The Differentiation of Quality among Auditors: Evidence from the Not-for-Profit Sector

By Krishnan, Jagan; Schauer, Paul C. | Auditing: A Journal of Practice & Theory, Fall 2000 | Go to article overview

The Differentiation of Quality among Auditors: Evidence from the Not-for-Profit Sector


Krishnan, Jagan, Schauer, Paul C., Auditing: A Journal of Practice & Theory


SUMMARY

The association between auditor size and audit quality is examined for a sample of not-for-profit (NFP) entities. The audit quality measure is based on the entities' compliance with eight GAAP reporting requirements. The numbers on compliance supports policymakers' contention (prior to the recent issuance of three new statements) that reporting by NFPs was inconsistent. Of the eight reporting requirements examined, noncompliance is highest for those that pertain specifically to NFPs, for example, disclosures about pledges and donated materials. However, the extent of noncompliance decreases as one moves from the small non-Big 6 to the large non-Big 6 and from the large non-Big 6 to the then Big 6. This positive association between auditor size and audit quality is borne out in multivariate regression analyses, after controlling for other correlates of audit quality. Another measure of audit firm size, based on the number of professionals employed by the firm, further confirms this finding. In addition, the results indicate that there are other factors, i.e., client size, financial health, client wealth, and participation in a peer-review process, that impact audit quality.

Key Words: Audit quality, Not-for-profit organizations, Voluntary health and welfare organizations.

Data Availability: Data used in this study will be available from the second author upon completion of a subsequent research project.

INTRODUCTION

This study examines the association between audit firm size and audit quality in the context of an audit environment that has not been studied by prior work, that is, the not-for-profit (NFP) sector. The perception of a positive association between auditor size and audit quality has been a subject of concern for some time (e.g., National Commission on Fraudulent Financial Reporting 1987; AICPA 1993). While regulators (AICPA 1980) have maintained that audit quality is independent of firm size, accounting researchers (e.g., DeAngelo 1981b) have argued that large accounting firms produce a higher quality audit than small accounting firms. Empirical work in auditing has generally assumed a positive association between audit quality and audit firm size, with firm size usually measured by the brand name of the auditor. Actual tests of the association have been hampered by the lack of observable measures of audit quality. Some studies use indirect measures such as audit fees or auditor litigation or users' perceptions about audit quality. Two recent studies use more directly observable measures, based on regulators' assessment of audits (Deis and Giroux 1992) and errors in accounting estimates (Petroni and Beasley 1996), which are likely to be positively correlated with elements of audit quality. However, these studies yield different results about the association between audit quality and auditor size. (1)

The not-for profit organizations provide a unique setting for a study of audit quality, particularly for the sample period. The sample period covers fiscal year-ends prior to June 1995, which precedes the effective date of adoption of three major statements pertaining to not-for-profit entities issued by the Financial Accounting Standards Board (FASB), Statement of Financial Accounting Standards (SFAS) No. 116 (FASB 1993a), SFAS No. 117 (FASB 1993b), and SFAS No. 124 (FASB 1995). (2) The issuance of these statements was in response to the increasing realization that reporting by NFPs was inconsistent. Thus Probst (1997, 24) notes:

The FASB has indicated that financial statements

of not-for-profit (NFP) organizations

cannot be compared because of inconsistencies

in reporting. Numerous examples exist

of two different organizations reporting the

same event in two different ways. The FASB

committed itself to obtain uniformity in financial

reporting among not-for-profit entities. …

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