deis and giroux - 1992 - determinants of audit quality in the public sector

Giroux Texas A&M University "brand name" e.g., Big Eight versus non-Big Eight is a factor affecting audit prices and auditor selection.1 As a quality surrogate, brand name re- flects d

Author(s): Donald R Deis, Jr and Gary A Giroux

Source: The Accounting Review, Vol 67, No 3 (Jul., 1992), pp 462-479

Published by: American Accounting Association

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July 1992

pp 462-479

Donald R Deis, Jr

Louisiana State University

Gary A Giroux

Texas A&M University

"brand name" (e.g., Big Eight versus non-Big Eight) is a factor affecting audit prices and auditor selection.1 As a quality surrogate, brand name re- flects differences between auditor size categories in concern for reputation (DeAngelo 1981b) and the ability to withstand client pressure (Goldman and Barlev 1974) It has not, however, been demonstrated that these fea- tures characterize quality differences within an auditor size category Although tests are difficult without a direct measure of quality, recent an- nouncements by the General Accounting Office on CPA quality in govern- mental audits indicate a need to determine the factors that affect quality differences within auditor size categories, which is the subject of this study

cover and report a breach in the client's accounting system (DeAngelo 1981a) Two explanations for variations in audit quality involve reputation and power conflict Because an incumbent auditor captures client-specific quasi-rents, there is incentive to lower audit quality to retain the client However, audit firm size is a moderating effect since a large client base

any given client The expectations are that (1) audit quality decreases as auditor tenure increases and (2) audit quality increases with the number of

' Several studies have addressed this issue, from the perspective of both the private sector (Danos and Eichenseher 1982; Eichenseher and Danos 1981; Francis 1984; Francis and Stokes 1986;Francis and Wilson 1988; Palmrose 1986, 1989; Simon 1985; Simunic 1980) and the public sector (Baber et al 1987; Copley 1989; O'Keefe et al 1990; Roberts et al 1990; Rubin 1988)

We received valuable comments from Earl Wilson, Kris Raman, Linda Ruchala, one anonymous referee, participants in an accounting workshop at Louisiana State University, the ad hoc associate editor, and the editor The first author gratefully acknowledges the Corpus Christi State University Grant Program for funding this research We are also grateful for the cooperation of Tom Canby and Ed Randall at the Texas Education Agency

Submitted April 1989 Accepted December 1991

462

clients In power conflicts, the client can exert pressure on the auditor to violate professional standards, and a large, financially healthy client can exert greater pressure with a threat of replacing the auditor However, the established review of audit results or audit working papers by third parties can increase the auditor's ability to withstand client pressure The expecta- tions are that (3) audit quality is negatively related to the size and financial health of the firm and (4) audit quality improves when the auditor knows work will be subject to review by third parties and that sanctions for poor quality work will occur

This article presents the results of an investigation into the determi- nants of audit quality provided by small, independent CPA firms in Texas

on audits of independent school districts The study analyzes quality control review (QCR) findings to obtain a relatively more direct measure of audit quality Between 1984 and 1989 the Audit Division of the Texas Education Agency (TEA) conducted 308 QCRs Numerical scoring of 232 QCR letters of findings represents the measure of minimum audit quality and the dependent variable in the regression analysis Explanatory variables associated with reputation effects, power conflict effects, report timeliness, audit hours, and reported breaches were obtained from TEA sources The major finding of the study is that audit quality definitions (DeAngelo 1981b; Goldman and Barlev 1974) considered descriptive among audit size cate- gories are sufficiently robust to explain quality variations within an audit size group The results also confirm earlier studies relating audit quality to audit report timeliness (Dwyer and Wilson 1989) and actual audit hours (Palmrose 1986, 1989) We conclude that audit hours is a suitable surrogate for audit quality when direct measures are unavailable

Key Words: Audit quality, Reputation, Power conflict, Public sector

Data Availability: The data for this study is available on a 3.5" low density

diskette from the first author To maintain confiden- tiality, neither the CPA firm nor the school district is identified in the data

sents hypotheses for testing The next section describes the empirical method, including the measurement of audit quality by using QCR results The last two sections cover empirical results and conclusions

I Theoretical Framework and Hypotheses Audit quality is a continuing issue in the profession (AICPA 1987; GAO 1985) A credibility gap in governmental financial reports arose following discovery that poor accounting practices contributed to the fiscal crises of New York and other cities in the

1970s.2 In response, the federal government issued OMB Circular A-102 in 1979 and

2 Besides the absence of an annual audit, Goldin (1985, 270-71) reports that New York City capitalized op- erating expenses, balanced budgets with uncollectible receivables, consistently overestimated revenues and underestimated expenses, recognized revenues on an accrual basis and expenses on the cash basis, did not

OMB Circular A-128 in 1984, seeking to improve financial reporting practices, increase auditor reporting responsibilities, and establish programs to monitor audit quality.3 Since then, the financial reporting practices of local governments have improved (Ingram and Robbins 1987) QCRs, however, find audit quality lacking in many CPA- prepared audits (GAO 1985, 1986, 1989; TSBPA 1987), and recent research suggests that audit quality may affect the public sector audit market in unique ways (Copley 1989; Roberts et al 1990) Like audit failures in the private sector, audit quality deficiencies in the public sector threaten the public's confidence in the profession

Aside from Dwyer and Wilson (1989), audit quality has not been the explicit focus

of public sector audit research Nonetheless, Rubin (1988) and other recent studies dem- onstrate that private sector research is generalizable to the public sector The theoreti- cal framework developed in this study is based primarily on private sector research and will be empirically tested to determine the merits of generalizing various conclusions about private sector audit quality to the public sector

DeAngelo (1981a) defines audit quality as the probability that an auditor will both discover and report a breach in the client's accounting system The probability of dis- covering a breach depends on the auditor's technical capabilities and the probability of reporting the error depends on the auditor's independence Prior studies (DeAngelo 1981a; Goldman and Barlev 1974; Nichols and Price 1976) generally assume that the probability of discovering a breach is positive and fixed (i.e., that all auditors are technically capable) and that auditor independence is the key issue However, without information about technical capabilities (e.g., auditor experience, education, profes- sionalism, and firm audit structure), capability and independence are difficult to disentangle Although this study also adopts the independence framework to evaluate the audit quality issue, the importance of technical capabilities is addressed Two explanations for variations in audit quality vis-a-vis the independence issue are found

in the literature These involve (1) auditor reputation (DeAngelo 1981b) and (2) power conflict (Goldman and Barlev 1974; Nichols and Price 1976) These explanations are adopted as a general theoretical framework for this study

The Auditor-Reputation Explanation

Incumbent auditors capture client-specific quasi-rents and have incentives to lower quality in future periods to retain the client (DeAngelo 1981b, 189) Audit firm size can militate against such opportunistic behavior because large firms have more audit clients and, therefore, have more to lose from loss of reputation Also, the threat to their survival from losing a particular client is minimal Thus, two proxies of audit firm size are thought to affect audit quality: (1) the number of clients and (2) the percentage of audit fees dependent on retaining any one client Most studies use "brand name" to articulate these definitions Brand name, however, reflects differences among audit firm size groups, but not within-group variations This study sidesteps the brand name

reconcile bank accounts, did not have a general ledger, and had no control over its cash flow An analysis of other cities indicated that procedures contrary to generally accepted accounting principles and unaudited fi- nancial statements were common practices In addition, financial difficulties in other cities were possibly ex- acerbated by poor accounting practices Cleveland, which defaulted on its long-term debt in 1977, is a well- known example

OMB Circular A-128 was issued to implement the requirements of the Single Audit Act of 1984

distinction to test the robustness of existing explanations for variations in audit quality within small (non-Big Eight) CPA firms.4

Several recent studies find evidence that auditors discount (i.e., "low ball") the price of initial audit engagements (Baber et al 1987; Ettredge and Greenberg 1990; Francis and Simon 1987; Roberts et al 1990; Simon and Francis 1988; Turpen 1990) Low-balling, however, does not imply poor quality on initial audit engagements since auditors are offering initial price discounts to capture future quasi-rents (DeAngelo 1981a, 113) It is the attempt to protect these quasi-rents that threatens auditors' independence Faced with competitive pricing pressures, an incumbent auditor can choose to lower audit quality and audit price contemporaneously to retain the client and preserve quasi-rents (DeAngelo 1981b, 189) Additionally, over a long association with a client, the auditor may become less challenged and less likely to use innovative audit procedures, or may fail to maintain an attitude of professional skepticism (Mautz and Sharaf 1961; Shockley 1982).- The first research hypothesis is based on DeAngelo's explanation of quality deterioration with auditor tenure

Hi: Audit quality decreases as auditor tenure increases

The consequences of a tarnished reputation contravene opportunistic behavior by

an incumbent auditor.' An auditor with many clients would be concerned about maintaining reputation and, hence, less likely to lower audit quality (DeAngelo 1981b) Moreover, when the client is an independent school district (ISD), the number of other ISD clients served reflects industry expertise and, therefore, measures variations in technical capabilities The expectation is that the number of ISD clients would also indicate audit quality, although the interpretation of that effect is confounded between reputational concerns and industry expertise

H2: Audit quality increases with the number of ISD audit clients

The Power-Conflict Explanation

This explanation centers on the ability of the auditor to resist pressure from the client to violate professional standards (Goldman and Barlev 1974; Nichols and Price 1976; Shockley 1982) The balance of power tilts toward the audited client whenever the auditor places "greater significance on the rewards mediated by the [client] than the [client] places on the rewards mediated by the auditor" (Nichols and Price 1976, 337)

4 Small CPA firms conduct a substantial portion of governmental audits; hence, understanding the factors that contribute to variations in audit quality among these firms is of interest to regulators, professional groups, managers of governmental units, and to CPAs active in the public sector The ability of existing theories to explain audit quality differences in the small CPA firm category enhances our understanding of audit quality, which is important as the profession continues to face threats of increased regulation and potential loss of its self-regulation status

I Mautz and Sharaf (1961, 208) state that "except in extreme cases, the problem of maintaining independence must rest with the individual practitioner Occasionally, of course, infringement will be so flagrant that it will come to the attention of those who use the auditor's report or of regulatory agencies or fellow practitioners, and steps will be taken to review the auditor's actions and relationship with the company

in question In a great many more cases, however, the greatest threat to his independence is a slow, gradual, almost casual erosion of his 'honest disinterestedness' " (emphasis added)

6 Several recent studies illustrate the importance of auditor reputation Wilson and Grimlund (1990) find that auditors experience business loss when low-quality audits are discovered; Palmrose (1988) found lower lit- igation rates associated with brand name auditors; and changes to a brand name auditor evoke favorable market responses (Eichenseher et al 1989)

The client desires attested financial statements that will have an expected effect on particular third parties,' and individual auditor expertise holds little value to the client Regardless of the nature of the specific audit issues, the client will use pressure to achieve the primary goal of influencing certain third parties Because the auditor must compete in a competitive market (Rubin 1988; Simon 1985; Simunic 1980) it is easier and less costly for the client to replace the auditor than it is for the auditor to replace lost business

Knapp (1985) suggests that the size and financial health of an audit client are associated with audit quality Financially sound audit clients have a low probability of financial failure and so are less likely to expose the auditor to the scrutiny common on such occasions In such situations, auditors may become complacent and, therefore, less diligent in conducting the audit Client size and audit price are correlated (Simunic 1980); hence, audits of large clients are enticing to the incumbent auditor's competitors Large clients, more so than small clients, may be able to use a competitive environment

to resolve audit conflicts in their favor Audit engagements of large, financially sound clients are not necessarily coincident with poor quality audits; rather, the potential for complacency on the part of the auditor and the power exercisable by such clients heighten the likelihood of lower audit quality The power-conflicts explanation leads to the expectation that threats to audit quality increase with the size and financial health

of the client

H3: Audit quality is negatively related to the size and financial health of the client, the ISD

The power of the auditor increases when there is less room for judgment and inter-

profession vigorously enforces professional standards (Goldman and Barlev 1974; Shockley 1982) The Single Audit Act passed by Congress in 1984 led to substantial im- provements in accounting and reporting by governmental units Shortly thereafter, QCR programs commenced and, starting in 1987, the results of those reviews became public

The auditor's ability to withstand client pressure is dependent on the economics of the contract and certain environmental and behavioral features, including (1) the state

of professional ethics, (2) the probability of detection of poor quality, (3) the vigor and visibility of enforcement actions by the profession, (4) the auditor's standing within the professional community, (5) the auditor's level of interaction with professional peer groups, and (6) the auditor's internalization of professional norms.9 The auditor's

7 Possible third parties the client seeks to influence include potential investors, creditors, suppliers, and government oversight agencies Both private and public sector firms are interested in these third parties

routine accounting issues are less likely to be a source of client pressure on the auditor Auditing for compliance with laws and regulations by governmental agencies, however, is a highly unstructured, non- routine attestation area-one that might subject the auditor to client pressure

groups Within a homogeneous size group, however, subtle differences in these factors may explain variations

in quality As Goldman and Barlev point out, "One should not conclude that large CPA firms are immune to pressures from their clients Competition among offices of some large firms for clients may be as great as com- petition among small, independent CPA firms" (1974, 716) Furthermore, many of these features are interre- lated with the technical capabilities of the auditor For instance, an auditor who internalizes professional norms and is concerned about his or her standing within the professional community is likely to also be devoted to maintaining technical competency

ability to withstand pressures from the client to compromise professional standards is enhanced when these features are present Conversely, as these features are diminished

or absent, the auditor is more vulnerable to pressure from the client Among these features, two are of particular interest because they have been adopted by regulators as techniques to improve audit quality: (1) detection of poor quality by QCRs and (2) enforcement actions by state accountancy boards

Increased authoritative guidance and vigorous review programs to monitor CPAs' compliance with professional norms is likely to increase the auditor's power to withstand client pressures Since initial reports from QCR programs report both substantial problems and sanctions for poor audit quality, auditors were more likely to benefit from increased regulation and monitoring after these reports were issued (i.e.,

1987 and thereafter) when the implications of poor work discovered by a QCR became public The foregoing is stated as the fourth research hypothesis:

H4: Audit quality improves when the auditor knows that his or her work will be subject to review by third parties and that sanctions for poor quality work will

be applied

II Empirical Method Audit Quality Model

Audit quality differences within a pooled cross-sectional sample of small, indepen- dent auditors is evaluated by using the following model:

where:

In (QUALITY)= natural log of the weighted quality metric based on the QCR

letters of findings.10 Reputation effects:

TENURE= number of years the auditor has audited the ISD;

Power conflict effects:

PEER=a dummy variable where a 1 indicates that the auditor is a

member of the AICPA's Peer Review Section;

BOARD=the percentage of new school board members elected in the

last two annual elections in an ISD;

In (SIZE)= natural log of average daily student attendance for the ISD;

'? The natural log of QUALITY was used to transform the dependent variable (Gujarati 1978, 210) since the Kolmogorov goodness-of-fit test for normality rejected the assumption of normality at the 0.01 level of significance Further, OLS regression results exhibit nonrandom patterns in plots of the residual against the predicted value when QUALITY (untransformed) is used as the dependent variable After transformation, the Kolmogorov test fails to reject the normality assumption at the 0.10 level, and residual plots depict a cloudlike pattern

In (WEALTH)= natural log of ISD wealth as measured by assessed property

values per student;

statements

Other variables:

material weaknesses in internal control or material instances

of noncompliance with laws and regulations;

TIME= the percentage of the 120 day period in which the audit report

must be filed with TEA; calculated as the number of days from fiscal year-end (8/31) to the date of the auditor's report divided

by 120 days;

in(HOURS)=natural log of the actual audit hours accumulated by the

auditor

QCR Results and Audit Quality Metric

TEA begins with the presumption that the auditor conducts a quality audit in accordance with professional standards The QCR engagement documents the auditor's breach of those standards Each QCR engagement culminates in a letter of findings sent to the auditor There are three possible outcomes: (1) a clean review with

no recommendations for improvement," (2) a nonreferred audit listing deficiencies the auditor should correct in future audits, and (3) a referred audit accompanied by a list of deficiencies causing the referral For clarification, a referred audit is one referred to the Technical Standards Committee of the Texas State Board of Public Accountancy The committee begins with an informal hearing attended by representatives of TEA and the referred audit firm A number of sanctions are possible Some auditors are prohibited from conducting ISD audits until certain continuing professional education (CPE) requirements are met, and others have been instructed to retake parts of the CPA exam;

A metric (QUALITY) is constructed from the QCR results to serve as the dependent variable in this study QUALITY measures poor quality as defined by the auditor's failure to comply with professional standards; high-quality audits have low QUALITY scores The advantage of this metric is that it reflects the judgment of those at TEA who make the referral decision Since they have the power to refer auditors for possible sanctions, their assessment of audit quality becomes important for CPA firms We use this same evidence to arrive at a quality measurement for the sample audits

A content analysis of the letters of findings identified 19 categories of audit deficiencies The director of audits ranked the importance of each category, from 1 (most important) to 19 (least important), in making the referral decision The deficiency categories, their assigned weights, and frequency of occurrence appear in table 1 Each letter was coded for the presence of each category of deficiency; a 1 indicating its

11 Clean reviews are rare; only five of the reviews were clean Two were conducted by large, national

auditors and three by small CPA firms

12 Attempts by the authors to determine the outcomes of these deliberations were unsuccessful Recently, the state board changed this policy and, in the future, many of these outcomes will be publicly disclosed in the board's periodic newsletter

Table 1 QCR Coding and Weights

Frequency

* SOURCE: Director of Audits, TEA

1 =most important deficiency area;

19=least important deficiency area

each deficiency code (O or 1) by its assigned weight (1-19) Major audit deficiency areas

deficiencies add more to QUALITY (1/ 5=0.20) than minor internal control deficiencies (1 / 18 = 0.056)

ciencies detected) The construct validity of the metric is verified according to the

nonreferred audits (t-statistic on referred vs nonreferred means: 12.78, p=0.0001).13

range for referred audits (from 0.563 to 3.068) and indicates that additional criteria

outside the metric influenced the referral decision (e.g., the cooperative attitude of the auditor during the QCR) Since the goal of this study is to seek explanations for variations in audit quality, as opposed to the prediction of QCR outcomes (i.e., the

attempting further modeling of the regulator's decision-making process

" Two other quality metrics were evaluated: (1) a simple additive measure summing the number of the 19 audit deficiency areas present and (2) doubling the weights of "major" deficiency areas Both of these quality measures are correlated with QUALITY at 0.90 or better and produced similar results to those reported in this study, which suggests that the results are robust regardless of the manner in which the audit deficiencies are weighed Since the weighted quality metric reported in this study reflects the thinking of those involved with the QCR engagements and the referral decision, all statistical results in this study are based on this metric

Auditor-Reputation Effects

As auditor tenure (TENURE) increases, audit quality is expected to decrease

expected with increases in the number of ISD audits conducted by the audit firm

reporting practices Texas ISDs, for example, are subject to extensive reporting and audit requirements, and compliance is monitored by TEA Poor quality audit work detected by TEA on any audit conducted by a CPA firm threatens that firm's ability to retain its other ISD clients An audit firm specializing in the ISD industry faces con- cerns about maintaining reputation to protect its investment in specialized resources (e.g., training, standardized audit materials, and decision aids)

Power-Conflict Effects

The importance of the service rendered depends on the nature of the problem and who will benefit from the service (Goldman and Barlev 1974, 711) When audit reports benefit a third party more than management, the auditing profession lacks power and is vulnerable to pressure from the client to resolve conflicts in its favor Audit firms can decrease the likelihood of succumbing to client pressures by a commitment to professional standards Membership in the AICPA's Peer Review Section is one way to make such a commitment Quality review programs tied to sanctions for violating professional standards is an approach the profession and regulators can take to increase an auditor's ability to resist client pressure

Voluntary membership in the Peer Review Section of the AICPA is evidence of a commitment to maintain professional standards, to interact with peers within the profession, and to internalize professional norms, all of which are likely to help the auditor to resist pressures from the client to deviate from professional standards (Goldman and Barlev 1974; Shockley 1982) Higher audit quality (lower QUALITY score) is expected when the firm is a member of the AICPA's Peer Review Section

(PEER)

Political competition within an ISD can result in changes on the school board and increase administrators' incentives to obtain an acceptable audit report Parents, teachers, and school board trustees tend to focus more on educational issues than on financial reporting issues (Banker et al 1989) Nonetheless, the board has the authority

to appoint and fire ISD administrators, and political competition may fuel uncertainty Faced with uncertainty, administrators may try to influence a favorable audit report because the school board's evaluation of their performance will be based, in part, on this report (Goldman and Barlev 1974, 708) Furthermore, the actions of the auditor may

be monitored less by an inexperienced board than by an experienced board, thereby allowing the auditor more freedom in the choice of quality A higher percentage of board turnover (BOARD) is expected, as a measure of political competition and board inexperience, to be associated with lower audit quality (higher QUALITY score) Certain client attributes increase the likelihood that client management will both apply pressure and win Prior studies suggest that as client size (DeAngelo 1981b) and financial health (Knapp 1985) increase, so does the perception that clients can obtain preferred outcomes in an audit conflict Audit conflict, however, does not always lead

to audit failure Nor should audits of large, financially sound entities be automatically deemed low quality The power-conflict explanation implies that if an audit conflict should occur, a large, financially sound auditee is more likely to resolve such conflicts