Conditional Conservatism, Listing Status, and Auditor Quality

Using a large sample of firms including both public and private companies, this paper investigates whether the effect of auditor conservatism is influenced by listing status. Prior studies have used Big 4 auditors as a proxy for high-quality auditors, and document that firms audited by Big 4 auditors show more conservative accounting attributes. Accounting conservatism is expected to contribute to efficient contracting because it is a means of mitigating agency pro- blems caused by information asymmetry and makes managers who have an asym- metric incentive reveal their private information (Watts 2003a). Although there are two related but distinct forms of conservatism – unconditional conservatism and conditional conservatism, we focus on conditional conservatism (i.e., timely loss recognition) to analyze the effect of auditor quality on accounting conservatism, because we focus on efficient contracting to which both auditor quality and listing status are related. In this paper, we focus on listing status as an important firm characteristic that influences the effect of auditor quality on earnings attributes, and in particular, accounting conservatism because listing status is a comprehensive and easily observable firm characteristic and it is also closely related to attributes such as firm size, ownership structure, and capital structure. In addition, recent studies provide evidence that market pressure is an important factor in determining earnings attribute (e.g., Ball and Shivakumar 2005). Finally, we believe that listing status might be a proxy for litigation risk, which is an important factor in auditor conservatism. Based on these backgrounds, we investigated the effect of a high-quality auditor on timely loss recognition and whether this effect differs according to the listing status of firms. We test two hypotheses. The first hypothesis posits that firms audited by Big 4 auditors report more conservative earnings than firms audited by non-Big 4 auditors. The second hypothesis posits that the effect of Big 4 auditors on accounting conservatism differs between private and public companies. Although prior research suggests that high-quality auditors (Big 4 auditors) are more conservative in determining reported earnings and that market pressure also affects accounting conservatism, no previous study has examined the relative effects of auditor quality and market pressure on accounting conservatism. We find that the auditing carried out by Big 4 auditors leads to conservative reported earnings by constraining aggressive and questionable accounting practices. This finding is consistent with the first hypothesis. In addition, we also find that for public firms, the incremental effect of Big 4 auditors on timely loss recognition does not hold. This result is robust after controlling for auditor selection bias. Therefore, our finding suggests that public firms are voluntarily conservative due to higher market pressure, regardless of auditor choice and confirms the substitutive relation between auditor quality and listing status in determining accounting conservatism. Our results are expected to enhance the understanding of differences between Big 4 and non-Big 4 auditors according to the listing status of firms. Given the importance of private firms in terms of the economy and accounting regulations, we expect the exploration of these differences to provide a rich avenue for further research.