This paper takes a fresh look at auditor independence for small and midsized audit prac-tices (SMPs) by analyzing a German sample of 1,052 firm-year observations between 2007 and 2014 about changes in earnings management (EM) behavior when client importance increases. In particular, we ask whether firms audited by SMPs use higher or lower accrual-based earnings management (AEM) around certain critical client importance thresholds and whether this in-volves a trade-off in real activities earnings management (REM). We compare two measures of client importance, (1) total sales from the client in relation to total sales of the audit firm from all (public interest entity (PIE) and non-PIE) clients and (2) non-audit sales in relation to total sales from the client. For measure (1), we find that clients below the threshold engage in less AEM and more REM as importance increases until reaching a threshold level of importance, at which point the relationship reverses. We do not find significant results for measure (2). Our results hold for de-facto office and partner level analysis, and we provide further reasoning for our re-sults, thereby offering a new perspective on small and midsized auditors’ eligibility to perform PIE audits.
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