2010-64
Auditor Conservatism, Abnormal Accruals,
and Going Concern Opinions
Katsuhiko Muramiya Tomomi Takada

Auditor Conservatism, Abnormal Accruals,
and Going Concern Opinions

Katsuhiko Muramiya
Kobe University, Research Institute for Economics and Business Administration
Tomomi Takada*
Kobe University, Graduate school of Business Administration*Corresponding author
Email: takada@pearl.kobe-u.ac.jp

Abstract
We investigate the Japanese Big 4 auditors’ conservatism. Recent increasing litigation risks andscrutiny from the public are likely to make the Japanese Big 4 auditors conservative. Our results
indicate that the Big 4 are effective in deterring income-decreasing earnings management byclients. Their motive for doing so may be to avoid scrutiny by the authorities, since financial
and tax accounting are strongly aligned in Japan. Furthermore, we show that among firms
receiving going concern opinions, those audited by the Big 4 report less negative abnormal
accruals than those audited by non-Big 4 This implies that they provoke accrual reversals to thefirms whose financial condition is less distressed, when they issue going concern opinions.

Keywords
auditor conservatism; auditor size; earnings management; going concern opinion; litigation risk

1

1. Introduction
This study investigates the Japanese Big 4 auditors’ conservatism in terms of auditors’ reaction
to clients’ earnings management behavior and thresholds for issuing going concern opinions.
Although a number of factors concerning auditor conservatism have been examined in previous
studies, they generally focus on one aspect of auditors’ conservatism. Furthermore, someresearchers show evidence implying auditor conservatism, whereas others do not. Thus, auditor
conservatism is an important issue that remains unresolved.
Given that many researchers have addressed auditor conservatism, it is obviously
thought to be one of the most important topics in the area of auditing. Prior studies have
exemplified that the level of auditor conservatism is influenced by litigation risk (e.g., Krishnan
and Krishnan, 1997; Cahan and Zhang, 2006) or public scrutiny (e.g., Geiger et al., 2005;
Fargher and Jiang, 2008). Although previous studies examine U.S. auditors in the American
context, with their high litigation risk and high-profile cases of audit failures, it would be aninteresting research question whether auditors’ conservative behavior is observed in otherinternationally developed markets such as Japan’s.
Several prior studies explore differences in the degree of auditor conservatism in termsof audit firm size (Feltham et al., 1991; Clarkson and Simunic, 1994; Jones and Raghunandan,
1998). Large audit firms are likely to be more conservative than small audit firms because of
their deeper pockets or the potential loss of their reputations, even though all auditors are tosome extent conservative. Our study also posits that larger audit firms are more conservative
than smaller audit firms; thus, auditor conservatism is examined in the light of firm size.
The two perspectives to be examined include (1) auditors’ reaction to clients’ earnings
management behavior, and (2) thresholds for issuing going concern opinions. The reason why
we investigate the Japanese Big 4 auditors’ conservatism from two perspectives is that we
intend to clarify the relation between the auditors’ conservatism and the firms’ earnings
management behavior in a comprehensive way. Abnormal accruals are often used byresearchers as a proxy for earnings management; hence, we posit that if the Big 4 auditors areconservative and deter clients’ earnings management behavior, the firms they audit are likely toreport lower abnormal accruals than those audited by non-Big 4 firms. Since auditors face2

asymmetric loss functions and have less incentives to prevent income-decreasing earnings
management (Kim et al., 2003; Caramanis and Lennox, 2008), the Big 4 auditors are likely todeter income-increasing earnings management, whereas they might not be effective inpreventing income-decreasing earnings management. Therefore, we separately investigate theimpact of the Big 4 auditors’ conservatism on the firms having equal to or more than zeroabnormal accruals and those having negative abnormal accruals.
Furthermore, since conservative auditors are likely to have lower thresholds for issuinggoing concern opinions, abnormal accruals of going concern firms might be dissimilar between
Big 4 and non-Big 4 clients. Rosner (2003), Ajona et al. (2008), and Arnedo et al. (2008) findthat auditors’ conservative behavior provokes reversals of accruals, which result in extremely
negative abnormal accruals when they issue going concern opinions. These findings are
justifiable since financially distressed firms are likely to engage in upward earnings
management activities (Dechow et al., 1996) and overstated accruals are reversed in a future
period (Guay et al., 1996; DeFond and Park, 2001). If auditor conservatism provokes reversalsof accruals in issuing going concern opinions, such reversal effects might differ between theclients audited by the Big 4 and those audited by non-Big 4 because of Big 4 auditors’
conservatism. The more firms are financially distressed, the more frequently they engage inearnings management to mask their poor performance. In addition, the reversal effect of
accruals might be significant when the firms have repeatedly engaged in income-increasing
earnings management. Therefore, we expect that going concern firms report relatively lessnegative abnormal accruals due to the reversal effect, if they are less financially distressed.
Since the Big 4 auditors are expected to have lower thresholds for issuing going concern
opinions than non-Big 4, Big 4 clients receiving going concern opinions are less financiallydistressed and supposedly have engaged less in earnings management. If so, the reversal effectin accruals for going concern firms audited by the Big 4 is less significant than for others. Stateddifferently, going concern firms audited by the Big 4 are expected to have less negative
abnormal accruals than those audited by non-Big 4. However, large negative abnormal accruals
for going concern firms might perhaps merely represent their serious distressed status (Butler etal., 2004) or the Big 4 auditors’ behavior might have no impact on their going concern clients’3

abnormal accruals. If such is the case, we will not find significant difference in abnormal
accruals between Big 4 going concern clients and non-Big 4 going concern clients.
The results show that the presence of Big 4 auditors makes no difference regarding
earnings management behavior for the full sample analysis. However, the sub-sample
examinations indicate that auditors are effective in deterring income-decreasing earnings
management, but not income-increasing earnings management. Since Japanese accounting
practice is strongly aligned with tax practice, Japanese managers are likely to have strong
incentives to decrease or smooth earnings in order to minimize taxable income (Hermann andInoue, 1996; Darrough et al., 1998). Therefore, Japanese auditors may try to prevent incomedecreasing earnings management so as to avoid scrutiny by the tax authority. Our results arecontrary to prior studies in the U.S., which find that conservative auditors are more effective indeterring income-increasing earnings management. Nevertheless, our findings are reasonable
under the Japanese setting in which management have strong incentives to decrease or smoothearnings. Thus, our findings contribute to prior literature on earnings management and auditor
conservatism, because we show that Japanese Big 4 auditors’ conservative reaction to earnings
management is different from that of their U.S. counterparts. Different environments could
render auditors conservative in different ways.
With respect to auditors’ conservatism in issuing going concern opinions, the results
support our hypothesis. Specifically, among firms receiving going concern opinions, those
audited by the Big 4 report less negative abnormal accruals than those audited by non-Big 4.
This indicates that going concern firms audited by the Big 4 report a less significant reversal
effect of accruals. Since firms having severe financial problems have probably engaged inincome-increasing earnings management more often, our results indicate that the Big 4 auditors
issue going concern opinions for the clients whose financial conditions are relatively lessdistressed. In short, the Big 4 auditors issue going concern opinions and provoke accrual
reversals to the firms whose financial problem is less severe. This implies that the Big 4 auditors
have lower thresholds for issuing going concern opinions. Our study adds to the literature thatseeks to identify the relation between clients’ earnings management behavior and going concern
issuance. The finding in this study is in line with the evidence provided by Rosner (2003),

4Ajona et al. (2008), and Arnedo et al. (2008). They show that auditors’ conservative behavior
provokes reversals of accruals when they issue going concern opinions. Our research extends
these studies by comparing the negative abnormal accruals of Big 4 and non-Big 4 going
concern client firms, and we find that the Big 4 clients experience a smaller reversal effectbecause of their auditors’ conservatism.
Our study contributes to the literature that examines Big 4 auditors’ conservative
behavior in an international context. Lee et al. (2006) and Cano-Rodriguez (2010) show that
Australian and Spanish Big 4 auditors are more conservative than non-Big 4, while Piot andJanin (2007) present that French Big 4 auditors are not more conservative than non-Big 4. For alarge sample of firms from 42 countries, Francis and Wong (2008) show that earnings
conservatism (quality) for Big 4 clients is greater than for non-Big 4 clients only in the countries
where investor protection is strong, while they exclude Japanese companies due to the limited
data collection. This result is robust even when excluding U.S. firms. These studies imply thatthe Big 4 auditors are likely to be more conservative than non-Big 4 even in countries other thanthe U.S. The recent changes in the Japanese audit environment have increased litigation risk andpublic scrutiny for Japanese Big 4 auditors1, but the level of risk and scrutiny is much lower
than that for the U.S. Big 4. Even so, the Big 4 auditors might be more conservative than nonBig 4 in Japan, given the prior results that non-U.S. Big 4 auditors are conservative. Our study
indeed finds Japanese Big 4 auditors being more conservative than non-Big 4 despite thegeneral belief that their litigation risk is low. This finding adds weight to the notion that Big 4
auditors are more conservative than non-Big 4 in non-U.S. countries, where litigation risk isgenerally not so high. However, it should be noted that different institutional backgrounds mightmake the Big 4 auditors conservative in different ways as our result shows that Japanese Big 4
auditors’ conservative reaction to earnings management differs from those by their Americancounterparts. In addition, the evidence raises a potential issue in that relying on outdated
research may yield wrong hypotheses; an apt example of this would be the fact that while ourresults show that the Japanese Big 4 auditors are conservative because of the recent increase in

1

Details are expressed in Section 3.

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the litigation risk, previous researchers have generally regarded as having low litigation risk.
The remainder of this paper proceeds as follows. Section 2 provides a literature review
of auditor conservatism. Section 3 explains the Japanese auditing background, and Section 4
describes the hypotheses developed for this study and the empirical model. Section 5 presents
the data and Section 6 reports and explores the empirical results. Section 7 provides theconcluding remarks.

2. Related Literature
Previous accounting research has addressed the issue of auditor conservatism in various ways.
These include deterring clients’ earnings management behavior and having lower thresholds for
issuing modified audit opinions (including going concern opinions)2. Litigation risk andreputation have been regarded as the main factors causing auditor conservatism, since litigation
against an auditor can damage its reputation by providing a negative signal about the quality of
its audit service (Palmrose, 1988; Pratt and Stice, 1994). Moreover, litigation entails further
costs associated with professional and regulatory sanctions; therefore, auditors are expected to
be strongly motivated to reduce their litigation risk.
DeAngelo (1981) shows that auditors are likely to be sued when they fail to discover a
breach in the client’s financial statements (or when they fail to issue going concern opinions) to
the firms that breach accounting rules (or later become bankrupt). Auditor conservatism has
been explored from different perspectives because there are several ways in which auditors can
avoid litigation and preserve their reputations3. In many cases, prior researchers haveinvestigated auditor conservatism in the U.S. context, whereas we shed light on it in theJapanese context. Therefore, this section mainly reviews related literature with regard to auditor
conservatism in the U.S. market.

2

Except in these two respects, auditors’ client portofolios are likely to relate to auditor conservatism.
Specifically, conservative auditors may avoid risky firms. Whether Japanese auditors conduct theirclient portfolio management in a conservative way is an interesting question for future research.
3
Although prior studies (Lennox, 1999; Numata and Takeda, 2010) have sometimes differentiatedthe deep pocket (insurance) and the reputation hypotheses as explanations for Big 4 auditors’
incentives to provide quality service, we regard both these auditor incentives as driving their quality
services in this study.

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The Big 4 auditors4 are likely to be more conservative than non-Big 4 auditors. This isbecause they have deeper pockets (Dye, 1993; Lennox, 1999) and have more to lose from anaudit failure5. In general, the Big 4 account for a large percent of shares in the audit market (inJapan as well). Since one audit failure may result in the loss of most of their incumbent clients,
the Big 4 auditors are likely to be sensitive to preserving their reputation6 (DeAngelo, 1981).
Furthermore, outside stakeholders might believe that the Big 4 auditors not only have deeper
pockets but also have higher insurance coverage, and thus they have more resources torecompense the plaintiffs through out-of-court settlements or court-awarded damages or costs(Kim et al., 2003). This means that the Big 4 auditors are more likely to be sued in comparison
with others. In short, there are rational reasons for the Big 4 auditors to be conservative.
As stated above, auditors may be motivated to be conservative in order to reduce theirlitigation risk and to preserve their reputations; therefore several previous studies examine
auditor conservatism in different ways. From these studies, we can identify two dimensions ofauditor conservatism in this study: (1) auditors’ reaction to earnings management behavior; and(2) thresholds for issuing modified audit opinions.
First, conservative auditors try to prevent management from engaging in incomeincreasing earnings management or to induce management to adopt conservative accounting. St.
Pierre and Anderson (1984) examine cases that were filed against public accountants and findthat none of the suits concerned errors in undervaluing assets, recognizing inadequate amountsof revenue, or recognizing excessive expenses. They conclude that a more rigid application of
the conservatism doctrine may have reduced the accountants’ risk of legal retribution. Lys andWatts (1994) also show that income-increasing accounting methods constitute one of the factors
4

The number of large audit firms varies depending on the period that researchers examine, but weconsistently use “the Big 4” in this paper for the sake of shorthand.
5
It might enable them to spread the risk of litigation associated with clients through diversification,
because the Big 4 audit firms have a larger client base (Raghunandan and Rama, 1999; Johnstone
and Bedard, 2004). Yet, against the recent backdrop of Arthur Andersen’s demise and higher
litigation risks, the Big 4 auditors are likely to be more conservative, and recent studies haveexamined this conservatism (e.g. Rama and Read, 2006).
6
Indeed, when one of the Japanese Big 4 audit firms, ChuoAoyama, failed to uncover its client’s
material misstatements in financial statements and to issue qualified audit opinions, many of theremaining clients changed auditors. Although the audit firm was said to be involved in several
accounting frauds, this is a good example of how the Japanese Big 4 auditors might damage theirreputation and lose their clients because of fiduciary failures.

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that increase the probability of lawsuits. Basu (1997) shows that asymmetric recognition of
economic losses relative to gains, which is regarded as accounting conservatism, is more
pronounced during the period when auditors’ litigation exposure is higher. Hence, if auditors try
to reduce litigation risk, they prevent clients from engaging in opportunistic earnings
management.
Since the Big 4 auditors are more likely to be sued, their incentive to deter clients’earnings management will be stronger than that of non-Big 4 auditors. Becker et al. (1998)
provide evidence that companies with non-Big 4 auditors report discretionary accruals that are
significantly greater than those of companies with the Big 4 auditors. This result indicates thatthe Big 4 auditors deter clients from engaging in income-increasing earnings management. Kim
et al. (2003) also show that when managers have the incentive to boost reported earnings, theBig 4 auditors are more effective compared with non-Big 4 auditors in deterring or monitoring
opportunistic earnings management. They also find that the Big 4 auditors are less effective than
non-Big 4 auditors when managers prefer income-decreasing earnings management. Basu et al.
(2001) and Chung et al. (2003) show that Big 4 clients’ earnings are more conservative thanthose of non-Big 4 clients, while Chung et al. (2003) find that such Big 4 clients’ conservatism
is observed only when the clients are performing poorly. In sum, previous research clearlyshows that the Big 4 auditors prevent opportunistic earnings management and/or induce clientsto adopt conservative accounting7.
With respect to Japanese auditors, Yoshida (2008) finds that the Big 4 auditors have noeffect on accruals reported by their clients. Usui (2007) examines the governance effect of theJapanese Big 4 auditor on IPO firms and find that they prevent only income-decreasing earnings

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Krishnan (2005a; 2005b) finds Big 4 auditors’ conservatism using Basu’s (1997) qualification
model of accounting conservatism; but he sheds light on only the Big 4 auditors’ conservatism, noton the relative differences in conservatism between the Big 4 and non-Big auditors. Moreover,
Krishnan (2007) shows that former Arthur Andersen clients audited by other Big 4 auditors
recognized earnings in more conservative ways than did non-Andersen clients. This result implies
that the Big 4 auditors use earnings conservatism as a risk management strategy so as to restore
financial reporting credibility, which had been reduced because of Andersen’s failure. These results
do not imply that the Big 4 auditors are more conservative as compared with non-Big 4 but indicatethat the Big 4 auditors tend to induce clients to adopt conservative accounting.

8management conducted by their clients. Thus, the results are mixed regarding the Japanese Big
4 auditors’ conservative reaction to clients’ earnings management behavior.
Second, conservative auditors are likely to have lower thresholds for issuing going
concern opinions, especially when they try to reduce litigation risk. Although issuing a going
concern opinion prior to bankruptcy does not necessarily reduce litigation risk (Carcello andPalmrose, 1994; Blacconiere and DeFond, 1997), prior research suggests that some auditors
believe that litigation related costs increase when they fail to issue going concern opinions prior
to bankruptcy (Kida, 1980; Mutchler, 1984; Geiger et al., 2005). Since auditors are more likely
to face litigation related costs when a client files for bankruptcy without a prior going-concern
opinion (type II error) (Matsumura et al., 1997; Vanstrealen, 2002; Geiger and Rama, 2006),
conservative auditors that try to reduce litigation risk have lower thresholds for issuing going
concern opinions.
Regarding this type of auditor conservatism, prior studies have produced several results.
Geiger et al. (2005) and Fargher and Jiang (2008) show that auditors are more likely to issue
going concern opinions during the period they are intensively scrutinized by the market andgovernment (such as right after the enactment of the Sarbanes Oxley Act. With regard to therelative frequency of issuing going concern opinions by the Big 4 and non-Big 4 auditors,
Geiger and Rama (2006) provide that both type I (misclassification of a non-failing company asa failing company) and type II errors for the Big 4 auditors are significantly lower than those for
non-Big 4.
Auditor conservatism in issuing going concern opinions has been sometimes examinedin terms of the relation to earnings management behavior. Financially distressed firms haveengaged in income-increasing earnings management so as to mask their poor performance(Argenti, 1976; DeAngelo, 1988; Dechow et al., 1996; Beneish, 1997; Rosner, 2003). If
auditors detect such overstatements, they may provoke reversals of accruals when issuing going
concern opinions. In keeping with this notion, Rosner (2003), Ajona et al. (2008), and Arnedo etal. (2008) find that firms report negative abnormal accruals when they receive going concern
opinions. In contrast, Butler et al. (2004) argue that large negative abnormal accruals for going

9

concern firms are not because of auditor conservatism, but because of their distressed financial
status.

3. Auditing in JapanThe audit environment in Japan has changed dramatically in the past several years. In thissection, we introduce the audit practices and environment in Japan.

3.1 Audit Practices in Japan
After the bad debt problem and stock market slump that began in the 1990s, Japanese auditors
were criticized for accepting window-dressed disclosure prepared by firms (especially banks)
and thus issuing clean audit opinions. The criticism was directed largely at the big international
accounting firms that had accepted the misleading opinions of the Japanese audit firms withwhich they were affiliated. In response, the Big 5 international audit firms at the time demandedthat the major Japanese audit firms with which they had cooperation agreements include awarning in the audit report that accompanied the English-language version of their Japaneseclients’ financial statements. The warning would say that the financial statements were intended
for users familiar with Japanese accounting principles and auditing standards; this warning
became a requirement between March 1999 and February 2004 (Fuchida, 2006, pp. 17-18).
In order to restore the trust in Japanese audit quality and to discipline audit practices,
the accounting system was reformed and the Auditing Standards in Japan were amended in
2002; as well, the Certified Public Accountants Law was amended in 2003. These amendmentssought to discipline audit practices in Japan so as to make the audit quality comparable to that in
the U.S.
Regarding the standard for going concern opinions, it was enacted in the reform of the
Auditing Standards in 2002 and went into effect in March 2003. Before the enactment, auditors
were not allowed to issue going concern opinions, even when there was substantial doubt about
the client’s going concern status. In terms of the institutional background of issuing going
concern opinions, Japanese auditors’ responsibilities are somewhat different from those in the
U.S. In Japan, according to the rules, company management have to disclose their going

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concern status if there is substantial doubt about their ability to continue as a going concern.
Auditors are required to verify that the disclosure provided by management reflects the actual
picture. Thus, management first evaluate their status as a going concern, and then auditors
verify the fairness of the evaluation. In this sense, there is a difference between the U.S. andJapan, because U.S. rules require auditors to evaluate their clients’ status as a going concern.
However, management are often unwilling to note such negative information in financial
statements in both the U.S. and Japan. Even if the firm is financially distressed and there issubstantial doubt about its ability to continue as a going concern, management might not reportsuch information. In order to maintain a high-quality financial statement, even Japanese auditors
are likely to require management to note the going concern status if the firm is facing substantial
doubt about its ability as a going concern, though management may be reluctant to note suchnegative information. Otherwise, auditors are subject to severe litigation risk because of audit
failure. Hence, as long as Japanese auditors have an incentive to reduce their litigation risk, they
are likely to be conservative in issuing going concern opinions in the same way U.S. auditorsare.

3.2 Audit Environment in Japan
Japan is known as a country that is less subject to litigation risk than the U.S. (Wingate, 1997;
Ball et al., 2000; Fukukawa et al., 2006), but the frequency of litigation against auditors has
increased during the past decade. According to the media and/or prior studies regarding thelitigation cases against Japanese auditors, the first case was filed in 1981. The plaintiff, theNihon Koppasu, alleged that it suffered damages due to fraud committed by its former accountmanager, and that the defendant, Meiwa Kansa Hojin, neglected to carry out the normal audit
procedures and therefore overlooked the fraud. At the first trial in 1991, the audit firm wasordered to pay about 48 million yen (about USD 320 thousand at the time) to the plaintiff,though about 60 million yen was sought. In other words, the court made a decision in theplaintiff’s favor. Both the plaintiff and the defendant appealed the ruling and a second trial took
place in 1995. This time the result quashed the verdict of the first trial and dismissed theplaintiff’s claim.

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Although this case resulted in the auditor paying no damages in reparation, the decisionat the first trial had a major impact on auditors. Even after the verdict was handed down, notonly audit scholars and practitioners but also law scholars put forward arguments about this case(Toba, 1997). Since then, Japanese auditors have tended to recognize litigation risk as being
relatively higher than before the case8.

(Insert Table 1 about here)

Table 1 summarizes litigation cases involving auditors in Japan. A large number ofJapanese firms went bankrupt in the late 1990s. After their bankruptcy, several cases ofwindow-dressing that had occurred prior to bankruptcy were revealed, and this resulted inlawsuits against auditors. Consequently, from 1999 to 2004, there was at least one case a year
wherein auditors were being sued because they had not qualified audit opinions for bankrupt
firms before the bankruptcy. After bankruptcy, it was often found that such firms engaged inearnings manipulation or had off-balance liabilities. After the discovery of such fraud, auditors
as well as the management of the firms were sued.
Several lawsuits filed in the 1990s began to be settled in the early 2000s. Mita was thefirst case where the audit firm, Murai Kansa Hojin, paid a settlement package (about 30 million
yen) to the plaintiff, its trustee, although the firm was not a listed company and damages weresought under the Commercial Code in Japan9. Although the above two cases were against
medium- or small-sized audit firms, for the first time in 2002, one of the large audit firms at thetime, Asahi Kansa Hojin, paid a settlement package (about 20 million yen) to the plaintiff, theshareholders of Jusen. It was the first in which an auditor paid reparations for lapses in the auditof a listed company.
Thus, even though the accounting environment in Japan has not been as litigious as in

8

Japan has no class action system (West, 2001) and this may result in the relatively low incidence of
litigation against auditors (or management); on the other hand, civil litigation and/or shareholder
litigation had increased dramatically during the 1990s (Ginsburg and Hoetker, 2006; West, 2001).
9
Since both the Commercial Code and Securities Act express auditors’ liability for damage in Japan,
auditors may be sued under the Commercial Code for private firms.

12the U.S., the number of lawsuits against auditors and the amount auditors pay have been
increasing, especially over the past decade. Taking this trend into consideration, it is likely that
auditors started to recognize their litigation risk, most likely, around 2002. In addition, theplaintiff’s burden of proof was lessened by the revision of the Securities Exchange Act in 2004
(Kuronuma, 2004), and it probably resulted in the increase in litigation wherein damages weresought for misstatement (Ikeya and Kishitani, 2009). Hence, unlike the variation in auditor
liability in the U.S. (Kothari et al., 1988; Holthausen and Watts, 2001), Japanese auditor liability
seems to have increased constantly since 2002.
Furthermore, as in the U.S., one of the largest audit firms, ChuoAoyama, collapsed
because it was discovered that several of the companies the firm audited was engaged in frauds.
The frauds perpetrated by Kanebo (ChuoAoyama’s client) attracted much publicity in Japan andmade the front page of the county’s foremost financial newspaper (NihonKeizaiShinbun); after
this fraudulent activity, Japanese auditors were scrutinized more closely by both authorities andinvestors. Accordingly, recent audit environmental changes were likely to make Japanese
auditors more conservative.
In addition, the Certified Public Accountants and Auditing Oversight Board (CPAAOB)
was established in 2004 to oversee JICPA’s (Japanese Institute of Certified Public Accountants)
quality control review process with the objectives of making the self-regulatory system more
effective and enhancing and managing the quality control of audit practices at audit firms(Kaneko, 2004). This institution is a legally appointed administrative agency whose remit
includes making recommendations to the Commissioner of the Financial Service Agency to takeadministrative dispositions and other measures when they find that quality control reviews are
not properly conducted by JICPA. The establishment of this institution means that auditors havea higher probability of being investigated by the authorities.

4. Hypothesis Development and Research Design
According to the discussion in the previous section, Japanese auditors are likely to havesome incentive to be conservative in order to reduce litigation risk and to preserve theirreputations. Moreover, as stated in Section 2, the Big 4 auditors are expected to have more13

incentives and to be more conservative than non-Big 4 auditors. Therefore, the Japanese Big 4
auditors are likely to be more conservative than others10. Accordingly, we develop the
hypothesis regarding conservative behavior by the Big 4 auditors in Japan (in alternative form):

H1: The Big 4 auditors are more conservative than non-Big 4 auditors.

In this study, H1 is examined from two perspectives. The first is from the viewpoint ofauditors’ reaction to clients’ earnings management behavior and the second is from theviewpoint of the threshold for issuing going concern opinions.

4.1 Auditor conservatism for clients’ earnings management behavior
From the first perspective, we expect that the Big 4 auditors are likely to deter clients’ earnings
management. Although the previous results regarding the Japanese Big 4 auditors’ reactions toclients’ earnings management are mixed, we reexamine this hypothesis by focusing only on thesample period in which the litigation risk against auditors is high and by controlling for several
influential factors on firms’ earnings management behavior. In terms of the Big 4 auditors’
reaction to earnings management, H1 can be stated as follows:

H1a: Firms audited by the Big 4 have lower abnormal accruals than those audited by nonBig 4 companies.

In order to estimate abnormal accruals, we utilize the CFO Jones model11 (Kasznik, 1999).

10

During the sample period, there were four large audit firms: Azsa, ChuoAoyama, ShinNihon, andTohomatsu. After a series of audit failure detections, ChuoAoyama was divided into Misuzu andAarata. Aarata was established by PricewaterhouseCoopers to respond to the possible loss of clientsin June 2006. Auditors who did not move to Aarata changed their firm name to Misuzu and worked
to restore confidence, but additional failures were revealed. Finally, Misuzu folded up in July 2007.
11
Suda and Shuto (2004) find that CFO-controlled models are a better fit for estimating Japanesefirms’ abnormal accruals among others. Furthermore, Chan et al. (2004) prove that the Jones modelsignificantly underperforms the CFO Jones model in explaining cross-sectional accrual variability
for American firms. Following these results, the CFO Jones model is utilized in this paper. To test
the robustness of the results, we estimate Models (1) and (2) using abnormal accruals as suggested
by Jones (1991) and confirm that the results are generally unchanged.

14

Accruals are calculated from the statement of cash flows (CFO is deducted from net income).
We do this since Hribar and Collins (2002) argue that a more accurate measure of cash flows is
obtained using this method. To examine H1a, we develop the regression model below. If thevalue of β1 is negative and significant, it indicates support for H1a.

Abnacct    1 Big 4t   2COMPt   3 LEVt   4 SIZEt   5 ROAt 1   6 Abnacct 1
  7 BOARDt 1   8 FIN t 1   9CORPt 1  10 KEIRETSU t  11SEC  (1)Since there are several conditions that give rise to earnings management (Schipper,
1989), those factors should be controlled. In this research, factors that are likely to induce
earnings management (those which relate to compensation contract12, debt contract, andpolitical cost) are controlled in the model examining auditor conservatism, following Teshima
and Shuto (2008) who examined Japanese firms’ earnings management activities. In addition,
we control for the effects of Japanese firms’ governance structure in Model (1).
Teshima and Shuto (2008) show that board ownership has a negative relation toabnormal accruals to the extent that management’s incentives are aligned with shareholders’interests. In addition, previous studies indicate that Japanese firms’ management behavior canbe influenced by financial institutions or corporate shareholders, who have roles in corporate
governance (Aoki et al., 2007; Nitta, 2008). Teshima and Shuto (2008) hypothesize and findthat financial institutions’ and other firms’ larger shareholdings decrease earnings management
behavior, since management is closely scrutinized by shareholders in these businesses.
Therefore, we include the percentage of shares held by boards (BOARD), by financial
institutions (FIN), and by other corporations (CORP), and construct Model (1). All of thesevariables are measured at the beginning of the period.

12

We use the change in cash compensation paid to the board of directors to control for their
incentive that relates to compensation contracts. This is because (1) companies are not required todisclose any information with regard to the compensation for individual executives; (2) the lists ofincome tax amounts paid by the executives, which are used to estimate individual executives’compensation by Basu et al. (2007) and Kato and Rockel (1992), are available only up to 2005; and(3) Kaplan (1994) and Shuto (2007) use the change in cash compensation paid to the board of
directors as a proxy for Japanese firms’ executive compensation.

15

Furthermore, keiretsu, which is another well-known Japanese corporate governancestructure, may influence firms’ earnings management behaviors. Since firms have stronger ties
to each other within a keiretsu group, there are expected to be several benefits, which include
effective monitoring, mitigating information asymmetry, and reducing conflicts between relatedparties (Aoki and Patrick, 1994). In relation to earnings management behavior, Douthett andJung (2001) show that abnormal accruals by keiretsu firms are smaller than those by nonkeiretsu firms. Since keiretsu relationships seem to influence management’s earnings
management behavior, we include KEIRETSU13, which is equal to one if the firm belongs one ormore Japanese keiretsu group, in Model (1). Furthermore, since cross-listed firms in the U.S. are
exposed to relatively higher litigation risks (Lang et al., 2003; Hujigen and Lubbernk, 2005;
Chung and Wynn, 2008), they may apply more conservative accounting as compared withothers. To control for this, we include SEC in Model (1).
Given that abnormal accruals are expected to sum to zero over the periods, managers’
ability to borrow or save earnings in the current period could be affected by the extent to which
earnings were borrowed or saved in previous periods (DeFond and Park, 2001; Kim et al, 2003;
Chan et al., 2004). Taking these factors into consideration, abnormal accruals in the previous
period (Abnacct-1) and performance measure (ROA) are controlled in the model. Table 2 depicts
the definitions of variables including those in Model (2).

(Insert Table 2 about here)

4.2 Auditor conservatism in issuing going concern opinions

When we examine auditor conservatism from the second viewpoint, the relations between
abnormal accruals and going concern opinions for financially distressed firms are highlighted.
Since the Big 4 auditors are expected to have lower thresholds for issuing going concern
opinions than non-Big 4, their clients are less financially distressed when they receive such
13

Japanese corporate groups are known as keiretsu. There are two types of keiretsu groups, namely,
horizontal- and vertical-keiretsu (Brown & Company, 2001), and we integrate these groups andmeasure KEIRETSU. We re-estimate Models (1) and (2) using horizontal- and vertical-keiretsu
dummies. The results are qualitatively unchanged.

16

opinions. Although auditors are likely to provoke accrual reversals when they issue going
concern opinions, the reversal effect for less financially distressed firms will be less significant,because such firms supposedly have engaged less in earnings management in previous periods.
This leads to the hypothesis that the reversal effect for the going concern firms audited by the
Big 4 indicates less than for those audited by non-Big 4. Therefore, H1 is stated below in termsof auditors’ thresholds for issuing going concern opinions.

H1b: Going concern firms audited by the Big 4 have less negative abnormal accruals thanthose audited by non-Big 4 firms.

In order to examine H1b, we develop Model (2), whose dependent variable is a binary
variable representing whether the firm receives going concern opinions or not. In evaluating theauditors’ propensity for issuing going concern opinions, Model (2) should be estimated using
only financially distressed firms (Hopwood et al.,1994; Reynolds and Francis, 2001; DeFond etal., 2002). We define financially distressed firms as firms that report (1) negative earnings, (2)negative operating cash flows, (3) negative working capital, or (4) negative retained earnings.
Going concern firms are defined as the firms receiving first-time going concern opinions.

Pr ob( GC  1 )    1 Big 4t   2 Abnacct   3 Big 4t * Abnacct   4 SIZEt   5 LEVt  6CRt 1   7 PRLOSSt   8 RETAIN t   9CFOt  10 EQUITYt  11 BOARDt 1

 12 FIN t 1  13CORPt 1  14 KEIRETSU  (2)Since auditors’ conservative reaction to going concern firms provokes reversals of
accruals (Rosner, 2003; Ajona et al., 2008; Arnedo et al., 2008), the coefficient on Abnacc is
supposed to have negative value when the cross term of Big4 and Abnacc (Big4*Abnacc) is
excluded from the model. If this relationship is not observed, the examination of H1b is nolonger justified. Therefore, we first investigate whether the coefficient on Abnacc is negative or
not where Big4*Abnacc is dropped. Our test variable is Big4*Abnacc for H1b. If the estimatedvalue of β3 is positive, it means that H1b is supported.

17

As in previous studies, the model controls for the effects of other factors that likely
affect auditors’ probability of issuing going concern opinions: client size, extent of financial
distress, and clients’ new financing. Moreover, we control for Japanese firms’ governancestructure in Model (2) as well as in Model (1).
In evaluating the auditors’ propensity to issue going concern opinions, the Japanese
corporate governance systems should be taken into account. The main bank system is one of the
distinguishing features of Japanese firms. One of the main bank’s roles is to rescue affiliatedfirms that face financial difficulty. Bankruptcy resolutions were rarely employed for Japanesefirms having a main bank (Hoshi et al., 1990). Instead, existing debt is refinanced and somebridging finance is provided or a senior incumbent manager is demoted or displaced by a mainbank14 (Sheard, 1994). Therefore, one might say that a firm closely affiliated with its main bankhas a lower possibility of receiving a going concern opinion from its auditor, since its main bankwill help it successfully recover from financial problems. Furthermore, Japanese firms generally
cross-hold shares with their main banks, as well as with other corporations (Aoki and Patrick,
1994; Nitta, 2008). These cross-hold relationships may also facilitate the recovery of financiallydistressed firms. Therefore, firms’ ownership structure might influence auditors’ probability of
issuing going concern opinions.
The above-mentioned role of the main bank in helping a financially distressed affiliatedfirm may also be observed if the firm belongs to keiretsu. Since firms have stronger ties witheach other within a keiretsu group, there are expected to be several benefits. Prior studies haveshown that a keiretsu relationship reduces the costs of financial distress (Hoshi et al., 1990;
Prowse, 1990). In short, the keiretsu relationship is likely to reduce the auditors’ probability of

14

The roles of the main bank were less observed after the mid-1990s. In other words, bank lenders
were less likely to rescue failing borrowers than they were before the early 1990s (Hirota andMiyajima, 2001; Xu, 2004, 2007). The number of bankruptcies in Japan skyrocketed from 6,468 in
1990 to 19,164 in 2001, whereas it moderately decreased to 15,480 in 2009 (Tokyo Shoko ResearchLtd., 2009). When the bubble economy burst, the roles of the main bank in the Japanese economy
weakened. Therefore, even if a firm is closely affiliated with its main bank, it may not be
reorganized privately, which might result in its being bankrupt during our sample period.
Nonetheless, Japanese firms closely affiliated with a main bank may enjoy a lower possibility offacing bankruptcy, because many Japanese firms still have a main bank and their bank lending ismuch higher than those for American firms. Therefore, we take into account the possible effect of
the intimate relationship between firms and financial institutions on issuing going concern opinions.

18

issuing going concern opinions. Hence, we include ownership variables as well as a dummy forkeiretsu in Model (2).

5 DataThe sample period is from April 2003 to March 2006. Financial statements and going concern
opinion data, auditor data, and keiretsu data were collected from Nikkei NEEDS Financial Quest,
Nikkei Kaisya Joho, and Brown & Company (2001), respectively. Abnormal accruals are
estimated cross-sectionally each year using all firm-year observations in the same two-digit
Nikkei medium classification industry code. To estimate nondiscretionary components of
accruals, we implement out-of-sample forecasts. Firms from the financial services industry are
excluded from the analysis as in previous research. ABNACC, COMP, LEV, SIZE, ROA, CR,
RETAIN, and CFO are winsorized at the 1 and 99 percentile. Table 3 reports industry
distribution of the sample. The Big 4 auditors’ clients are not concentrated in any particularindustry, except for the air transportation industry. Therefore, the sample firm composition of
the Big 4 is unlikely to affect our regression examinations.

(Insert Table 3 about here)

Table 4 provides the samples and descriptive statistics. The total sample of 7,198 is divided into
two in two ways: whether or not a firm is audited by the Big 4, and whether or not it receives agoing concern opinion. According to Table 4, 1,171 firms are audited by non-Big 4 companies,
and this accounts for about 16.3% of the total sample. Of the total sample, 62 firms receive firsttime going concern opinions.

(Insert Table 4 about here)

6. Results
6.1 Comparison between the Big 4 and non-Big 4 clients

Table 5 provides means of the variables for Big 4 and non-Big 4 clients, respectively.

19

Univariate t-tests indicate that the Big 4 auditors conduct audits less frequently on firms
receiving going concern opinions. This result suggests that the Big 4 auditors try not to audit
going concern firms that potentially relate to future concerns such as litigations. With respect toabnormal accruals, there is no difference between the Big 4 clients and non-Big 4 clients, whichis inconsistent with H1a. Since H1b tests the abnormal accruals between going concern firms
audited by the Big 4 and those audited by non-Big 4 companies, it cannot be tested in a
univariate analysis in Table 5. Overall, Table 5 indicates that Big 4 clients are bigger and more
profitable relative to non-Big 4 clients. These differences between Big 4 and non-Big 4 clientsare similar to the findings of Becker et al. (1998) and Kim et al. (2003) regarding U.S.
companies. Regarding other variables, the difference in board ownership and keiretsu
participation between Big 4 clients and non-Big 4 clients is statistically significant.

(Insert Table 5 about here)

6.2 Regression Analysis

Table 6 presents the evidence of Model (1)15. Column (1) in Table 6 indicates that thecoefficient on Big4 is positive and insignificant. This result is contrary to our prediction andimplies that the Big 4 auditors do not prevent clients from opportunistic earnings management.
With respect to control variables, some of them have significant values. A positive coefficienton COMP is consistent with the bonus plan hypothesis (Watts and Zimmerman, 1986), which
predicts that management have incentives to maximize their bonuses when their cash
compensations are linked to reported earnings. However, a negative coefficient on LEV isinconsistent with the debt/equity hypothesis, which predicts that the higher the firm’s
debt/equity ratio (debt/asset ratio in this study), the more management use accounting accrualsthat increase income. However, leverage can relate to the degree of distress risk, whereby thenegative coefficient might imply that firms with higher leverage may face severe financial

15

We report t-statistics based on standard errors clustered at the firm and year level, which arerobust to both heteroskedasticity and within-firm serial correlation (Cameron et al., 2006; Thompson,
2006; Petersen, 2009) for all the regressions.

20difficulty and may have negative abnormal accruals16.

(Insert Table 6 about here)

While Teshima and Shuto (2008) find negative associations between unsigned abnormal
accruals and the percentages of shares held by (1) board, (2) financial institutions, and (3) othercorporations, Table 6 indicates that all the coefficients are positive. We use signed abnormal
accruals and, therefore, it is not clear whether these positive coefficients are contrary to Teshima
and Shuto (2008). Our results are somehow different from those in Teshima and Shuto (2008),
but the differences, which include sample periods and accounting variables definitions, probably
cause the inconsistent results. Regarding other control variables, the negative coefficient on SEC
is as we expected, whereas the positive coefficient on Abnacct-1 is not. Kim et al. (2003) also
show that the relation between abnormal accruals in a certain period and those in the previous
period is positive in both their univariate and multivariate analyses. In sum, the results of Table
6 do not support H1a, though some control variables are statistically significant as we expected.
Table 7 presents the evidence of Model (2), which examines H1b. Column (1) indicatesthe results without the Big4*Abnacc variable, while column (2) indicates the results using all the
independent variables. According to column (1) in Table 7, the coefficient on Abnacc isnegative and significant at the 1% level. This result is consistent with our prediction that
auditors provoke accrual reversals in issuing going concern opinions; therefore, our examinationof H1b is justified. We then look at the result of the test variable for H1b in column (2).
According to column (2) in Table 7, the coefficient on Big4*Abnacc is positive and significant.
This result supports H1b.

(Insert Table 7 about here)

16

Butler et al. (2004) suggest that firms experiencing severe financial issues engage in liquidityrelated transactions and record impairment charges to reflect economic declines in asset values.
Since asset write-offs decrease accruals, negative abnormal accruals for firms facing financial
difficulty may correspond to their poor performance (Kothari et al., 2005).

21

With respect to the coefficients on control variables, the estimated values are generally
consistent with our predictions. All the significant coefficients on LEV, CR, PRLOSS, RETAIN,
and CFO have signs as we expected, whereas some of the coefficients have insignificant values.
We posit that firms’ intimate relationship with financial institutions or other firms and keiretsu
participation reduce the possibilities of receiving going concern opinions, but only FIN is
negative and significant in Table 7. This result indicates that only when firms have an intimate
relation to financial institutions do they reduce the probability of receiving going concern
opinions.
In sum, we find that the Big 4 auditors are conservative when they issue going concern
opinions, while they do not deter clients’ earnings management behavior. As we discussed in
Section 3.2, the litigations against Japanese auditors relate to firms’ bankruptcy. Given thisbackground, the Japanese Big 4 auditors have incentives to be conservative, especially when
they make decisions on whether to issue going concern opinions. Although Japanese auditors
were not sued because they had not issued going concern opinions prior to a bankruptcy in thelitigation cases, the fact the litigations mostly relate to bankruptcy is likely to make Japanese
auditors, especially the Big 4 auditors, conservative when they issue going concern opinions.

6.3 Sub-sample Analyses

6.3.1 The sign of abnormal accruals
Caramanis and Lennox (2008) find that the magnitude of income-increasing abnormal accruals
is greater when audit hours are lower, whereas the magnitude of income-decreasing abnormal
accruals has a weak or an insignificant association with audit hours. This implies that auditors
have strong incentives to prevent earnings management only when such management is toincrease earnings. If so, auditors’ conservative reaction to earnings management behavior may
be observed only when we focus on the firms reporting positive abnormal accruals.
Columns (2) and (3) in Table 6 present the results of Model (1) for firms reporting
negative abnormal accruals and equal to or more than zero abnormal accruals, respectively. If
auditors are more efficient only when they prevent income-increasing earnings management, thecoefficient on Big4 is not significant in column (2) but it has negative and significant value in22

column (3). According to the results in Table 6, however, the coefficient on Big4 is positive andsignificant in column (2), whereas it has insignificant positive value in column (3). These results
indicate that auditors are effective when they deter income-decreasing earnings management,
but they are not for income-increasing earnings management17.
This result, which is inconsistent with Caramanis and Lennox (2008), may be explainedby the importance of tax laws for Japanese firms. Japan is one of the countries where accounting
practice is strongly aligned with tax practice, and therefore Japanese managers are likely to havestrong incentives to decrease or smooth earnings in order to minimize taxable income (Hermann
and Inoue, 1996; Darrough et al., 1998). Japanese auditors may try to prevent incomedecreasing earnings management so as to avoid scrutiny by the tax authority.

6.3.2 Management’s incentives to manage earnings
Kim et al. (2003) reveal that external auditors act as an effective deterrent to opportunistic
earnings management only when auditors’ preferences concerning accrual choices conflict withmanagement’s preferences. This means that auditors’ preferences for conservative accounting
are likely to be prominent only when management have an incentive to increase accruals. For
this reason, we construct a sub-sample consisting of financially distressed firms, following on
from Kim et al. (2003). Management of financially distressed firms are likely to have incentives
to increase earnings in order to conceal their deteriorating financial conditions. To investigate
the relation between management’s incentives and auditors’ effectiveness in deterring incomeincreasing earnings management, we estimate Model (1) again using the same definition offinancially distressed firms as used in estimating Model (2). Table 8 presents the result of Model(1) using financially distressed firms. Similar to the results in column (1) of Table 6, thecoefficient on Big4 is not significant, whereas the value is negative as we expect.

(Insert Table 8 about here)

17

This result is consistent with Usui (2007) that examines the effect of the Japanese Big 4 auditorson accruals reported by the IPO firms, while he does not discuss the reason why only incomedecreasing earnings management is deterred by the Big 4.

23

In sum, our sub-sample analyses based on (1) the sign of abnormal accruals and (2) the
management incentives to upwardly manage earnings do not support H1a. Our findings indicatethat Japanese auditors have limited incentives to prevent income-increasing earnings
management. Rather, they seem to have incentives to deter income-decreasing earnings
management. Furthermore, they do not act as an effective deterrent to income-increasing
earnings management, when firms are financially distressed and assumed to have incentives to
upwardly manage earnings.

7. Concluding Remarks

In this study, Big 4 auditors’ conservatism is examined from two perspectives using abnormal
accruals. One is from the viewpoint of auditors’ reaction to clients’ earnings management
behavior and the second is from the viewpoint of thresholds for issuing going concern opinions.
The results indicate that the Japanese Big 4 auditors (1) are effective in deterring incomedecreasing earnings management and (2) have a lower threshold for issuing going concern
opinions. Although U.S. auditor’s conservatism may deter income-increasing earnings
management, Japanese auditors prevent income-decreasing earnings management. Thisdifference might be caused by dissimilar backgrounds in these two countries. U.S. management
seem to have incentives to increase earnings for several reasons, such as the pressure from themarket or earnings-based compensation contracts. On the other hand, Japanese management
have relatively strong incentives to decrease or smooth earnings so as to reduce taxable income,because accounting practice is strongly aligned with tax practice. Our findings imply thatdifferent auditing environments affect the Big 4 auditors’ conservatism in different ways.
This study also indicates that abnormal accruals for receiving going concern opinions
result in negative abnormal accruals. It implies that auditor conservatism provokes accrual
reversals when they issue going concern opinions. Nevertheless, going concern firms audited by
the Big 4 report less negative abnormal accruals than those audited by non-Big 4. The morefinancially distressed firms are, the more often they engage in earnings management. If firms
receive going concern opinions even when they are less financially distressed, they are supposed24

to have engaged less in earnings management; thereby they indicate a less significant reversal
effect. Therefore, the result indicates that the Big 4 auditors issue going concern opinions to thefirms whose financial status is less severe and supposedly have not engaged in heavy earnings
management. In short, our finding supports that the Japanese Big 4 auditors have a lower
threshold for issuing going concern opinions. This study extends prior literature clarifying that
auditors’ conservatism induces accrual reversals when auditors issue going concern opinions.
We provide new evidence that the degree of such reversal effect is different between Big 4 andnon-Big 4 clients due to their difference in conservative behavior.
[2010.12.20 1014]

25

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34

Table 1 Cases of Litigation Involving Auditors
Firm
name

Year
filed

DamagessoughtNihon
Koppasu

1981

60

Jusen

1996

90

Yamaichi

1998

32

Mita

1998

500

Yaohan

1999

420

Chuo
(Big N)

Chogin1999

90

Yamaichi

1999

6,000

Nissaigin

2000

42

Sogo

2001

30

Nanaboshi

2002

1,000

OtaShowa(Big N)
Chuo(Big N)
Century(Big N)
OtaShowa
Century(Big N)
Tohmatsu(Big N)

Chogin

2002

FE

2003

33

Ashigin

2004

1,575

Livedoor(multiple
cases)
Yuniko2006
2008

23,067

AuditorPlaintiff(s)(whether or
not the Big 4)

Meiwa
Asahi
(Big N)
and
Sanko
Chuo
(Big N)
Murai

OtaShowa(Big N)
Mizuho(Big N)
ChuoAoyama(Big N)
Koyo

Outcomes
Resolution

Year

Damagesawarded

T

1991

48

D

1995

Shareholders

S

2002

Shareholders

D

2008

Trustee

S

2000

30

Shareholders
and convertible
bond holders
Shareholders

S

2004

109

NR

Trustee

S

2003

166

Shareholders

NR

Shareholders

D

2008

Trustee

T
S
S*1

2008
2008
2002

D

2006

D
S

2006
2007

265

T

2009

7,600

2006

6,500

Nihon Koppasu

RRC
Shareholders ofFI
Shareholders
Shareholders
and Livedoor

1,180

*2

S

20

17
40
200

Azusa
Credit Union
NR(Big N)(Creditors)
Notes: Data are current as of December 2009. The data have been taken from several sources, suchas Shoji-Homu, LEX/DB Internet (TKC), and Nihon Keizai Shinbun. “Big N” indicates that the audit
firm is one of the large audit firms when they were sued. Damages sought and damages awarded arein million yen. Some firm names are referred to in abbreviated form as follows: Jusen-Jutaku Kinyu
Senmon Gaishya, Yamaichi-Yamaichi Shoken, Mita-Mita Kogyo, Chogin-Nihon Choki Shinyo Ginko,
Nissaigin-Nihon Saiken Shinyo Ginko, RRC-Resolution and Collection Corporation, FE-Footwork
Express, FI-Footwork International, Ashigin-Ashikaga Ginko. FE was one of the equity partners ofFI, while FE was not the parent company of FI. T, D, S, NR on Resolution column stands for trial,
dismissed, settlement, and not resolved.
*1 RRC filed for settlement in April 2002 and the auditor agreed on the settlement in July 2002.
*2 This settlement was proposed by Livedoor, which was one of defendants in this trial. The firm has
filed litigation against the former president and auditor to seek compensation for this settlement.

35

Table 2 Variables Definition
Variables
ABNACC
Big4
GC
COMP
LEV
SIZE
ROA
CR
PLOSS
RETAINCFO
EQUITY
BOARD
FIN
CORP
KEIRETSU
SEC

Definitions
abnormal accruals estimated using the CFO Jones model
Big 4 dummy which is equal to one if the firm is audited by the Big 4 andzero otherwise
Going concern dummy which is equal to one if the firm receives a going
concern opinion and zero otherwisechange in managerial compensation deflated by the market values of equity atthe beginning of the period
total debt divided by total assets at the end of the period
natural logarithm of sales
net income in the previous year divided by the yearly average of total assets atthe beginning of the period
current assets divided by current liabilities at the end of the period
loss dummy which is equal to one if the firm reports negative net income in
the previous period and zero otherwise
retained earnings divided by total assets at the end of the period
cash flow from operation deflated by the yearly average of total assets
equity dummy which is equal to one if the firm issues equity in thesubsequent period
the percentage of shares held by boards at the beginning of the period
the percentage of shares held by financial institutions at the beginning of theperiodthe percentage of shares held by other corporations at the beginning of theperiodkeiretsu dummy which is equal to one if the firm belongs to one or more
Japanese keiretsu group
SEC dummy which is equal to one if the firm discloses financial statement
complied with SEC standard and zero otherwise

36

Table 3 Industry Distribution
Industry
Foods
Textile Products
Pulp & Paper
Chemicals
Drugs
Petroleum
Rubber Products
Stone, Clay & Glass Products
Iron & SteelNon ferrous Metal & Metal
Products
Machinery
Electric & Electronic Equipment
Shipbuilding & Repairing
Motor Vehicles & Auto Parts
Transportation Equipment
Precision Equipment
Other Manufacturing
Fish & Marine Products
MiningConstruction
Wholesale Trade
Retail Trade
Real Estate
Railroad Transportation
Trucking
Sea Transportation
Air Transportation
Warehousing&
HarborTransportation
Communication Services
Electric
Gas
Services

Non-Big4
68
27
11
104
18
3
14
13
34

Big4
270
145
46
384
89
23
48
141
114

Total
338
172
57
488
107
26
62
154
148

% of Big4
79.9%
84.3%
80.7%
78.7%
83.2%
88.5%
77.4%
91.6%
77.0%

51

243

294

82.7%

108
99
2
29
15
21
43
5
3
70
139
69
43
6
5
6
0

426
621
15
175
21
121
203
15
19
396
727
379
127
77
84
44
12

534
720
17
204
36
142
246
20
22
466
866
448
170
83
89
50
12

79.8%
86.3%
88.2%
85.8%
58.3%
85.2%
82.5%
75.0%
86.4%
85.0%
83.9%
84.6%
74.7%
92.8%
94.4%
88.0%
100.0%

15

88

103

85.4%

9
3
11
127

53
28
27
866

62
31
38
993

85.5%
90.3%
71.1%
87.2%

Total

1,171

6,027

7,198

83.7%

37

Table 4 Samples and Descriptive Statistics
Panel A Sample distribution
Non-Big4 Big4
Clean
1,155
5,981
7,136
GC
16
46
62
1,171
6,027
7,198
Panel B Descriptive statistics
ABNACC BIG4
GC
COMP
LEV
SIZE
ROA
ABNACCt-1 CR
mean
0.001
0.837
0.009 0.000
0.541
24.588 0.020 0.002
1.776
sd
0.063
0.369
0.092 0.007
0.204
1.483 0.043 0.064
1.232
p5-0.0870.000
0.000 -0.010
0.185
22.395 -0.048 -0.087
0.602
p10
-0.0480.000
0.000 -0.004
0.250
22.826 -0.016 -0.049
0.784
p25
-0.0191.000
0.000 -0.001
0.389
23.540 0.006 -0.019
1.051
median 0.003
1.000
0.000 0.000
0.555
24.449 0.019 0.004
1.413
p75
0.023
1.000
0.000 0.001
0.697
25.492 0.038 0.025
2.067
p90
0.050
1.000
0.000 0.005
0.808
26.610 0.063 0.052
3.142
p95
0.079
1.000
0.000 0.009
0.860
27.377 0.084 0.082
4.208
PRLOSS RETAIN CFO EQUITY BOARD FIN
CORP KEIRETSU SEC
mean
0.153
0.222
0.013 0.189
0.085
0.221 0.277 0.275
0.000
sd
0.360
0.197
0.015 0.392
0.132
0.141 0.188 0.446
0.000
p5
0.000
-0.054-0.011 0.000
0.000
0.029 0.038 0.000
0.000
p10
0.000
0.009
-0.003 0.000
0.001
0.053 0.062 0.000
0.000
p25
0.000
0.085
0.006 0.000
0.003
0.110 0.124 0.000
0.000
median 0.000
0.205
0.013 0.000
0.017
0.195 0.244 0.000
0.000
p75
0.000
0.348
0.021 0.000
0.121
0.314 0.395 1.000
0.000
p90
1.000
0.491
0.030 1.000
0.273
0.430 0.558 1.000
0.000
p95
1.000
0.578
0.036 1.000
0.3760.485 0.642 1.000
1.000
Notes: The sample consists of Japanese listed companies having fiscal year end from April 2003 to
March 2006. All variables are defined in Table 2. Panel A reports the sample distribution, which is
divided in two ways: whether or not a firm is audited by the Big 4, and whether or not it receives agoing concern opinion. Panel B presents descriptive statistics.

38

Table 5 Univariate Differences between the Big 4 and non-Big 4 Clients
Big4
Non-Big4
diff.
t-stat.
p-value
ABNACC
0.001
0.001
0.000
-0.179
0.858
GC
0.008
0.014
-0.006*-1.687
0.092
COMP
0.000
0.000
0.000
-0.966
0.334
LEV
0.541
0.541
0.000
-0.0380.969
SIZE
24.64324.3040.339***
7.854
0.000
ROA
0.021
0.014
0.006***
4.560
0.000
ABNACCt-1
0.002
0.003
-0.001-0.237
0.813
CR
1.774
1.786
-0.012-0.2830.777
PRLOSS
0.148
0.180-0.033***-2.681
0.007
RETAIN
0.224
0.210
0.014**
2.208
0.027
CFO
0.014
0.011
0.002***
4.751
0.000
EQUITY
0.191
0.183
0.008
0.082
0.935
BOARD
0.087
0.077
0.010**
2.330
0.020
FIN
0.221
0.217
0.004
0.929
0.353
CORP
0.278
0.273
0.005
0.879
0.379
KEIRETSU
0.287
0.208
0.079***
5.973
0.000
Notes: This table reports mean values of variables for Big 4 and non-Big 4 clients. A two-sample ttest is used to test for significant differences in means between these groups. ***, **, and * indicate
significance at the 0.01, 0.05, and 0.10 level (two-tailed), respectively.

39

Tale 6 Examination of Big 4 Auditor’s Conservatism to Earnings Management
column (2)column (3)Expected column (1)signs
Full sample
Abnacc<0Abnacc>=0
Constant
0.034-0.117***0.116***(0.89)(-4.01)(4.72)
Big4
(–)
0.000
0.002*
0.001(0.37)(1.75)(0.78)
COMP(+)
0.220***
0.211***
0.387***(2.77)(5.46)(2.95)
LEV(+)-0.024***-0.027***0.004(-6.48)(-5.22)(0.60)
SIZE(–)-0.0010.003***-0.003***(-0.63)(3.52)(-3.26)
ROA(+)-0.0570.219-0.175***(-1.04)(1.58)(-8.42)(–)
0.181***-0.004
0.097***ABNACCt-1(3.03)(-0.18)(2.58)
BOARD(–/+)
0.018***
0.002
0.034***(3.87)(0.091)(4.60)
FIN(–/+)
0.010***
0.040***-0.022*(2.69)(3.84)(-1.84)
CORP
(–/+)
0.005
0.019**-0.006(0.74)(1.99)(-0.64)KEIRETSU(–/+)-0.0010.000-0.001(-0.47)(0.019)(-0.37)SEC(–)-0.010***-0.019***0.027(-3.20)(-2.82)(1.48)
Observations
7,198
3,328
3,870
Adjusted R-squared
0.04090.06070.0809Notes: This table reports the parameter estimates and t-statistics from the OLS estimation ofabnormal accruals (Abnacc) on Big 4 dummy (Big4) and other control variables (Model (1)). Allvariables are defined in Table 2. Column (1), column (2), and column (3) presents the results using
full-sample, sample of firms reporting negative abnormal accruals, and sample of firms reporting
equal to or more than zero abnormal accruals, respectively. t-statistics are provided in parentheses.
They are based on standard errors clustered at the firm and year level. ***, **, and * indicate
significance at the 0.01, 0.05, and 0.10 level (two-tailed), respectively.

40

Table 7 Examination of Big 4 Auditor’s Conservatism in Issuing Going Concern
Opinions
Expected signs

column (2)-0.135(-0.065)
Big4
(–)
0.025
(0.12)
ABNAC(–)-5.499***(-6.75)BIG4*ABNAC(+)
2.607**(2.51)
SIZE(–)-0.113-0.118(-1.58)(-1.55)LEV(+)
1.241**
1.218**(2.40)(2.49)
CR(–)-0.125-0.124*(-1.63)(-1.70)PRLOSS(+)
0.253***
0.267***(2.85)(2.98)RETAIN(–)-2.343***-2.364***(-4.73)(-4.41)
CFO(–)-23.262***-22.783***(-8.82)(-8.73)
EQUITY
(–)
0.527
0.525
(1.33)(1.32)
BOARD(–/+)-0.399-0.413(-0.73)(-0.81)FIN(–)-0.864**-0.936*(-2.18)(-1.81)
CORP(–)-0.346-0.326(-0.91)(-0.88)KEIRETSU
(–)
0.212
0.219
(0.81)(0.82)
Observations
2848
2848
2
0.4286
0.4331
Pseudo R
Notes: This table reports the parameter estimates and z–statistics from a probit model of going
concern dummy (GC) on Big 4 dummy (Big4), abnormal accruals (Abnacc), and cross term of Big 4
and abnormal accruals (Big4*Abnacc) and other control variables (Model (2)) for the sample offirms that report (1) negative earnings, (2) negative operating cash flows, (3) negative working
capital, or (4) negative retained earnings. All variables are defined in Table 2. Column (1) presents
the results dropping Big4*Abnacc from the independent variables and column (2) presents the results
using all the independent variables. z-statistics are based on standard errors clustered at the firm andyear level and provided in parentheses. ***, **, and * indicate significance at the 0.01, 0.05, and0.10 level (two-tailed), respectively.
Constant

41

column (1)-0.132(-0.066)-0.130(-0.59)-3.392***(-2.91)

Table 8 Examination of Big 4 auditor’s Conservatism to Earnings Management for
Financially Distressed Firms
Expected signs
0.015(0.27)
Big4(–)-0.000(-0.13)COMP(+)
0.452***(5.87)
LEV(+)-0.032***(-4.23)SIZE(–)-0.000(-0.18)ROA(+)-0.093(-1.47)
ABNACCt-1(–)
0.234***(2.66)
BOARD(–/+)
0.043***(3.07)
FIN(–/+)
0.019**(2.02)
CORP
(–/+)
0.024
(1.19)KEIRETSU
(–/+)
0.002
(0.45)
SEC(–)-0.049*(-1.95)Observations
2848
Adjusted R-squared
0.0516
Notes: This table reports the parameter estimates and t-statistics from the OLS estimation ofabnormal accruals (Abnacc) on Big 4 dummy (Big4) and other control variables (Model (1)) for the
sample of firms that report (1) negative earnings, (2) negative operating cash flows, (3) negative
working capital, or (4) negative retained earnings. All variables are defined in Table 2. t-statistics areprovided in parentheses. They are based on standard errors clustered at the firm and year level. ***,**, and * indicate significance at the 0.01, 0.05, and 0.10 level (two-tailed), respectively.
Constant

42