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Earnings Management and AuditQuality in Europe: Evidence fromthe Private Client Segment Market

BRENDA VAN TENDELOO and ANN VANSTRAELEN,

Universiteit Maastricht, The Netherlands,

Universiteit Antwerpen, Belgium

ABSTRACT This paper contributes to the recent literature on financial reporting qualityin 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 highquality auditors, provide a constraint on earnings management. Considering incentivesof auditors to supply a high audit quality in private firms, we expect that Big 4 auditorshave an incentive to constrain earnings management only in high tax alignmentcountries, where financial statements are more scrutinized by tax authorities and theprobability 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,

Burgstahleret al.(2006) find that private firms engage more in earnings manage-

ment compared to public firms, and Ball and Shivakumar (2005) find that privatefirms 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 reporting quality in private

firms. In particular, this study examines (1) whether Big 41 audit firms provide a

European Accounting Review

Vol. 17, No. 3, 447469, 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: [email protected]

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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 financial 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 private 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 (Chaneyet 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 ofstock 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 taken 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 expect 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 Netherlands, 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 Burgstahleret al.(2006), we find that

private companies domiciled in countries with stronger legal systems 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; Beattyet 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 insideraccess 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 likely 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 thegovernment. To protect the interests of these stakeholders, private European

companies that exceed certain size criteria4 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 potentially engage in earnings management are tax minimization and

obtaining better terms of trade with banks, suppliers, customers, 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 criteria6 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 thegoing 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, resulting 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 financialreporting 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


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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 auditors 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-

tors 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 auditors 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 inclinedto 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 DeAngelos 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 enforcement8 could

enhance audit quality in private firms, in countries with a high alignmentbetween 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 be 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


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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 privately held companies 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 tobe 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


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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 industrycountry 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 asearnings 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 ofearnings management activities: the magnitude of total accruals14 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 medianabsolute 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


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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 21 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 industrycountryaudit quality subgroup, multiplied by 21, so that

higher values again correspond to more earnings smoothing.15

Finally, the individual earnings 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 (EMAgg).

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 Spain16) 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 TAX. As we

expect private firms to engage significantly less in earnings management whenaudited 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 expected sign of the coefficient on TAX is positive, as prior research has

shown that earnings management is more pervasive in high tax alignment

countries (Burgstahleret 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 weaklegal 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


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variation in audit quality differentiation in private firms, we additionally include

an interaction term B4 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 intwo 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 income-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:

EMAgg b0 b1B4 b2TAX b3B4 TAX b4LEGAL

b5B4 LEGAL b6LNASSETSt b7LEVt b8GROWTHt b9ROAt b10IND 1

where:

Dependent variable

EMAgg aggregate earnings management measure (EMAgg)

Independent variables

B4 dummy variable (company has a Big 4 auditor 1, else 0)

TAX dummy variable (high tax alignment 1, else 0)

LEGAL legal enforcement computed as the mean of three legal vari-

ables which measure the quality of the legal system or


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enforcement, for instance, efficiency of the judicial system,

rule of law and corruption index (La Porta et al., 1998)

LNASSETSt natural logarithm of total assets in year t

LEVt ratio of total liabilities to total assets in year t

GROWTHt yearly percentage change in sales

ROAt yearly return on assets as measured by earnings divided by

lagged total assets

IND 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 (EMAgg) for the different industrycountry groups. As illus-trated in Table 2, a large percentage of European private firms are audited by

non-Big 4 audit 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 presents 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 92 Petroleum industry 13, 29

3 Consumer durables 25, 30, 36 37, 39, 50, 55, 574 Basic industry 10, 12, 14, 24, 26, 28, 335 Food/tobacco 1, 20, 21, 546 Construction 15 17, 32, 527 Capital goods 34 35, 388 Transportation 40 42, 44, 45, 479 Utilities 46, 48, 49

10 Textiles/trade 22 23, 31, 51, 53, 56, 5911 Service 72 73, 75, 76, 80, 81, 82, 83, 84, 86 88, 8912 Leisure 27, 58, 70, 78 79


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variable. In our sensitivity analysis, we consider the litigation 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 managementmeasures by country and auditor

Country Auditor Industryobs.

Firm-years EM1 EM2 EM3 EM4 EMAgg

Belgium B4 10 3,478 0.712 2.165 2

0.618 0.896 54.082NB4 11 5,762 0.689 3.295 20.584 0.928 68.152

Finland B4 10 1,427 0.513 4.926 20.761 0.798 28.839NB4 5 155 0.685 2.017 20.628 0.84 40.487

France B4 11 2,653 0.683 2.184 20.637 0.878 48.029NB4 10 15,829 0.626 3.941 20.616 0.91 61.814

Netherlands B4 9 868 0.661 2.299 20.631 0.865 46.079NB4 4 154 0.598 0.875 20.522 0.853 40.044

Spain B4 11 5,701 0.63 3.779 20.684 0.878 51.659NB4 10 14,886 0.587 6.642 20.604 0.898 62.544

UK B4 12 6,126 0.684 2.292 20.614 0.876 50.95

NB4 10 7,314 0.631 1.961 2

0.684 0.866 39.226

TotalMean 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 54.962Median B4 0.655 2.35 20.650 0.88 47.788

NB4 0.632 3.086 20.603 0.9 52.434Standard B4 0.114 2.012 0.102 0.062 15.397Deviation 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 industrycountryauditor 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 by21, so that higher values correspond to more earnings smoothing. EMAggis an aggregate earnings management measure, obtained by transforming the individual earnings man-

agement scores into percentage ranks and averaging these percentage ranks.


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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 correlated with

each other, except for EM2 (loss avoidance), which is only significantly correlated

with EMAgg. 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 EMAggas dependent variable for the multivariate analyses,which is expected to mitigate potential measurement error.19 Audit quality is sig-

nificantly negatively correlated with EMAgg. While legal enforcement (LEGAL) is

strongly negatively correlated with EMAgg, TAX is positively correlated with

EMAgg. 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 0.64Finland 1 10.00 0.66 0.77

France 1 8.68 0.22 0.64Netherlands 0 10.00 0.89 0.77Spain 1 7.14 0.66 0.77UK 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 Portaet 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 Comprixet al. (2003) and captures differences in accrual accounting rules.


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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 4auditor 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 Industryobs.

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 0.015Finland B4 10 1,427 9.339 0.03 0.599 0.05

NB4 5 155 8.919 0.062 0.66 0.013France B4 11 2,653 9.826 0 0.725 0.027

NB4 10 15,829 9.412 0.004 0.742 0.032Netherlands B4 9 868 10.018 20.022 0.718 0.039

NB4 4 154 9.799 20.027 0.726 0.048Spain B4 11 5,701 9.884 0.015 0.687 0.039

NB4 10 14,886 9.215 0.02 0.679 0.036UK B4 12 6,126 9.959 0.026 0.698 0.041

NB4 10 7,314 9.323 0.078 0.691 0.042

TotalMean B4 63 20,253 9.898 0.01 0.694 0.035

NB4 50 44,100 9.339 0.037 0.712 0.035Median B4 9.861 0.015 0.703 0.033

NB4 9.288 0.034 0.728 0.034Standard B4 0.536 0.032 0.08 0.017Deviation 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. LNASSETStis the natural log-

arithm of total assets in yeart. GROWTHtis the yearly percentage change in sales. LEVtis the ratio of

total liabilities to total assets in yeart. ROAtis the yearly return on assets as measured by earnings

divided by lagged total assets.


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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 aboveSpearman below the diagonal)

Variable EM1 EM2 EM3 EM4 EMAgg B4 LEGAL TAX

EM1 1 20.212 0.242 0.108 0.472 0.055 0.060 20.061

EM2 2

0.143 1 2

0.016 0.157 0.3702

0.132 2

0.378 0.356

EM3 0.279 20.87 1 0.488 0.662 20.204 20.009 20.063EM4 0.234 0.271 0.523 1 0.714 20.21720.217 0.108EMAgg 0.550

0.397 0.688 0.826 1 20.22520.276 0.200

B4 0.066 20.161 20.221 20.242 20.216 1 0.075 20.057LEGAL 20.049 20.326 20.030 20.309 20.278 0.092 1 20.372

TAX 20.090 0.420 20.037 0.203 0.198 20.057 20.285 1

The table reports Pearson and Spearman correlation coefficients. , 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 industrycountryauditor subgroup. The table presents mean values

by country and auditor size. EM1 measures the magnitude of total accruals relative to operational cashflow 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 by21, so

that higher values correspond to more earnings smoothing. EMAggis 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 auditorand 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).


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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 significant.

This implies that legal enforcement does not significantly increase audit quality

differentiation. 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 regressionresults 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 explanations

regarding the cross-country variation in audit quality differentiation in private

firms. In this respect, we include the litigation index from La Portaet al. (2006),

LITIGATION which measures the effectiveness with which investors can

Table 6. Univariate analysis

EMAgg Big 4Mean

Median(N )

Non-Big 4Mean

Median(N )

Total sampleMean Median

(N )

t-StatisticZ-StatisticWilcoxon

Mann Whitney

Total sample 46.855 54.962 50.442 22.433

47.788 52.434 50.332 22.286

(63) (50) (113)High tax alignment 45.852 60.991 52.839 23.992

45.243 64.712 52.102 23.759

(42) (36) (78)Low tax alignment 48.862 39.46 45.101 1.711

55.642 33.85 45.133 21.886

(21) (14) (35)

t-Statistic 2

0.729 3.868

2.150

Z-Statistic WilcoxonMann Whitney

20.700 23.446 22.099

The table reports mean and median values of the aggregate earnings management index, EMAgg.

EMAggis constructed such that higher values correspond to higher levels of earnings management.

Further, test statistics on differences in mean and median values of EMAggare reported., , 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


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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

EMAgg b0 b1B4 b2TAX b3B4TAX b4LEGAL b5B4

LEGAL

b6LNASSETSt b7LEVt b8GROWTHt b9ROAt b10IND 1

Variables 1 2 3

Intercept 37.020(0.746)

23.713(20.064)

82.867(1.270)

B4 27.680(22.364)

6.694(1.403)

14.222(0.501)

TAX 17.347(3.743)

11.822(2.262)

B4 TAX 220.861(23.780)

222.038(23.561)

LEGAL 25.286

(2

2.249)B4 LEGAL 20.474

(20.166)LNASSETSt 20.177

(20.041)2.119

(0.467)21.757

(20.365)GROWTHt 250.573

(20.891)29.043

(20.157)210.029(20.175)

LEVt 44.098(1.849)

43.086(2.026)

41.237(1.863)

ROAt 2406.245(23.751)

2309.607(23.230)

2381.437(23.676)

IND Included Included IncludedN 113 113 113R2 (Adjusted) 0.360 0.413 0.510F 4.932 5.376 6.830

The table reports OLS coefficients and t-statistics are based on heteroscedastic-consistent standard

errors. , , indicate statistical significance at the 0.10, 0.05 and 0.01 level, respectively (two-

tailed). EMAggis 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 Portaet al., 1998). TAX takes on a value of one whenfinancial 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.

LNASSETSt is the natural logarithm of total assets in year t. GROWTHt is the yearly percentage

change in sales. LEVt is the ratio of total liabilities to total assets in year t. ROAt 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.


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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 incremental

explanatory power with regard to audit quality differentiation in private firms

across European countries.

As a second 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 4auditor (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 forself-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, herebypossibly 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 industrycountry subgroup with a Big 4 auditor has a non-Big 4 counterpart

and vice versa. This reduced sample results in 98 industrycountry observations

and provides similar results as our initial sample


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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 industrycountry 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 Burgstahleret 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 generallyconsidered as having a strong legal enforcement.

Other institutional 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 provide support 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


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on public firms use DeAngelos auditor reputation theory (1981) to explain the

observed audit quality differentiation (e.g. Francis et al., 1999; Gore et al.,

2001), other studies have shown that audit quality differentiation 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 DeAngelos reputation rational (1981) is conditional

upon a high probability of audit failure detection and litigation, damaging the

auditors 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 anaggregate 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 auditquality. 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 management, 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 Goteborg, 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


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Notes

1For 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 mergersresulted 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.2It 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.3Amadeus 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.

4In accordance with the Fourth Council Directive (78/660/EEC) of 25 July 1978 only smallcompanies are exempted from a statutory audit. During our sample period 19982002, 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.5While 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).6See note 4.7Similar 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.8Tax 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.9However, 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 Burgstahleret al.(2006). They argue that stronger

tax alignment is associated with more earnings management, since companies have more directincentives to influence financial reporting income to minimize their tax expense when this

income figure is taken as the basis for taxation.10For example, KPMG tax shelter fraud in 2005.11Listing 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.12Financial 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.13This makes the calculation of EM2, described in Section 3.2, impossible.


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14Following Dechow et al. (1995), we compute total accruals as (Dtotal current assets2

Dcash) 2 (Dtotal current liabilities2 Dshort-term debt)2 depreciation expense, where D

denotes the change over the fiscal year.15While 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 (Leuzet al., 2003).16While 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).17This variable is the same as the institutional variable used by Burgstahleret al. (2006).18We truncate firm-level realizations at the 0.5 and 99.5 percentile before computing subgroup

medians.19We 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.20Comparison 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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