Audit Quality and Audit Firm Size: Revisited by Dan A. Simunic

2589 Words Sep 20th, 2010 11 Pages
Audit Quality and Audit Firm Size: Revisited

by

Dan A. Simunic
The University of British Columbia

December, 2003

Background:

1. Audit quality is an important element of corporate governance – although it’s unclear whether audit quality and other aspects of corporate governance (e.g. director knowledge and independence) are fundamentally complements or substitutes.

2. Notion that audit quality varies systematically across classes of audit firms (now Big 4 vs. non-Big 4) has been a very productive research hypothesis since early 1980’s:

* audit quality = level of assurance (probability that financial statements are fairly stated when an unqualified opinion is given)

* “product differentiation hypothesis”
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* U.S. market for audits of publicly held companies (with high agency costs from separation of ownership and management) was dominated by Big 8 firms. (Higher audit quality has value in this context.)

* IPO firms appeared to “seek out” Big 8 firms prior to a share offering. (Higher audit quality has value in this context).

* Peat Marwick Mitchell (now KPMG) lost significant market share among small U.S. OTC public companies in 1970’s when that firm faced many lawsuits (e.g. National Student Marketing) and was the subject of SEC sanctions. (Auditor reputation is likely most important to small companies.)

Thus, D&S don’t really provide “theory”, but logical arguments together with empirical observations.
Critique of D&S: * Argument underlying a constant expected audit quality for an audit firm (in a place at a moment in time) is still reasonable, but assumes limited information about an audit.

* Other credible information about a specific audit available to users, makes auditor brand name less important. e.g. audit fees (where disclosed) might also proxy for audit quality.

* Some empirical regularities supporting the notion of higher audit quality by Big firms noted by D&S have changed or have alternative interpretations:

> PW audit fee premium not subsequently observed, but most subsequent studies find evidence of a Big 8(6)(4) fee premium

> Big firm dominance in
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