The Joint Effect of Audit Quality and Legal Regime on the Use of Real versus Accrual-based Earnings Management: International Evidence

This study investigates whether and how firms' REM activities are influenced by the strength of country-level legal regime, and examines whether the role of Big 4 auditors on mitigating REM is different between countries with strong and weak legal regimes. It also analyzes the effect of legal regime and audit quality on the relative use of REM over AEM. We first find that the intensity of REM increases as legal regime strengthens. However, this increased use of REM is mitigated by higher audit quality of Big 4 auditors, especially in strong legal regime countries due to their increasing concerns about litigation risk and reputations in those countries. We also find that the relative intensity of REM over AEM increases with stronger legal regime because more firms switch from AEM to REM due to higher relative cost of AEM in those countries, and that this relative intensity is mitigated by higher audit quality because Big 4 auditors are concerned about REM as well as AEM. These findings are robust to a battery of sensitivity tests.