Big 4 Auditors, Litigation Risk, and Disclosure Tone

Abstract

We examine the effect of Big 4 auditors on management’s use of optimistic language in audited financial statement disclosures. While regulators and practitioners consider the audit of disclosures to be increasingly important, empirical evidence of an auditor’s effect on management’s qualitative disclosure choices is limited. Focusing on the notes to the financial statements, which are the primary disclosure item subject to audit, we find that the tone of the qualitative footnote disclosures is significantly more reflective of bad economic news in the presence of a Big 4 auditor compared with a non-Big 4 auditor. This Big 4 effect on footnote disclosure tone is more pronounced for the sub-sample of firms with high litigation risk and continues to hold for a matched sample constructed using entropy balancing to control for inherent differences between clients of Big 4 and non-Big 4 auditors. Finally, when we examine Management’s Discussion and Analysis, which is not subject to audit, we do not find a Big 4 effect on the sensitivity of its tone to bad news. Our results are consistent with higher litigation exposure motivating Big 4 auditors to constrain management’s use of optimistic language while auditing financial reports. This research provides new evidence to the ongoing regulatory discussions regarding the value of auditing disclosures.

Keywords: Big 4 audit, Tone, Disclosure, Footnotes, Litigation risk

JEL Classification: M40, M41, M42