Office Size of Big 4 Auditors and Client Restatements

Francis and Yu (2009) and Choi, Kim, Kim, and Zang (2010) report evidence that Big 4 audits are of higher quality when the engagement office is of larger size. Specifically, client earnings quality is higher and auditors in larger offices are more likely to issue going‐concern audit reports. We extend this line of research to test if larger Big 4 offices have fewer client restatements. A client restatement provides more direct evidence of a low‐quality audit than earnings quality metrics or going‐concern reports, because a restatement indicates the client's auditor did not effectively enforce the correct application of GAAP at the time the original financial statements were issued. We analyze 2,557 firm‐year restatements in a sample of 23,190 financial statements originally issued by U.S. firms from 2003 to 2008. We find that Big 4 office size is associated with fewer client restatements after controlling for innate client characteristics that may affect restatements (client size, financial performance, industry membership, nonfinancial measures, off‐balance sheet activities, and market‐related measures), and a set of controls for other auditor factors such as fees and industry expertise. The study raises important questions about the ability of smaller offices to deliver high‐quality audits for SEC registrants.     

Did the PCAOB's 2009 Office Expansion Improve Audit Quality?*

We investigate whether the PCAOB's decision to expand the number and location of its inspection offices in 2009 improved the reliability of US audits. We use a difference-in-differences empirical design to consider the impacts of the expansion on audit quality and find that audit quality significantly improved following the PCAOB's expansion in markets where new offices opened relative to markets without an office opening. We find that the improvement in audit quality appears to be driven by auditors' reaction to real changes in PCAOB oversight and that triennially inspected auditors appear to be impacted the most by this office expansion. Our findings provide new insights into the PCAOB's operational decision-making and suggest that the regulator's additional investment in audit oversight was effective in improving audit quality.     

Awareness of SEC Enforcement and Auditor Reporting Decisions

We find that non‐Big 4 audit offices with greater awareness of SEC enforcement are more likely to issue first‐time going‐concern reports to distressed clients; where SEC “awareness” is measured using (i) audit office proximity to SEC regional offices, and (ii) proximity to specific SEC enforcement actions against auditors. We also show that these non‐Big 4 audit offices issue more going‐concern opinions to clients who do not subsequently fail, indicating a conservative bias that reduces the informativeness of audit reports. This conservative reporting bias is also associated with higher audit fees and higher auditor switching rates. These findings are important because non‐Big 4 firms now audit 39 percent of SEC registrants and issue 88 percent of going‐concern audit reports. For Big 4 offices, we find some evidence that awareness of SEC enforcement may improve reporting accuracy by reducing Type II errors (failing to issue a going‐concern report to a company that fails), although the number of cases is small.     

Did the 1998 Merger of Price Waterhouse and Coopers & Lybrand Increase Audit Quality?

We examine the effects of the 1998 merger of Price Waterhouse (PW) and Coopers & Lybrand (CL) on the audit quality of the merged firm PricewaterhouseCoopers (PwC) at both the firm and office levels, where audit quality is surrogated by the auditor's propensity to issue a going‐concern opinion, clients’ likelihood of meeting or beating analysts’ earnings forecasts, and clients’ accrual quality. At the firm level, we find that the merger increased audit quality for PwC relative to the audit quality of the other Big N firms. At the office level, our findings, albeit mixed, collectively suggest that the improvement in firm‐level audit quality was likely driven by the improvement in audit quality at PwC's overlapping offices, that is, offices in cities where both PW and CL had separate offices prior to the merger. Further, our findings suggest that although the PW/CL merger increased auditor concentration in local audit markets with PwC overlapping offices, the merger improved (rather than hurt) audit quality in those markets. Overall, our study contributes to the extant sparse literature on the effect of Big N mergers on audit quality, and is of potential interest to regulators.     

PCAOB Inspections and the Differential Audit Quality Effect for Big 4 and Non–Big 4 US Auditors*

In this study, we investigate whether the increase in regulatory scrutiny epitomized by the initial PCAOB inspection impacted audit quality differentially for Big 4 and non–Big 4 auditors to better understand the consequences of PCAOB inspections for different audit firm types. Because of competing views on the effect of PCAOB inspections, the relation between PCAOB inspections and the audit quality differential between Big 4 and other auditors is an empirical issue. Empirically, we take the endogenous choice of auditor as a given and utilize a difference‐in‐differences specification that takes into account the staggered timing of the initial PCAOB inspection for different‐sized auditors in the United States. Our results suggest that the initial PCAOB inspection improved audit quality more for Big 4 auditors than for other annually inspected or triennially inspected non–Big 4 auditors. We also examine annually and triennially inspected non–Big 4 auditors separately, and find that the pre‐post Big 4/non–Big 4 differential audit quality effect is more pronounced for the triennially inspected non–Big 4 firms. In the larger context of the highly concentrated US audit market, our findings that PCAOB inspections accentuate the Big 4/non–Big 4 audit quality differential are of potential interest to public company audit clients contemplating an auditor change, investors interested in learning about the consequences of PCAOB inspections, regulators concerned about the Big 4 dominance of the US audit market, and academics investigating audit quality differences.     

Market Structure and Audit Fees: A Local Analysis*

This study conducts a local analysis of the relation between market structure and audit fees. The research question of interest to us is how audit fees are determined by each practicing local office, after taking into account the auditor's own position in a local market and the influence exerted by his or her clients. Appealing to the economic theories of monopoly and monopsony power, we hypothesize a positive audit fee‐concentration relation, and a negative audit fee‐client influence relation. Results indicate that auditor market concentration is positively associated with the non‐Big 6 audit fees but is unrelated to the Big 6 audit fees. Evidence is mixed concerning the client influence hypothesis. When this construct is proxied by the number of rival auditors operating within a geographic area centered on the municipality, the prediction of negative audit fee‐client influence relation is strongly supported for both groups of auditors. Results are much weaker using measures developed based on the relative importance of a municipal client to its auditor's audit portfolio. The issues addressed in this study are important at a time when the Canadian municipal sector is undergoing major changes because of municipal amalgamation, altering the underlying market structure for audit services and the bargaining position of a municipality vis‐Ã‐vis its auditor. More broadly speaking, our analysis implies that when assessing an auditor's report for signs of client pressure, the professional oversight bodies and regulatory authorities need to consider the relative, rather than the absolute, bargaining position of the client in question.     

Audit Office Reputation Shocks from Gains and Losses of Major Industry Clients

Our study reports evidence on the dynamic effects of client switches on auditor reputations and fee premia. Offices of large accounting firms that lose (gain) major industry clients experience a reputation shock leading to more same‐industry client losses (gains) over the next two years. There is also a shift in audit fees charged to other same‐industry clients when a major client loss (gain) results in an audit office losing (gaining) city‐level industry leadership. A major client loss or gain also creates a short‐term capacity shock to an audit office's ability to supply high‐quality audits. However, there is no evidence of reputation spillovers to other‐industry clients in the audit office, or to clients in other offices of the accounting firm.     

Did Houston Clients of Arthur Andersen Recognize Publicly Available Bad News in a Timely Fashion?*

Despite the allegations of audit failure and the enormous publicity surrounding Arthur Andersen's indictment, there is no systematic empirical evidence on characteristics of accounting information of clients of Arthur Andersen vis‐à‐vis other Big 6 auditors. I examine whether earnings of Andersen's Houston‐based clients are timely in reporting bad news about future cash flows. I find that relative to a control group consisting of Houston‐based clients audited by other Big 6 auditors, earnings of Andersen clients are less timely in reporting bad news. Further, it appears that operating accruals of Andersen clients are less effective in accelerating the timely recognition of bad news than operating accruals of non‐Andersen clients. The findings suggest that the clients of Andersen's Houston office engaged in aggressive accounting practices, including delayed recognition of publicly available bad news.     

The Effect of Joint Auditor Pair Composition on Audit Quality: Evidence from Impairment Tests

Using a sample of firms from France, where the law requires the use of two auditors, we study the effect of auditor pair composition on audit quality by examining a specific account, goodwill impairment. We document that firms audited by a Big 4–non‐Big 4 auditor pair (BS) are more likely to book an impairment and book a larger impairment than firms audited by a Big 4–Big 4 auditor pair (BB) when low‐performance indicators suggest a greater likelihood of impairment. Moreover, firms audited by a BB pair reduce impairment disclosures when they book impairments, while firms audited by a BS pair do not, suggesting lower transparency for firms audited by a BB pair. Our results inform investors and firms in mandatory joint audit regimes, as well as regulators who are considering requiring joint audits.     

Does Audit Market Concentration Harm the Quality of Audited Earnings? Evidence from Audit Markets in 42 Countries*

Audit regulators around the world have expressed concern over market dominance by Big 4 accounting firms and the potential adverse effect it may have on the quality of audited financial statements. We use cross‐country variation in the audit market structure of 42 countries to examine two separate aspects of Big 4 dominance: (1) Big 4 market concentration as a group relative to non–Big 4 auditors; and (2) concentration within the Big 4 group in which one or more of the Big 4 firms is dominant relative to the other Big 4 firms. We find that in countries where the Big 4 (as a group) conduct more listed company audits, both Big 4 and non–Big 4 clients have higher quality audited earnings compared to clients in countries with smaller Big 4 market shares. In contrast, in countries where there is a greater concentration within the Big 4 group, we find that Big 4 clients have lower quality audited earnings compared to countries with more evenly distributed market shares among the Big 4. Thus concentration within the Big 4 group appears to be detrimental to audit quality in a country and of legitimate concern to regulators and policymakers. However, Big 4 dominance per se does not appear to harm audit quality and is in fact associated with higher earnings quality, after controlling for other country characteristics that potentially affect earnings quality.     

Learning by Doing and Audit Quality*

In this study, we present a nonstrategic, dynamic Bayesian model in which auditors' learning on the job and their choice of professional services jointly affect audit quality. While performing audits over time, auditors accumulate client‐specific knowledge so that their posterior beliefs about clients are updated and become more precise (that is, precision is our surrogate for audit quality) — what we call the learning effect. In addition, auditors can enrich their knowledge accumulation by performing nonaudit services (NAS) that, in fact, may influence clients' managerial decisions — what we call the business advisory effect. This advisory effect permits auditors to anticipate and to learn about changes in clients' business models, which in turn improves their advisory capacity. These dual “learning” and “advisory” effects are interdependent and mutually reinforcing. The advisory effect of NAS may increase or reduce auditors' engagement risk. We show that large professional fees can induce auditors to provide NAS that increase engagement risk and diminish audit quality. However, when NAS reduce engagement risk and increase audit quality, auditors may provide NAS without charging clients. The feature that distinguishes our study — the interdependence between the learning and advisory effects — provides new insight into the trade‐off between audit fees and audit quality. Consequently, our analysis helps explain why the scope of the audit has evolved over time and why the boundaries between audit and NAS are constantly shifting. A recent example of such a shift is that the Sarbanes‐Oxley Act adds control attestation to audits for public companies traded in U.S. markets.     

Auditors' Responses to Workload Imbalance and the Impact on Audit Quality*

Using detailed data for fieldwork hours and audit hours by rank from audit engagements in Korea, we examine whether audits conducted under workload imbalance, proxied by busy‐season audits, impair audit quality, and how auditors adjust staff assignments for busy‐season audits. We generally find that busy‐season audits are associated with lower audit quality, and that audit firms reduce the involvement of senior auditors during busy‐season audits. In addition, the greater the involvement of senior auditors and junior auditors, the lesser the deterioration in audit quality. Finally, although there is no increase in interim audits in response to workload imbalance during busy seasons, increasing interim audits can mitigate the negative impact of busy‐season audits on audit quality. Our results are relevant to auditors and regulators, who have expressed concerns about the adverse effects of workload imbalance on audit quality.     

IQ and Audit Quality: Do Smarter Auditors Deliver Better Audits?

This study examines the role of an individual auditor's cognitive ability in delivering high‐quality audits. Our results from analyzing archival data from Sweden show that audit partners' IQ scores obtained from psychological tests are positively associated with going‐concern audit reporting accuracy and audit fee premiums. We also find some, albeit weak, evidence that audit partners' IQ scores are negatively associated with the income‐increasing abnormal accruals of the client. These results suggest that, although audit services are standardized through various control mechanisms and audits are conducted by teams rather than by individual auditors, the cognitive ability of audit partners responsible for an audit remains important in delivering high‐quality audit services.     

Growing Pains: Audit Quality and Office Growth

This study provides evidence on how local office growth affects audit quality. We predict that significant recent growth will temporarily stress office resources, leading to a negative relation between office‐level growth and audit quality. To test this prediction, we examine a sample of 17,062 firm‐year observations from 2005 to 2010. Results indicate a consistent negative relation between changes in volume of audit work and audit quality. Specifically, clients of offices that experience increases in workload over the prior year have greater absolute discretionary accruals as well as an increased likelihood of restatement. Our tests also indicate that the effect of office growth is transient and vanishes after one year. We find limited evidence that the size of the auditor's national network of offices partially mitigates the negative effects of office growth on audit quality. We further show that proxies for audit quality are negatively related to office‐level growth from new and existing clients. These findings are robust to controls for client and auditor characteristics as well as alternative specifications of growth. Taken together, evidence indicates that while larger offices provide higher audit quality, the benefits of office size are not realized immediately and rapid growth temporarily impairs audit quality. These results are informative to regulators concerned with audit quality and to practitioners charged with adjusting to office growth.     

Auditor Quality and the Accuracy of Management Earnings Forecasts*

In this study, we appeal to insights and results from Davidson and Neu 1993 and McConomy 1998 to motivate empirical analyses designed to gain a better understanding of the relationship between auditor quality and forecast accuracy. We extend and refine Davidson and Neu's analysis of this relationship by introducing additional controls for business risk and by considering data from two distinct time periods: one in which the audit firm's responsibility respecting the earnings forecast was to provide review‐level assurance, and one in which its responsibility was to provide audit‐level assurance. Our sample data consist of Toronto Stock Exchange (TSE) initial public offerings (IPOs). The earnings forecast we consider is the one‐year‐ahead management earnings forecast included in the IPO offering prospectus. The results suggest that after the additional controls for business risk are introduced, the relationship between forecast accuracy and auditor quality for the review‐level assurance period is no longer significant. The results also indicate that the shift in regimes alters the fundamental nature of the relationship. Using data from the audit‐level assurance regime, we find a negative and significant relationship between forecast accuracy and auditor quality (i.e., we find Big 6 auditors to be associated with smaller absolute forecast errors than non‐Big 6 auditors), and further, that the difference in the relationship between the two regimes is statistically significant.     

Do Clients Get What They Pay For? Evidence from Auditor and Engagement Fee Premiums

Despite the intuitive appeal, prior research finds mixed evidence on whether higher audit fees translate to superior audit quality. Under the assumption that product differentiation between auditors is based, in large part, on the level of financial statement assurance, we propose more refined measures of excess audit fees that separate auditor premiums from other fee premiums. Consistent with our conjecture, we identify significant variation in audit pricing across auditors (i.e., auditor premiums) that relates positively to audit quality. Conversely, we find no evidence that higher engagement‐specific fee premiums (i.e., fee model residuals) are positively related to proxies for audit quality. Additional tests indicate that our results do not simply reflect premiums attributable to auditor characteristics evaluated in prior research (e.g., Big 4 membership, office size, and industry expertise). In fact, our findings suggest that the positive association between auditor premiums and audit quality is better captured at the auditor level than it is at the auditor “tier,” office, auditor‐industry, or engagement levels. In sum, our results suggest that auditors charging higher fees, on average, deliver superior levels of financial statement assurance, but engagement‐specific fee premiums do not reflect quality‐enhancing audit effort. These contrasting results provide a possible explanation for the mixed findings in prior research.     

Auditor Reputation,Auditor Independence,and the Stock‐Market Impact of Andersen's Indictment on Its Client Firms*

In this paper, we study a broad sample of Arthur Andersen clients and investigate whether the decline in Andersen's reputation, due to its criminal indictment on March 14, 2002, adversely affected the stock market's perception of its audit quality. Because these reputa‐tional concerns are more of an issue if an auditor's independence is impaired, we investigate the relationship between the abnormal market returns for Andersen clients around the time of the indictment announcement and several fee‐based measures of auditor independence. Our results suggest that when news about Andersen's indictment was released, the market reacted negatively to Andersen clients. More importantly, we find that the indictment period abnormal return is significantly more negative when the market perceived the auditor's independence to be threatened. We also examine the abnormal returns when firms announced the dismissal of Andersen as an auditor. Consistent with the audit quality explanation, we document that when firms quickly dismissed Andersen, the announcement returns are significantly higher when firms switched to a Big 4 auditor than when they either switched to non‐Big 4 auditors or did not announce the identity of the replacement auditor. Our empirical results support the notion that auditor reputation and independence have a material impact on perceived audit quality and the credibility of audited financial statements, and that the market prices this.     

Evidence of Industry Scale Effects on Audit Hours,Billing Rates,and Pricing

Using a proprietary data set consisting of all private firm audit engagements in 2000 from one Big 4 firm in Belgium, we investigate (i) whether audit office industry scale is associated with a reduction of total, partner, and staff audit hours and thus with efficiency gains triggered by organizational learning from servicing more clients in an industry and (ii) whether the extent of efficiency pass‐on from the auditor to its clients depends on the audit firm's market power. We find that auditor office industry scale is associated with efficiency gains and a reduction of the variable costs (i.e., fewer total audit hours, partner hours, and staff hours), ceteris paribus. Our results also suggest that, on average, realized efficiencies are entirely passed on, as evidenced by a nonsignificant effect of auditor industry scale on the auditor's billing rate. Furthermore, we find that the extent of the efficiency pass‐on decreases with the market power of the audit firm in the industry market segment as we document a higher billing rate for auditors with high market power (versus low market power). In addition, we find that the lower audit hours associated with auditor industry scale do not compromise audit quality.     

Auditor Conservatism,Asymmetric Monitoring,and Earnings Management*

In this paper, we investigate whether, and how, audit effectiveness differentiation between Big 6 and non‐Big 6 auditors is influenced by a conflict or convergence of reporting incentives faced by corporate managers and external auditors. In so doing, we incorporate into our analysis the possibility that managers self‐select both external auditors and discretionary accruals, using the two stage “treatment effects” model. Our results show that only when managers have incentives to prefer income‐increasing accrual choices are Big 6 auditors more effective than non‐Big 6 auditors in deterring/monitoring opportunistic earnings management. Contrary to conventional wisdom, we find Big 6 auditors are less effective than non‐Big 6 auditors when both managers and auditors have incentives to prefer income‐decreasing accrual choices and thus no conflict of reporting incentives exists between the two parties. The above findings are robust to different proxies for opportunistic earnings management and different proxies for the direction of earnings management incentives.