Jere R. Francis
University of Missouri
Dechun Wang
University of Missouri
Alex Nikitkov
University of Missouri
Abstract: Audit clients that are large relative to an auditors portfolio of clients create a potential fee dependence that could compromise the auditors objectivity. However, large and visible clients also pose a risk to the auditors reputation and the potential for litigation if the quality of the auditors work is questioned, which could lead auditors to treat larger clients conservatively. The purpose of our study is to extend Reynolds and Francis (2000) to investigate countries beyond the U.S. where there is a wide variation in legal systems. We conjecture that Big 5 auditors are more conservative in their treatment of larger clients in countries whose legal systems provide stronger protection of investors than they are in countries with weaker investor protection, and where auditor litigation and the loss of reputation are less likely. Our results are consistent with this conjecture. Using a large sample from 27 countries, we document that Big 5 auditors allow their larger clients significantly less discretion with respect to accounting accruals in countries with stronger investor protection than in countries with weaker investor protection. In addition, we find that Big 5 auditors treat larger clients more conservatively than smaller clients in countries with strong investor protection, but do not do so in countries with weaker investor protection. These results are consistent with a countrys endogenous legal system affecting the behavior of Big 5 auditors and the discretion they allow clients with respect to accounting accruals and, by implication, the discretion to aggressively manage earnings. Overall the study adds to a growing body of research that the nature of accounting and auditing practices are endogenously driven by a countrys legal system and in particular the protection of investors rights.
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