Audit Quality and Audit Firm Size: Revisited by Dan A. Simunic
Audit Quality and Audit Firm Size: Revisited
by
Dan A. Simunic
The University of British Columbia
December, 2003
Background:
1. Audit quality is an important element of corporate governance – although it’s unclear whether audit quality and other aspects of corporate governance (e.g. director knowledge and independence) are fundamentally complements or substitutes.
2. Notion that audit quality varies systematically across classes of audit firms (now Big 4 vs. non-Big 4) has been a very productive research hypothesis since early 1980’s:
* audit quality = level of assurance (probability that financial statements are fairly stated when an unqualified opinion is given)
* “product differentiation hypothesis” in auditing traces back to work of Dopuch & Simunic (“Competition in Auditing: An Assessment”, 1980 U of Illinois Auditing Research Symposium) and DeAngelo (“Auditor Size & Audit Quality”, JAE, 1981)
3. Much empirical evidence that Big 4(6)(8) average audit quality > non-Big 4(6)(8) average audit quality:
* Big firms’ audit fees are higher (about 30%?) than non-Big firms’ fees.
* Big firms’ litigation rates are lower (at least in the U.S.) than non-Big firms’ rates (3% vs. 5%?).
* The stock market reacts more strongly (higher earnings response coefficient) to positive unexpected company earnings that are audited by a Big firm rather than by a non-Big firm. * Companies making initial public offerings of shares experience less underpricing when a Big firm rather than a non-Big firm is associated with the IPO. * Income increasing discretionary accruals of Big firm clients are lower (about 2% of assets?) than for clients of non-Big firms.
Why Revisit the Issue?
* Profession’s recent problems (e.g. Enron, Worldcom, Arthur Andersen’s failure, etc.) have largely involved the Big firms – not the “lower quality” non-Big firms.
* Firm mergers and AA’s
by
Dan A. Simunic
The University of British Columbia
December, 2003
Background:
1. Audit quality is an important element of corporate governance – although it’s unclear whether audit quality and other aspects of corporate governance (e.g. director knowledge and independence) are fundamentally complements or substitutes.
2. Notion that audit quality varies systematically across classes of audit firms (now Big 4 vs. non-Big 4) has been a very productive research hypothesis since early 1980’s:
* audit quality = level of assurance (probability that financial statements are fairly stated when an unqualified opinion is given)
* “product differentiation hypothesis” in auditing traces back to work of Dopuch & Simunic (“Competition in Auditing: An Assessment”, 1980 U of Illinois Auditing Research Symposium) and DeAngelo (“Auditor Size & Audit Quality”, JAE, 1981)
3. Much empirical evidence that Big 4(6)(8) average audit quality > non-Big 4(6)(8) average audit quality:
* Big firms’ audit fees are higher (about 30%?) than non-Big firms’ fees.
* Big firms’ litigation rates are lower (at least in the U.S.) than non-Big firms’ rates (3% vs. 5%?).
* The stock market reacts more strongly (higher earnings response coefficient) to positive unexpected company earnings that are audited by a Big firm rather than by a non-Big firm. * Companies making initial public offerings of shares experience less underpricing when a Big firm rather than a non-Big firm is associated with the IPO. * Income increasing discretionary accruals of Big firm clients are lower (about 2% of assets?) than for clients of non-Big firms.
Why Revisit the Issue?
* Profession’s recent problems (e.g. Enron, Worldcom, Arthur Andersen’s failure, etc.) have largely involved the Big firms – not the “lower quality” non-Big firms.
* Firm mergers and AA’s