5. Earnings management measures: correlation coefficients (Pearson above
Spearman below the diagonal)
Variable EM1 EM2 EM3 EM4 EM
Agg
B4 LEGAL TAX
EM1 1 2 0.212

Ã
0.242
ÃÃ
0.108 0.472
ÃÃ
0.055 0.060 2 0.061
EM2 2 0.143 1 2 0.016 0.157 0.370
ÃÃ
2 0.132 2 0.378
ÃÃ
0.356
ÃÃ
EM3 0.279
ÃÃ
2 0.87 1 0.488
ÃÃ
0.662
ÃÃ
2 0.204 2 0.009 2 0.063
EM4 0.234
Ã
0.271
ÃÃ
0.523
ÃÃ
1 0.714
ÃÃ
2 0.217
Ã
2 0.217

Ã
0.108
EM
Agg
0.550
ÃÃ
0.397
ÃÃ
0.688
ÃÃ
0.826
ÃÃ
1 20.225
Ã
2 0.276
ÃÃ
0.200
Ã
B4 0.066 2 0.161 2 0.221
Ã
2 0.242
ÃÃ
2 0.216
Ã
1 0.075 2 0.057
LEGAL 20.049 2 0.326
ÃÃ
2 0.030 20.309
ÃÃ
2 0.278

ÃÃ
0.092 1 2 0.372
ÃÃ
TAX 2 0.090 0.420
ÃÃ
2 0.037 0.203
Ã
0.198
Ã
2 0.057 2 0.285
ÃÃ
1
The table reports Pearson and Spearman correlation coefficients.
Ã
,
ÃÃ
indicate statistical significance
at the 0.05 and 0.01 level, respectively (two-tailed). EM1, EM2, EM3 and EM4 are earnings manage-
ment scores measured for each industry–country– auditor subgroup. The table presents mean values
by country and auditor size. EM1 measures the magnitude of total accruals relative to operational cash
flow and is computed as the median absolute value of total accruals scaled by the corresponding
median absolute value of operational cash flow. EM2 measures the avoidance of small losses and
is computed as the ratio of small profits to small losses. A firm-year observation is classified as a
small profit (small loss) if positive (negative) earnings fall within the range of 1% of lagged total
assets. EM3 measures smoothing of operating income and is computed as the standard deviation of
operating income divided by the standard deviation of cash flow from operations. EM4 also measures
the degree of income smoothing and is calculated as the Spearman correlation between the changes in
total accruals and the changes in operational cash flow. Both EM3 and EM4 are multiplied by 2 1, so
that higher values correspond to more earnings smoothing. EM
Agg

is an aggregate earnings manage-
ment measure, obtained by transforming the individual earnings management scores into percentage
ranks and averaging these percentage ranks. B4 takes on a value of one when a firm has a Big 4 auditor
and zero otherwise. LEGAL is the mean of three variables which measure the quality of the legal
system or enforcement: efficiency of the judicial system, rule of law and corruption index (La
Porta et al., 1998). TAX takes on a value of one when financial reporting and tax rules are highly
aligned (Belgium, Finland, France and Spain) and zero otherwise (the Netherlands and the UK).
460 Brenda Van Tendeloo & Ann Vanstraelen
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explanatory power of the model. The results presented in column 3 show a sig-
nificant negative coefficient for legal enforcement implying that legal enforce-
ment provides a constraint on earnings management in private firms. This
finding is consistent with the results of Burgstahler et al. (2006). The interaction
variable between Big 4 auditor and legal enforcement is, however, not sign ificant.
This implies that legal enforcement does not significantly increase audit quality
different iation. This result is consistent with our expectation that litigation risk
for auditors in the private client segment market is not necessarily higher in
countries with stronger investor protection or legal enforcement. The regression
results further show that leverage and return on assets are significant control vari-
ables in all three models.
4.4. Sensitivity Analyses
As a first sensitivity analysis, we replace LEGAL by other institutional variables
which could potentially influence earnings management or audit quality differen-
tiation. In this way, we further mitigate potential alternative expl anations
regarding the cross-country variation in audit quality differentiation in private
firms. In this respect, we include the litigation index from La Porta et al. (2006),
LITIGATION, which measures the effectiveness with which investors can
Table 6. Univariate analysis
EM
Agg

Big 4
Mean
Median
(N)
Non-Big 4
Mean
Median
(N)
Total sample
Mean Median
(N)
t-Statistic
Z-Statistic
Wilcoxon
Mann– Whitney
Total sample 46.855 54.962 50.442 2 2.433
ÃÃ
47.788 52.434 50.332 2 2.286
ÃÃ
(63) (50) (113)
High tax alignment 45.852 60.991 52.839 2 3.992
ÃÃÃ
45.243 64.712 52.102 2 3.759
ÃÃÃ
(42) (36) (78)
Low tax alignment 48.862 39.46 45.101 1.711
Ã
55.642 33.85 45.133 2 1.886
Ã
(21) (14) (35)

t-Statistic 2 0.729 3.868
ÃÃÃ
2.150
ÃÃ
Z-Statistic Wilcoxon
Mann– Whitney
2 0.700 2 3.446
ÃÃÃ
2 2.099
ÃÃ
The table reports mean and median values of the aggregate earnings management index, EM
Agg
.
EM
Agg
is constructed such that higher values correspond to higher levels of earnings management.
Further, test statistics on differences in mean and median values of EM
Agg
are reported.
Ã
,
ÃÃ
,
ÃÃÃ
indi-
cate statistical significance at the 0.10, 0.05 and 0.01 level, respectively (two-tailed). Companies either
have a Big 4 auditor or a non-Big 4 auditor. Belgium, Finland, France and Spain are classified as high
Earnings Management and Audit Quality in Europe 461
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recover damages from companies, directors and auditors when misleading infor-

mation is disclosed, and the accruals index from Hung (2001), ACCRUAL, to
control for differences in accounting regulation. These variables (results not
reported) are not significant. Also their interactions with auditor quality are not
Table 7. Earnings management and audit quality in private firms
EM
Agg
¼
b
0
þ
b
1
B4 þ
b
2
TAX þ
b
3
B4
Ã
TAX þ
b
4
LEGAL þ
b
5
B4
Ã
LEGAL
þ

b
6
LNASSETS
t
þ
b
7
LEV
t
þ
b
8
GROWTH
t
þ
b
9
ROA
t
þ
b
10
IND þ 1
Variables 1 2 3
Intercept 37.020
(0.746)
2 3.713
(2 0.064)
82.867
(1.270)

B4 2 7.680
(2 2.364)
ÃÃ
6.694
(1.403)
14.222
(0.501)
TAX 17.347
(3.743)
ÃÃÃ
11.822
(2.262)
ÃÃ
B4
Ã
TAX 2 20.861
(2 3.780)
ÃÃÃ
2 22.038
(2 3.561)
ÃÃ
LEGAL 2 5.286
(2 2.249)
ÃÃ
B4
Ã
LEGAL 2 0.474
(2 0.166)
LNASSETS
t

2 0.177
(2 0.041)
2.119
(0.467)
2 1.757
(2 0.365)
GROWTH
t
2 50.573
(2 0.891)
2 9.043
(2 0.157)
2 10.029
(2 0.175)
LEV
t
44.098
(1.849)
Ã
43.086
(2.026)
ÃÃ
41.237
(1.863)
Ã
ROA
t
2 406.245
(2 3.751)
ÃÃÃ

2 309.607
(2 3.230)
ÃÃÃ
2 381.437
(2 3.676)
ÃÃÃ
IND Included Included Included
N 113 113 113
R
2
(Adjusted) 0.360 0.413 0.510
F 4.932
ÃÃÃ
5.376
ÃÃÃ
6.830
ÃÃÃ
The table reports OLS coefficients and t -statistics are based on heteroscedastic-consistent standard
errors.
Ã
,
ÃÃ
,
ÃÃÃ
indicate statistical significance at the 0.10, 0.05 and 0.01 level, respectively (two-
tailed). EM
Agg
is an aggregate earnings management measure, constructed such that higher values cor-
respond to higher levels of earnings management. B4 takes on a value of one when a firm has a Big 4
auditor and zero otherwise. LEGAL is a measure of legal enforcement, computed as the mean of three

legal variables which measure the quality of the legal system or enforcement: efficiency of the judicial
system, rule of law and corruption index (La Porta et al., 1998). TAX takes on a value of one when
financial reporting and tax rules are highly aligned (Belgium, Finland, France and Spain) and zero
otherwise (the Netherlands and the UK). Control variables are subgroup medians. We truncate
firm-level realizations at the 0.5 and 99.5 percentile before computing subgroup medians.
LNASSETS
t
is the natural logarithm of total assets in year t. GROWTH
t
is the yearly percentage
change in sales. LEV
t
is the ratio of total liabilities to total assets in year t. ROA
t
is the yearly
return on assets as measured by earnings divided by lagged total assets. IND, a vector of industry
dummies with Campbell industry group No. 1 as industry of reference, are included but not reported.
462 Brenda Van Tendeloo & Ann Vanstraelen
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significant and including these variables does not alter our results. Hence, neither
the litigation variable nor the accounting regulation variable has increm ental
explanatory power with regard to audit quality differentiation in private firms
across European countries.
As a secon d sensitivity analysis, we further subdivide the non-Big 4 audit firms
into the so-called second-tier audit firms and small audit firms. Since Big 4 audit
firm concentration of the European private client audit market is much lower
compared to the public client market, the traditional distinction between Big 4
and non-Big 4 audit firms might not be adequate in these less concentrated
markets. We expect a large auditor to provide a higher audit quality compared
to a small auditor. In particular, Big 4 auditors are expected to provide a

higher audit quality compared to non-Big 4 (both second-tier and small) auditors,
while second-tier auditors are considered to provide a higher audit quality com-
pared to small auditors. To examine this, we include in our regression analysis, a
vector of audit dummies (AUD) indicating whether the company has a Big 4
auditor (B4) or not and whether the company has a second-tier auditor (ST) or
not. The auditor of reference is the small auditor. Second-tier audit firms are
identified as member firms of the Top 20 International Accounting Firms and
Networks, excluding Big 4 audit firms (Broom, 2002).
20
Subdividing the non-
Big 4 audit firms into the so-called second-tier audit firms and small audit
firms does not show significant differences in audit quality between these two
types of audit firms (results not reported).
In addition, the following sensitivity checks (results not reported) were per-
formed to verify the robustness of our results. First, we attempt to control for
self-selection bias. The results of Chaney et al. (2004) indicate that certain
private firm-specific characteristics that influence financial reporting, and more
specifically earnings management behaviour, might also influence auditor
choice. When certain variables that both affect earnings management and
auditor choice have not been adequately controlled for in our regression analysis,
auditor choice (Big 4/non-Big 4) would be endogenous in our analysis, hereby
possibly confounding our results (e.g. Heckman, 1978). The existence of an
endogeneity problem can be tested by performing the extended regression
version of the Hausman specification test (Maddala, 2001, p. 498; Wooldridge,
2003, p. 506). Hence, in a first stage, auditor choice is explained by all the
exogenous variables of the earnings management model. Including the first
stage residual does not influence results nor is the coefficient on the first stage
residuals significant, which would indicate that the model does not suffer from
an endogeneity bias.
Furthermore, to address the concern that, in some instances, there is no

head-to-head comparison possible between companies with a Big 4 auditor and
companies with a non-Big 4 auditor, we construct a balanced sample, in which
each industry– country subgroup with a Big 4 auditor has a non-Big 4 counterpart
and vice versa. This reduced sample results in 98 industry –country observations
and provides similar results as our initial sample.
Earnings Management and Audit Quality in Europe 463
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Finally, as companies with a Big 4 auditor are on average larger than
companies with a non-Big 4 auditor, we also perform our regressions using
only the largest quartile of companies with a non-Big 4 auditor. Hereby, we
improve the size comparability between the two groups. As we require a
minimum of 10 observations per industry –country–auditor subgroup, this
results in 109 industry–country observations. Results are qualitatively similar.
5. Conclusion
Previous studies have documented that Big 4 audit firms, compared to non-Big 4
audit firms, do a better job in constraining earnings management in public firms
domiciled in strong investor protection countries. This study examines (1)
whether Big 4 audit firms provide a constraint on earnings management in
private firms and (2) to what extent this audit quality differentiation is uniform
across countries.
Using data on private firms in European countries, this study provides evidence
that privately held companies engage less in earnings management when they
have a Big 4 auditor compared to a non-Big 4 auditor. However, consistent
with our hypothesis, we find that this association only exists in countries with
a high tax alignment. We attribute this result to the increased enforcement of
tax authorities with respect to financial statements in these countries. In high
tax alignment countries, tax authorities rely on financial statements to determine
taxable income and are as such considered a direct stakeholder and user of the
financial statements. Hence, financial statements are likely to be more scruti-
nized, which increases the probability of audit failure detection, which will

negatively affect auditor reputation.
In addition, we find consistent with Burgstahler et al. (2006), that private com-
panies domiciled in countries with a stronger legal environment engage less in
earnings management. As expected, we do not find audit quality differentiation
to be larger in countries with stronger legal systems. This is consistent with the
argument that the probability of audit failure detection and the risk of litigation
or disciplinary sanctions is much lower in private firms because financial state-
ments of private firms are not scrutinized as much, even in countries generally
considered as having a strong legal enforcement.
Other institutio nal variables such as litigation or accrual accounting do not
provide incremental explanatory power above tax alignment in explaining
cross-country variation in audit quality differentiation. Although the private
client audit market in Europe is less concentrated compared to the public client
audit market, subdividing non-Big 4 audit firms into second-tier and small
audit firms does not provi de suppor t for an audit quality difference between
second-tier audit firms and small audit firms with regard to earnings management.
Further, our results are robust to a number of other sensitivity tests.
These findings contribute to the literature on audit quality differentiation
between Big 4 and non-Big 4 auditors. While various Anglo-American studies
464 Brenda Van Tendeloo & Ann Vanstraelen
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on public firms use DeAngelo’s auditor reputation theory (1981) to explain the
observed audit quality differentiation (e.g. Franc is et al., 1999; Gore et al.,
2001), other studies have shown that audit quality differ entiation is weak or
absent for public companies in countries with weak investor protection, as the
probability of reputational damage due to a low quality audit is much lower in
these countries (e.g. Maijoor and Vanstraelen, 2006; Francis and Wang, 2008).
These studies indicate that DeAngelo’s reputation rational (1981) is conditional
upon a high probability of audit failure detection and litigation, damaging the
auditor’s reputation. Our results contribute to this viewpoint by showing that a

negative association between earnings management in private firms and having
a Big 4 auditor only exists in high tax alignment countries. In addition, this
study contributes to the recent literature on demand and supply of financial
reporting quality in private firms, constituting the majority of the EU economy
and the EU audit services market.
Our results are subject to the following limitations. First, while we use an
aggregate earnings management measure that is expected to mitigate potential
measurement error (Leuz et al., 2003), we acknowledge that earnings manage-
ment remains difficult to measure. Second, although we have controlled for
various earnings management incentives, there may be other incentives that we
have not controlled for. Third, as every cross-country study, our research is
subject to the influence of different institutional factors which are difficult to dis-
entangle, making it difficult to control for the potential impact of other insti-
tutional differences than those investigated in the study. Finally, our study is
focused on earnings management which is only one indirect measure of audit
quality. Future research is encouraged to consider other measures of audit
quality and to further examine factors influencing audit quality in private client
firms and to assess to what extent agency theory provides an explanation for
auditor choice and audit quality in the private client segment market. In this
respect, it seems warranted to make a distinction between private companies
with separation of ownership and managem ent, and private companies that are
run by owners.
Acknowledgements
The authors are grateful for the comments received from Walter Aerts,
Christof Beuselinck, Willem Buijink, Marc Deloof, Rajib Doogar, Jere
Francis, Ann Jorissen, Steven Maijoor, Jeffrey Pittman, Carl Reyns, Srinivasan
Sankaraguruswamy, Stuart Turley and the participants of the 2005 Annual
Congress of the European Accounting Association in Go
¨
teborg, the 2005

Belgian Financial Research Forum in Antwerp, the 2005 Annual Conference
of the American Accounting Association in San Francisco, the 2005 Symposium
of the European Auditing Research Network in Amsterdam, the workshop at
Tilburg University and the 2007 Annual Congress of the European Accounting
Association in Lisbon.
Earnings Management and Audit Quality in Europe 465
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Notes
1
For convenience we use the term Big 4 auditor to identify the large international audit firm
networks (Big 6/5/4). Some of the studies we refer to were conducted before the mergers
resulted in a reduction to four international audit networks. Up to 2002, Big 5 audit firms
included PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young, KPMG and
Arthur Andersen. In 2002, Arthur Andersen disappeared after the high profile financial
scandal in its client firm Enron.
2
It can be argued that in low tax alignment countries with a higher litigation risk (such as the
UK), Big 4 auditors will also have an incentive to constrain earnings management to avoid
private litigation (for example, bank lawsuits). To control for this, we perform a sensitivity
analysis (see Section 4) with a litigation index as control variable. From this analysis, it
appears that litigation does not provide incremental explanatory power above tax alignment
in explaining cross-country variation in audit quality differentiation.
3
Amadeus is a database containing financial data of public and private firms in Europe. Due to
data limitations (see Section 3.1), we could only include 6 out of the 15 EU member states
in 2002.
4
In accordance with the Fourth Council Directive (78/660/EEC) of 25 July 1978 only small
companies are exempted from a statutory audit. During our sample period 1998– 2002, small
companies are companies that do not exceed more than one of following criteria: (a) average

number of employees: 50; (b) balance sheet total: 3,125,000 EUR; (c) annual net turnover:
6,250,000 EUR. Companies with more than 100 employees are always considered as large
companies. These exemption criteria have, however, been revised over time. Since 2005,
small companies are defined as companies with less than 50 employees and whose annual turn-
over or annual balance sheet total does not exceed 10 million EUR.
5
While the exercised discretion in reporting earnings can also be used to signal private infor-
mation and reduce information asymmetry (e.g. Subramanyam, 1996), we assume earnings
are managed for opportunistic reasons to mislead some stakeholders or influence contractual
outcomes, following the definition of Healy and Wahlen (1999).
6
See note 4.
7
Similar to DeFond and Hung (2004) we define investor protection as ‘the extent of laws that
protect investors’ rights and the strength of the legal institutions that facilitate law enforcement’.
8
Tax enforcement is considered to be stronger in high tax alignment countries with respect to
financial statements and with respect to the auditors, which are considered to provide assurance
over the accuracy of these financial statements. We hereby do not claim that tax authorities are
better at enforcing tax law in these countries compared to low tax alignment countries.
9
However, increased enforcement due to the increased scrutiny of financial statements by tax
authorities does not appear to lead to less earnings management in countries with a strong
tax alignment, as indicated by the results of Burgstahler et al. (2006). They argue that stronger
tax alignment is associated with more earnings management, since companies have more direct
incentives to influence financial reporting income to minimize their tax expense when this
income figure is taken as the basis for taxation.
10
For example, KPMG tax shelter fraud in 2005.
11

Listing status and audit firm data is provided in Amadeus only for the final year. Therefore,
previous versions of the Amadeus database were used to verify the listing status and audit
firm data.
12
Financial institutions are excluded because of their specific accounting requirements, which
differ substantially from those of industrial and commercial companies. Public administrative
institutions are excluded because of their specific nature. Similar to Fenn (2000) we exclude
subsidiaries of quoted companies as their management and financial reporting decisions are
likely to be influenced by public parent companies.
13
This makes the calculation of EM2, described in Section 3.2, impossible.
466 Brenda Van Tendeloo & Ann Vanstraelen
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14
Following Dechow et al. (1995), we compute total accruals as (Dtotal current assets 2
Dcash) 2 (Dtotal current liabilities 2 Dshort-term debt) 2 depreciation expense, where D
denotes the change over the fiscal year.
15
While a negative correlation between accruals and operating cash flow is inherent to accrual
accounting, differences in the magnitudes of this correlation indicate, ceteris paribus, variation
in the extent of earnings smoothing. Moreover, because accounting systems likely underreact to
economic shocks, using accruals to signal firm performance results on average in a less negative
(and in specific cases even positive) correlation with cash flows (Leuz et al., 2003).
16
While Spain theoretically experienced a great reduction in tax alignment in the early 1990s, in
practice a strong tax link still exists in Spanish individual financial statements (Oliveiras and
Puig, 2005).
17
This variable is the same as the institutional variable used by Burgstahler et al. (2006).
18

We truncate firm-level realizations at the 0.5 and 99.5 percentile before computing subgroup
medians.
19
We have also performed our analyses with EM2 excluded from the aggregate earnings measure.
Our conclusions with respect to audit quality differentiation and tax alignment remain qualitat-
ively similar.
20
Comparison of this list with the 1999 list revealed only one difference. In 2002 one firm had
been replaced by number 23 of 1999.
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