Audit Quality and Audit Firm Size: Revisited by Dan A. Simunic

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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 failure reduced the Big firms to only four – while the empirical evidence on audit quality differentiation largely comes from the 1980’s and 90’s (Big 8 and Big 6 eras). Do four firms behave differently from eight or six firms?

* “Theory” underlying the “quality differentiation hypothesis” in auditing is sketchy and, in parts, controversial.

* There is no direct evidence – based on studies of audit production - of Big firm vs. non-Big firm quality differences. How (if at all) do Big firm audit processes differ from those of non-Big firms?

* Big firm audits may not be of higher quality in all contexts (e.g. when litigation risk is low). What does this imply?

* Is there audit quality differentiation in countries where the Big 4 are not major players? In such countries, is audit firm size a good proxy for audit quality?

* The audit quality ranking of Big > non-Big firms has always been controversial to (rejected by) most practitioners.

Therefore:

Given the recent problems and changes in the profession, and the many unanswered questions, revisiting this issue seems worthwhile!

Revisit and Critique of “Theory” – D&S

1.In two conference papers (UCLA and University of Illinois) presented in 1980, Dopuch & Simunic (D&S) argued that audit quality was associated with audit firm reputations or brand names. Why?

* audit is purchased by management to influence the decisions of financial statement users, but the audit process is not visible to external users

* at a given time and in a given place, an audit firm has a single brand name

* therefore audits by a firm (at a time, in a place) would be of constant quality, plus (probably) random noise:

>no incentive for client to purchase or auditor to deliver higher quality

>protection of reputation provides incentive for auditor to deliver expected quality 2.Empirical evidence (at the time) that audit quality was...
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