Collateral damage: real earnings management under expanded auditor liability ^*

This study investigates how expanded auditor liability affects corporate earnings management. Following pivotal U.S. court rulings, increased litigation risk makes auditors more conservative toward accrual-based earnings management (AEM), prompting firms to shift toward real earnings management (REM). This shift has downstream effects on both the audit market and firm value. Specifically, it realigns the audit market: risk-averse, non-Big N auditors drop risky clients, who then migrate to Big N auditors better equipped to handle legal exposure. While REM helps companies meet earnings targets, it depresses Tobin’s Q and stock returns. Consequently, by prompting value-destroying REM, expanded auditor liability harms shareholders.