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Audit Quality and Audit Firm Size: Revisited by

Dan A. Simunic The University of British Columbia

December, 2003

Background: 1. Au it !uality is an im"ortant element of cor"orate #overnance $ althou#h it%s unclear &hether au it !uality an other as"ects of cor"orate #overnance 'e.#. irector (no&le #e an in e"en ence) are fun amentally complements or substitutes. *otion that au it !uality varies systematically across classes of au it firms 'no& Bi# + vs. non, Bi# +) has been a very "ro uctive research hy"othesis since early 1-.0%s/ au it !uality 0 level of assurance '"robability that financial statements are fairly state &hen an un!ualifie o"inion is #iven) 1"ro uct ifferentiation hy"othesis2 in au itin# traces bac( to &or( of Do"uch 3 Simunic '1Com"etition in Au itin#/ An Assessment2, 1-.0 U of 4llinois Au itin#

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5esearch Sym"osium) an DeAn#elo '1Au itor Si6e 3 Au it 7uality2, JAE, 1-.1) 3. 8uch em"irical evi ence that Bi# +'9)'.) avera#e au it !uality : non,Bi# +'9)'.) avera#e au it !uality/ Bi# firms% au it fees are higher 'about 30;<) than non,Bi# firms% fees. Bi# firms% liti#ation rates are lower 'at least in the U.S.) than non,Bi# firms% rates '3; vs. =;<). The stoc( mar(et reacts more strongly 'hi#her earnin#s res"onse coefficient) to "ositive une>"ecte com"any earnin#s that are au ite by a Bi# firm rather than by a non,Bi# firm. Com"anies ma(in# initial "ublic offerin#s of shares e>"erience less underpricing &hen a Bi# firm rather than a non,Bi# firm is associate &ith the 4?@. 4ncome increasin# iscretionary accruals of Bi# firm clients are lower 'about 2; of assets<) than for clients of non,Bi# firms.

Why Revisit the Issue? ?rofession%s recent "roblems 'e.#. Anron, Borl com, Arthur An ersen%s failure, etc.) have lar#ely involve the Bi# firms $ not the 1lo&er !uality2 non,Bi# firms. Cirm mer#ers an AA%s failure re uce the Bi# firms to only four $ &hile the em"irical evi ence on au it !uality ifferentiation lar#ely comes from the 1-.0%s an -0%s 'Bi# . an Bi# 9 eras). Do four firms behave ifferently from ei#ht or si> firms< 1Theory2 un erlyin# the 1!uality ifferentiation hy"othesis2 in au itin# is s(etchy an , in "arts, controversial. There is no irect evi ence $ base on stu ies of au it "ro uction , of Bi# firm vs. non,Bi# firm

!uality ifferences. Do& 'if at all) o Bi# firm au it "rocesses iffer from those of non,Bi# firms< Bi# firm au its may not be of hi#her !uality in all conte>ts 'e.#. &hen liti#ation ris( is lo&). Bhat oes this im"ly< 4s there au it !uality ifferentiation in countries &here the Bi# + are not maEor "layers< 4n such countries, is au it firm si6e a #oo "ro>y for au it !uality< The au it !uality ran(in# of Bi# : non,Bi# firms has al&ays been controversial to 'reEecte by) most "ractitioners.

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

Revisit and Criti ue o! "#heory$ % &'S 1. 4n t&o conference "a"ers 'UCFA an University of 4llinois) "resente in 1-.0, Do"uch 3 Simunic 'D3S) ar#ue that au it !uality &as associate &ith au it firm reputations or brand names. Bhy< au it is "urchase by mana#ement to influence the ecisions of financial statement users, but the au it "rocess is not visible to e>ternal users at a #iven time an in a #iven "lace, an au it firm has a sin#le bran name therefore au its by a firm 'at a time, in a "lace) &oul be of constant !uality, "lus '"robably) ran om noise/ : no incentive for client to "urchase or au itor to eliver hi#her !uality

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: "rotection of re"utation "rovi es incentive for au itor to eliver e>"ecte !uality Am"irical evi ence 'at the time) that au it !uality &as ifferentiate across firms/ ?rice Baterhouse seemin#ly char#e ifferentially hi#her au it fees 'in 1-G0%s in U.S.) than any other firm. U.S. mar(et for au its of "ublicly hel com"anies '&ith hi#h a#ency costs from se"aration of o&nershi" an mana#ement) &as ominate by Bi# . firms. 'Di#her au it !uality has value in this conte>t.) 4?@ firms a""eare to 1see( out2 Bi# . firms "rior to a share offerin#. 'Di#her au it !uality has value in this conte>t). ?eat 8ar&ic( 8itchell 'no& H?8I) lost si#nificant mar(et share amon# small U.S. @TC "ublic com"anies in 1-G0%s &hen that firm face many la&suits 'e.#. *ational Stu ent 8ar(etin#) an &as the subEect of SAC sanctions. 'Au itor re"utation is li(ely most im"ortant to small com"anies.)

Thus, D ! don"t really provide #theory$, but logical arguments together with empirical observations. Criti ue o! &'S: Ar#ument un erlyin# a constant e>"ecte au it !uality for an au it firm 'in a "lace at a moment in time) is still reasonable, but assumes limite information about an au it. @ther cre ible information about a s"ecific au it available to users, ma(es au itor bran name less im"ortant. e.#. au it fees '&here isclose ) mi#ht also "ro>y for au it !uality. Some em"irical re#ularities su""ortin# the notion of hi#her au it !uality by Bi# firms note by D3S have chan#e or have alternative inter"retations/ : ?B au it fee "remium not subse!uently observe , but most subse!uent stu ies fin evi ence of a Bi# .'9)'+) fee "remium : Bi# firm ominance in au itin# "ublic com"anies has increase , but coul be riven by economiesJefficiencies $ not au it !uality

: Deman for Bi# au itors in 4?@ conte>t is closely lin(e to un er&riter !uality 'Bi# un er&riters insist on use of Bi# au itor) $ not a free client choice. Revisit and Criti ue o! "#heory$ % &eAngelo 1. T&o seminal "a"ers in JAE in 1-.1 'a/ 1Au itor 4n e"en ence, KFo& Ballin# 3 Disclosure 5e#ulation2 an b/ 1Au itor Si6e 3 Au it 7uality2). ?a"er 'a) analy6es multi,"erio 'infinite hori6on) "ricin# un er "erfect com"etition an conclu es that learnin# 3Jor transaction costs of au itor chan#e &ill im"ly a Klo&ball% "rice 'belo& avoi able cost) in first "erio . This creates an economic interest in the client 'value of incumbency) an !uasi,rents '"rice : avoi able costs) in future "erio s. ?a"er 'b) ra&s on results in 'a) combine &ith ar#uments in a classic "a"er by Hlein 3 Feffler 'H3F) 'J%E, 1-.1, 1The 5ole of 8ar(et Corces in Assurin# Contractual ?erformance2). (') *ro+lem $ un er &hat con itions &ill &ealth ma>imi6in# su""liers of a #oo or service be motivate to honor a commitment to su""ly a

2.

3.

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level of "ro uct !uality : some arbitrary minimumL i.e. &hen &oul a "romise to eliver such a hi#h !uality level be self,enforcin#< (') assum*tions: "ro uct !uality cannot be observe or measure com"letely "rior to contractin# buyer 3 seller rely solely on the threat of termination of a business relationshi" for contract enforcement actual !uality elivere by su""lier is 'someho&) iscovere after contract e>ecution if actual !uality M "romise !uality, all consumers learn this an seller loses all future sales 'firm is labele a 1cheater2, no one &ill buy from it so it must sell its assets for salva#e an e>it in ustry) after contractin# to su""ly a !uality level : minimum, su""lier can 1cheat2 an eliver the minimum. Therefore a mar(et for hi#h !uality "ro ucts can only evelo" &hen/

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?resent value 'benefits of cheatin#) M "resent value 'costs of cheatin#) (') argument: e!uilibrium in a mar(et &here both base !uality an hi#her !uality "ro ucts are sol , #iven "revious assum"tions, re!uires that there is a quality assuring price, &hich e>cee s the com"etitive "rice. 4n such a mar(et e!uilibrium, e>cess "rofits are issi"ate because su""liers must "urchase firm,s"ecific assets 'e.#. re"utation) that are non,salva#eable. These assets act as a collateral bon . So lon# as su""liers on%t 1cheat2, they earn !uasi,rents on the firm s"ecific assets sufficient to constitute a normal return. Conversely, a 1cheater2 &ill lose the stream of future !uasi,rents.

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A mar(et for hi#her !uality &ill e>ist if the ?N of !uasi,rents "otentially lost : ?N 'benefits of cheatin#).

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DeAn#elo%s ar#ument in "a"er 'b)/ nature of !uality ifferentiation in au itin# $ ifference in "robability of 1truthful re"ortin#2, #iven tests "erforme . 'Alternative is ifferences in tests "erforme , &hich im"lies ifferences in "robability of etection) non,salva#eable investment in au itin# is the amount of 1lo&ball2 'au it fee minus avoi able cost) in "erio 1 ?N 'benefits of cheatin#) is to retain the !uasi, rent stream from a client &ho &ants an au itor to 1cheat2 an Jor collect a s"ecific bribe from the client ?N 'costs of cheatin#) is the loss of !uasi,rent stream from clients &ho eman 1truthful re"ortin#2 if cheatin# is iscovere 'e.#. throu#h liti#ation)

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4f benefits of cheatin# are constant across au itors, the e& ante "robability of truthful re"ortin# is an increasin# function of the sum of !uasi,rents earne from all clients, &hich is "ositively correlate &ith au it firm si6e. Criti ue o! &eAngelo: Cocus on a##re#ate !uasi,rents associate &ith 1lo&,ballin#2 as the collateral bon that su""orts a !uality assurin# "rice creates a mechanical relationship between audit firm si'e and audit quality( This is not consistent &ith em"irical evi ence that fin s only t&o !uality levels 'Bi# vs. non,Bi# firms) in the mar(et. Bhile "a"er focuses on truthful reporting, it seems that ar#ument can be rea ily e>ten e to inclu e iscovery of material misstatements. DeAn#elo 'a) assumes an infinite hori'on 'no au itor chan#e), but actual client tenures &ith clients have been ecreasin#. Shorter tenure im"lies lo&er a##re#ate !uasi,rents im"lies lo&er au it !uality. 4s this consistent &ith evi ence<

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*o istinction bet&een in ivi ual au it "artners an the au it firm. ?a"er oes not a ress the (ey issue of incentives and controls within audit partnerships 'e.#. ho& o in ivi ual "artners 1tra e off2 the benefits of client loss 3Jor "ersonal bribes a#ainst the loss of !uasi,rents for "artnershi" as a &hole<) Im*lications o! "theory$ revie,: Theoretical un er"innin#s for Bi# firm au it !uality : non,Bi# firm !uality are not stron#. 8ore com"lete an coherent theory of the lin(a#es bet&een au it !uality an au it firms is nee e . 8ost "a"ers seem to loosely combine D3S, H3F, an DeAn#elo ar#uments an assume that Bi# firms have #reater re"utation investments at ris( an Jor face ifferentially #reater "enalties from liti#ation than non,Bi# firms. This motivates a Bi# firm to K&or( har er% than &oul a non,Bi# firm in the same circumstances. )eteris paribus, more effort im"lies hi#her au it !uality. H3F assum"tions su##est that many forces can "ressure the au it !uality of Bi# firms/

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: rela>in# au itor liability 'e.#. 1--= liti#ation reforms in U.S.) can ma(e e& post iscovery of actual au it !uality more ifficult : benefits of cheatin# may increase 'e.#. rents from #ro&in# volume of non,au it services) : cheatin# 'e.#. allo&in# earnin#s mana#ement) may become more valuable to clients 3 users, re ucin# eman for truthful re"ortin# Conclusion ' issues ,arranting !urther research: There is good reason for concern that audit quality of Big firms may become (be) no higher than some minimum (e.g. GAAS audit). 8any issues &arrant further research, inclu in#/ : Differential im"act of Bi# firm au its on ca"ital mar(ets 'e.#. A5C%s an in 4?@ conte>t), #iven the current structure of in ustry 'i.e. Bi# +). : Au it !uality in icators beyon au it firm si6e an Jor firm bran name 'e.#. re"utation in local mar(ets, liti#ation ris( in local mar(ets, au it fee as a "ro>y for au it !uality).
: Differences in au it "ro uction "rocesses of Bi#

firms vs. non,Bi# firms '&ithout irect evi ence,

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&e cannot istin#uish bet&een "erceive an actual au it !uality ifferences).

: *ature an effects of incentives an controls

&ithin au it "artnershi"s.

-vidence on di!!erences +et,een *roduction *rocesses o! Big vs. non/Big !irms: T&o recent "a"ers by Blo( iE(, Drieenhui6en, Simunic 3 Stein 'BDSS), 1Determinants of the 8i> of Au it ?roce ures/ Hey Cactors that Cause Au itors to Chan#e &hat They Do2 an by SSDB, 1The Afficiency of Au it ?ro uction of ?ublic Accountin# Cirms2. Data come from 113 au its of Dutch com"anies in manufacturin#, merchan isin#, an non, financial services, "erforme in 1--.,--.

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9G au its "erforme by Bi# = firms '3 by AAL = by D3TL 32 by A3OL 3 by H?8IL 2+ by ?BC). +9 au its "erforme by ei#ht ifferent non,Bi# = Dutch au it firms.

(ey !indings related to Big 0 vs. non/Big 0: After controllin# for client characteristics, total audit hours do not differ, on avera#e, bet&een Bi# = an non,Bi# = firms in the sam"le. There are statistically si#nificant ifferences in the allocation of effort &ithin an au it by the t&o #rou"s of firms. Avera#e "ercenta#e of hours by au it "hase/ Bi# = ?lannin# 3 ris( assessment 39; non,Bi# = 2.;

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Substantive testin# 3 com"letion

9+;

G2;

Use of the mo ern, strate#ic systems base au it a""roach in uces non,Bi# = firms to si#nificantly re uce their total au it effort, &hile Bi# = firms allocate more effort to "lannin# 3 ris( assessment, &hile re ucin# substantive testin# '1ote/ there are no stan ar s to #ui e au it "ro uction in this area) Both Bi# = an non,Bi# = firms si#nificantly re uce their total au it effort &hen subEect to severe time an fee "ressure from the client, but ma#nitu e of re uction by non,Bi# = firms is lar#er, &hile Bi# = com"ensate some&hat by increasin# substantive testin#. Bi# = eal &ith hi#h reliance on client internal controls in 1te>tboo( fashion2 $ increasin# "lannin# 3 ris( assessment hours, &hile re ucin# substantive testin# an total hours. 4n the same situation, non,Bi# = increase "lannin#, ris( assessment, substantive testin# an total hours. This ma(es no senseP

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Conclusion: 4n this ata, the details of au it "ro uction are consistent &ith Bi# = au it !uality : non,Bi# = !uality ,,, at least in the *etherlan sP

Incentives and controls ,ithin audit *artnershi*s: There is har ly any research in this area. *ormally, &e assume 1the au itor2 is e!uivalent to the firm, an the au it firm is sim"ly a "ro uction function that transforms labor 'an other) in"uts into out"ut 'au it assurance). Fimite stu ies 'e.#. Trom"eter%s 1-.. thesis at U. Bisconsin) have investi#ate "artner behavior in 1lar#e "rofit "ool2 firms 'e.#. AA) an 1local "rofit "ool2 firms 'former C3F). 'e.#. Trom"eter QAJ%T, 1--+R fin s that "artners in 1local "ool2 conte>t are less li(ely to re!uire a o&n&ar a Eustment of earnin#sL Carcello, Dermanson 3 Duss QAJ%T,

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2000R fin that "artners in 1local "ool2 firms are less li(ely to issue a K#oin# concern% mo ification for a lar#e client in financial istress). Fiu 3 Simunic 'F3S) '1?rofit Sharin# in an Au itin# @li#o"oly2) analytically e>amine ho& "artners in an au it firm can use revenue an liability sharin# rules to in uce o"timal "ricin# an effort ecisions from the firm"s point of view( Some analytical results from F3S/ : Au itor behavior is critically affecte by the liability sharin# rule. 5ule is use to foster coo"eration amon# "artners, an in uce an o"timal mi> of effort by multi"le "artners in a firm. : 5evenue sharin# amon# "artners is also o"timal, other&ise a "artner has incentive to "rice an au it belo& the firm%s total costs. : Bhen clients iffer as to ty"e an re!uire ifferent e#rees of "artner co,o"eration 'e.#. sim"le vs. com"le> clients) the o"timal sharin# rules &ill iffer by client ty"e.

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: Bhen client ty"e is not contractible 'too ifficult to measure) au it firms &ill s"eciali6e by client ty"e 'e.#. AA in com"le> clients an H?8I in sim"le clients<). 4n e!uilibrium, s"ecialist firms &ho are strate#ic com"etitors, #ain some mono"oly "o&er an earn economic rents. Conclusion / To un erstan ho& real &orl Bi# firm au itors behave '&ill they eliver hi#her !uality<) &e must un erstan the incentive systems an controls o"eratin# in their firmsP