Journal of Governance and Regulation / Volume 11, Issue 3, 2022

AUDIT COMMITTEE, EXTERNAL AUDIT

AND ACCOUNTING CONSERVATISM:
DOES COMPANY’S GROWTH MATTER?
Sandra Alves *, Cecília Carmo **
* Corresponding author, GOVCOPP (Research Unit on Governance, Competitiveness and Public Policies), ISCA-UA (Higher Institute of
Accounting and Administration), University of Aveiro, Aveiro, Portugal
Contact details: University of Aveiro, Rua Associação Humanitária dos Bombeiros Voluntários de Aveiro, 3810-902 Aveiro, Portugal
** GOVCOPP, ISCA-UA, University of Aveiro, Aveiro, Portugal

Abstract
How to cite this paper: Alves, S., & The objective of this analysis is to examine the joint effect of
Carmo, C. (2022). Audit committee, external the audit committee and external audit on conservatism accounting
audit and accounting conservatism: Does
company’s growth matter? Journal of and how a company’s rate of growth influences these relationships.
Governance & Regulation, 11(3), 17–27. The sample used in this study comprises all non-financial listed
https://doi.org/10.22495/jgrv11i3art2 Portuguese firms from 2005 to 2017. A fixed-effects regression is
Copyright © 2022 The Authors
performed to examine the association between the audit committee
and external audit and conservatism accounting and how
This work is licensed under a Creative the company’s rate of growth influences these relationships. Using
Commons Attribution 4.0 International an accruals-based proxy to compute accounting conservatism, this
License (CC BY 4.0).
https://creativecommons.org/licenses/by/ study indicates that companies audited by Big 4 audit firms report
4.0/ more conservative accounting than firms audited by non -Big 4
audit firms and that audit committee and external auditors
ISSN Print: 2220-9352
ISSN Online: 2306-6784 together appear to increase accounting conservatism. Additionally,
the findings suggest that the degree of conservatism reduction
Received: 01.02.2022 related to more growth is diminished when the companies are
Accepted: 24.06.2022
examined by a Big 4 auditor and the board of directors have
JEL Classification: M41, M42, G34 an audit committee. The findings based on this study offer valuable
DOI: 10.22495/jgrv11i3art2 data to investors and regulators in assessing the effect of the audit
committee and external audit on the quality of earnings.

Keywords: Audit Committee, External Audit, Conservatism Accounting,

Growth Opportunities

Authors’ individual contribution: Conceptualization — S.A. and C.C.;

Methodology — S.A. and C.C.; Investigation — S.A. and C.C.; Writing —
Original Draft — S.A. and C.C.; Writing — Review & Editing — S.A.
and C.C.; Funding Acquisition — S.A. and C.C.

Declaration of conflicting interests: The Authors declare that there is no

conflict of interest.

Acknowledgements: This work was financially supported by

the Research Unit on Governance, Competitiveness and Public Policy
(UIDB/04058/2020) + (UIDP/04058/2020), funded by national
funds through FCT — Fundação para a Ciência e a Tecnologia
(The Foundation for Science and Technology).

1. INTRODUCTION asymmetry between executives and shareholders,

rises stakeholder trust, increases the share value,
Accounting earnings are considered an important and thus reduces the cost for firms to obtain
indicator to stakeholders. The independent new stock (Jensen & Meckling, 1976). The audit
certification of the financial statements is committees and external auditors are important
an important element to guarantee the quality of mechanisms to ensure the regularity of the financial
financial reporting. Agency theory points out that reporting process (Zalata, Tauringana, & Tingbani,
reliable financial reporting decreases the information 2018). Prior literature finds that audit quality and

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 Journal of Governance and Regulation / Volume 11, Issue 3, 2022

audit committee increase earnings quality (Becker, 2) the company’s rate of growth is not known.
DeFond, Jiambalvo, & Subramanyam, 1998; Francis, Furthermore, no study has been made on this issue
Michas, & Seavey, 2013; Zalata et al., 2018). based on information from Portuguese listed firms.
According to Jensen and Meckling (1976), This study’s goal is to fill these three gaps in
the auditing function “serve[s] to more closely the academic literature. Consequently, the research
identify the manager’s interests with those of questions are:
the outside equity holders” (p. 323). Audit committees RQ1: Is there a relationship between audit
play an important role as an internal monitoring committee, external auditor, and accounting
device. Further, audit committees are also important conservatism in Portuguese listed firms?
to guarantee an appropriate relationship exists RQ2: Is there an association between the joint
between the auditor and the firm whose financial effect of the audit committee and external audit on
statements are being audited. Therefore, external accounting conservatism in Portuguese listed firms?
auditors and audit committees are fundamental RQ3: Are these relationships moderated by
governance mechanisms that help to monitor the company’s rate of growth?
managers, reduce information asymmetry, and The article builds several contributions to
prevent them from engaging in opportunistic the present literature. This paper adds to prior
behaviour. Accordingly, auditors may have a role to literature on audit committees, external audit,
act in defining the proper degree of conservatism in and financial accounting options by increasing
a client’s financial reporting. the evidence on the consequences of audit
Because large auditing firms (big audit firms) committees and external audit on conservative
devote more resources to training, their audit accounting outside the US and the UK backgrounds
services are perceived as more effective (Francis & (Chung et al., 2003; Francis & Krishnan, 1999;
Krishnan, 1999). Big audit companies have Krishnan & Visvanathan, 2008). Portugal has a lower
motivations to provide high-quality audits since they litigation risk environment; thus, it is likely that
have a reputation to protect. Large audit firms have the audit committee and external audit (big audit
greater lawsuit expenses than small auditors, too. firm) would have little incentive to supply higher-
Mistaken opinions or failure to find violations lead quality audits. That is, whether or not audit
to large auditors experiencing major harm to their committees and big auditors may lead a greater level
brand name and great lawsuit expenses if litigated of conservatism than do non-big auditors in
(Becker et al., 1998; DeAngelo, 1981; Francis & backgrounds with inferior lawsuit risk and lesser
Krishnan, 1999). Extant literature indicates that big requests for accounting quality — in a code-law
audit firms are more probable to identify earnings country such as Portugal — continues to be an open
management since they have more resources and issue. Second, the setting up and establishment of
face more reputation risks (Becker et al., 1998; audit committees are presently not mandatory, thus
Francis, Maydew, & Sparks, 1999). Empirical studies permitting listed firms significant choice in whether
indicate that higher-quality auditors decrease to implicate corporate administrators in audit
earnings management (Becker et al., 1998; Krishnan, excellence issues. Thus, the Portuguese setting
2003; Gul, Tsui, & Dhaliwal, 2006). Previous studies provides the occasion to assess the function of audit
also indicate that the auditors’ concerns about future committees in relation to earnings quality and
status and lawsuit expenses incentive them to to offer particular understanding into regulating
favour more conservative (or income-decreasing) improvements concerning the performance of these
accounting choices and to supervisor income- supervising mechanisms. Third, in the US and
increasing accounting adoptions more attentively the UK, the ownership is extensively diffused in
(Chung, Firth, & Kim, 2003; DeFond, Lim, & Zang, contrast with the ownership in Portuguese listed
2012; Kim, Chung, & Firth, 2003). firms which is extremely concentrated, therefore
Accounting conservatism makes financial the Portuguese capital market (Euronext Lisbon)
statements more useful by decreasing remaining offer a distinctive case in the analysis of auditing.
damages occurring from asymmetric information The Portuguese stock exchange is also a remarkable
among executives and stakeholders. Conservative setting to examine such association since, unlike
reporting decreases the possibility of overestimations major markets like the US, listed firms in Euronext
by alleviating aggressive accounting (Khan & Lisbon are not mandatory to file financial reporting
Watts, 2009; Watts, 2003). Accounting conservatism in complete agreement with US GAAP (generally
reduces executives’ propensity to misrepresent and accepted accounting principles). Fourth, this
therefore decreases the likelihood of auditors analysis adds to the reduced Portuguese corporate
neglect misstatements, which negatively impacts governance literature by studying the effect of
the auditor’s capacity to maintain clients (Hennes, the audit committee and audit quality on
Leone, & Miller, 2014; Weber, Willenborg, & Zhang, conservatism accounting. Fifth, this research also
2008). As a result, it is expected that Big 4 auditors contributes to the audit literature by indicating
and audit committees enforce additional conservatism that audit quality is a vital corporate governance
on their clients than non-Big 4 auditors aiming to characteristic. Sixth, these results can offer valuable
decrease their risk exposure (litigation risk and information for auditors, regulators, standard
reputation risk). setters, and shareholders, mostly whether the audit
The impact of the audit committee and external committee and external audit enhance earnings
auditor on the accounting conservatism has been quality, especially in a country with an lower lawsuit
studied before (Chung et al., 2003; Piot & Janin, risk background, which is probable to remove
2007; Wistawan, Subroto, & Ghofar, 2015). However, the deep pockets motivation for investors, and in
how that influence is affected by 1) the joint effect companies with a higher level of ownership
of the audit committee and external auditor and by concentration. Finally, results based on Portuguese

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 Journal of Governance and Regulation / Volume 11, Issue 3, 2022

data also assist in constructing an additional auditors, while a lost reputation harms the capacity
extensive international support of the effect of to maintain and attract clients (DeFond, Lim, & Zang,
the audit committee and audit quality on 2016). Companies with superior quality in financial
conservatism accounting. reporting are less prone to the lawsuit. In this vein,
The remainder of this paper is organized as for example, Houston, Peters, and Pratt (1999)
follows. Section 2 presents the theoretical framework document that the existence of accounting choices
and hypotheses development. Section 3 describes produces higher risks of accounting anomalies,
the variables and research methodology. The sample which induces greater lawsuit risk evaluations and
and data collection are presented in Section 4. fee remunerations. Heninger (2001) documents
Section 5 presents the study results and a significant positive association between earnings
the discussion of these results. Lastly, Section 6 management and subsequent auditor litigation.
provides the summary and conclusion. Palmrose, Richardson, and Scholz (2004) found
higher incidence of lawsuits against auditors when
2. THEORETICAL FRAMEWORK AND HYPOTHESES annual restatements occur.
DEVELOPMENT Previous empirical studies propose that
the auditors’ worries over future reputation and
Comparative to the market value of equity, lawsuit costs encourage them to promote further
conservatism leads to an understatement of conservative accounting selections, too (DeFond &
accounting book value due to the underestimation Subramanyam, 1998; DeFond et al., 2012; Kim et al.,
of assets and revenues and/or the overestimation of 2003; Ani & Chong, 2021). Therefore, big audit firms
liabilities and expenses. Conservatism improves would incite additional conservative accounting in
the quality of accounting information since it their clients’ financial statements to decrease
increases the contracting effectiveness of financial the likelihood of audit failure and safeguard their
statements (Watts, 2003). Literature also advocates market reputation. Really, auditors’ negligence to
that conservatism increases financial statement discover accounting anomalies may produce
usefullness by limiting earnings management, significant lawsuit risks and impact their status in
matching the interests of executives and the auditing marketplace. Prior studies suggest that
stockholders, and decreasing the consequences of audit failures result in a diminishing of auditor
information asymmetry (Francis et al., 2013; Goh, reputation, as shown by a decline in client stock price
Lim, Lobo, & Tong, 2017; LaFond & Watts, 2008; (Krishnamurthy, Zhou, & Zhou, 2006; Weber et al.,
Watts, 2003). 2008), a loss in market share (Weber et al., 2008), and
Theoretically, audit quality is the combined lower audit fees (Fan, Li, Nagarajan, & Smith, 2015).
likelihood that the outside auditor identifies Litigation penalties are more likely to happen
material errors in the financial report, and then for overstatement rather than understatement
discloses it to the outside users (DeAngelo, 1981). (Heninger, 2001; Kellogg, 1984; Kim et al., 2003).
An independent audit should give integrity to For example, Kellogg (1984) finds that companies
financial report (Jensen & Meckling, 1976). Auditors and auditors are further expected to be litigated
are considered a central part of the election of for overestimations of assets or profits than for
accounting practices used in compiling annual underestimations. Heninger (2001) finds a significant
accounts. Extant literature suggests that auditing positive relation between income-increasing abnormal
decreases information asymmetry among executives accruals and subsequent auditor lawsuits. Thus,
and the market, offering additional integrity to litigation risk is a motivation that is probable to
the company’s financial reporting (Becker et al., 1998) prompt auditors to favour accounting choices that
and thus is an important monitoring mechanism diminish earnings. Companies with great litigation
expended by companies to decrease agency costs are probable to be the most conservative. DeFond
(Jensen & Meckling, 1976; Watts & Zimmerman, and Subramanyam (1998) find that the firms with
1983). The fundamental purposes of the audit the highest litigation risk are additionally inclined to
committee are to supervise the financial reporting report higher magnitudes of negative discretionary
procedure and to monitor the executive’s tendencies accruals. This is consistent with litigation risk
to influence earnings. The key function of outside inducing auditors to made more conservative
auditors is to give a judgement on whether accounting options. Therefore, imposing additional
an entity’s financial reporting is free of substantial conservative accounting selections decreases the risk
misstatements. In comparison with small auditors, of audit negligence because auditors are more
high-quality auditors (big audit firms) are more probably to be involved in litigations for accounting
probable to discover dubious accounting choices. judgement that exaggerates earnings.
Therefore, audit committees and external auditors Conservative financial reporting decreases
play to determine the reliability and consistency of the propensity for overstatements by alleviating
the related earnings. aggressive accounting choices (Khan & Watts, 2009;
The audit reporting literature points out that Watts, 2003). Consequently, conservatism is expected
reputation risk and lawsuit risk are two principal to decrease litigation risk since auditors are
factors that stimulate auditors to offer high-quality principally sued for permitting overstatements or
auditing (Francis & Wang, 2008; DeFond et al., 2012). when clients announce bankruptcy. Conservative
Auditors risk to damage their reputation when audit firms are less probably to employ earnings
market participants identify that they have permitted management (Goa, 2013; Khalifa & Othman, 2015).
misrepresenting (Weber et al., 2008). Previous studies In this vein, Donelson, McInnis, Mergenthaler, and
document that restatements damage auditors’ Yu (2012) find that previous disclosure of bad
names by prompting auditor dismissals (Hennes earnings news decreases the possibility of litigation.
et al., 2014). Lawsuit imposes financial penalties on Biddle, Ma, and Song (2020) demonstrate that

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 Journal of Governance and Regulation / Volume 11, Issue 3, 2022

conservatism alleviates bankruptcy risk by limiting In Portugal, the Securities Market Supervisory
earnings management. DeFond et al. (2012, 2016) Authority (Comissão de Mercado de Valores
document that client conservatism is related to Mobiliários, henceforth “CMVM”), suggests that
fewer litigations against auditors. Consequently, the board of directors should establish internal
auditors are probably to have regular propensities audit committees with the authority to evaluate
towards accounting conservatism. the corporate structure and its governance. Hence,
Accounting conservatism decreases executives’ audit committees are not mandatory but only
propensity to misrepresent (LaFond & Watts, 2008; recommended by CMVM’s regulation. This permits
Watts, 2003); thus, decreasing the likelihood that listed companies’ significant freedom whether to
auditors will neglect to avoid misrepresenting, which implicate directors in the audit process.
negatively impacts the auditor’s capacity to attract Extant literature advocates that the presence of
and preserve clients (Hennes et al., 2014; Weber an audit committee (Baioco & de Almeida, 2017;
et al., 2008). DeFond et al. (2012, 2016) report Dechow, Sloan, & Sweeney, 1996) and audit committee
that conservative audit clients are less probably characteristics (expertise, independence, and size)
to disclose accounting restatements. Consequently, (Lin, Li, & Yang, 2006; Sultana & Zahn, 2015; Zalata
accounting conservatism supports the supervision et al., 2018), are related with more reliable financial
of the managerial decision-making procedure and reporting.
supports outside auditors in formulating informed Audit committees have motivations to limit
decisions around the clearness and authenticity of opportunistic financial reporting by reason of
a firm’s financial reporting practices. professional penalties and adverse advertising when
As a result, auditors may impose more financial reporting problems happen. Therefore, if
conservative accounting practices on their clients conservative accounting facilitates monitoring of
aiming to avoid or reduce their risk exposure managerial behaviour, the financial reporting
(litigation risk and reputation risk). For instance, process, and the auditing process, it is likely that
Basu, Hwang, and Jan (2002), Chung et al. (2003), firms with audit committees normally request more
and Iatridis (2012) find evidence that firms audited conservative accounting reporting. In addition,
by a Big 4 auditor display more conservatism. Krishnan and Visvanathan (2008) point out that
Fafatas (2010) finds that Big 4 auditors involved in litigation risk also rises the incentive for audit
audit omission incidents occurring in the post-Enron committee members to stimulate conservatism. Piot
and Sarbanes-Oxley period impose additional and Janin (2007) find that audit committees are
conservative accounting in the year subsequent to related to a high earnings conservatism. Krishnan
the incident. DeFond et al. (2012) document that and Visvanathan (2008) document that the level of
auditors’ lawsuit risk is lower in more conservative accounting knowledge on audit committees is
clients. Liu and Elayan (2015) find a negative positively associated with accounting conservatism.
association between higher conservatism and lower Ahmed and Henry (2012) and Wistawan et al. (2015)
litigation risk. Hence, auditors may have an impact document that the presence of an audit committee is
on the financial reporting quality of their clients in associated with greater conservatism. Sultana (2015),
answer to litigation distresses and public scrutiny. Sultana and Van der Zahn (2015), and Yunos, Ahmad,
Portugal is a code-law country with low and Sulaiman (2014) find that audit committee
investor protection, and investors are minus capable financial know-how is positively related to
to litigate auditors for failure or misbehaviour. conservatism. Sultana (2015) and Yunos et al. (2014)
Thus, it is possible that the audit committee and find that audit committee meeting frequency is
external audit (big audit firm) would have little positively related to conservatism. Olyhoek (2017)
incentive to provide higher quality audits. For finds that audit committee financial knowledge and
example, Liu and Elayan (2015) find that Big 4 audit committee age are positively associated with
auditors request more timely loss recognition only conservatism.
when confronted with raised ex-ante litigation risk. As mentioned before, the CMVM’s guideline
However, auditors with a higher reputation may suggests that the board of directors should have
have a motivation to report further conservatively, internal audit committees. Hence, our first hypothesis
aiming to reduce adverse reputational effects is the following:
from supervisory inspection or to avoid their H1: The presence of an audit committee is
personal potential lawsuit expenses. In addition, positively associated with accounting conservatism.
the apprehensions over the maintenance of Previous analyses suggest that big N audit firms
an auditor’s client might influence the auditor’s have superior audit quality than non-Big N auditors
decision mainly when the risk of a lawsuit is small (Francis et al., 1999). In this sense, Becker et al. (1998)
(Gramling, Jenkins, & Taylor, 2010). In this sense, find that Big 6 auditors are of better superiority than
Salehi, Tarighi, and Sahebkar (2018) find that a high non-Big 6 auditors and that greater audit excellence
auditor reputation constrains earnings management. is related to minus “accounting flexibility”. Francis
Overall, this study points out that audit et al. (2013), Krishnan (2003), and Sun and Liu (2011)
committees and big audit firms are more capable observe that big firm auditors limit earnings
to recognise the advantages of conservatism in management.
decreasing agency conflicts and deadweight loss, in Big audit firms are likely to be more conservative
contracting with debtholders and/or shareholders, than non-big audit firms, as their employees have
diminishing the lawsuit risks for administrators, superior knowledge and incur greater risk of
auditors, and executives, and in decreasing the reputational loss. In fact, if big audit firms are more
reputation costs, mainly for auditors. Consequently, concerned about litigation and reputation risk, they
it is expected that audit committees and big audit will be expected to promote more conservatism,
firms favour the adherence to conservative reporting. because conservatism helps to mitigate the risk

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 Journal of Governance and Regulation / Volume 11, Issue 3, 2022

exposure (Cano-Rodríguez, 2010). Big audit firms future assets (Myers, 1977). High-growth firms are
have also great power to influence listed clients to also probably to have more volatile stock returns
implement conservatism. In fact, the loss of a listed because a higher percentage of their market value is
client, through divergence in accounting rules, is associated with risky growth options. Companies
probably to be less expensive for a big audit firm with high volatile stock returns are also more
than for a non-big audit firm. Listed firms are a expected to have very large losses that trigger
prestigious portion of a non-big audit firm’s clientele lawsuits. As a result, high-growth firms tend to have
and so they may be able to consent minus a higher litigation risk (Francis, Philbrick, & Schipper,
conservative accounting in order to preserve the 1994). Executives in high-growth firms are more
audit appointment (Chung et al., 2003). Consistent probably to have opportunistic behavior (Skinner,
with these arguments, Reynolds and Francis (2001) 1993; Watts & Zimmerman, 1986). Further,
find that reputation protection leads to big auditor the encouragement to exaggerate earnings is highest
reporting conservatism. Basu, Hwang, and Jan for high-growth clients because these companies are
(2001), Cano-Rodríguez (2010), Chung et al. (2003), most extremely penalised by investors for omitted
Francis and Krishnan (1999), Francis and Wang earnings forecasts. Dechow et al. (1996) document
(2008), Gor, Karakvs, and Tasar (2017), Hamdan, that companies with growth opportunities are
Kukrija, Awwad, and Dergham (2012), associated with the occurrence of accounting choices
Kim et al. (2003), and Souza, Paulo, Roberto, that do not follow US GAAP. High-growth firms
Cavalcante, and Paulo (2013) find that big audit are more expected to participate in earnings
clients exhibit more accounting conservatism than management, which will additionally intensify
non-big audit clients. the condition of inferior observability in the growth
Therefore, to safeguard their status and to of firms (Chen, Elder, & Hung, 2010; Zalata et al.,
prevent legal responsibility, the big firm auditors 2018). Furthermore, discretionary accruals intensify
will be more conservative and will limit clients from the audit risk since they are intrinsically harder to
employing discretionary accruals. Furthermore, audit.
a Big 4 auditor will be encouraged to stimulate Collectively, research suggests that high-growth
conservative accounting as the implementation of clients face greater risk environments, which affect
“conservative” accounting choices is less expected to auditor engagement risk. Higher audit quality is
draw censure from investors and regulators compared related to more useful and predictable earnings
to aggressive accounting practices. Therefore, our (DeFond, Erkens, & Zhang, 2017), therefore, clients
next hypothesis is: with high-growth pose superior reputation risk to
H2: Portuguese companies audited by Big 4 their auditors, leading the auditor to demand more
audit firms use more accounting conservatism than conservative accounting in the high-growth clients’
firms audited by non-Big 4 auditors. financial statements. Moreover, even if litigation risk
Prior research has considered audit committees is estimated to be lower in Portuguese listed
and external auditors as independent supervising firms, auditors can also try to alleviate this risk
instruments as they report to conservatism by promoting more conservatism, mainly in high-
accounting (Ahmed & Henry, 2012; Mohammed, growth clients for which the risk of a lawsuit or
Ahmed, & Ji, 2017). Nonetheless, both supervising public involvement is superior.
devices are a part of the complete corporate Therefore, audit committees and Big 4 auditors
governance organisation of the company; accordingly, will require higher conservatism on the financial
it is improbable that they work individually inside statements of high-growth clients in response to
the corporate structure. higher risk.
The audit committee is a vital function as H4a: High growth moderates the association
a supervising mechanism to assess the internal and between audit committee existence and accounting
external auditors’ work. External auditors play a vital conservatism.
function to guarantee the excellence of financial H4b: High growth moderates the association
reporting, decrease agency costs resulting from among Big 4 audit firms and accounting conservatism.
executives’ devious conduct, and diminish asymmetric
information between companies and stakeholders 3. RESEARCH METHODOLOGY
(Francis & Wang, 2008; Iatridis, 2012). Thus,
the audit committee and external auditor have 3.1. Variables measurement
the motivation to produce high-quality statements.
Furthermore, the audit committee and external Audit committee existence (Audit) is computed as
auditor are also likely to implement high-quality a binary variable coded 1 if the firm has an audit
audit procedures in order to preserve status, audit committee and 0 otherwise.
market, and prevent legal responsibility. External audit (Big4), coherent with previous
By working closely together, the audit committee studies (Basu et al., 2001; Cano-Rodríguez, 2010;
and external auditor can preserve and promote Chung et al., 2003), was calculated as an indicator
financial reporting quality. Thus, our third variable taking the value 1 if the auditor is a Big 4
hypothesis is: audit firm (Deloitte Touche Tohmatsu, Ernst &
H3: Audit committee existence and Big 4 audit Young, KPMG, PricewaterhouseCoopers), and 0
firms together inside the company have otherwise.
a supplementary impact on the degree of accounting Growth opportunities (Growth), are quantified
conservatism. as the market-to-book ratio.
High-growth firms are by essence harder For accounting conservatism (CONS_ACC), like
to supervise due to the presence of discretionary previous research, is used an accruals-based proxy
investments and measurement difficulties related to (Ahmed & Henry, 2012; Givoly & Hayn, 2000;

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 Journal of Governance and Regulation / Volume 11, Issue 3, 2022

Kim et al., 2013). The CONS_ACC is income from 3.2. The empirical equations and control variables
operations plus depreciation less cash flows from
operations deflated by average total assets, multiplied To assess the impact of audit committee existence
by a negative one. Positive values of CONS_ACC and external audit on conservatism accounting, we
designate higher conservatism. estimate the following regression:

𝐶𝑂𝑁𝑆_𝐴𝐶𝐶𝑖𝑡 = 0 + 1 𝐴𝑢𝑑𝑖𝑡𝑖𝑡 + 2 𝐵𝑖𝑔4𝑖𝑡 + 3−5 𝐶𝑜𝑛𝑡𝑟𝑜𝑙 + 𝜀𝑖𝑡 (1)

We analyse the combined effect of the audit conservatism by estimating the following
committee and external auditors on earnings regression:

𝐶𝑂𝑁𝑆_𝐴𝐶𝐶𝑖𝑡 = 0 + 1 𝐴𝑢𝑑𝑖𝑡𝑖𝑡 +  2 𝐵𝑖𝑔4𝑖𝑡 + 3 𝐴𝑢𝑑𝑖𝑡𝑖𝑡 ∗ 𝐵𝑖𝑔4𝑖𝑡 + 4−6 𝐶𝑜𝑛𝑡𝑟𝑜𝑙 + 𝜀𝑖𝑡 (2)

To test the potential moderating effect of conservatism, audit committee and Big audit firms,
company’s rate of growth on the association among we estimate the next regression:

𝐶𝑂𝑁𝑆_𝐴𝐶𝐶𝑖𝑡 = 0 + 1𝐴𝑢𝑑𝑖𝑡𝑖𝑡 +  2𝐵𝑖𝑔4𝑖𝑡 +  3𝐺𝑟𝑜𝑤𝑡ℎ𝑖𝑡 + 4𝐴𝑢𝑑𝑖𝑡𝑖𝑡 ∗ 𝐺𝑟𝑜𝑤𝑡ℎ𝑖𝑡 + 5𝐵𝑖𝑔4 ∗ 𝐺𝑟𝑜𝑤𝑡ℎ𝑖𝑡 +

(3)
6−8 𝐶𝑜𝑛𝑡𝑟𝑜𝑙 + 𝜀𝑖𝑡

where, measured as the natural logarithm of the market

CONS_ACCit = is the accruals-based measure of value of equity. Watts and Zimmerman (1986) claim
conservatism, defined as the income from operations that larger firms use more conservative accounting
plus depreciation less cash flows from operations because compared with small firms, they have more
deflated by average total assets, multiplied by political costs due to greater analyst following and
a negative one for firm i for period t. investor inspection. Sun and Lin (2011) document
Auditit = dummy variable: 1 if the firm has an audit a positive relationship between large firms and
committee and 0 otherwise. accounting conservatism.
Big4it = dummy variable: 1 if the auditor is a Big 4
and 0 otherwise. 4. SAMPLE AND DATA COLLECTION
Growthit = is the market-to-book ratio.
Controlit = defined below. Our sample comprises all listed firms in Euronext
εit = residual term of firm i for period t. Lisbon for the period 2005–2017 (642 firm-year
0 is a constant,  1 to 8 are the coefficients. observations in total). Foreign firms (53 in total) and
We also introduced some control variables to football club companies (37 in total) are eliminated.
consider the effect of the other elements that can Consequently, we get an unbalanced panel of
determine executives’ accounting alternatives. We 552 firm-year observations over the 2005 to 2017
control for the impact of board composition (BComp) period.
on conservatism, measured as the number of Information on depreciations, income operations,
non-executive directors divided by the total number operational cash flows, total assets, total equity,
of board members. Literature indicates that audit committee, audit quality (Big 4 audit firm or
conservatism is positively related to non-executive non-Big 4 audit firm), market-to-book ratio,
directors (Mohammed et al., 2017). We control for board composition, and leverage are obtained from
Leverage measured as the ratio between the book the Annual Report (CMVM, 2022a) and Corporate
value of all liabilities and the total assets. Watts Governance Report (CMVM, 2022b). The information
(2003) claims that conservatism is a significant to measure the variable firm size (Size), is collected
characteristic of financial reporting in safeguarding from Euronext Lisbon.
effective contracting among stockholders and Table 1 exhibits the variables’ descriptive
lenders. Ahmed and Henry (2012) and Chen et al. analysis. Table 2 presents the Spearman correlations
(2010) verify a positive association between leverage among the explanatory variables.
and conservative reporting. We also control for Size

Table 1. Variable descriptive analysis

Variable Mean Median Min. Max.

CONS_ACC 0.083 0.064 -0.662 0.980
Audit 0.375 1.000 0.000 1.000
Big4 0.709 1.000 0.000 1.000
Growth 1.575 1.008 -37.710 27.678
BComp 0.421 0.464 0.000 0.888
Leverage 0.789 0.769 0.072 4.523
Size 19.069 18.854 11.918 23.517
Note: Number of observations: 552; Period: 2005–2017. CONS_ACC denotes the income from operations plus depreciation less cash
flows from operations deflated by average total assets, multiplied by negative one; Audit binary variable coded 1 if the firm has
an audit committee and 0 otherwise; Big4 dummy variable, which takes a value 1 if the auditor is a Big 4 and 0 otherwise; Growth is
the market-to-book ratio; BComp is the number of non-executive directors divided by the total number of board members; Leverage
represents the ratio between the book value of all liabilities and the total assets; Size represents the firm’s size.

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 Journal of Governance and Regulation / Volume 11, Issue 3, 2022

Table 2. Spearman correlation coefficients matrix

Variable CONS_ACC Growth BComp Leverage Size

CONS_ACC 1
Growth -0.136** 1
BComp 0.262** 0.165** 1
Leverage 0.115* 0.689** -0.060 1
Size 0.613** 0.183** 0.324** -0.155** 1
Note: CONS_ACC represents the income operations plus depreciation less cash flows from operations deflated by average total assets,
multiplied by negative one; Growth is the market-to-book ratio; BComp is the number of non-executive directors divided by the total
number of board members; Leverage represents the ratio between the book value of all liabilities and the total assets; Size represents
the firm’s size. *** Correlation is significant at the 0.01 level (2-tailed); ** Correlation is significant at the 0.05 level (2-tailed).

Table 1 displays that the variable CONS_ACC with BComp, Leverage, and Size. CONS_ACC has a
has a mean (median) of 0.083 (0.064), with significant positive correlation with BComp,
a minimum of -0.662 and a maximum of 0.980. Leverage, and Size. Size is positively correlated with
This indicates that there is a variation between BComp, suggesting that large firms have a higher
companies in applying conservatism policies. number of non-executive directors on the board. Size
On average, about 37.5% of Portuguese firms signal is negatively associated with Leverage. The
the existence of an audit committee (Audit). About correlation coefficients suggest the non-existence of
70.9% of the firms in Portugal over the observed severe statistical issues associated with
period are audited by the Big 4 auditors. The mean multicollinearity (Tabachnick & Fidell, 2001).
(median) Growth is 1.575 (1.008), with a minimum
of -37.71 and a maximum of 27.678. The board 5. MULTIVARIATE REGRESSION RESULTS AND
composition (BComp) exhibits a mean of 0.421, DISCUSSION
which signals that about 42.1% of the firms have
a board filled with members of the board who are
We use the Breusch-Pagan test to compare
non-executive directors. The minimum (0.0%) and
the outcomes of the pooled OLS model to those
the maximum (88.8%) of the board composition
of the random-effects model. This test reveals that
(BComp) suggest that there is a great variance
the random-effects model is better than the pooled
through distinctive firms for this variable. Leverage
regression model. We also use the F-test, which
variable has a mean of 0.789 of the total assets of
reveals that the fixed-effects model is also superior
the firm. The mean firm size (Size) shows EUR 985
to the pooled regression. Finally, we used
million with a minimum of EUR 150 thousand and
a maximum of EUR 16.345 million. the Hausman specification test to compare random-
Table 2 details the Spearman correlations and fixed-effects models. The test suggests that
among the variables used in this study. The binary the fixed-effects model is proper. Accordingly, this
variables (Audit and Big4) are not contained in study selects the fixed-effects model as the best-fit
Table 2, because the Spearman correlation coefficient regression model to determine an association among
is not calculated for binary variables. Growth is the variables.
negatively related to CONS_ACC, implying that Table 3 reports fixed-effects regression estimates
high-growth companies have less conservatism. for the equations established in Section 3.
On the other hand, Growth is positively correlated

Table 3. Fixed-effects regressions results

Dependent variable CONS_ACC

Independent variables (1) (2) (3) (4) (5) (6) (7)
Constant 0.059 -0.056 -0.122 -0.070 -0.006 -0.014 -0.008
Audit 0.010 0.014 0.093 0.056 0.063 0.031 0.012
Big4 0.026* 0.101** 0.232*** 0.112** 0.199*** 0.086* 0.054*
Audit * Big4 0.251*** 0.161***
Growth -0.054** -0.063** -0.079**
Audit * Growth 0.081* 0.108**
Big4 * Growth 0.236*** 0.248***
BComp 0.099*** 0.147*** 0.194***
Leverage 0.076*** 0.154*** 0.201***
Size 0.087*** 0.097*** 0.1230**
R-squared 10.70% 30.77% 15.35% 33.78% 18.13% 20.67% 38.09%
Adjusted R-squared 7.12% 21.60% 9.88% 22.04% 10.89% 15.00% 26.3%
F-statistic 8.252*** 21.168*** 8.546*** 22.436*** 10.594*** 11.807*** 25.927***
Note: Number of observations: 552; Period: 2005–2017. CONS_ACC represents the income operations plus depreciation less cash flows
from operations deflated by average total assets, multiplied by negative one; Audit dummy variable which takes a value 1 if the firm
has an audit committee and 0 otherwise; Big4 dummy variable which takes a value 1 if the auditor is a Big 4 and 0 otherwise;
Audit * Big4 represents the interaction between the audit committee and Big4; Growth is the market-to-book ratio; Audit * Growth
represents the interaction between the audit committee and Growth. Big4 * Growth represents the interaction between Big4 and
Growth. BComp represents the ratio between the number of non-executive directors and the total number of board members; Leverage
represents the ratio between the book value of all liabilities and the total assets; Size represents the firm’s size. *** Significant at
the 1% level; ** Significant at the 5% level; * Significant at the 10% level.

Table 3 presents the results from equations (1), conservatism, as well as the potential moderating
(2), and (3) which examine the effects of audit effect of company’s rate of growth on the association
committee existence, external audit, and the among conservatism, audit committee and big audit
interaction among these variables on accounting firms. Columns (1) and (2) present the results from

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 Journal of Governance and Regulation / Volume 11, Issue 3, 2022

equation (1) without and with the control variables, quality audits. For the Big 4 audit firms, the status in
respectively. Columns (3) and (4) show the results auditing financial reports is a significant qualified
from equation (2) without and with the control asset in preserving present clients and attracting
variables, respectively. Column (5) presents new audit clients. Additionally, for these big audit
the results from equation (3) without interactions companies reputation is a essential asset that may
between Audit and Growth and Big4 and Growth. assist to create “market permissions” for new
Columns (6) and (7) present the results from non-audit services. Therefore, reputation concerns
equation (3) without and with the control variables, could postulate enough motivation for Big 4
respectively. auditors to require greater excellence audits in
We document a positive relationship, but not settings with less litigation risk coherent with their
statistically significant between audit committee brand name reputation.
existence and conservatism accounting. Some
possible explanations for this result may be: 6. CONCLUSION
1) the company’s audit committee is ineffective,
because the members may have multiple non- Conservatism is considered a successful governance
executive directorships or because they have device in decreasing agency costs and litigation risk.
absence or low levels of knowledge to analyse Thus, it is predictable that an efficient audit
whether the accounting judgments made by committee and a high-audit quality will contemplate
the executive are adequate; 2) a high-quality audit conservatism as an appropriate attribute of financial
committee may be contingent on other corporate reporting and will encourage more conservative
governance features, and 3) the lack of “roles” accounting.
that can increase audit committee effectiveness. Using a sample of non-financial listed
Empirical studies suggest that audit committee Portuguese firms-year from 2005 to 2017, this study
independence (Marzuki, Wahab, & Haron, 2016), analyses the effect of audit committee existence and
audit committee expertise (Krishnan & Visvanathan, external auditor on conservatism accounting.
2008; Marzuki et al., 2016) and audit committee Furthermore, as the external auditor is chosen by
meetings (Yunos et al., 2014) have a significant role and reports to the audit committee, it is expected
in demanding conservatism accounting. that these two devices work together to demand
We document a positive significant association accounting conservatism. Further, it is also studied
between Big 4 and conservatism accounting. As in the potential moderating effect of a company’s rate
Basu et al. (2001), Cano-Rodríguez (2010), Chung of growth on the association among conservatism,
et al. (2003), Francis and Wang (2008), Hamdan et al. audit committee, and big audit firms. Our findings
(2012), Gor et al. (2017), and Kim et al. (2003), this indicate that the audit committee’s existence
result indicates that companies audited by Big 4 per se has no impact on conservatism. Therefore,
audit firms present more conservative accounting the Portuguese regulator (CMVM) should emphasise
than firms audited by non-Big 4 audit firms. questions associated with enhancing the supervisory
The relationship between the interaction effectiveness of audit committees. We find that
variable and the conservatism accounting is companies audited by Big 4 audit firms present
positively significant. Thus, the result indicates that more conservative accounting than firms audited by
audit committee existence and external audit (Big 4 non-Big 4 audit firms.
audit firm) together seem to increase the degree of Our results suggest that audit committee
conservatism accounting. existence and external audit (Big 4 audit firm)
We find a positive relationship between Growth together seem to increase the degree of conservatism
and conservatism accounting, which indicates that accounting. Thus, firms audited by Big 4 auditors
high-growth companies are less conservative in with a separate board audit committee display high
accounting choices. This result is consistent with conservatism accounting. Additionally, we document
the argument that high-growth companies are that the increase in conservatism accounting for
related to greater insecurity that, in turn, causes firms audited by Big 4 auditors is magnified for
supervising executive actions more problematic. high-growth firms. In other words, this finding
Consequently, executives in high-growth firms are suggests that executives of companies with great
more expected to have opportunistic comportment investment opportunities are more probably to
(Skinner, 1993; Watts & Zimmerman, 1986). employ discretionary accruals (less conservatism).
With respect to the impact of Growth on However, they are less prone to do so when their
the association between the audit committee and firms have enhanced audit monitoring. This result
conservatism and between Big4 and conservatism, should be interpreted cautiously as there exists
the coefficients on Audit * Growth and Big4 * Growth alternative justification for the relationship.
are positive and significant. These findings suggest The alternative explanation for our results is that
that the level of conservatism reduction associated companies with high growth are more probably
with more growth is attenuated when the firms are to appoint Big 4 auditors to signal conservative
audited by a Big 4 auditor and the board of directors accounting than firms with low growth.
has an audit committee. Thus, this result indicates Moreover, the results also reveal higher
that audit committees and Big 4 auditors enforce conservatism accounting when the percentage of
superior conservatism on the financial reporting of non-executive directors, leverage, and firm size
high-growth clients in answer to higher risk. is high.
Overall, our findings show that even in The results of this analysis generate the next
an institutional setting with low litigation risk, contributions. First, the findings seem to indicate
which is presumably to remove the deep pockets that audit committee existence does not affect
motivation for investors, such as Portugal, Big 4 the level of accounting conservatism in Portuguese
audit firms would have an incentive to offer greater listed firms. Second, our findings also suggest that

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 Journal of Governance and Regulation / Volume 11, Issue 3, 2022

Big 4 auditors promote conservative accounting. Portugal and the European Union as well as to
This result is in line with previous evidence showing stakeholders interested in audit committees and
that Big 4 auditors enhance conservatism. However, Big 4 auditors’ effectiveness on earnings quality.
using a sample of firms from a code law country Lastly, audit companies can find these outcomes
(Portugal) extends that evidence to a context in beneficial if they desire to increase audit quality and
which the reduced litigation risk faced by auditors preserve a positive reputation, too.
does not provide an incentive to preserve their This paper has some limitations. First, we use
independence. Third, this study also suggests that an accruals-based proxy to quantify accounting
the audit committee interacted with Big 4 auditors conservatism. The perception essential to this
to increase the degree of conservatism accounting. measure is that conservative accounting results
Thus, audit committee existence and external audit in recurrent negative accruals. However, negative
together appear to improve earnings quality. Fourth, accruals may result from income decreasing
high-growth firms are more probably to have less earnings management (e.g., decreasing stock price in
conservatism. Nevertheless, this association is an attempt to gain economic benefits). In addition,
weaker when they are audited by Big 4 auditors. this study also assumes that there is a divergence
Therefore, the engagement of higher quality auditors of reporting incentives between auditors and
is favourable to users of financial statements of executives. However, as pointed out by Kim et al.
firms with high growth. Therefore, our outcomes (2003) “when both managers and auditors have
indicate that high-quality auditors are more incentives to prefer income-decreasing accrual
expected to keep their reputation capital in choices … no conflict of reporting incentives exists
circumstances where the threat to auditor between the two parties” (p. 323).
independence is higher. Fifth, the findings are Future studies can examine the effects of other
significant for nations with an institutional proxies to measure accounting conservatism. This
background comparable to that of Portugal. Sixth, analysis may be also extended to other countries.
our findings are also important to regulators in

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