In this paper, we investigate whether, and how, audit effectiveness differentiation between Big 6 and non‐Big 6 auditors is influenced by a conflict or convergence of reporting incentives faced by corporate managers and external auditors. In so doing, we incorporate into our analysis the possibility that managers self‐select both external auditors and discretionary accruals, using the two stage “treatment effects” model. Our results show that only when managers have incentives to prefer income‐increasing accrual choices are Big 6 auditors more effective than non‐Big 6 auditors in deterring/monitoring opportunistic earnings management. Contrary to conventional wisdom, we find Big 6 auditors are less effective than non‐Big 6 auditors when both managers and auditors have incentives to prefer income‐decreasing accrual choices and thus no conflict of reporting incentives exists between the two parties. The above findings are robust to different proxies for opportunistic earnings management and different proxies for the direction of earnings management incentives.

Investment institutions with substantial shareholdings in a firm have the resources and incentives to monitor and influence management decisions. Whether the institutions actually monitor and exert pressure on managers is an empirical question. Previous studies have reported mixed results on this question. We examine whether large institutional shareholdings in a firm deter earnings management by its managers when those executives otherwise have incentives to increase or decrease reported profits. Using discretionary accounting accruals as the measure of earnings management, we find that the presence of large institutional shareholdings inhibit managers from increasing or decreasing reported profits towards the managers' desired level or range of profits. The evidence is consistent with institutional investors monitoring and constraining the self-serving behavior of corporate managers.