Guardians or Bystanders? Auditors’ Role in Curbing Earnings Management during Financial Distress in Indonesia

Introduction/Main Objectives: This study aims to investigate the role of auditors in mitigating earnings management when firms experience financial distress, focusing on the effectiveness of Big 4 auditors in maintaining reporting quality in Indonesia. Background Problems: Firms under financial distress often manipulate earnings to preserve legitimacy and maintain investor confidence. In emerging markets such as Indonesia, weak institutional enforcement and client pressures raise questions about whether auditors can effectively constrain such opportunistic behavior. Novelty: By applying prospect theory to explain managerial risk-taking under financial distress and role theory to examine how structural capacity influences auditors’ monitoring effectiveness, the study provides new insights into the conditional effectiveness of Big 4 auditors in an emerging market setting. Research Methods: The study uses 5,008 firm-year observations of non-financial companies listed on the Indonesia Stock Exchange (IDX) from 2010 to 2024. Earnings management is measured using the modified Jones model (Kothari et al., 2005), financial distress is proxied by Altman’s Z-score, and auditor quality is captured with a Big 4 dummy. Robustness tests and additional analyses are employed for validation. Findings/Results: Results show financial distress is positively associated with earnings management, consistent with prospect theory. Big 4 auditors are associated with lower levels of earnings management overall, but their moderating effect under distress is not significant. Additional analyses reveal that Big 4 auditors are more effective in reinforcing reporting discipline across broader financial conditions than in severe distress scenarios. Conclusion: Auditor effectiveness in Indonesia is highly contextual. While Big 4 auditors improve reporting quality in general, their ability to curb opportunistic behavior in distressed firms remains limited under a weak institutional environment. This study contributes to the accounting literature by extending prospect and role theory applications in auditing, and offers policy implications for strengthening auditor capacity and institutional enforcement in emerging markets.