What do we know about audit quality?*
Jere R. Francis*
University of Missouri—Columbia, 432 Cornell Hall, Columbia, MO 65211, USA University of Melbourne, Victoria, Australia
Abstract This paper reviews empirical research over the past 25 years, mainly from the United States, in order to assess what we currently know about audit quality with respect to publicly listed companies. The evidence indicates that outright audit failure rates are infrequent, far less than 1% annually, and audit fees are quite small, less than 0.1% of aggregate client sales. This suggests there may be an acceptable level of audit quality at a relatively low cost. There is also evidence of voluntary differential audit quality (above the legal minimum) along a number of dimensions such as ﬁrm size, industry specialization, ofﬁce characteristics, and cross-country differences in legal systems and auditor liability exposure. The evidence is very positive although there is some indication that audit quality may have declined in the 1990s, in which case there could be merit in recent reforms such as the Sarbanes-Oxley Act of 2002 in the US. However, we do not know from research the optimal level of audit quality and therefore whether we currently have ‘too little’ or ‘too much’ auditing? Despite this lacuna we are entering an era of more mandated auditing in response to high-proﬁle corporate governance failures including the Enron–Andersen affair. Finally, while recent reforms have scaled back the scope of non-audit services due to independence concerns, a case can be made that audit quality will always be somewhat suspect if other services are provided that are perceived to potentially compromise the auditor’s objectivity and skepticism. For this reason public conﬁdence in audit quality may be increased by proscribing all non-audit services for audit clients. Recommendations are also proposed with respect to legal liability reform and changes in partner compensation arrangements. q 2004 Elsevier Ltd. All rights reserved. Keywords: Audit quality; Sarbanes-Oxley Act; Audit failure rates
* I appreciate the helpful comments of an anonymous referee and colleagues at University of Missouri— Columbia and University of Melbourne. The paper is based on the author’s plenary lecture at the 2004 annual meeting of the British Accounting Association, York University. * Tel.: C1 573 882 5156; fax: C1 573 882 2437. E-mail address: firstname.lastname@example.org.
0890-8389/$ - see front matter q 2004 Elsevier Ltd. All rights reserved. doi:10.1016/j.bar.2004.09.003
J.R. Francis / The British Accounting Review 36 (2004) 345–368
This paper reviews research on audit quality from the past 25 years, with a particular focus on empirical research from the United States. In the aftermath of the Enron bankruptcy in 2001 and the related collapse of Arthur Andersen in 2002, it has become fashionable to criticize auditing and to question the quality of audits being performed by accounting ﬁrms, especially the large international Big 4 accounting ﬁrms.1 Indeed this criticism motivated recent regulatory changes in the United States brought about by the Sarbanes-Oxley Act of 2002 (Public Law No. 107-204) in which self-regulation by the accounting profession has been replaced with direct regulation by a new independent agency, the Public Company Accounting Oversight Board. My emphasis is on publicly listed companies because the separation of ownership and management control in listed companies makes the independent external audit especially important with respect to corporate governance and the oversight of such companies. The review is not meant to be comprehensive and encyclopedic but is instead a more selective survey whose purpose is to identify and assess a wide range of evidence on audit quality from academic research. It turns out that we know quite a bit, and despite Enron and other...