francis - 2004 - what do we know about audit quality [aq]

Francis* University of Missouri—Columbia, 432 Cornell Hall, Columbia, MO 65211, USA University of Melbourne, Victoria, AustraliaAbstract This paper reviews empirical research over the pa

What do we know about audit quality? *

Jere R Francis*

University of Missouri—Columbia, 432 Cornell Hall, Columbia, MO 65211, USA

University of Melbourne, Victoria, AustraliaAbstract

This paper reviews empirical research over the past 25 years, mainly from the United States, inorder to assess what we currently know about audit quality with respect to publicly listed companies.The evidence indicates that outright audit failure rates are infrequent, far less than 1% annually, andaudit fees are quite small, less than 0.1% of aggregate client sales This suggests there may be anacceptable level of audit quality at a relatively low cost There is also evidence of voluntarydifferential audit quality (above the legal minimum) along a number of dimensions such as firm size,industry specialization, office characteristics, and cross-country differences in legal systems andauditor liability exposure The evidence is very positive although there is some indication that auditquality may have declined in the 1990s, in which case there could be merit in recent reforms such asthe Sarbanes-Oxley Act of 2002 in the US However, we do not know from research the optimal level

of audit quality and therefore whether we currently have ‘too little’ or ‘too much’ auditing? Despitethis lacuna we are entering an era of more mandated auditing in response to high-profile corporategovernance failures including the Enron–Andersen affair Finally, while recent reforms have scaledback the scope of non-audit services due to independence concerns, a case can be made that auditquality will always be somewhat suspect if other services are provided that are perceived topotentially compromise the auditor’s objectivity and skepticism For this reason public confidence inaudit quality may be increased by proscribing all non-audit services for audit clients.Recommendations are also proposed with respect to legal liability reform and changes in partnercompensation arrangements

q2004 Elsevier Ltd All rights reserved

Keywords: Audit quality; Sarbanes-Oxley Act; Audit failure rates

0890-8389/$ - see front matter q 2004 Elsevier Ltd All rights reserved.

* Tel.: C1 573 882 5156; fax: C1 573 882 2437.

E-mail address: francis@missouri.edu.

This paper reviews research on audit quality from the past 25 years, with a particularfocus on empirical research from the United States In the aftermath of the Enronbankruptcy in 2001 and the related collapse of Arthur Andersen in 2002, it has becomefashionable to criticize auditing and to question the quality of audits being performed byaccounting firms, especially the large international Big 4 accounting firms.1Indeed thiscriticism motivated recent regulatory changes in the United States brought about by theSarbanes-Oxley Act of 2002 (Public Law No 107-204) in which self-regulation by theaccounting profession has been replaced with direct regulation by a new independentagency, the Public Company Accounting Oversight Board.

My emphasis is on publicly listed companies because the separation of ownership andmanagement control in listed companies makes the independent external audit especiallyimportant with respect to corporate governance and the oversight of such companies Thereview is not meant to be comprehensive and encyclopedic but is instead a more selectivesurvey whose purpose is to identify and assess a wide range of evidence on audit qualityfrom academic research It turns out that we know quite a bit, and despite Enron and otherhigh-profile failures, the evidence indicates that the general level of audit quality issatisfactory with very few outright audit failures, although there is some evidence that bothearnings quality and audit quality may have declined during the 1990s

1 What are outright audit failure rates?

Audit quality can be conceptualized as a theoretical continuum ranging from very low

to very high audit quality Audit failures obviously occur on the lower end of the qualitycontinuum, and so a good starting point in thinking about audit quality is to ask what therate of outright audit failure is? An audit failure occurs in two circumstances: whengenerally accepted accounting principles are not enforced by the auditor (GAAP failure);and when an auditor fails to issue a modified or qualified audit report in the appropriatecircumstances (audit report failure) In both cases, the audited financial statements arepotentially misleading to users

As a first approximation of audit quality, we can think of audits as either meeting or notmeeting minimum legal and professional requirements Audit quality is inversely related

to audit failures: the higher the failure rate, the lower the quality of auditing What do weknow about audit failure rates? Outright audit failures are difficult to determine withcertainty but can be inferred from several sources including auditor litigation and business

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The studies cited in this review date to earlier periods when the dominant group was the Big 8 prior to 1989, the Big 6 from 1989–1997, Big 5 from 1998 to 2001, and the Big 4 since the collapse of Arthur Andersen in 2002 For convenience the term ‘Big 4’ will generally be used through the paper to refer to all of these groupings The Big 8 firms were Arthur Andersen, Arthur Young, Coopers and Lybrand, Deloitte Haskins and Sells, Ernst and Whinney, KPMG, Price Waterhouse, and Touche Ross The Big 6 came into being in 1989 when Ernst and Whinney merged with Arthur Young in the US to become Ernst and and Young, and Deloitte Haskins and Sells merged with Touche Ross to become Deloitte Touche The Big 5 came into being in 1997 when Coopers and Lybrand merged with Price Waterhouse in the US to become Pricewaterhousecoopers Note that in some countries these mergers played out differently in terms of who merged with whom.

failures, investigations by the Securities and Exchange Commission (SEC), and earningsrestatements Each of these is now reviewed.

Arguably the most convincing evidence of an outright audit failure occurs when there islitigation against auditors (Palmrose, 1988) It turns out that the number of lawsuits againstauditors in the United States is small, despite the often-heard claim about rampantlitigation (Andersen et al., 1992).2 Using a comprehensive dataset, Palmrose (2000)

documents around 1000 lawsuits against the large national accounting firms over theperiod 1960–1995, or an average of only 28 lawsuits per year Given a population ofaround 10,000 publicly listed companies in the United States, 28 lawsuits per year imply

an annual audit failure rate of 0.28%, i.e 28 hundredths of one per cent The number ofsuccessful lawsuits is even smaller and is generally estimated to be around 50% of totallawsuits after excluding cases successfully defended by accounting firms and non-meritorious cases dismissed by courts (Palmrose, 1997) The bottom line is that thenumber of proven audit failures is so small as to approach a rate of zero, and so it isdifficult to imagine what could be done to change auditing practices or the regulatoryenvironment that would result in a significantly lower audit failure rate

A broader definition of auditor failure could be based on business failure rates It turnsout that failures of publicly listed companies in the United States are also small in number,averaging around 40 per year (Francis and Krishnan, 2002) However, it may be wrong topresume an audit failure has occurred just because a business failure occurs, and this isborne out by the fact that auditors of bankrupt companies are sued only 25% of the time(Palmrose, 1987).3Regardless, the audit failure rate implied by bankruptcy rates is verysmall and comparable to the low failure rate based on auditor litigation

Since 1982, the SEC has issued Accounting and Auditing Enforcement Releases(AAERs) which report outcomes of its investigations against companies and auditors.AAERs are the result of consent decrees in which companies and/or their auditors do notformally plead guilty to misdeeds, but instead accept an administrative action such as afine, or other reprimand, and agree that they will not engage in the kind of behaviordescribed in the AAERs which the SEC deems unacceptable (Feroz et al., 1991).Arguably, these consent decrees could be interpreted as evidence of ‘audit failures’ eventhough they are not legally described as such.Dechow et al (1996)examine the first 436AAERs issued from 1982 to 1993 Over this 12-year period there were 165 actionsdescribing auditor deficiencies representing about 14 actions per year Given the USpopulation of approximately 10,000 publicly listed companies which are subject to SECregulations, 14 yearly actions against auditors is an annual audit failure rate of 0.14% (i.e

14 hundredths of one per cent) from 1982 to 1993 More recently, 1485 new AAERs havebeen issued from 1994 to 2003, or an average of 149 per year, and this may reflect an

An auditor is responsible for issuing a going concern report if the auditor believes a company may not survive

12 months from the balance sheet date However, the auditor is not responsible for predicting bankruptcy per se, and it is possible for companies to fail for reasons an auditor could not have reasonably anticipated 12 months in advance.

increase in questionable financial reporting practices during the 1990s While there hasbeen no formal study (to date) of these AAERs actions, my informal review based on arandom sample indicates that a majority of these AAERS are not directed toward auditors.The bottom line is that the annual audit failure rate implied by AAERs is well under 1%even since the mid-1990s when the number of AAERs began to increase.

Another potential source of audit failure data comes from earnings restatements filedwith the SEC and recently summarized in a report by the Government Accounting Office(GAO, 2003) Arthur Levitt, former SEC Chairman, was concerned by the increase inearnings restatements in the late 1990s, and was convinced they indicated past accounting(and auditing) failures due to the kind of aggressive earnings management he warned of in

a 1998 speech entitled ‘The Numbers Game’ (Levitt, 1998)

GAO (2003)covers earnings restatements from 1997–2002, and restatements increasedmonotonically over the period from 92 (1997) to 250 (2002), with a sharp increase in 1999coinciding with Chairman Levitt’s concerns However, my informal review of theserestatements indicates a majority are straightforward adjustments of accounting

‘estimations’ in prior-year financial statements and therefore (arguably) not audit failures.Indeed in about one-fourth of the cases the auditor identified the problem and initiated there-statement, and in the majority of cases there was no related SEC action againstcompanies or litigation against auditors, which means that most earnings restatements arenot interpretable as audit failures

In sum, the ex post evidence of audit failures from SEC sanctions, litigation rates,business failures and earnings restatements all point to a very low failure rate, much lessthan one per cent annually This may understate the true failure rate if there are undetectedaudit failures However, if an audit failure goes undetected, it most likely means that thecompany and its stakeholders have not suffered adverse economic effects such asbankruptcy or financial distress arising from the audit failure What we can more properlyconclude is that known audit failures with material consequences are relatively infrequent.While there may be other audit failures with lesser consequences, we have no evidence onthe rate of these occurrences

2 How costly is auditing?

The evidence reviewed so far indicates that outright audit failures with materialconsequences are very infrequent, fewer than 100 per year in a population of over 10,000listed companies However, in evaluating audit quality it is important to assess both thebenefits and costs of auditing For example, while audit failure rates are low, if audit feesare large it is possible that too much investment is being made in audit quality relative tothe benefits achieved Audit costs are analyzed using 2002–2003 audit fee disclosure data

in the United States I made the following calculations for 5500 large US publicly listedcompanies, having aggregate sales of $8177 billion and aggregate market value of $9912billion (note all monetary amounts are in US dollars) Aggregate audit fees for these 5500companies totalled $3.4 billion which means audit fees represented only 0.04% of salesand 0.03% of market value I also analyzed audit fees for each decile of companies fromthe smallest decile of firm size to the largest decile As expected average fees as

a percentage of sales decrease as firm size becomes larger For the smallest decile, auditfees average 2% of sales, but for the largest decile audit fees average less than 1/100 of oneper cent of sales.

So auditing appears to be a relative ‘bargain’ in the sense that audits cost a relativelysmall fraction of client sales However, the low cost of auditing does not necessarily meanthat audit quality is low since the outright audit failure rate is also quite low While thisdata may give some comfort that the social benefit of auditing (as suggested by low failurerates) is achieved at a reasonable social cost, this kind of cost–benefit analysis does not tell

us anything about audit quality for the vast majority of companies which have ‘legally’satisfactory audits.4Remember, audit quality is conceptualized as a continuum from verylow to very high quality, and outright failures occur on the extreme low end of quality Theremainder of this paper surveys what we know about audit quality over the remainder ofthe quality continuum and focuses primarily on the two empirical observables in auditing:(1) auditor–client alignments, or who audits whom; and (2) audit outcomes which includeaudit reports and the audited financial statements which are a joint outcome of auditor–client negotiations (Antle and Nalebuff, 1991)

3 What do we know from audit report research?

Since 1989 there are effectively two types of audit reports issued in the United States:the standard clean unmodified report and a modified report for going concern uncertainty.5

Butler et al (2004)calculate that 6.6% of US listed companies received a going concernreports during the period 1994–1999 Another study documents yearly going concernreporting rates ranging from 9 to 5%, with a monotonic decline over the period 1990–1997(Francis and Krishnan, 2002)

Even though modified going concern reports represent less than 10% of total auditreports, one way of determining if audits are of high quality is to determine if investorsrespond to going concern reports in a manner consistent with such reports conveying ‘badnews’ about the client If auditing is of high quality then going concern audit reportsshould convey useful information; however, if auditing is of low quality, then modifiedaudit reports would have little or no informational value to investors Before examiningthe empirical evidence, it is useful to first consider ‘misreporting’ rates Misreportingcomes about from false negatives (a type 2 statistical error), i.e issuing a clean audit reportwhen in fact a going concern report was appropriate, and from false positives (a type 1statistical error), i.e issuing a going concern report for firms that do not subsequently fail

or otherwise become financially distressed Both false negatives and false positives are

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A referee points out that individual accounting firms may be highly profitable and may earn economic rents due to the accounting profession’s exclusive monopoly over the supply of audits From this viewpoint it is possible that audits currently cost more than they would in a more competitive market setting for the existing level

of audit quality However, absent firm-level production cost data it is not possible to know if this is the case.

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Qualified and adverse opinions cannot be issued for SEC registrants, and disclaimers are rarely issued There are other kinds of ‘technical’ modified opinions such as a change in accounting methods However, the essential reporting choice is now between a standard clean opinion and a going concern report.

(arguably) reporting failures in the sense that the right audit report was not issued whichreduces the informational value of audit reports due to noise.

3.1 False negatives and false positives in audit reporting

With regard to false negatives,Carcello and Palmrose (1994) find that only 30% ofbankruptcies are preceded by a going concern audit report In other words, 7 in 10bankruptcies have a ‘false negative’ or clean audit report Of course, as already noted,there are only around 40 bankruptcies of publicly listed companies per year, so theabsolute number of false negatives per year is quite small Strictly speaking, bankruptciesnot preceded by going concern audit reports are not necessarily audit failures since theobjective of an audit is not the prediction of bankruptcy However these cases are widelyviewed as audit failures and for this reason false negatives (clean reports) for bankruptcompanies can create potentially significant litigation risk for auditors Carcello andPalmrose (1994) document that auditors not issuing a going concern report beforebankruptcy are sued twice as often (64 versus 36%), have lower lawsuit dismissal rates,and higher resolution payments (around $10 million versus $1 million) Settlements canalso increase the cost of future insurance premiums There may also be a cost to investorswho are less well informed about bankruptcy risks than they might otherwise have been.Consistent with this,Chen and Church (1996)find the market response to a bankruptcyannouncement is less negative (by 13%) when the auditor has previously issued a goingconcern report, indicating that bankruptcy is less of a surprise to investors In general alarge negative stock market reaction is also more likely to trigger an investor lawsuitagainst auditors, so this is less likely if auditors give an early warning of bankruptcy risk

by issuing a going concern report

With regard to false positives,Francis and Krishnan (2002)document that around sevengoing concern reports were issued (nZ1003) per bankrupt company (nZ143) in theirsample over the period 1990–1994, which means that on average six out of seven goingconcern reports were false positives This implies that auditors are conservative in thesense of ‘over issuing’ going concern reports.6 However, despite over issuing goingconcern reports, auditors’ diagnostic skills apparently fail to get it right when it mattersand companies actually fail, i.e as already indicated most bankruptcies are not preceded

by a going concern report

The low cost of false positives relative to false negatives may explain why there are somany going concern audit reports.7The largest potential cost of false positives is clientdissatisfaction, andKrishnan (1994)documents a higher rate of auditor switches for firmsreceiving false positives, around 22% compared to a base line switching rate of 6% There

is also a social cost of auditor switches as the client and new auditor incur transaction andstart-up costs related to the switch In addition, there is evidence that ‘new audits’ may be

of lower quality due to a learning curve effect (Johnson et al., 2002), in which case

a reduction in audit quality may occur when false positives induce auditor changes.Finally, another cost of false positives is the self-fulfilling prophecy problem Whenauditors issue a going concern report, it may trigger a sequence of events that has theunintended consequence of pushing a client into bankruptcy For example, banks or otherlenders may not extend or renew lines of credit, and suppliers may change their terms inorder to speed up cash payments.

To sum up, auditors are not always accurate in their reporting choices and this canpotentially reduce audit quality They report conservatively (too many false positives) butmore often than not they fail to get it right when it matters (too many false negatives).While the existence of false positives and false negatives creates noise and reduces theinformativeness of audit reports, it does not necessarily eliminate their informational valuealtogether I now review research which indicates that modified audit reports do haveinformational value, despite the presence of false positives

3.2 Do modified audit reports really matter?

The informativeness of audit reports is difficult to assess for two reasons First, auditreports are typically released concurrently with the 10-K annual report filed with the SECand therefore it is virtually impossible to separate information in the audit report from theoverall set of information in the 10-K Second, most going concern reports are repeatoffenders and so there is little or no surprise value in the audit report For this reason, much

of the going concern literature examines first-time report modifications, and there isevidence that first-time going concern reports which come as a surprise do result in theexpected negative stock market reaction (Dodd et al., 1984; Loudder et al., 1992).Another approach to informational value examines if modified audit reports havepredictive power.Raghunandan (1993)investigates the predictive ability of audit reportsmodified for contingent losses arising mainly from lawsuits These audit reports wererequired prior to 1989, and he finds they were more predictive of actual litigation outcomesthan were financial statements having footnote-only disclosures of loss contingencies Inother words, when auditors commented directly on loss contingencies in the audit report,there was a significantly greater likelihood that a litigation-related loss would be incurred,which provides evidence that modified audit reports are informative

Initial public offerings (IPOs) are a particularly rich setting to investigate audit reportsbecause less is known about companies due to greater information asymmetry andtherefore the reports of auditors may potentially convey important information toinvestors A study which exploits this setting is Weber and Willenborg (2003) Theyexamine a sample of small microcap IPOs with market capitalization under $10 million.Surprisingly they document that around 25% of microcap IPOs go public with an auditreport modified for going concern, and find that the pre-IPO audit reports have predictiveability with respect to both future stock returns and subsequent delistings

In sum, there is not a large amount of research on the informativeness of modified auditreports, in part because of the difficulty in developing a research design that can tease outthe informativeness of such reports However, there is evidence that modified audit reportsare informative and have predictive ability, despite the noise created by false positives

4 Auditor differentiation and audit quality

It is difficult to assess audit quality ex ante because the only observable outcome of theaudit is the audit report which is a generic template and the overwhelming majority ofreports are standard clean opinions While it is possible to assess audit quality ex post inthe case of outright audit failures, as already noted, these are relatively infrequentoccurrences An important development in audit quality research is based on the premisethat ‘differences’ in audit quality exist and can be inferred by comparing different groups

or classes of auditors This research implicitly assumes that all audits meet minimum legaland professional standards (except of course the cases of outright audit failure), andtherefore the research focuses on differential audit quality above and beyond the legalminimum At an intuitive level we observe that there are many different kinds of auditfirms which suggest there is a supply of differential auditing demanded by differentclienteles

4.1 The big firm–small firm dichotomy

The first wave of auditor-differentiation research focused on the dichotomy betweenlarge and small firms as a basis for differential audit quality.DeAngelo (1981)argues thataccounting firm size is a proxy for quality (auditor independence) because no single client isimportant to a large auditor and the auditor has a greater reputation to lose (their entireclientele) if they misreport By contrast, an accounting firm with only one client maylogically conclude that they have more to gain by going along with their client andmisreporting than by being tough and potentially getting fired A related line of researchargued that the large ‘Big 8’ international accounting firms had established brand namereputations and therefore had incentives to protect their reputation by providing high-quality audits (Simunic and Stein, 1987; Francis and Wilson, 1988) These arguments donot necessitate that Big 8 (now Big 4) audits are always superior Individual audit failures

by Big 4 firms can and do occur Rather, the arguments simply mean that audits of Big 4firms as a group will, on average, be of higher quality than other (smaller) accounting firms.There are several streams of research motivated by the big firm-small firm dichotomy.Many studies document that Big 4 audits around the world carry a premium relative to theaudits of other firms, after controlling for client characteristics affecting audit fees such assize, complexity and auditor-client risk sharing (Simunic, 1980) On average the Big 4premium has been around 20%.Moizer (1997)provides a review of earlier studies, and formore recent evidence seeDeFond et al (2000), Ferguson et al (2003) A higher audit feeimplies higher audit quality, ceteris paribus, either through more audit effort (more hours)

or through greater expertise of the auditor (higher billing rates).8

The question then arises as to whether or not there is a demand for differential auditquality given that any licensed auditor can legally satisfy the requirement to have an audit

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A higher audit fee per se does not necessarily ensure a higher quality audit, particularly if accounting firms have pricing power over clients However, the evidence on audit outcomes reviewed later in the paper provides confirmatory evidence that accounting firms charging higher fees (such as the Big 4) also provide higher quality audits on average.

In other words, why do firms voluntarily pay more for a higher quality audit when priced and legal alternatives exist? Research has focused on those clienteles that logicallymight be expected to demand higher quality audits Specifically, the evidence indicatesthat firms with greater monitoring needs due to higher agency costs are more likely to useBig 4 auditors (Francis and Wilson, 1988; DeFond, 1992; Francis et al., 1999) A secondline of argument is that firms with greater inherent uncertainty (and greater informationasymmetry between the firm and outsiders) have an incentive to communicate theirintrinsic quality by hiring a more credible, high-quality auditor This argument has mostlybeen made in the context of IPOs and the evidence indicates there is reduced informationasymmetry (i.e less underpricing) when going public with larger brand name auditors(Beatty, 1989; Willenborg, 1999).

lower-Corroborative evidence from other research supports the notion that larger accountingfirms supply higher quality audits For example, the Big 4 firms are sued relatively lessfrequently after controlling for clientele size, and Big 4 firms are sanctioned lessfrequently by the Securities and Exchange Commission (Palmrose, 1988; Feroz et al.,

1991) A counter explanation is that the large accounting firms are not really better, theyjust have more resources to fight lawsuits and regulators However, research on auditoutcomes, which is discussed next, rebuts this view with evidence of higher quality audits

by larger (Big 4) accounting firms

There are two observable audit outcomes, audit reports and audited financialstatements Evidence from audit report research supports that Big 4 auditors are ofhigher quality.Francis and Krishan (1999)show that Big 4 auditors have lower thresholdsfor issuing modified audit reports, which indicates greater reporting conservatism for agiven set of client characteristics.Lennox (1999) finds that Big 4 auditors report withgreater accuracy in the United Kingdom, andWeber and Willenborg (2003)find that thepre-IPO audit reports of large national and international (Big 4) accounting firms havemore predictive accuracy than smaller accounting firms with respect to future stock returnsand subsequent delistings

The evidence from financial statements also supports that Big 4 audits are of higherquality Using the abnormal accruals paradigm (Jones, 1991), the evidence indicates thatclients of Big 4 audited companies have lower abnormal accruals which implies lessaggressive earnings management behavior and therefore higher earnings quality (Becker

et al., 1998; Francis et al., 1999).9Consistent with these findings,Nelson et al (2002)

report evidence from one Big 4 accounting firm that auditors detect earnings managementattempts (especially income-increasing attempts) and require clients to make appropriateadjustments In addition,Teoh and Wong (1993)document that the earnings surprises ofBig 4 audited companies are valued more highly by the stock market which is consistentwith higher earnings quality when a Big 4 firm is the auditor

In sum, despite some recent high-profile cases, the collective evidence is stronglysupportive that audits of large (Big 4) accounting firms are of higher quality There is one

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The accrual paradigm calculates unexpected or abnormal accruals relative to an expectation model of normal accruals Abnormal accruals imply that managerial discretion over accounting is used to distort reported earnings for private benefits, and that managed earnings are different from the outcome of a neutral application of generally accepted accounting principles ( Schipper, 1989 ).

troubling aspect to this line of research An alternative explanation may simply be that

‘good’ companies are more likely to select Big 4 auditors, are less likely to manageearnings, and in general are more likely to have higher quality earnings In other words,it’s not high-quality auditing that causes the observed audit outcomes; rather, auditorchoice is endogenous and it may simply be that good firms with good earnings quality hirehigh-quality auditors Even though prior research has controlled for systematic clienteledifferences between Big 4 and non-Big 4 auditors, endogeneity and selection cannot beentirely ruled out as an alternative explanation and more work is needed on this importanttopic A few studies have examined endogeneity and these studies are generally supportive

of the research results cited above SeeHogan (1997), Ireland and Lennox (2002), andWeber and Willenborg (2003)

5 Moving beyond the big firm-small firm dichotomy

The first wave of research described above viewed the Big 4 as a homogenous group offirms The second wave of research relaxes this assumption and has begun examiningpotential sources of differentiation in audit quality within the dominant Big 4 group ofaccounting firms.10 Three primary sources of differentiation have been investigated todate: differences due to industry specialization, differences across individual practiceoffices (cross-city differences), and institutional differences across countries (cross-country differences)

5.1 Industry expertise

Big 4 accounting firms promote their industry expertise and we observe empirically thatindustry market shares are not evenly distributed among the large accounting firms Thelinkage between industry market share and industry expertise is as follows.Solomon et al.(1999)argue that industry experts have a deeper knowledge than non-experts due to greaterexperience in the industry which enables experts to make more accurate audit judgments Ifaccounting firms have more clients/fees in an industry, then they have more opportunitiesfor their auditors to acquire the kind of deep industry knowledge which leads to industryexpertise.Francis et al (2005)use the new US audit fee disclosures for 2000–2001 andcalculate industry fee leaders for 63 non-financial industries based on two-digit SICindustry codes On average they find that industry leaders have 50% of industry fees, whilethe number two firm has only 22% of industry fees Industry leadership in the 63 industries

is widely dispersed among firms and distributed as follows: Arthur Andersen (14), DeloitteTouche (5), Ernst and Young (16), KPMG (9), and Pricewaterhousecoopers (19).The evidence in support of industry expertise parallels the research on Big 4audit quality Audit fees are higher for industry leaders implying higher audit quality,

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Another reason for this development is that Big 4 market shares continue to expand globally and now exceed 90% of publicly listed companies in the US From a practical viewpoint this means there is low power in research designs of studies comparing large and small auditors because there is such low variance in the experimental variable, i.e most observations are audited by large (Big 4) auditors.

and consistent with this there is evidence that earnings are of higher quality when theauditor is an industry expert Regarding audit fees,Francis et al (2005)document that theindustry leader in the US has a fee premium relative to other Big 4 auditors;Ferguson et al.(2003)find that the top two industry leaders in Australia earn a premium relative to otherBig 4 auditors; andDeFond et al (2000)find that the top three industry leaders in HongKong earn a premium relative to other Big 4 auditors The fee premia in these studiesrange from 10 to 30% There is also evidence that audited financial statements are ofhigher quality when audited by an industry expert.Balsam et al (2003)document thatabnormal accruals are smaller for companies audited by industry experts, which impliesless managerial discretion and higher earnings quality, whileBalsam et al (2003) andKrishnan (2003)document that earnings surprises are valued more highly by the stockmarket, which is also consistent with higher earnings quality There is additional evidencefrom Elder and Zhou (2002) who find that IPOs having industry experts exhibit lessunderpricing and smaller abnormal accruals, andKrishnan (2004a)who finds that earningsaudited by industry experts are more conservative using theBasu (1997)framework.5.2 Cross-office differences in audit quality

In a series of recent papers I have argued that it may be more insightful to analyzespecific offices of large accounting firms rather than the firm as a whole (Reynolds andFrancis 2000; Ferguson et al., 2003; Francis et al., 2005) The reason for this view is thatindividual audit engagements are administered by an office-based engagement partnerwho is typically located in the same city as the client’s headquarters The way we thinkabout an accounting firm changes dramatically when we shift the unit of analysis awayfrom the firm as a whole, to the analysis of specific city-based offices within a firm Interms ofDeAngelo’s (1981)argument, a Big 4 accounting firm is not so big when we shift

to the office level of analysis For example, while Enron represented less than 2% of ArthurAndersen’s national revenues from publicly listed clients, it was more than 35% of suchrevenues in the Houston office

Reynolds and Francis (2000)report the first office-level of study of US companies andauditors They find that auditors treat relatively larger clients in offices moreconservatively than smaller clients Specifically, larger clients in offices have smallerabnormal accruals (implying less earnings management) and larger clients are also morelikely to receive a going concern audit report By contrast, when client size is measured atthe firm level using national clienteles (instead of office-level clienteles) there is noassociation between client size and auditor behavior The study demonstrates theimportance of an office-level analysis: we see a different picture when decomposing firmsinto practice offices and analyzing the offices separately

The next development in office-level research is a re-examination of auditor industryexpertise as an office-specific phenomena rather than a firm-wide characteristic across alloffices of accounting firms The central issue in the ‘national’ versus ‘city’ perspective onindustry expertise is the degree to which there is a transfer of expertise wherein a Big 4firm ‘captures’ the office-based industry expertise of its accounting professionals anddistributes it to other offices in the firm’s network beyond specific offices where the expertsreside and work The argument for the transfer of expertise is that accounting firms can

capture industry expertise through knowledge-sharing practices such as internalbenchmarking of best practices, the use of standardized industry-tailored audit programs,and extending the ‘reach’ of professionals from their primary local-office clientele to otherclients through travel and internal consultative practices The alternative viewpoint is thatauditor expertise is uniquely held by individual professionals through their deep personalknowledge of clients, and cannot be readily captured and distributed by the firm to otheroffices and clients Transfer of expertise would be evidenced if national (firm-wide)reputation for industry expertise is priced by the audit market, but would not be supported

if it turns out that only local-office (city-specific) reputation is priced

Studies using Australian and US data indicate that auditor reputation for industryexpertise is neither strictly national nor strictly local in character (Ferguson et al., 2003;Francis et al., 2005) Rather, the evidence indicates that auditor industry expertise is mostcredible when the auditor is jointly the national industry leader and the city-specificindustry leader, indicating that there is both a national and local-office reputation effect inthe pricing of industry expertise The premium for joint national–city leaders is around20–25% higher relative to fees of other Big 4 auditors This is evidence of the transfer ofexpertise since national leadership does affect the audit fee premium However, the results

do not strongly support the transfer of expertise argument since national leaders alone,without also being city-specific industry leaders, never have a significant fee premium.There is also some evidence that city-specific industry leadership alone (without alsobeing a national industry leader) may result in a fee premium in the US, although thisresult does not hold in all of the sensitivity analyses.11Basioudis and Francis (2004)report

an even stronger city reputation effect in the United Kingdom They report no significantpremium for national industry leadership, while city-specific industry leaders (alone) earn

a premium of around 20% relative to other Big 4 auditors, with no additional premium forbeing joint national–city leaders In sum, these studies demonstrate significant cross-cityvariation in auditing and support that the office-level of analysis is an importantdevelopment in research on audit quality

5.3 Other approaches to the study of audit quality

There are other approaches to the study of auditor quality including research on audittenure, non-audit fees, audit committees, accounting firm alumni, and the effect of legalsystems on auditor incentives Each of these is now briefly discussed

Auditor tenure research examines if the length of the auditor-client relationship affectsaudit quality, and is motivated in part by calls for mandatory auditor rotation Theargument for rotation is that auditors can become captive to clients in long tenuresituations The counter-argument is that auditors have strong economic incentives tomaintain their independence and internal mechanisms such as the rotation of engagementpersonnel are sufficient to maintain the skepticism and independence of auditors

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In follow-up research-in-progress, the authors find that earnings quality also follows the same implied hierarchical ordering, with clients of joint city–national leaders having the highest earning quality, clients of city leaders (alone) the next highest earnings quality, and clients of national leaders (alone) being no different than other (nonleader) auditors.