Collateral Damage: Real Earnings Management Under Expanded Auditor Liability

This study investigates the unintended consequences of expanded third-party auditor liability following pivotal U.S. court rulings. We find that increased auditor legal liability leads auditors to adopt a more conservative stance on accrual-based earnings management (AEM), prompting client firms to shift towards greater real earnings management (REM). Additionally, these legal changes result in a significant surge in auditor switches from non-Big 4 to Big 4 auditors. While Big 4 firms possess the resources to manage risks and legal defenses more efficiently than their non-Big4 counterparts, they may afford greater flexibility to clients engaging in REM. Though REM enables companies meet earnings targets, it adversely affects Tobin’s Q and stock returns. Consequently, expanded auditor legal liability inadvertently imposes costs on shareholders by encouraging REM, which can harm long-term firm value.