The Role of Audit Firm Size, Non-Audit Services, and Knowledge Spillovers in

Mitigating Earnings Management during Large Equity Issues

by

Aasmund Eilifsen and Kjell Knivsfl

NHH Norwegian School of Economics

April
2015

Address correspondence to Aasmund Eilifsen, NHH, 5045 Bergen, Norway, or by e-

mail to aasmund.eilifsen@nhh.no. Thanks to Jochen Bigus, David Hay, Arngrim
Hunnes, Tiago Pinheiro, Per Christen Tronnes, and participants at the workshop at
Free University Berlin and NHH Norwegian School of Economics for comments on
earlier versions.
The Role of Audit Firm Size, Non-Audit Services, and Knowledge Spillovers in
Mitigating Earnings Management during Large Equity Issues

ABSTRACT

We investigate how audit firm size and large auditor-provided non-audit ser-
vices (NAS) affect accruals quality around large equity issues and acquisi-
tions in Norwegian public companies 1999-2013. We find poorer accruals
quality around large equity increases. Big 4 audit firms mitigate adverse ac-
cruals quality but only if the provision of NAS is moderate or low. In contrast,
non-Big 4 audit firms are associated with lower accruals quality around large
equity increases, but this effect is moderated if the provision of NAS is high.
The findings are consistent with joint provision of audit and NAS being an
effective learning mechanism to mitigate earnings management for smaller
audit firms and a lesser willingness of larger audit firms to protect earnings
when the provision of NAS is high. The evidence contrasts the notion of large
audit firms as universally superior audit quality suppliers and provides new
evidence on how knowledge spillovers from NAS may improve audit quality.

Keywords: Abnormal accruals; audit firm size; audit quality; earnings quality; equity issues
and acquisitions; knowledge spillovers; non-audit services.
INTRODUCTION

The purpose of this study is to examine how audit firm size (a common indicator for audit quality)

and large auditor-provided NAS (potentially impairing auditor independence and generating spill-

over knowledge benefits to the audit) affect abnormal accruals (our proxy for earnings manage-

ment) around the time of large equity issues and acquisitions (a circumstance with presumed strong

incentives to manage earnings). Our motivation for the investigation is the apparent contrast be-

tween regulatory policy-decisions and research evidence on adverse effects of auditor-provided

NAS (Francis, 2011; DeFond & Zhang, 2014), the presumption that NAS regulations may be mo-

tivated by concern for low audit quality when the audited financial statements are highly vulnerable

to earnings management (Carson et al., 2014),1 and the limited research evidence on how auditor-

provided NAS may create knowledge spillover benefits (Christensen et al., 2014).

Regulators continue to mandate new regulations on the provision of NAS to audit clients

(European Union, 2014) while there is not compelling evidence that NAS diminish actual audit

quality (DeFond & Zhang, 2014). At the same time, legislators and regulators seek to promote the

role of non-Big 4 firms in the market for large audits to encourage more competition (European

Union, 2014; European Commission, 2011), while research consistently finds that large firms pro-

vide higher audit quality when compared to smaller audit firms (Francis, 2004; 2011).

One may question why regulators are not attuned more to insights from research in this area

(Francis, 2011). One reason may be that archival auditing research typically investigates associa-

tions between the averages of variables in samples while regulators find reasons to intervene to

repair problems existing in tails of sample distributions or in their envisioned distribution of cases

(Carson et al., 2014). For example, regulatory interventions may be motivated by concern for low

audit quality when auditors provide large NAS in circumstances when management has strong

incentives to manage earnings. A second reason may be that regulators devote too much attention
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to auditor independence and do not give enough focus on auditor competence (Humphrey et al.,

2007). Insight from the provision of NAS may improve auditors ability to deliver higher audit

quality through knowledge spillovers or economies of scope (Arruada, 1999). A third reason is

that research is silent or incomplete or provides inconsistent evidence of the many complex rela-

tionships and variables that may affect audit quality (Francis, 2011; DeFond & Zhang, 2014). For

example, inconclusive evidence exists on how audit quality indicators such as audit firm size and

auditor industry expertise affect the knowledge spillover benefits that may accrue from the provi-

sion of NAS (Lim & Tan, 2008; Eilifsen & Knivsfl, 2013).

Biased financial reporting is more likely to occur in circumstances where the audit client

has strong incentives to manage earnings (Schipper, 1989). Incentives to engage in earnings man-

agement are arguably high when large increases in equity take place through issues and acquisi-

tions. Research indicates that earnings management of audited financial numbers takes place during

initial public offerings (IPOs), seasonal equity offerings (SEOs), and merger and acquisitions

(M&As) (e.g., Rangan, 1998; Teoh et al., 1998a; 1998b; Morsfield & Tan, 2006). Research also

finds that larger firm audits on average are of higher quality (Francis, 2011; DeFond & Zhang,

2014). Consistent with this finding, some studies of equity offerings suggest that large audit firms

reduce earnings management during IPOs, SEOs, and M&As (e.g., Zhou & Elder 2002; 2004;

Chen et al., 2005; Ahmad-Zaluki et al., 2008).

In general, research has been unable to support the commonly held view by regulators and

others that the joint provision of audit and NAS impairs auditor independence and negatively af-

fects the quality of earnings (Schneider et al., 2006; DeFond & Zhang, 2014). The findings may

reflect the existence of economies of scope from audit-provided NAS that improve the auditors

ability to detect misstatement and control earnings management (e.g., Arruada, 1999; Kinney et

al., 2004; Antle et al., 2006). Empirical evidence on knowledge spillovers remains, however, mixed
-2-
and elusive (Krishnan & Yu, 2011). It is an open question in the literature if the auditor-provided

NAS triggers knowledge spillovers that are more beneficial for smaller firms audits than larger

firms audits or vice versa (Louis, 2005; Lim & Tan, 2008; Krishnan & Yu, 2011; Knechel et al.,

2012; Eilifsen & Knivsfl, 2013).

Our sample consists of Norwegian public companies for the period 1999-2013. Accruals

quality is measured by the standard deviation of the residuals (Dechow & Dichev, 2002; Francis et

al., 2005) obtained from the modified and performance-adjusted Jones model (Jones, 1991;

Dechow et al., 1995; Kothari et al., 2005).

We find poorer accruals quality in periods surrounding (i.e., two years before, during, and

one year after) large non-earned equity increases. Big 4 audit firms mitigate the adverse effect on

accruals quality but only if the provision of NAS is moderate or low. In contrast, non-Big 4 audit

firms are associated with lower accruals quality during large equity issues but this association is

moderated if the provision of NAS is high. The findings are consistent with the joint provision of

audit and NAS being an effective learning mechanism to mitigate earnings management for smaller

audit firms and a lesser willingness of larger audit firms to protect earnings when the provision of

NAS is high. The evidence contrasts the notion of large audit firms as universally superior audit

quality suppliers and provides new evidence supporting that knowledge spillovers may induce

higher audit quality.

The next section provides an overview of prior research and develops our hypotheses. This

is followed by a discussion of our research methodology. In the fourth section, we describe our

sample and our variable measurement and report our descriptive statistics and correlations. The

following sections present our results and those of our robustness tests. The last section provides a

summary of conclusions.

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LITERATURE AND HYPOTHESES

Issues of new equity through IPOs, SEOs, and M&As offer a setting with strong incentives to

manage earning to attract capital or negotiate stock swaps on favorable terms (Schipper, 1989;

Healy & Wahlen, 1999). This has encouraged researchers to investigate earnings management

around the times of equity issues.

Equity issuers may be motivated to adopt higher abnormal (discretionary) accruals, for ex-

ample, lower than normal depreciations, to inflate reported earnings to influence stock prices (Teoh

et al., 1998b). Several studies provide evidence of higher abnormal accruals (lower accruals qual-

ity) around equity increases such as IPOs, SEOs, or M&As (e.g., Friedlan, 1994; Rangan, 1998;

Teoh et al., 1998a; Erickson & Wang, 1999; Shivakumar, 2000; DuCharme et al., 2001; Louis,

2004; Morsfield & Tan, 2006; Botsari & Meeks, 2008; Cohen & Zarowin, 2010).2 Some studies

find a weak or no association between equity increases and abnormal accruals (Aharony et al.,

1993; Armstrong et al., 2009), while Ball & Shivakumar (2008) report lower abnormal accruals for

equity-offering companies.3 4

Although mixed evidence exists, the majority of evidence documents that earnings manage-

ment takes place during the time of large non-earned equity increases. We therefore propose the

following hypothesis:

H1: Large equity issues are associated with lower accruals quality.

Audit quality through auditors independence and competence is a component of financial

reporting quality because the audited financial statements are the joint product of the management

and the auditor, where the auditor assures that the financial statements are fairly presented (DeAn-

gelo, 1981; DeFond & Zhang, 2014). The audit quality literature examines if systematic differences

in earnings quality are conditional on presumed audit quality related factors such as audit firm size

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and provision of NAS (Francis, 2011). This study, therefore, first investigates if large equity issues

are associated with lower accruals quality (earnings quality), i.e., skewed towards the tails of the

abnormal accrual distribution. If H1 is supported by our data, we have a basis for investigating how

audit firm size and large provisions NAS affect accruals quality around the time of large equity

increases.

The audit literature posits that large audit firms, captured by the Big 4 (or generally Big N)

membership, positively affect audit quality. Large audit firms have stronger incentives to deliver

higher audit quality because they are more exposed to reputation and litigation risk and have higher

competence in providing audit quality than do smaller audit firms (DeAngelo, 1981; Arruada,

1999). A large body of evidence supports this conjecture (e.g., Becker et al., 1998; Francis et al.,

1999; Francis, 2004; DeFond & Zhang, 2014).

Of specific relevance for our study, companies with IPOs and SEOs audited by large audit

firms tend to engage in less opportunistic earnings management (Zhou & Elder, 2002; 2004; Chen

et al., 2005; Ahmad-Zaluki et al., 2008).5 6 Also supporting the idea of more credible attestation of

assertions of financial information by large audit firms, Big N audits are associated with reduced

underpricing in IPOs (e.g., Balvers et al., 1988; Beatty, 1989; Hogan, 1997).7 Pointing in the same

direction, evidence indicates that the market reaction to announcements of SEOs positively asso-

ciates with employing Big N auditors (Slovin et al., 1990).

Based on the significant evidence that Big 4 (N) provide higher audit quality during times of

equity increases, we propose the following hypothesis:

H2: Big 4 audit firms moderate the lower accruals quality associated with large equity in-

creases.

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 Auditing research has identified two main effects on earnings quality from the provision of

NAS by the incumbent auditor. First, large provision of NAS increases the economic bonds be-

tween the auditor and client (management), which may dilute auditor objectivity (DeAngelo, 1981;

Simunic, 1984; Beck et al., 1988; Arruada, 1999). Second, provision of NAS may lead to

knowledge spillovers from NAS to the audit and improve the auditors ability to detect biases in

the financial reporting (Simunic, 1984; Arruada, 1999).8 For example, the auditor may gain audit-

relevant insight into client risks, internal systems and controls, and tax provisions from supplying

NAS (Christensen et al., 2014). In addition, auditor-provided NAS services may enhance the over-

all audit effectiveness through better communication within the audit firm, particularly mitigating

auditor information asymmetry (Krishnan & Visvanathan, 2011). In sum, NAS provision may di-

minish as well as improve audit quality, and the balance between costs and benefits of auditor-

provided NAS determines the net effect on audit quality.

In general, studies using actual (output-based) audit quality fail to find that NAS impair audit

quality (Schneider et al., 2006; DeFond & Zhang, 2014).9 This relates also to accruals-based earn-

ings management studies (e.g., DeFond et al., 2002; Ashbaugh et al., 2003; Chung & Kallapur,

2003; Antle et al., 2006; Huang et al., 2007; Knechel & Sharma, 2012; Koh et al., 2013), but some

exceptions exist (e.g., Larcker & Richardson, 2004; Srinidhi & Gul, 2007). The lack of compelling

evidence that NAS impair actual audit quality may reflect counterbalancing knowledge spillover

benefits (DeFond & Zhang, 2014).10 Research also provides evidence that knowledge spillovers

are associated with higher audit quality, particularly related to tax services (Kinney et al., 2004;

Huang et al., 2007; Christensen et al., 2014).11

Notwithstanding that large audit firms as well as industry specialist firms have stronger in-

centives and higher competence in providing audit quality, it remains an open question whether the

provisions of large NAS improve or weaken smaller audit firms relative ability to deliver audit
-6-
quality. Lim and Tan (2008) argue that industry specialists may be the ones benefiting the most

from knowledge spillovers because they have the background knowledge to perform NAS more

efficiently and to acquire and leverage on the spillovers.12 In contrast, Eilifsen & Knivsfl (2013)

suggest that small, and possibly non-specialized, audit firms are the ones benefiting the most from

knowledge spillovers, as large audit firms already possess more competence and have less learning

potential from providing NAS. If the larger audit firms comparative competence advantage dimin-

ishes, the audit quality difference between the large and smaller audit firms may be affected. Point-

ing in the same direction, Louis (2005), looking at the interaction between auditor size and the

market reaction to merger announcements, finds that non-Big 4 auditors outperform Big 4 auditors

at merger announcement.13

Recognizing the competing arguments and mixed evidence on how the accumulation of

knowledge spillover and expertise from provision of NAS may differ between larger and smaller

audit firms, we propose the following non-directional hypothesis:

H3: Large provision of NAS by the incumbent audit firm affects the predicted effects in H1

and H2.

TEST METHODOLOGY

To test H1, we use the regression model:

AAC = 0 FIX + 1 LEQI + 2 BIG4 + 3 LNAS + 4 BIG4 LNAS + 5 INNATE

+ , (1)

where AAC is the standard deviation of the estimated abnormal accruals (AAC), see Model

(5) in the following. AAC relates inversely to accruals quality (Dechow & Dichev, 2002; Francis

-7-
et al., 2005). We choose to use the variability of abnormal accruals to the abnormal accruals them-

selves as our prime measure of accruals quality because equity issues may be timed to periods of

high non-discretionary accruals (Loughran & Ritter, 1995). In addition, the standard deviation cap-

tures abnormally high accruals as well as potentially abnormally low accruals during equity in-

creases (Ball & Shivakumar, 2008) and the possibility of reversion of abnormally high accruals

after the equity issues (Dechow et al., 2012). We also report the results when signed AAC replaces

AAC in Model (1).

FIX represents the intercept and fixed industry and year effects. LEQI is an indicator variable

for large non-earned equity increases (Rangan, 1998; Teoh et al., 1998; Erickson & Wang, 1999).

BIG4 is an indicator variable for Big 4 firm membership, a common proxy for audit firm quality

(Francis, 2004; 2011; DeFond & Zhang, 2014). LNAS is an indicator variable for a large non-audit

service (NAS) fee ratio, assumed to be inversely related to audit firm independence (DeAngelo,

1981) and positively related to knowledge spillover benefits from NAS (Simunic, 1984).14 The

interaction term BIG4 LNAS accounts for the possibility that the association between BIG4 and

AAC depends on provision of large NAS. INNATE is a vector of other variables potentially af-

fecting AAC. The control variables represent economic fundamentals, including the innate factors

of Dechow & Dichev (2002) and Francis et al. (2005). is the error term, and the betas are the

regression coefficients of the respective variables. Observing 1 > 0 with statistical significance is

consistent with H1.

To test H2 and H3, we extend Model (1) with the interactions terms between LEQI, BIG4,

and LNAS and use the model:

AAC = 0 FIX + 11 LEQI + 12 LEQI BIG4 + 13 LEQI LNAS + 14 LEQI

BIG4 LNAS + 2 BIG4 + 3 LNAS + 4 BIG4 LNAS + 5 INNATE + . (2)

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Model (2) implies that the association between the accruals quality measure AAC and large equity

increases LEQI is:

AAC / LEQI = 11 + 12 BIG4 + 13 LNAS + 14 BIG4 LNAS, (3)

where LEQI is the change from LEQI = 0 to LEQI = 1. Expression (3) splits the association

between LEQI and AAC, captured in (1) by the single coefficient 1, into four parts. 1) The initial

association, 11, i.e., the baseline effect for small audit firms with small or moderate NAS ratios.

2) The effect associated with large audit firms (BIG4) (and LNAS = 0) with coefficient 12. 3) The

effect associated with large provisions of non-audit services, LNAS (and BIG4 = 0) with coefficient

13. 4) The effect of both BIG4 and LNAS with coefficient 14.15

Conditioned on the provision of large NAS (LNAS = 1), the association between BIG4 and

AAC is:

( AAC/ LEQI) / BIG4 = 12 + 14 LNAS, (4)

where BIG4 is the change from BIG4 = 0 to BIG4 = 1. The association consists of an effect for

large audit firms (BIG4 = 1) with small or moderate NAS ratios (LNAS = 0) with coefficient 12,

and an effect for BIG4 with large NAS (LNAS = 1) with coefficient 14. H2 proposes that (4) is

negative, independent of LNAS = 0 or LNAS = 1, i.e., 12 < 0 and 12 + 14 < 0. This reflects that

Big 4 membership reduces AAC and improves accrual quality around significant equity issues

(e.g., Zhou & Elder 2002; 2004).

H3 proposes that 14 0, i.e., (4) is conditional on LNAS. When providing large (LNAS =

1) relative to small or moderate NAS (LNAS = 0), the tradeoff between impaired independence

(DeAngelo, 1981) and knowledge spillover benefits (Simunic, 1984) will determine whether 14 is

positive, negative or zero. When reduced independence dominates, 14 > 0, indicating that the mod-

eration effect of BIG4 = 1 is less when LNAS = 1 (i.e., 12 < 12 + 14), When knowledge spillovers
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dominate, 14 < 0, indicating that LNAS = 1 amplifies the moderation effect of BIG4 = 1 (i.e., 12

> 12 + 14).

Similarly, the effect of large NAS on small audit firms (BIG4 = 0) is measured by 13 in (3).

H3 proposes that also 13 0 and that 13 may differ from 14. For example, the effect of reduced

independence could dominate for large audit firms (14 > 0), while knowledge spillover benefits

could dominate for small audit firms (13 < 0); or vice versa. The analysis of the data will reveal

which of the two effects will dominate for each type of audit firm when the firms provide large

NAS.

SAMPLE, VARIABLES, DESCRIPTIVE STATISTICS, AND CORRELATIONS

The sample consists of companies listed on the Oslo Stock Exchange over the period 1999-2013.

Accounting and stock market data are collected from the Stock Market Database at the Norwegian

School of Economics and supplemented with data from Thomson Reuters Datastream and hand-

collected data from annual reports. As reported in Panel A of Table 1, the available number of

company-year observations over the 15-year period is 3,337. We delete the observations from com-

panies in the financial sector (410) and companies with incomplete data (863). Our sample for

estimating abnormal accruals (AAC) consists of 2,438 company-year observations from 372 indi-

vidual companies. Panel B of Table 1 defines and explains the variables involved in the main tests

of H1-H3.

- INSERT TABLES 1 AND 2 ABOUT HERE -

Table 2, Panel A, presents descriptive statistics, except for fixed effects (FIX) and indicator

variables derived from continuous variables (LEQI and LNAS). We estimate AAC as the residual

in the modified, performance-adjusted Jones model (Jones, 1991; Dechow et al., 1995; Kothari et

al., 2005):

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 TAC/ATA = 0 + 1 1/ATA + 2 (DREV - DREC)/ATA + 3 PPE/ATA + 4

EARN/ATA + AAC, (5)

where TAC is total accruals, calculated as reported earnings minus cash flow from opera-

tions; ATA is average total assets; DREV is change in revenues; DREC is change in receivables;

PPE is property, plant, and equipment; EARN is earnings; and AAC is abnormal accruals, i.e., the

residual. The performance-adjustment is based directly on return on assets (EARN/ATA) and not

by performance matching (Kothari et al., 2005). Our estimation of Model (5) are cross-sectional

for each industry and year combination (Dechow et al., 2010). Being the residual, the average AAC

is 0.16

Following Dechow & Dichev (2002) and Francis et al. (2005), we measure accrual quality

inversely to the standard deviation of AAC (i.e., AAC). However, we calculate AAC by the

rolling standard deviation based on AAC in year t+1, t, and two years before t, to capture standard-

ized abnormal accruals deviations in periods around year t, the year of the non-earned equity ex-

pansions. By forwarding AAC, we lose 374 observations; the sample reduces to 2,064 company-

years. The mean AAC is 0.072.

The variable NEWEQ is the non-earned change in the book value of equity, except dividends

and excluding any revenues and costs recognized directly in equity (dirty surplus), divided by

average total assets. The mean value is 8.1 percent. The median is 0 percent, while the 75th percen-

tile is 5.3 percent. Our basic cut-off for large equity increases (LEQI) is the 75th percentile, i.e.,

large non-earned equity increases are those just above 5 percent of total assets. Thus, LEQI is 1 if

NEWEQ is above the 75-percentile and 0 otherwise.

BIG4 is the indicator variable for large audit firms, a common proxy for high audit quality

(Francis 2004; 2011). BIG4 takes a value of 1 if the audit firm is among the four largest audit firms

- 11 -
and 0 otherwise. Panel A of Table 2 shows that 90.3 percent of the observations are associated with

Big 4 firms.

NASR is the non-audit services (NAS) fee ratio, i.e., NAS fee relative to the sum of the audit

fee and the NAS fee. The mean ratio is 34.2 percent. Our cut-off for large provisions of non-audit

services (LNAS) is NASR above its 75th percentile, i.e., NAS fees above 46.8 percent of total fees.

The indicator variable LNAS = 1 if NASR is above the 75th percentile and 0 otherwise.

Panel A of Table 2 also reports descriptive statistics for control variables commonly associ-

ated with the standard deviation of abnormal accruals, AAC, including the innate factors of

Dechow & Dichev (2002) and Francis et al. (2005). Loss (LOSS) is reported in 40.3 percent of

2,064 company-years. The average intangible assets (INTAN) is 16.4 percent, relative to average

total assets; the leverage (LEV) is 33.2 percent; and the log of operating cycle (OPCY) is 4.920.

The mean value of the four-year rolling standard deviation of operating cash flows and revenues

relative to assets, denoted OCF and REV, are 0.061 and 0.116. The average systematic risk

(BETA) is 1.086, the average SIZE in terms of the log of the inflation-adjusted market value is

6.938, and the average book-to-market ratio (BTM) is 0.885.

Panel B of Table 2 presents the pairwise correlations between AAC, NEWEQ, BIG4, and

NASR. All correlations are significant. Consistent with H1, we observe that AAC is positively

correlated to NEWEQ (0.323). AAC is negatively correlated with BIG4 (-0.121), consistent with

large audit firms providing higher accrual quality (H2). The correlation between AAC and NASR

is positive (0.056), indicating that the provision of NAS lower audit quality (H3).

BIG4 is negatively correlated with NEWEQ, indicating that companies audited by small au-

dit firms are over-represented among equity issuing companies. For example, this correlation could

- 12 -
be driven by a larger need of equity financing by companies with small audit firms. BIG4 is posi-

tively correlated with NASR, indicating that large audit firms provide relatively more NAS than

do small audit firms. Finally, the correlation between NEWEQ and NASR is positive, indicating

higher NAS if equity issues and acquisitions take place.

MAIN TESTS OF HYPOTHESES

Panel A of Table 3 reports the results of estimating Model (1), except the common intercept and

the fixed industry and year effects. The first regression model has AAC and the second has the

mean AAC as the dependent variable.

- INSERT TABLE 3 ABOUT HERE -

The association between our (inverse) accrual quality measure, AAC, and the indicator var-

iable for large equity issues and acquisitions, LEQI, is positive (0.012) and significant (t-value =

3.92).17 The result remains for the alternative accrual quality measure, mean AAC (0.017, t-value

= 4.05).18 Our result supports H1 and is in line with prior studies documenting that non-earned

equity expansions are associated with lower accrual quality (e.g., Rangan, 1998; Teoh et al., 1998a;

1998b; Erickson & Wang, 1999).19

Panel B of Table 3 reports the results of estimating Model (2). Independent of NAS, H2

predicts higher accrual quality around large equity expansions for issuing companies with a Big 4

auditor than with a non-Big 4 auditor. We test H2 by examining whether BIG4 moderates the

association between AAC and LEQI when LEQI = 1, irrespective if the magnitude of the provi-

sions of NAS.

We first investigate H2 when LNAS = 0. Table 3, Panel B, shows that the initial impact of

BIG4 when LEQI = 0 is -0.002 (2 in (2)). The gross influence of BIG4 on the association between

AAC and LEQI = 1 when LNAS = 0, is -0.068 (-0.066 - 0.002; i.e., 12 + 2 in (2)). The effect is

- 13 -
significant. Since the initial impact of LEQI = 1 is 0.074 (11), the coefficient is moderated to 0.006

(0.074 - 0.068) when LNAS = 0. (The coefficient 0.006 is found in the last section of Table 3,

Panel B, which summarizes the relevant coefficients for investigated combinations of LEQI, BIG4,

and LNAS.) The net influence of BIG4 on the association is -0.066 and significant. This finding

indicates that Big 4 firms improve accrual quality when the provision of NAS is low or moderate,

consistent with H2 (21 < 0). Before we proceed to the results when Big 4 firms provide large NAS

(LNAS = 1), we first examine non-Big 4 firms behavior. This will provide evidence relevant for

H3.

For small audit firms (BIG4 = 0), the initial impact of providing large NAS (LNAS = 1) when

LEQI = 0 is 0.015 (3 in Model (2)). The gross influence of large NAS on the association between

AAC and LEQI = 1 is -0.073 (-0.088 + 0.015, i.e., 13 + 3 in (2)). The effect is significant. Since

the initial impact of LEQI = 1 is 0.074, the coefficient is moderated to 0.000 (0.074 - 0.073) when

BIG4 = 0, consistent with H3 (13 0). Large provisions of NAS supplied by smaller audit firms

improve accrual quality (13 < 0), consistent with knowledge spillover benefits dominating loss of

independence. The explanation may be that the smaller audit firms learn from providing NAS, and

this improves their ability to control earnings management. This is in line with the suggestion of

Eilifsen & Knivsfl (2013) and consistent with the findings of Louis (2005).

We now return to the question on how large NAS (LNAS = 1) provided by Big 4 firms (BIG4

= 1) affects the association between AAC and LEQI = 1. The initial impact of BIG4 and LNAS

when LEQI = 0 is 0.006 (-0.002 + 0.015 - 0.007, i.e., 2 + 3 + 4 in (2)). The gross effect of BIG4

and LNAS on the association between AAC and LEQI = 1 is -0.058 (-0.066 - 0.088 + 0.090 +

0.006, i.e., 12 + 13 + 14 +2 + 3 + 4). The effect is significant. Since the initial impact of LEQI

= 1 is 0.074, the coefficient is moderated to 0.016 (0.074 - 0.058) when BIG4 = 1 and LNAS = 1.

- 14 -
The combined effect of a Big 4 firm and a high level of NAS increases accruals quality, relative to

engaging smaller audit firms that provide low or moderate levels of NAS. This finding provides

support for H3 (13 0 and 14 0). Large provisions of NAS deteriorate accrual quality of Big 4

firms (14 > 0), consistent with loss of independence dominating knowledge spillover benefits.

Large audit firms already possess much of the knowledge benefits accrued by smaller audit firms

from provision of large NAS, as argued by Eilifsen & Knivsfl (2013), Big 4 firms are over-

whelmed with the effect of less independence when providing large NAS.

To summarize; consistent with H1, accruals quality is lower when companies expand equity

financing (coefficient of LEQI equals 0.012 in Panel A). Consistent with H2: when Big 4 audited

companies issue equity, the companies experience higher accrual quality given that the auditors

provide low or moderate levels of NAS (marginally, the effect on the coefficient is -0.066 in Panel

B). Audit firm size is associated with higher audit quality. If the Big 4 firms provide high levels of

NAS, the effect is, however, moderated (-0.066 + 0.090 = 0.024, i.e., to an insignificant level),

which is consistent with H3. For Big 4 firms, provisions of large NAS impair audit firm independ-

ence. For smaller audit firms, audit relevant client-specific knowledge obtained through the provi-

sion of large NAS improves audit quality (-0.088). This indicates that the learning mechanism

contributes to constrain earnings management.

To provide more insight into the signed direction of the identified accrual quality effects,

Panel C of Table 3 reports the effect of LEQI, BIG4, and LNAS on AAC in year t-2, t-1, t, and t+1,

where t is the year of the non-earned equity expansion. The adjusted R2 is much lower for the yearly

AAC than for the rolling standard deviation AAC (see also panel A), and few of the marginal

effects are significant. The sum of coefficients in the last section of Panel C indicates that accruals

are managed upward in year t-1 and t and then reversed in year t+1.20

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ROBUSTNESS TESTS

The first robustness test restricts the sample to the 524 observations of large non-earned equity

increases (LEQI = 1). We remove LEQI and its interactions with BIG4 and LNAS as variables in

Model (2) and estimate the model with remaining variables on the selected subsample.

- INSERT TABLE 4 ABOUT HERE

Inspection of the column for the LEQI = 1 sample of Table 4, Panel A, shows results con-

sistent with those of the pooled model in Panel B of Table 3. When LNAS = 0, the effect of BIG4

taking the value 1 is significantly negative (-0.058, where the statistical inferences now take into

account first-order autocorrelation and multi-way clustering on firms and years), while the effect

is significantly moderated (0.075) when LNAS = 1. When BIG4 = 0, the effect of LNAS taking

the value 1 is significantly negative (-0.066). Thus, the findings of the restricted model are con-

sistent with those of the pooled model.

The second robustness test restricts and expands the definitions of large non-earned equity

increases and large provisions of NAS. In the main tests in Panel B of Table 3, LEQI and LNAS

are indicators of large equity increases and large NAS ratios when above their respective third

quartiles. We now first tighten the definitions of large LEQI and NAS to observations above the

90th percentile and then relax the definitions to observations above their median. Panel A of Table

4 shows that the tightening of the definitions increases the significance of the test variables (the

relevant coefficients are -0.092, -0.158, and 0.173) and the relaxation decreases the significance of

the test variables (coefficients -0.051, -0.051, and 0.051) relative to the main test (-0.066, -0.088,

and 0.090).

The third robustness test changes the calculation of the rolling standard deviation, AAC.

The main tests base the standard deviation of abnormal accruals on the four years t-2 to t+1, relative

- 16 -
to t; the year of the equity expansion. Instead, we now base the standard deviation from the year t-

3 to t. Because we drop the forwarding, the number of observations increases from 2,064 to 2,438.

The column for AAC in Panel B, Table 4, shows that identified effects remain (the coefficients

of the test variables are now -0.047, -0.047, and 0.049). When the rolling standard deviation is

replaced by the mean absolute value of AAC from the year t-2 to t+1 (see the column for Mean

absAAC in Panel B, Table 4), the effects still remain but are less significant (-0.053, -0.046, and

0.048).

The fourth robustness test changes the models for estimating abnormal accruals. In the main

test, we use the modified and performance-adjusted Jones model where the performance adjust-

ment is based on return on assets. In the robustness test, we first drop the performance adjustment

altogether and use the modified Jones model (Dechow et al., 1995); next we base the performance

adjustment on cash flow from operations deflated by average total assets (Kothari et al., 2005); and

then we consider non-linear performance-adjustment (Ball & Shivakumar, 2006). Panel C of Table

4 reports the results of the three alternative performance-adjustment of abnormal accruals. The

results show that our findings are robust to common variations in the model for estimating abnor-

mal accruals.

Fifth, we first drop the fix effects, the control variables, and the winsorizing; we next run a

median regression model with all controls instead of OLS, and we then use GLS instead of OLS.

The re-estimated results tabulated in Panel D of Table 4 suggest that the results from our main test

are robust for econometric specification changes.

Finally, we question whether the 62 firm-year observations of Arthur Andersen audits in-

cluded in the sample from 1999 until 2001 influence the observed negative effect of providing NAS

- 17 -
for large audit firms. Untabulated results show that the negative effect of large provisions of NAS

for large audit firms is not sensitive to the deletion of observations related to Arthur Andersen.

CONCLUSIONS

This study investigates how audit firm size and the provision of large NAS, separately and com-

bined, affect accruals quality around large non-earned equity expansions. Our findings indicate that

accruals quality, measured inversely to the standard deviation of abnormal accruals, deteriorates

around large equity issues and acquisitions, consistent with earnings management taking place.

We demonstrate that the effect of audit firm size is mixed and dependent on the provision of

NAS. When the provision of NAS is low or moderate, large audit firms provide better accrual

quality around large equity issues relative to smaller audit firms. The result is consistent with the

notion that large audit firms are better to constrain clients attempts to manage earnings. The supe-

riority of large audit firms in protecting earnings no longer persists, however, when they provide

large NAS. This result is in line with the few prior studies suggesting that the commonly presumed

audit quality stamp of large audit firms should not be taken for granted in all circumstances (Louis,

2005; Leone et al., 2013). Smaller audit firms behave differently; large NAS facilitates smaller

audit firms ability to constrain earnings management. This suggests that smaller firms extract rel-

atively more knowledge spillovers to the audit from NAS and provides new evidence supporting

the benefits of knowledge spillovers.

Our study provides regulators, audit committee members, and researchers with a more com-

plete understanding of the relationship between audit firm size and the provision of NAS and their

impact on audit quality. The potential harmful effects of NAS to audit quality continue to raise

public concerns. Our findings draws the attention to the often-ignored potential for knowledge

spillover benefits from auditor-provided NAS and to the fact that there are costs to decouple audit

- 18 -
and NAS providers. Knowledge spillovers from the joint provision of audit and NAS may be an-

other means to constrain earnings management.21

Our findings suggest that the mechanism through which joint provision of audit and NAS

may create knowledge spillovers is more complex than assumed in the prior literature. We restrict,

however, our investigation to audit quality around large equity increases, audit firm attributes re-

lated to Big 4 and non-Big 4, and NAS related to NAS fee relative to total auditor fee. Future

research should investigate how knowledge spillovers trigger audit quality in other business cir-

cumstances and how other audit firms attributes (for example, the dissemination of skills and

knowledge within the audit firm) and the nature of the provided NAS affect the knowledge spillo-

vers.

- 19 -
NOTES

1
Carson et al. (2014) argue that regulators may have an asymmetric preference to instigate regulation to improve
low audit quality due to the high potential costs involved with an audit failure and are perhaps relatively less con-
cerned with the regulations impact on high, or even on the average, level of audit quality.
2
Other studies document real earnings management (i.e., management of earnings through operating activities with
direct cash effects) around equity increases (Cohen & Zarowin, 2010; Kothari et al., 2012). Consistent with the fact
that up-ward earnings management takes place during equity issues, several studies document price corrections and
firm under-performance post-IPOs, SEOs, and M&As (e.g., Ritter, 1991; Loughran & Ritter, 1995; Spiess & Af-
fleck-Graves, 1995; Louis, 2004).
3
Ball & Shivakumar (2008) attribute the result to higher monitoring, including that by auditors and litigants, and
greater regulatory scrutiny of financial statements during equity offerings. They also argue that upward-biased
estimates of abnormal accruals occur in some of the other studies.
4
The literature acknowledges that earnings management may take place in the years before the equity increase event
and that reversal of accruals is inevitable. In addition to the equity increase event year, most studies cover two or
more preceding years. Some studies also cover post-event years to control for the reversal of accruals. This raises
the question of whether the most appropriate inter-period proxy for accruals quality is abnormal accruals, the ab-
solute value of abnormal accruals, or a rolling standard deviation of abnormal accruals. This study measures ac-
cruals quality by the rolling standard deviation of abnormal accruals (Dechow & Dichev, 2002; Francis et al.,
2005).
5
Zhou & Elder (2002; 2004) also find that audit firm industry specialization contributes to constrain earnings man-
agement around IPOs. The finding is in line with other studies showing that specialist auditors provide higher audit
quality (DeFond & Zhang, 2014). Investment bankers may demand change of audit firm before IPOs (Menon &
Williams, 1991). Kim & Park (2006) report that audit firm changes increase SEO underpricing (i.e., the difference
between the offering price and the market clearing price at issuance), but that the switch from a non-Big N to a Big
N audit firm leads to less underpricing than do the other types of switches.
6
Reduced accruals-based earnings management may encourage real earnings management (Cohen & Zarowin,
2010).
7
Leone et al. (2013) shows that Big 5 auditors are less likely to render going concern opinions when companies are
going public during stock market euphoria (bubbles), challenging audit firm size as an audit quality indicator at
some IPOs.
8
In addition, Beck & Wu (2006) show that auditors can enrich their knowledge accumulation and improve audit
quality by performing NAS that may influence clients' managerial decisions (i.e., the business advisory effect).
9
The evidence from the more limited literature on capital market participants perceptions of NAS are weighted
toward the conclusion that auditor-provided NAS are perceived as negative (Francis, 2006; DeFond & Zhang,
2014), consistent with concerns of auditor independence dominating any knowledge spillover benefits.
10
In archival research, it is inherently difficult to disentangle how audit efficiency improvements and threat to auditor
independence from the provision of NAS affect audit quality, and researchers base their audit quality inferences on
the measured net effect of NAS. Analytical research discusses conditions for the benefits of improved competency
to outweigh the costs of reduced independence (Beck & Wu, 2006; Lu & Sapra, 2009).
11
Other studies focus on audit efficiency rather than on audit effectiveness (quality). Knechel et al. (2012) document
a negative association between NAS fees and audit lag (an indicator of auditor efficiency); suggesting the presence
of knowledge spillovers, but the effect is limited to the city offices providing both the audit and NAS. Similarly,
Walker & Hays (2013) results indicate that companies purchasing NAS from their incumbent auditors benefit
from knowledge spillovers by achieving a shorter audit report lag, but not immediately. Also supporting the argu-
ment of knowledge spillover from NAS, Knechel & Sharma (2012) find that higher NAS fees are associated with
shorter audit report lags prior to the passage of SOX, but such effects dissipate after SOX. They observe (p. 86):
The little research available provides mixed evidence, and thus no conclusions can be made about the association
between non-audit services and audit efficiency.
12
Krishnan & Yu (2011) argue and find that brand name auditors are more likely to reap economies of scope from
joint offering of audit and NAS relative to non-brand name auditors. Knechel et al. (2012) report that their
knowledge spillovers results using audit report lags as an indicator of audit efficiency are qualitatively similar for
large and small audit firms while Knechel & Sharma (2012) find that knowledge spillovers are more likely to occur
in Big N firms than smaller non-Big N firms.

- 20 -
13
Louis (2005) results indicate that smaller, local firms have a comparative advantage in assisting their clients in
merger transactions. The effect is more pronounced when the likelihood of the auditors playing a prominent advi-
sory role increases and when the targets are privately held. Likewise, Choi et al. (2012) find support for the idea
that local audit firms provide higher audit quality.
14
Supporting a multi-period perspective, Walker & Hay (2013) results suggest that loss of independence would take
effect immediately, while knowledge spillovers might take time. Thus, the LNAS - effect could be lagged relative
to AAC but simultaneous relative to AAC.
15
For example, (3) is reduced to 11 + 12 1 + 13 1 + 14 1 1 = 11 + 12 + 13 + 14 for large audit firms (BIG4
= 1) with large non-audit services (LNAS = 1), while the effect for large audit firms with small or moderate provi-
sions of NAS is 11 + 12.
16
The standard deviation of AAC is 0.109 and in line with other studies (Dechow et al., 1995; Kothari et al., 2005).
In the main tests, AAC is performance-adjusted based on earnings since this gives a lower standard deviation than
the adjustment based on cash flow from operations (0.179). Our choice of performance-adjustment yields the high-
est explanatory power for the normal accruals model.
17
We refer to statistical significance if p-values are at 5 percent or below.
18
The coefficient of LEQI is -0.006 in year t-2, 0.018 in year t-1, 0.028 in year t, and 0.021 in year t+1; see Panel C
of Table 3 and the later discussion of the significance of the yearly coefficients.
19
The most significant control variable is CFO. This supports Hribar & Nichols (2007) argument to control for
operating volatility to reduce the bias of unsigned AAC tests to over-reject the null hypothesis of no earnings
management.
20
In year t-1, the sum of coefficients is significant for LNAS = 1 (0.046 and 0.037) and in year t for BIG4 = 1 (0.023
and 0.037). Interestingly, the coefficient of LEQI is negative (-0.069) and significant in t+1, suggesting that accruals
reverse significantly for companies with small audit firms providing low or moderate NAS; an indication of ac-
cruals management (Dechow et al. 2012). BIG4 significantly moderates this effect (-0.069 - 0.018 + 0.091 = 0.006
when LNAS = 0, and -0.069 - 0.018 - 0.014 + 0.019 + 0.091 + 0.136 - 0.126 = 0.020 when LNAS = 1). LNAS also
significantly moderates the initial effect (-0.069 - 0.014 + 0.136 = 0.053 when BIG4 = 0 and 0.020 when BIG4 =
1). The results indicate that a significant part of the accruals quality effects of BIG4 and LNAS relates to reversal
of abnormal accruals after t. As argued, the use of AAC as accrual quality measure better captures the reversal of
abnormal accruals.
21
Regulators have proposed and EU regulations encourage joint audits between one of the Big 4 and a second-tier
audit firm to bolster audit quality and improve competition in the audit market (EC 2010, 2011; EU 2014). Our
results raise the question whether it would be beneficial if the second-tier firm were to provide the NAS to the joint-
audit client.

- 21 -
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Public Offering Firms, Available at SSRN: http://ssrn.com/abstract=321041.

Zhou, J. & Elder, R. (2004), Audit Quality and Earnings Management by Seasoned Equity Offering Firms,
Asia-Pacific Journal of Accounting and Economics, Vol. 11, No. 2, pp. 95-120.

Walker, A. & Hay, D. (2013), Non-Audit Services and Knowledge Spillovers: An Investigation of the
Audit Report Lag, Meditari Accountancy Research, Vol. 21, No. 1, pp 32-51.

White, H. (1980), A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Het-
eroskedasticity, Econometrica, Vol. 48, No. 4, pp. 817-838.

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TABLES
Table 1: Sample selection and variable definitions
Panel A: Sample selection on the Oslo Stock Exchange
Company-year
observations

Available company-year observations on OSE 1999 - 2013 3,337

- Financial company-year observations 410
= Non-financial company-year observations 2,927
- Missing observations, e.g., due to lagging of variables 489
= Sample available for estimating AAC 2,438
- Observations lost when calculating AAC 374
= Sample available for analyzing AAC 2,064
Number of companies involved 372/329

Panel B: Definition of variables used in the main tests of hypotheses

FIX Fixed industry and year effects. Thus, FIX = (INTERCEPT, INDU, YEAR), where IN-
TERCEPT is the constant term, INDU is a vector of indicator variables for each industry,
and YEAR is a vector of indicator variables for each year.
AAC/AAC/ AAC is the estimated abnormal accruals for company j = 1, , 372 in year t = 1999, ,
mean AAC 2013 by Model (5). AAC is the rolling standard deviation of AAC estimated over year
t+1, t, and two years before (Francis et al. 2005). When there in the time series are less
than four years, the length of the estimation period is reduced backwards and finally re-
placed by the absolute value. Because the calculation of AAC is also based on t+1, 374
observations are lost. Mean AAC is the corresponding rolling average AAC from t-2 to
t+1.
NEWEQ/LEQI New equity, NEWEQ, is measured in terms of the non-earned changed in the book value
of equity, excluding normal dividends, divided by average total assets. NEWEQ is net of
stock buybacks and other equity distributions not included in dividends. LEQI is an in-
dicator variable for large equity increase, taking the value 1 if NEWEQ is among the 25
percent highest and 0 otherwise.
BIG4 Indicator variable for a large audit firm, taking the value 1 if the audit firm is large and 0
otherwise. Deloitte, Ernst & Young, KPMG, and PwC are classified as large audit firms.
In 1999-2001, Arthur Andersen is also among the large audit firms, meaning that Big4 is
actually Big5 in these years. The largest among the small audit firms are BDO and Grant
Thornton.
NASR/LNAS The non-audit service ratio, NASR, is measured as non-audit service fees divided by total
fees, i.e. the sum audit fees and non-audit fees. LNAS is an indicator variable for a large
non-audit service ratio, taking the value 1 if NASR is among the 25 percent highest and
0 otherwise.
LOSS Indicator variable for negative earnings.
INTAN Intangible assets divided by average total assets.
LEV Financial debt divided by average total assets.
CFO Standard deviation of CFO, the cash flow of operations divided by average total assets,
where estimation period is consistent with the calculation of AAC.

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REV Standard deviation of operating revenue divided by average total assets.
OPCY The logarithm of the length of the operation cycle, which is calculated as 360 divided by
the turnover ratio of stocks and operating receivables, i.e. operating income divided by
stocks and operating receivables.
BETA Stock market beta estimated based on the time-series of monthly stock returns.
SIZE Log of the market value of equity, adjusted for inflation.
BTM Book-to-market ratio.

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Table 2: Descriptive statistics and selected correlations
Panel A: Descriptive statistics
Obs. Mean St. dev. 25-percent Median 75-percent

AAC 2,438 0.000 0.109 -0.049 0.004 0.050

AAC 2,064 0.072 0.066 0.029 0.052 0.093
NEWEQ 2,064 0.081 0.288 0.000 0.000 0.053
BIG4 2,064 0.903 0.296 1.000 1.000 1.000
NASR 2,064 0.342 0.189 0.205 0.333 0.468
LOSS 2,064 0.403 0.491 0.000 0.000 1.000
INTAN 2,064 0.164 0.198 0.011 0.085 0.254
LEV 2,064 0.332 0.749 0.092 0.285 0.484
OPCY 2,064 4.920 1.432 4.328 4.736 5.125
CFO 2,064 0.061 0.075 0.014 0.040 0.078
REV 2,064 0.116 0.142 0.015 0.072 0.160
BETA 2,064 1.086 1.050 0.410 0.959 1.571
SIZE 2,064 6.938 1.781 5.721 6.801 8.138
BTM 2,064 0.885 2.320 0.357 0.629 1.113

Obs. is the number of observations, mean is the average value, st. dev. is the standard deviation, 25-percent is the 25th
percentile, median is the 50th percentile, and 75-percent is the 75th percentile. The variables are defined and explained
in Table 1, Panel B.

Panel B: Correlations among AAC and the test variables NEW, BIG4 and NASR
AAC NEWEQ BIG4

NEWEQ 0.323 ***

BIG4 -0.121 *** -0.095 ***
NASR 0.056 ** 0.060 *** 0.104 ***

The panel displays the Pearson correlation coefficients. To ease the impact of extreme observations, the variables are
winsorized 1% in each tail by years. *, **, and *** indicate statistical significance at the 10%, 5% and 1% level,
respectively, when tested two-sided.

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Table 3: Main tests
Panel A: Test of H1

Variable AAC Mean AAC

Coef. t-val. Coef. t-val.

FIX Yes Yes

LEQI 0.012 *** 3.92 0.017 *** 4.05

BIG4 -0.020 *** -3.37 0.000 0.01

LNAS -0.011 -0.91 0.024 * 1.73
BIG4 LNAS 0.020 1.53 -0.018 -1.28
LOSS 0.012 *** 4.94 0.019 *** 5.75
INTAN -0.012 -1.53 -0.031 *** -2.99
LEV -0.007 -1.12 0.017 ** 1.96
OPCY 0.003 *** 2.74 0.008 *** 4.48
CFO 0.325 *** 12.76 -0.079 ** -2.44
REV 0.003 0.32 0.043 *** 3.52
BETA 0.002 1.24 0.002 1.08
SIZE -0.005 *** -6.24 -0.001 -0.82
BTM -0.005 *** -4.30 0.001 0.91

Adjusted R2 0.371 *** 0.082 ***

Number of obs. 2,064 2,064

The regressions are given by Model (1) with AAC as the dependent variable in the first regression and the mean AAC
as dependent variables in the second regression. All variables are defined and explained in Table 1, Panel B. The
variables are winsorized 1% in each tail by years. The coefficients are OLS, and statistical inferences are robust to
arbitrary heteroskedasticity (White, 1980). *, **, and *** indicate statistical significance at the 10%, 5% and 1% level,
respectively, when tested two-sided.

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Panel B: Test of H2 and H3

AAC
Coef. t-val.

FIX Yes

LEQI 0.074 *** 4.53

LEQI BIG4 -0.066 *** -3.95
LEQI LNAS -0.088 *** -2.87
LEQI BIG4 LNAS 0.090 *** 2.87

BIG4 -0.002 -0.53

LNAS 0.015 1.33
BIG4 LNAS -0.007 -0.58
LOSS 0.012 *** 4.89
INTAN -0.014 * -1.71
LEV -0.011 * -1.80
OPCY 0.003 *** 2.61
CFO 0.318 *** 11.73
REV 0.002 0.24
BETA 0.002 1.53
SIZE -0.005 *** -6.10
BTM -0.004 *** -4.21

Adjusted R2 0.386 ***

Number of obs. 2,064

LEQI BIG4 LNAS:

1 0 0 0.074 *** 4.53
1 1 0 (0.074 0.002 0.066) 0.006 1.01
1 0 1 (0.074 + 0.015 0.088) 0.000 0.02
1 1 1 # 0.016 ** 2.38
LEQI, Unconditioned 0.012 *** 3.92

The regression model is given by Model (2), where the variables are defined and explained in Table 1, Panel B. The
variables are winsorized 1% in each tail by years. The coefficient of the unconditional LEQI is estimated in Panel A
and represents the average of specified conditional samples. The coefficients are OLS, and statistical inferences are
robust to arbitrary heteroskedasticity (White, 1980). *, **, and *** indicate statistical significance at the 10%, 5% and
1% level, respectively, when tested two-sided. # The sum of coefficients is 0.074 - 0.002 - 0.066 + 0.015 - 0.088 -
0.007 + 0.090 = 0.016.

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Panel C: AAC in year t-2, t-1, t, and t+1

t-2 t-1 t t+1

AAC Coef. Coef. Coef. Coef.

FIX Yes Yes Yes Yes

LEQI -0.025 0.026 0.022 -0.069 **

LEQI BIG4 0.023 -0.015 0.003 0.091 ***
LEQI LNAS 0.002 0.018 0.024 0.136 ***
LEQI BIG4 LNAS -0.011 0.045 -0.018 -0.126 **

BIG4 -0.005 0.002 -0.003 -0.018 **

LNAS 0.043 * 0.038 0.006 -0.014
BIG4 LNAS -0.033 -0.041 0.002 0.019
LOSS 0.024 *** 0.028 *** 0.009 * 0.020 ***
INTAN -0.007 -0.008 -0.010 -0.076 ***
LEV 0.017 0.021 0.027 ** 0.005
OPCY 0.008 *** 0.008 *** 0.008 *** 0.007 ***
CFO -0.005 0.010 -0.090 -0.085
REV 0.059 *** 0.012 0.026 0.034
BETA 0.001 -0.000 0.002 0.002
SIZE -0.001 0.002 -0.001 -0.002
BTM 0.002 0.004 *** -0.002 ** 0.001

Adjusted R2 0.027 *** 0.039 *** 0.028 *** 0.050 ***

Number of obs. 1,735 2,064 2,438 2,064

LEQI BIG4 LNAS:

1 0 0 -0.026 0.026 0.023 -0.069 **
1 1 0 -0.007 0.012 0.023 ** 0.006
1 0 1 0.020 0.046 * 0.053 0.053
1 1 1 -0.006 0.037 ** 0.037 *** 0.020
LEQI, Unconditioned -0.006 0.018 *** 0.028 *** 0.021 ***

The regressions are given by Model (2) where AAC is replaced by AAC. The variables are defined and explained in
Table 1, Panel B, and their values are winsorized 1% in each tail by years. The coefficient of the unconditional LEQI
is estimated as in Panel A. The coefficients are OLS, and statistical inferences are robust to arbitrary heteroskedasticity
(White, 1980). *, **, and *** indicate statistical significance at the 10%, 5% and 1% level, respectively, when tested
two-sided.

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Table 4: Robustness tests of H2 and H3
Panel A: Sample of large equity issues only and changed definition of LEQI and LNAS
LEQI = 1 LEQI and LNAS LEQI and LNAS
only 10% largest 50% largest
AAC Coef. t-val. Coef. t-val. Coef. t-val.

FIX Yes Yes Yes

LEQI 0.105 *** 6.71 0.052 ** 2.69

LEQI BIG4 -0.092 *** -6.29 -0.051 ** -2.46
LEQI LNAS -0.158 *** -5.03 -0.051 -1.64
LEQI BIG4 LNAS 0.173 *** 4.15 0.051 1.63

BIG4 -0.058 ** -2.29 -0.004 -0.64 0.003 0.48

LNAS -0.066 *** -3.13 0.009 0.28 0.015 1.69
BIG4 LNAS 0.075 *** 3.05 0.003 0.11 -0.010 -1.08
LOSS 0.011 * 1.80 0.011 *** 3.92 0.013 *** 4.31
INTAN -0.008 -0.34 -0.012 -0.91 -0.009 -0.68
LEV 0.001 0.07 -0.010 -1.66 -0.008 -1.07
OPCY 0.001 0.65 0.003 * 2.04 0.004 ** 2.44
CFO 0.267 *** 5.28 0.313 *** 11.23 0.331 *** 11.30
REV -0.003 -0.11 0.006 0.68 0.004 0.47
BETA -0.000 -0.17 0.003 1.53 0.002 * 2.08
SIZE -0.008 *** -3.40 -0.005 *** -6.04 -0.005 *** -5.43
BTM -0.008 *** -5.26 -0.004 *** -3.92 -0.005 *** -5.71

Adjusted R2 0.375 *** 0.401 *** 0.371 ***

Number of obs. 524 2,064 2,064

The regressions are given by Model (2). However, in the first regression, the sample is restricted to LEQI = 1 and
LEQI is removed from (2) as a variable. The variables are defined in Table 1, Panel B, and their values are winsorized
1% in each tail by years. The coefficients are based on OLS. Statistical inferences are robust to first-order autocorre-
lation and multi-way clustering on companies and years (Driscoll & Kraay, 1998; Cameron et al., 2011; Thompson,
2011). *, **, and *** indicate statistical significance at the 10%, 5% and 1% level, respectively, when tested two-
sided.

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Panel B: Alternative measures of accruals quality
Variables AAC Mean absAAC
t, t-1, t-2, t-3 t+1, t, t-1, t-2
Coef. t-val. Coef. t-val.

FIX Yes Yes

LEQI 0.058 *** 3.37 0.064 *** 3.24

LEQI BIG4 -0.047 ** -2.40 -0.053 ** -2.54
LEQI LNAS -0.047 ** -2.34 -0.046 * -2.14
LEQI BIG4 LNAS 0.049 ** 2.17 0.048 * 2.01

BIG4 -0.003 -0.44 0.005 0.30

LNAS 0.018 ** 2.78 0.010 1.35
BIG4 LNAS -0.011 -1.42 -0.006 -1.33
LOSS 0.009 ** 2.79 0.010 *** 4.91
INTAN -0.023 * -2.03 -0.022 * -1.80
LEV -0.015 * -1.87 -0.029 *** -3.62
OPCY 0.004 ** 2.42 0.002 * 1.96
CFO 0.349 *** 7.51 0.232 *** 9.23
REV 0.001 0.03 -0.012 -1.41
BETA 0.002 * 1.80 0.002 1.62
SIZE -0.003 ** -2.68 -0.004 *** -3.04
BTM -0.001 -0.82 -0.006 *** -3.75

Adjusted R2 0.394 *** 0.400 ***

Number of obs. 2,438 2,064

The regressions are given by Model (2), where AAC is replaced by the mean absolute value of AAC in the last
regression. The variables are defined in Table 1, Panel B, and their values are winsorized 1% in each tail by years. The
coefficients are based on OLS. Statistical inferences are robust to first-order autocorrelation and multi-way clustering
on companies and years (Driscoll & Kraay, 1998; Cameron et al., 2011; Thompson, 2011). *, **, and *** indicate
statistical significance at the 10%, 5% and 1% level, respectively, when tested two-sided.

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Panel C: Alternative performance-adjustment of abnormal accruals
No performance-ad- Performance adjust- Non-linear perfor-
justment AAC ment by CFO mance adjustment
AAC Coef. t-val. Coef. t-val. Coef. t-val.

FIX Yes Yes Yes

LEQI 0.085 ** 2.86 0.072 ** 2.52 0.090 *** 3.33

LEQI BIG4 -0.062 ** -2.31 -0.050 * -2.05 -0.072 ** -2.84
LEQI LNAS -0.097 ** -2.78 -0.082 ** -2.39 -0.091 ** -2.45
LEQI BIG4 LNAS 0.085 ** 2.77 0.073 ** 2.35 0.081 * 2.09

BIG4 -0.006 -0.62 -0.014 -1.68 -0.006 -0.64

LNAS -0.004 -0.51 -0.009 -0.81 -0.003 -0.18
BIG4 LNAS 0.013 0.95 0.016 1.63 0.006 0.36
LOSS 0.029 *** 5.30 0.030 *** 5.54 0.031 *** 5.86
INTAN -0.015 -0.64 -0.014 -0.72 -0.008 -0.39
LEV -0.026 * -1.96 -0.024 * -2.10 -0.003 -0.13
OPCY 0.008 ** 2.76 0.007 ** 2.87 0.013 ** 2.48
CFO 0.251 *** 6.49 0.170 *** 3.55 0.201 *** 2.99
REV 0.033 * 1.91 0.032 1.60 0.033 1.51
BETA 0.011 ** 2.32 0.010 ** 2.28 0.008 * 1.90
SIZE -0.008 ** -2.31 -0.008 ** -2.32 -0.010 * -2.14
BTM -0.008 ** -3.97 -0.008 *** -3.76 -0.009 *** -3.23

Adjusted R2 0.264 *** 0.250 *** 0.258 ***

Number of obs. 2,064 2,064 2,064

The regression models are given by Model (2). The variables are defined in Table 1, Panel B, and their values are
winsorized 1% in each tail by years. The coefficients are OLS. In the second regression model, AAC is calculated by
Model (5) where EARN is replaced by CFO. In the final regression, EARN is replaced by CFO as in the second
regression model and then expanded with variables NEG and NEG CFO, where NEG is an indicator variable for
negative CFO (Ball & Shivakumar 2006). The AAC based on performance-adjustment by CFO are more noisy than
based on EARN (AAC-EARN = 0.104 while AAC-CFO = 0.170, after considering non-linearity). Statistical infer-
ences are robust to first-order autocorrelation and multi-way clustering on companies and years (Driscoll & Kraay,
1998; Cameron et al., 2011; Thompson, 2011). *, **, and *** indicate statistical significance at the 10%, 5% and 1%
level, respectively, when tested two-sided.

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Panel D: No fixed effects, no innate factors or winsorizing - and alternatives to OLS co-
efficients
No fixed, innate, Median regression GLS
or winsorizing instead of OLS instead of OLS
AAC Coef. t-val. Coef. t-val. Coef. t-val.

Intercept/FIX 0.060 *** 8.80 Yes Yes

LEQI 0.141 *** 3.11 0.041 ** 2.32 0.057 *** 12.36

LEQI BIG4 -0.107 ** -2.49 -0.071 ** -2.21 -0.055 *** -11.60
LEQI LNAS -0.143 *** -3.15 -0.104 ** -2.56 -0.063 *** -6.17
LEQI BIG4 LNAS 0.136 *** 3.03 0.109 *** 2.66 0.067 *** 6.39

BIG4 -0.001 -0.21 -0.000 -0.13 -0.003 -1.16

LNAS 0.038 *** 2.70 0.024 *** 2.69 0.017 *** 2.68
BIG4 LNAS -0.028 * -2.06 -0.021 ** -2.24 -0.013 ** -2.11
LOSS 0.005 ** 2.35 0.004 *** 6.63
INTAN -0.005 -0.70 -0.013 *** -3.99
LEV -0.013 ** -2.48 -0.006 ** -2.58
OPCY 0.002 ** 2.51 0.004 *** 8.70
CFO 0.427 *** 14.17 0.203 *** 14.09
REV 0.004 0.36 0.012 ** 2.39
BETA 0.002 1.44 -0.000 -0.09
SIZE -0.003 *** -6.94 -0.005 *** -14.26
BTM -0.003 *** -3.93 -0.003 *** -7.24

Adjusted/pseudo R2 0.124 *** 0.261 *** 0.367 ***

Number of obs. 2,064 2,064 2,021

The regression models are given by Model (2), and the variables are defined in Table 1, Panel B. Except in the first
regression, the variables are winsorized 1% in each tail by years. The coefficients in the first regression are OLS.
Statistical inferences are robust to first-order autocorrelation and multi-way clustering on companies and years (Dris-
coll & Kraay, 1998; Cameron et al., 2011; Thompson, 2011). The statistical inferences in the second regression model
are based on bootstrapped standard deviations with 1000 replications. The coefficients in the last regression model are
estimated based on GLS allowing for heterogeneous panels and first-order autocorrelation (meaning that companies
with only one year of observations are lost). *, **, and *** indicate statistical significance at the 10%, 5% and 1%
level, respectively, when tested two-sided.

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