Academic journal article Quarterly Journal of Finance and Accounting

Audit Quality, Auditor Size and Legal Environments

Academic journal article Quarterly Journal of Finance and Accounting

Audit Quality, Auditor Size and Legal Environments

Article excerpt

Introduction

Right after the turn of the last century the world was shocked by several substantial cases of accounting fraud, as the Enron and Arthur Anderson debacles, proving, once again, the necessity and requirement for high quality audits. DeAngelo (1981) formulated a two-dimensional definition of audit quality as detecting misstatements and errors in financial statements and then reporting these material misstatements and errors. Due to the lack of direct measurement possibilities for these characteristics, prior literature came up with several surrogates, like audit fees and hours, reputation, litigation risk, auditor size and abnormal accruals. This research will focus on the latter three, formulated in two hypotheses. The first part examines the relation between the audit quality an auditor provides to its clients and the size of the auditor, where audit quality is measured by the client's abnormal accruals and auditor size by a three-tier classification. Prior studies suggest that the main drivers of audit quality are reputational loss and litigation cost. In particular, DeAngelo (1981) states that audit firm size is an important determinant of audit quality. Consistent with her work, Palmrose (1988) and Simunic and Stein (1987) argue that due to deeper pockets and extensive investment in their reputations, large audit firms have higher incentives to minimize litigation risk and protect their reputation by providing high quality audits. DeAngelo (1981) further claims that large auditors possess more financial resources for training and technology enhancement and are less dependent on an individual client.

The second part focuses on the association between audit quality and the legal regime by which a firm is governed. According to La Porta, Lopez-De-Silanes, Shleiferand Vishny (1997), Europe accommodates three fundamentally different legal environments: English common law, German civil law and French civil law. Based on their levels of investor protection, and with that the litigation risk for auditors, the audit quality is assumed to differ between these countries (Francis and Wang 2008). Prior studies provide evidence of greater financial transparency in countries with high investor protection (Bhattacharya, Daouk and Welker 2003 and Bushman, Piotroski and Smith 2004). Ball, Robin and Wu (2000) document that in these highly protective countries earnings are less managed and more value relevant.

Consistent with prior research, the results of this study suggest that larger audit firms show greater ability in restraining clients' abnormal accruals. According to Jones (1991), abnormal accruals are a valid measure for earnings quality and should therefore give a fair representation of the quality an auditor provides. Additional analysis on firms with positive abnormal accruals fails to find a significant difference between the audit qualities provided by first, second and third tier auditors. The analysis of audit quality in different legal environments reveals no significant difference between the assessed common and civil law countries. This contradicts the argument of La Porta et al. (1997) on diverging investor protectionism in European legal regimes. The additional test for the positive abnormal accruals subsample reveals similar results to those for the entire sample.

This research contributes to extant academic literature in several ways. First, audit firm size has proved itself to be a valid measure for audit quality. However, nearly all previous studies on this topic focus on the Big N/non-Big N dichotomy. This study uses a three-tier classification, which gives better insight in the audit quality distribution over different sized auditors. Unlike Francis, Maydew and Sparks (1999) who proxy for a three-tier classification by the level of operations (Big 6/national/local), this research bases the distinction on net income from audit practices. According to DeAngelo's (1981) argument that the value of an audit firm is determined by the present value of its future quasi rents, we believe this classification is more consistent with the established theory on audit quality and should give a better representation of the auditors' incentives. …

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