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A Review of Archival Auditing Research

Determinants of Audit Quality

Client Demand Client Incentives (e.g. agency cost) Client Competency (e.g. IAF)

Auditor Supply Auditor Incentives for Independency (e.g. reputation, litigation) Auditor Competency (e.g. expertise, inputs to audit process)

Regulation intervention shapes both incentives and competency.

Definition of Audit Quality

Old: Probability that an auditor both detect and report the breach. (understates high AQ benefits)

New: Assure that financial statements faithfully reflect the firm's underlying economics.

Substance over form: There will be litigation risks even statements comply with GAAP. Audit opinion only reflects form, not AQ.

Financial Reporting Quality

Audit Quality

Financial Reporting System: maps underlying economics into reports.

Inner Characteristics: characterized by its underlying economics.

R and I constrain FRQ.

Financial Reporting Quality (reflect underlying economics)

Audit Quality (High AQ increases FRQ)

Financial Reporting System (pre-audited statements): maps underlying economics into reports.

Inner Characteristics: characterized by its underlying economics.

R & I constrain FRQ. Conflicts b/w auditors and managers in choosing FRS.Relation b/w AQ, R and I.

AQ Proxies

Supply Side - Output-based proxies (Constrained by the R and I).

Demand Side - Input-based proxies (Observable noisy inputs).

Output-based proxies

Material Misstatement: auditors erroneously issued an unqualified opinion on materially misstated financial statements.E.g. Restatement and AAERsLimitation: only detect large material errors.

Auditor communicationE.g. GC modified audit opinion, which is client's ability to continue as a going concern.Limitation: issued to financially distressed firms, lose generalizability; excessive conservatism.

Output-based proxies

Financial reporting quality characteristics: use earnings quality to detect opportunistic earnings management E.g. DAC, Accrual Quality, Meat/BeatAdvantage: their continuous captures variations in AQLimitation: measurement error and bias.

Perception-based measuresE.g. ERC, Cost of Capital, Stock Market ReactionLimitation: endogeneity

Input-based proxies

Auditor characteristics: examine clients demand for AQE.g. Auditor Size, Industry SpecializationLimitation: fail to capture subtle variation.

Auditor client contracting featuresE.g. Audit Fee (both demand and supply factors)Limitation: endogeneity

Choose Best AQ Measure

Most appropriate for research setting

Since proxies have complementary strength, can more than one proxies be used in one research?

Further research: inferences from proxies based on their weaknesses or strengths.

AQ Models

Problems:Some control variables are correlated with I and R.Omitted correlated variables

Client Demand for AQ

Research on value of auditing Compare audited versus unaudited financial informationUsefulness of GC to predict bankruptcyMarket does not react to Section 404 ICMWsAuditor change conveys information

Critique: Lack generalizability

Future research: beyond traditional financial statements (environmental concerns)

Client Demand for AQ

Factors Driving Client Demand for AQClient IncentiveAgency conflicts (management ownership or leverage)Higher AC demand higher AQ (auditor characteristics)

Client CompetencyCorporate governance StrengthSpecific Governance Mechanisms: IAF

Critique Rely on input measures of AQ Endogeneity

Auditor Supply for AQ

ReputationMarket-based incentives for independence Litigation Inputs to audit processCompetency Expertise

Auditor Incentives

RegulationEngagement Risk: Reputation Litigation (Self-fulfilling prophecy?)

Client Business Risk & Auditor Business Risk (Litigation Risk)

Auditor Incentives: Reputation Risk

Reputation: upside and downside; Litigation: only downside.Litigation risk is subject to legal environment changes(PSLRA).Critique: limited US evidence; rely on extreme cases; confounded by litigation risk.Reputation AQIncrease AQ to improve reputation (no evidence)

Auditor Incentives: Litigation Risk

Auditor effort (reduce risk) and fees (bear risk)Higher litigation risk Higher feesFees also reflect risk premium (transfer risk)Disentangle effort (actual hours) and premia (billing rates) why not just control one variable?Effort cant eliminate all litigation risksClient satisfaction & fees (positive association)Non-fee studiesShifts in litigation risk (e.g. PSLRA)Misstatement risk (e.g. accruals)

Auditor Incentives: Litigation Risk

Client acceptance and retention (avoid risk)Avoid risky clients (not afraid of affecting market share)High quality auditor choose low quality client is possibleLobbying activitiesPSLRA: reduced auditor liability, litigation reliefDeterminants of litigation riskAuditor characteristics (large, shorter tenure etc.)Client characteristics (large, distressed, high growth etc.)Engagement characteristics

Auditor Incentives: Auditor size associated with AQD

Material misstatementsBig N fewer restatements (weak evidence)Auditor communicationDisentangle incentive effects from competencyFRQLower DAC, timely management forecast, lower forecast error, greater conservatism(?)Perceptions of AQLarger ERC, higher analyst forecast accuracyAuditor changes; IPOAudit feesFee premium: higher AQ, monopoly pricing or risk premium (which one?)

Auditor Competency

Competency IncentiveIndustry specialization (Big N auditors)Motivation: increase fees and market share, economies of scaleGreater knowledge of industryHigher reputational capital, higher incentiveMeasurement: industry market shareApproaches: audit quality proxies; market reaction to auditor switches; fee premiaSelf-selection problemDistance between competitorsGeographic proximityAuditor office sizeGreater in-house expertiseAudit processMateriality level; audit adjustments; audit partner compensation

Critique

Limited research on reputation riskReputation risk is confounded by litigation riskFee study: tease audit effort form risk premiaNon-fee study: conservatismBig-N: endogeneity and self selection; mixes incentives and competencyMeasurement of specialization

Future researchAuditor competency (e.g. ownership structure, compensation scheme)Individual auditor characteristic (e.g. education background)Audit process (black box)