The Joint Effect of Investor Protection and Big 4 Audits on Earnings Quality around the World*

Abstract

The association of a country's investor protection regime with the quality of reported earnings is examined for a large sample of firms from 42 countries. Three attributes of earnings are evaluated: the magnitude of abnormal accruals, the likelihood of reporting losses, and earnings conservatism (timely loss recognition). We find that earnings quality increases for firms with Big 4 auditors when a country's investor protection regime gives stronger protection to investors; specifically, abnormal accruals are smaller, there is a greater likelihood of reporting losses, and earnings conservatism is greater. In contrast, earnings of firms with non-Big 4 auditors are largely unaffected by different investor protection regimes. The study adds to a growing body of research showing that accounting practices are influenced by a country's institutions. However, our results differ from prior studies by demonstrating that country-level effects are mediated by audit enforcement, and in particular the incentives of Big 4 auditors to perform higher quality audits in countries with stricter investor protection regimes.