Understanding earnings quality - MIT Sloan School of Management

management related to incentives provided by control mechanisms, and perhaps react favorably to it,
is limited.
5.4 Auditors as determinants of earnings quality
The impact of auditors on EQ derives from their role in mitigating intentional and
unintentional misstatements. The ability of an auditor to mitigate misstatements is a function of both
the auditor’s ability to detect a material misstatement and to adjust for or report it (DeAngelo, 1981).
Researchers predict that an auditor’s ability to detect errors is a function of auditor effort and
effectiveness. Researchers predict that an auditor’s incentives to report or correct errors depends on
factors such as litigation risk, reputation costs, and auditor independence (e.g., Caramanis and
Lennox, 2008).
The two most commonly studied features of auditors are audit firm size and fee structures.
Both features can be correlated with an auditor’s ability to detect errors and an auditor’s incentives
to report, which makes it difficult to disentangle the reason for the auditor’s impact on quality.
5.4.1 Studies of auditor size
Firms with Big-X auditors 58 have significantly lower discretionary accruals than firms with
non-Big-X auditors (Becker, DeFond, Jiambalvo, and Subramanyam, 1998; Francis, Maydew, and
Sparks, 1999; Kim, Chung, and Firth, 2003). Petroni and Beasley (1996) do not find that the
accuracy and bias of the loss reserve account in property-casualty insurers in the insurance industry
varies based on audit firm size, but Gaver and Paterson (2001) find that weak insurers do not
understate their reserve account when they have both Big-six auditors and Big-six actuaries. While
these studies consistently suggest that effective auditing limits earnings management, Dechow et al.
58 Big-eight, Big-six, or Big-five, depending on the timing of the study.
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