The CPA Journal

By Thomas C. Wooten

The term “quality audit” means different things to different people. For example, one survey of financial statement users (Epstein and Geiger, 1994) indicated that 70% of investors believe that audits should provide absolute assurance that there are no material misstatements or fraud in the financial statements. An auditor is likely to think about audit quality in other ways. In addition to strictly following GAAS, an auditor also assesses business risk with the intention of avoiding litigation, minimizing client dissatisfaction, and limiting the damage to a reputation that could follow a “bad” audit.

Somewhere within this continuum is the perspective of the courts. When potential audit failure cases are brought before a judge or jury, no one is certain of the outcome. Audit quality as determined by the courts sometimes results in standards that are more specific than GAAS, other times less.

Measuring audit quality is also problematic. The outcome of audit quality is not directly or immediately observable. Audit quality-control procedures attempt to maintain high standards of control over the process of an audit, but an audit failure usually becomes known in the context of a business failure. When a major company experiences an audit failure, the business press will broadcast it. It is impossible to know the number of poor-quality audits that simply go undetected and unpublicized. A firm may perform a poor-quality audit but, without knowledge of the planning and fieldwork, there could be no indication of it if the financial statements are not materially misstated. Similarly, if a poor-quality audit were performed and a material misstatement overlooked, there may have been no negative repercussions.

Since audit quality is unobservable, researchers look at surrogates or indicators of audit quality, such as the opinions of experts, to determine the inputs and outputs of a quality audit. Other researchers use more objective outputs as a source of determining audit quality. If a firm has a low rate of litigation, gets very good ratings on peer reviews, and seldom has to reissue audit opinions, then one can infer that it performs high-quality audits.

Audit Quality Model

DeAngelo developed a two-dimensional definition of audit quality in 1981 that set the standard for addressing the issue. First, a material misstatement must be detected, and second, the material misstatement must be reported. Audit quality is influenced by many other factors as well. Since 1981, accounting researchers have attempted to define, measure, and study multiple dimensions of audit quality. The model presented in the Exhibit summarizes the results of this theory building and empirical research.

Factors related to detection. Detecting material misstatements is influenced by how well the audit team performs the audit, which in turn is influenced by the quality control system and management resources of the audit firm. Many studies have used firm size as a surrogate for these audit firm and audit team factors, and their findings have been controversial.

Audit firm size. The most commonly studied factor has been audit firm size. Most commonly, researchers have defined large firms as the Big Four (or their precursors). Results have shown that larger firms receive larger audit fees than smaller firms. Even after controlling for audit risk, client size, and audit complexity, there is an additional premium based on auditor identity. Attempts to determine whether this premium is attributable to higher audit quality have been mostly unsuccessful.

DeAngelo (1981) theorized that larger firms perform better audits because they have a greater reputation at stake. In addition, because larger firms have more resources at their disposal, they can attract more highly skilled employees. Others have theorized that large auditors attract a fee premium because their greater wealth reduces clients’ exposures in litigation (the deep pockets theory) (Lennox, 1999). Others have theorized that there is no real audit quality difference, but the perception exists because large firms are well known and have gained a reputation for high quality. Interestingly, the AICPA has maintained that audit quality is independent of firm size. On the whole, the evidence is mixed, but it does appear that there is some relationship between size and quality. What is unclear is whether this difference is actual or perceived.

Actual quality difference. Palmrose (1988) found that the Big Eight were less likely to have litigation brought against them than the non–Big Eight national firms. Deis and Giroux (1992) examined a sample of audit work papers and found that larger firms had less deficient work papers than smaller firms.

Krishnan and Schauer (2000) studied the relationship between firm size and compliance with reporting requirements by not-for-profit entities. They found that compliance increases with firm size. Hardiman et al. (1987) found a higher rate of reporting format noncompliance by smaller firms when reviewing audit reports submitted to the GAO, indicating that the larger firms have a process in place to ensure that the financial statements are in compliance with GAAP. These studies, however, address the compliance of financial reports to current GAAP rather than the competence and sufficiency of audit evidence or its documentation.

Mutchler et al. (1997) found that Big Six auditors are more likely than non–Big Six auditors to issue going concern opinions. This indicates that the larger firms are willing to take a more aggressive stance in issuing the appropriate opinion, have better technical ability to detect the going concern issue, or have more clients with such issues.

Perceived quality difference. Other research findings deal more with a user’s perception of audit quality rather than tangible indicators of audit quality. Palmrose (1986) and Francis and Simon (1987) found that a premium price was paid for Big Eight firms’ audit services.

Menon and Williams (1991) found that companies using the Big Eight get better pricing of stock issues. Jang and Lin (1993) found that information associated with a Big Eight firm is perceived to be more reliable for firms involved with an IPO. Morris and Strawser (1999) found that banks receiving modified audit reports by Big Six firms were more likely to be closed by regulators than banks receiving modified audit reports by non–Big Six firms.

No quality difference. Some studies have not supported the existence of a quality difference. Other studies have found that there is no significant price difference between Big Eight and non–Big Eight services (Sumunic, 1980). Nichols and Smith (1983) found that switching from a small firm to the Big Eight did not provide any stock return benefit to the switching company. Wyer, White, and Janson (1988) found no greater likelihood that smaller CPA firms would issue inappropriate opinions. The question of size versus quality will continue to be studied by accounting researchers.

Audit firm factors. Researchers have turned to panels of experts to identify characteristics at the firm level. Firms that are able to devote a sufficient amount of resources to hiring and training the best people and then giving them a well-developed audit methodology are likely to excel in detecting errors in the financial statements.

Human resources. The experts associated higher quality with firms able to field employees that are up to date technically and professionally. This dimension is associated with hiring and training. If firms can attract the best and brightest, they have the potential to become more proficient auditors. Likewise, firms that provide well-planned training enable their staffs to learn the skills and knowledge needed to perform their audit tasks well.

Control processes. Panels of experts also associate high quality with a firm that has strong controls in place over its audit process. GAAS requires a firm to maintain a quality-control system and requires auditors to adequately plan their audits. There is much leeway, however, in determining how formal and prescriptive these systems need to be. Firms with a more rigorous quality-control system and a more systematic audit methodology process are less likely to have material misstatements go undetected by their audit procedures.

Several studies have supported the idea that a strong audit methodology is associated with higher quality. Carcello et al. (1995) found that a more structured audit approach is associated with firms that have a higher propensity to issue going concern opinions.

GAAS requires the auditor to have processes in place for the acceptance and continuation of clients. Research indicates that the Big Six were less likely to accept risky clients (Raghunandan and Rama, 1999).

Research indicates that a firm participating in a peer-review process is more likely to correctly report financial disclosures (Krishnan and Schauer, 2000). Firms that closely monitored the outcome of their audit process were associated with higher quality.

Malone and Roberts (1996) found that auditors with stronger quality control systems were less likely to participate in reduced audit quality behaviors, such as inappropriately signing off on audit steps. Thus, a strong quality control system produces a higher-quality audit.

Industry experience. Firms that have multiple clients in the same industry bring a more in-depth understanding to the unique audit risks presented by a particular industry. Firms that have few clients in a particular industry may not have the critical mass to keep up with industry news and practices. Research indicates that specialization in a particular industry is a growing trend, and researchers have found that firms with specializations have financial savings and quality gains (Hogan and Jeter, 1999). Craswell et al. (1995) reported that industry specialist firms command a fee premium, which may indicate a price differential for quality. The more clients a firm has in a particular industry, the more it can build a reputation for servicing that industry. Thus, researchers have hypothesized that firms with a higher concentration of clients in a particular industry will have higher quality because they have more to lose (Deis and Giroux, 1992).

Audit Team Characteristics

The second group of characteristics identified by the expert panels relates specifically to the audit team members. When the accounting and auditing experts were surveyed, they indicated that audit team factors were more important than firm-wide factors in determining audit quality. The firm that hires well, implements a strong control process, and has industry experience will likely field a high-quality audit team.

Partner and manager attention. The experts reported that partner and manager attention to the engagement is associated with audit quality. GAAS requires that audits be properly supervised and assigned. The availability during fieldwork of the seasoned judgment of an experienced auditor provides authoritative responses to technical and procedural questions.

Planning and conduct of the audit work. GAAS states that the audit must be properly planned and performed to have reasonable assurance of detecting material misstatements. Firms that have strong audit firm factors will likely have the people and processes in place to ensure proper planning and performance.

Professionalism, persistence, and skepticism. Expert panels also identify the integrity of the individuals assigned to the engagement as a factor in detecting material misstatements. Staff that exhibit a high level of professionalism are more likely to perform their audit tasks correctly and not sign off on uncompleted audit steps. Similarly, staff that maintain persistent skepticism are less likely to accept insufficient evidence.

Experience with the client. The experts reported that experience with a specific client leads to a higher-quality audit. Staff on repeat audits are more likely to gain a better understanding of how the client’s business processes work and the particular strengths and weaknesses in the client’s accounting systems. They are able to more readily identify the areas that had the most risk and errors from the previous year and then devote additional time to these areas.

Experience in the industry. Working on multiple clients within the same industry allows the staff to become expert in the processes and procedures unique to that industry. By understanding the common weaknesses, risks, and issues faced by a particular industry, an auditor can be more confident and persistent when assessing the evidence presented by the client.

Factors Related to Reporting

The ability to properly report a material misstatement depends upon independence. If the auditor falls prey to personal, emotional, or financial pressure, then the auditor’s independence has been compromised and there is a greater chance that poor audit quality will result. The factors of audit pricing, tenure, and providing other services are theorized to affect not only independence, but also the audit team’s ability to detect financial statement misstatements.

Pricing. In order to avoid losing future audit fees (and therefore ultimate profitability on a particular client), the auditors may face pressure to avoid reporting certain accounting deficiencies. It is easier for the client to change auditors than for the auditor to develop new business; therefore, there is some incentive for the auditor to do whatever it takes to keep the client.

Researchers have also tested whether pricing pressure (lowballing) influences audit quality. Obviously, if a firm is making much lower fees, then profitability can be restored only by cutting back on the amount of audit work, thus lowering the auditor’s ability to detect misstatements. If the auditor views the client primarily as a future income stream, questions arise about the auditor’s financial independence. Thus, the issue becomes a combination of pricing and tenure where an auditor must hold on to a client in order to recoup costs and to ultimately reach profitability.

Tenure. Tenure relates to both audit team factors and independence. Audit failure appears more common with short tenures and very long tenures. After auditors have accepted a new client, some time is required to gain an understanding of the client, which leaves the auditor susceptible to missing material misstatements. As tenure increases, the auditor gains a more thorough understanding of the client’s risks and how its systems operate, and the auditor can adjust audit procedures and processes to detect misstatements.

Conversely, long tenure with the client has been associated with low audit quality. Long associations have the potential to breed complacency, less rigorous audit procedures, and too much dependence on management representations (Shockley, 1982; Deis and Giroux, 1992). The auditor can become too comfortable with the client and not adjust audit procedures to reflect the changing business and associated risks. The auditor becomes less skeptical and less diligent in gathering evidence.

Additional Services

Providing other services to audit clients may influence pricing. It is highly likely that when a firm provides both auditing and consulting services, some type of fee savings is given to the client. The firm can lose its independence if it becomes economically bonded to the client through the receipt of large fees unrelated to the audit. Additionally, the auditor may be put in the position of auditing its own work if the additional services relate to installing or maintaining the accounting function.

Until the SEC began requiring disclosure of fees in February 2001, researchers had not been able to gather much data regarding the amount of audit fees in relation to nonaudit fees. One initial study of 4,200 companies gives a preliminary indication that large consulting fees negatively affect auditor independence and reduce audit quality (Elstein, 2001). It appears that firms that provide nonaudit services are more likely to give the client more flexibility in recording and adjusting discretionary reserves that could be used to manipulate future earnings.

Last, some auditors have argued that there is actually a positive relationship between audit quality and providing additional services. They argue that providing additional services allows them to gain a better understanding of the client and its business processes.

Thomas C. Wooten, PhD, CMA, CPA, is an associate professor of accounting at the Jack C. Massey Graduate School of Business, Belmont University, Nashville, Tenn.