Earnings management within Europe: the effects of member state audit environment, audit firm quality and international capital markets

Abstract

This paper studies earnings management in a European context. More specifically, the effects of three factors on earnings management within Europe are studied: member state audit environment, audit firm quality and presence in international capital markets. The national audit environments within Europe vary strongly in terms of independence rules and auditor liability. Hence, it can be expected that the restrictions imposed by national audit environments on earnings management vary. However, there are two factors that can mitigate the national audit environment effect: Big Four audit firm quality and a company's reliance on international capital markets. Using data for the period 1992–2000 from listed firms in three EU countries with clearly distinct audit environments (France, Germany and the UK), we have the following main findings. First, a stricter audit environment reduces the magnitude of earnings management, irrespective of the type of auditor (Big Four audit firm or non-Big Four audit firm). Second, there is no evidence of an international Big Four audit quality effect in Europe. Third, a company's reliance on international capital markets does not limit its earnings management. The evidence provided in this study is relevant for the current debate in the European Union on the harmonisation of auditing. For the comparability of earnings, not only is the standardisation of financial reporting important but also the standardisation of enforcement mechanisms, as embodied in the national audit environment and the quality of audit firms. The results of this study suggest that the enforcement of financial reporting still varies strongly across member states of the EU.