Academic journal article Academy of Accounting and Financial Studies Journal

The Audit Firm's Effect on the Informational Trading Experienced by Their Clients in the Stock Market: A Study of Audit Quality

Academic journal article Academy of Accounting and Financial Studies Journal

The Audit Firm's Effect on the Informational Trading Experienced by Their Clients in the Stock Market: A Study of Audit Quality

Article excerpt


This paper examines the association between the bid-ask spreads for a company and the auditor that audits that company. Prior research has shown that a portion of the bid-ask spread arises from differences in the information asymmetry among stock market participants. The results of the regression analysis presented in this paper provide evidence that there is a difference in a company's level of information asymmetry based on the Big 6 firm they engage, that most Big 6 firms reduce a company's information asymmetry more than do National and other audit firms, and that National audit firms reduce information asymmetry more than do non-Big 6, non-National firms. Since the purpose of an audit is to reduce information risk, the reduction in information asymmetry associated with the various classes of audit firms is attributed to a higher level of audit quality in that group of audit engagements. These results support the contentions that audit quality within the Big 6 is not homogenous, and that, in general, there are differences in audit quality between the Big 6, National, and other audit firms.


A large prior literature has argued that auditor size is positively associated with audit quality. These studies have used a number of different measures to proxy for audit quality including audit fees (Anderson & Zeghal, 1994; Francis & Simon, 1987), the propensity for litigation (Palmrose, 1988), the earnings response coefficient (Teoh & Wong, 1993), errors in accounting estimates (Petroni & Beasley, 1996), discretionary accruals (Becker et al. , 1998), management forecasts (Davidson & Neu, 1993), and enforcement actions against audit firms (Campbell & Parker, 1992) to provide evidence the Big 6 provide a higher level of audit quality than other audit firms. The underpricing of securities (Clarkson & Simunic, 1994), the percentage of retained ownership (Balvers, McDonald & Miller, 1988), and investment banker fees (Menon & Williams, 1991) in an initial public offering have also been used as proxies for audit quality.

This paper extends previous research in three significant ways. First it re-examines the Big 6 non-Big 6 dichotomy using a more direct measure of audit quality than used in previous research, the client's bid-ask spread. The bid-ask spread, defined as the difference between the ask price and the bid price for a company's stock has been shown to be positively associated with the level of information asymmetry. Since the role of the audit is to reduce information risk (Boynton & Kell, 1996, 36), and higher quality auditors mitigate information risk (Firth & Liau-Tan, 1998), differences in information asymmetry between companies may result from differences in audit quality.

Second, this paper examines differences in the audit quality of the firms within the Big 6. Prior research has found differences in audit quality within the Big 6 but the results are inconsistent and generally not statistically significant (Davidson & Neu, 1993; Palmrose, 1988; Balvers, McDonald & Miller, 1988).

Third, this paper segments the audit population into three tiers, Big 6, National, and third tier firms. Prior research (Francis, Maydew & Sparks, 1999) has found a difference in the level of audit quality among these three tiers, but the consolidation of the audit firms and an audit firm bankruptcy that has occurred since the time period used in their study provides an incentive to reexamine this association between audit quality and audit firm size.

The remainder of this paper is organized as follows: The next section presents the motivation for the study. The following two sections describe the research method and provide the empirical results. The final section contains the conclusions.


When the audit market is characterized by significant audit start-up costs, an incumbent auditor has the ability to set future audit fees above the cost of producing audits. …

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