Big 4 Conservatism Around the World

Abstract

Conservatism is a long-established underlying principle of accounting but its implementation has come under the spotlight in recent years following the spate of well-publicized corporate collapses in the U.S. and elsewhere. Previous studies have shown that the Big 4 audit firms are more conservative than the non-Big 4 in the U.S. The current study examines whether the U.S. findings extend to other countries. In doing so, we make use of a relatively new measure of conservatism, namely, the C-score developed by Khan and Watts. We find that the conclusion drawn from U.S. studies, namely that the Big 4 are more conservative, extends to the international setting but only under certain conditions. Specifically, the Big 4 are more conservative in those countries where litigation and reputation risks, broadly defined, are high. This increase in conservatism represents a rational response by the Big 4 auditors to their greater exposure, vis-a-vis the non-Big 4 auditors, to litigation and reputation loss in those countries.

Appendices

Appendix 1

Table 16 Definitions of litigation and other country institutions variables and data sources

Appendix 2

Table 17 Details on auditor litigation risk, legal institutions, security law, political economy, and financial market factor

Appendix 3

Table 18 Classification of auditor litigation risk, legal institutions, security law, political economy, and financial market factor variables: high versus low realization

	Political economy			Financial market factors
Country	Risk of expropriation	State–operated business	Tax burden	Stock return comovement	Concentrated ownership	Insider trading	Access to equity
Argentina	High	Low	Low	High	High	High	High
Australia	Low	Low	High	Low	Low	Low	Low
Austria	Low	Low	High	High	High	Low	High
Belgium	Low	Low	High	High	High	Low	Low
Brazil	High	Low	Low	–	High	High	High
Canada	Low	Low	Low	Low	Low	Low	Low
Chile	High	High	Low	Low	Low	High	High
Colombia	High	High	Low	Low	High	High	High
Denmark	Low	Low	Low	Low	Low	Low	Low
Egypt	High	High	Low	_	High	_	High
Finland	Low	Low	High	Low	Low	Low	Low
France	Low	High	High	Low	Low	Low	Low
Germany	Low	High	High	High	Low	Low	Low
Greece	High	Low	High	_	High	High	Low
Hong Kong	High	Low	Low	High	High	Low	Low
India	High	High	Low	High	Low	High	Low
Indonesia	High	High	Low	Low	High	High	High
Ireland	Low	Low	High	Low	Low	Low	Low
Israel	High	High	High	_	High	Low	Low
Italy	Low	High	High	_	High	High	High
Japan	Low	Low	Low	High	Low	Low	High
Korea	High	Low	Low	High	Low	Low	High
Malaysia	High	High	Low	High	High	Low	High
Mexico	High	Low	Low	High	High	High	High
New Zealand	Low	Low	Low	Low	Low	Low	Low
Norway	Low	Low	High	Low	Low	High	Low
Peru	High	Low	Low	Low	High	High	High
Portugal	Low	High	High	Low	High	Low	High
Singapore	Low	Low	Low	High	Low	Low	Low
South Africa	High	High	High	Low	High	High	Low
Spain	Low	High	Low	High	High	High	High
Sri Lanka	High	High	Low	_	High	High	_
Sweden	Low	High	High	Low	Low	Low	Low
Thailand	High	High	Low	High	Low	High	High
Turkey	High	High	High	High	High	High	High
United Kingdom	Low	Low	Low	Low	Low	Low	Low

Appendix 4

X :

is earnings before interest and taxes deflated by lagged market capitalization.

R :

is stock return, inclusive of dividends, over the fiscal year.

SIZE :

is the natural log of market capitalization at the end of the fiscal year (in USD, $million).

MB :

is the ratio of market value of equity to the book value of equity, measured at the end of the fiscal year.

LEV :

is the total liability divided by total assets, measured at the end of the fiscal year.

LNTA :

is the natural log of total assets at the end of the fiscal year (in USD, $million).

CAPINT :

is the fixed assets divided by total assets at the end of the fiscal year.

INVREC :

is the sum of inventory and receivables divided by total assets, measured at the end of the fiscal year.

LOSS :

is equal to 1 if net income before extraordinary is negative in the prior year and 0 otherwise.

CROSS :

is equal to 1 if a company trades ADRs (American Depository Receipts) and 0 otherwise.

BIG4 :

is equal to 1 if a company appoints one of the Big 4 auditors and 0 otherwise.

C-score:

is estimated from Eq. 2 in a pooled regression.

Cdec:

is decile ranking of C-score, estimated from Eq. 2 in a pooled regression.

Industry indicators:

are based on the two-digit SIC code.

FDI:

is the net foreign investment scaled by total GDP for the country in each year.

STK:

is the total market capitalization to scaled by total GDP for the country in each year.

GDP:

is the natural log of Gross Domestic Investment (in thousands of US dollars) for the country in each year.