Audit quality is measured by audit fees

Audit efforts are directly related to the extent of due care. For independent and competent auditors, the audit efforts spent on audit planning, execution, and reporting determine the quality of the whole audit process. Therefore, audit quality can be measured by audit efforts. Because efforts equal the audit fees divided by unit price, audit fees are a potential proxy for audit efforts (Simunic 1980).

The relationship between audit fees and audit efforts can be distorted by two issues. The first is efficiency. Some auditors may be able to plan the audit better and achieve a higher-quality audit with less effort. The efficient auditors are usually the more competent auditors who have a better understanding of the client business and are able to use more efficient audit procedures to reduce the audit risks. Therefore, to use the audit fees as a proxy for audit quality, the effect of the auditor competence should be controlled for. Second, the extent of competition in the audit market also affects the relationship between audit fees and audit efforts. As discussed in Chapter 8, audit fees can contain rents which are not related to audit efforts.

If audit efforts are measured by the actual labor inputs, this can mitigate the concerns relating to the second issue. For example, if the chargeable hours of engagement team members at various levels of expertise are known, the audit quality can then be proxied by a weighted index for the inputs of labors at each level of expertise. We can argue that one hour of partners’ time can increase the quality of the audit more than one hour of managers’ time, and so on.

Finally, the audit effort may be more related to the improvement of the quality of the financial statements, but not necessarily to the quality of the post-audit financial statements. This is a very subtle point. As we mentioned before, for a given quality of preaudit financial statements, the auditors improve the quality of the financial statements through the audit examination. When the quality of the pre-audit financial statements is very low, significant audit effort can improve the quality markedly. However, even with significantly higher quality relative to that of pre-audit statements, the quality of the postaudit financial statements may not necessarily be very high because of the initial low preaudit quality. In contrast, when the quality of the pre-audit financial statements is very high, the quality of the post-audit financial statements is high even if the audit effort is minimum. Therefore, audit efforts are more directly related to the improved quality of the financial statements, but the relationship between the audit effort and the post-audit quality of the financial statements is not clear.

Non-audit fees have been used as a proxy for auditors’ independence. Since non-audit services are usually lucrative, auditors would compromise their independence for the purpose of maintaining the profitable non-audit services, and the higher the non-audit service fees, the greater the compromise to independence will be.

Since the individuals involved in audit and non-audit services are usually not the same people, the individuals in charge of the audit services must consider their professional and legal obligations before conceding their independence. It is arguable that the costs to these individuals from conceding independence must be significantly higher than the profits shared by them from the non-audit services. Consequently, non-audit fees may only have remote impacts on auditors’ independence, unless the auditors are myopic or careless in risk management.

Other proxies for audit quality

Audit firms

Each accounting firm should hire, develop, and maintain their employees for providing the audit services to their clients. Although the detailed audit procedures are carried out by individual employees, the quality control of the firm has significant influences on the performance of the individual accountants. A firm’s quality-control policies touch many aspects of the firm’s operations, including hiring, developing, and compensating employees, managing the firm’s independence from engaged clients, risk assessment and management of engagements, staffing engagements, guidance for audit planning, execution and reporting, second partner review, resolving disagreements, technical supports, etc. Some argue that systematic difference in the quality controls among firms may exist. DeAngelo (1981b) argues that large audit firms have more to lose from audit failures. In particular, large audit firms have great wealth that attracts lawsuits and results in greater payments to plaintiffs. Furthermore, large audit firms also have more and larger clients, and any negative news about these firms would result in significant exoduses of their current clients. Therefore, because of the desire to reduce litigation and protect its reputation, a large audit firm has a greater incentive to render a high-quality audit than a small audit firm. Furthermore, large firms may have larger economic scale to train and allocate their personnel and to develop more effective and efficient audit methods and approaches for audit testing. Consequently, it is suggested that Big 4 auditors, including Deloitte, KPMG, PWC, and EY, are of higher quality than other auditors.

There are counter-arguments that audit quality is not determined by auditor sizes. First, all professional accountants are similarly qualified for their basic accounting and auditing knowledge. Second, all auditors must obtain sufficient understanding of their clients’ business and internal controls for proper planning and execution of the audit programs. Third, the audits of various clients demand different expertise, and the audit firms will selfselect the clients that they can competently audit. Fourth, the impact of litigation and reputation may be greater on partners of small audit firms since one audit failure is too much for them. Fifth, the expertise of individual accountants can be transferred from large firms to small firms through the fluid auditor labor market.

Auditor market share

The argument that an auditor’s market share is a proxy for audit quality is similar to those for the size of audit firms. If an auditor has significant market share in an audit market, the auditor is exposed to better opportunities to obtain experience. The experience will then translate into greater expertise and better audits. Furthermore, the large scale of the operation allows better training, better audit techniques, and more efficient staffing.

There are several counter-arguments. First, auditors must be competent to audit their clients. The auditors with a smaller share of the market must also be able to provide quality audits to their clients. Second, if clients have preferred audit quality, then the distribution of the demanded quality must be the same as the distribution of the provided audit quality. If the largest auditor in a market has the highest quality, this implies that in every market the largest portion of clients demand the highest audit quality, which to a certain extent is not consistent with real-life experience. With most products, the demand for the highest quality is usually lower than the demand for good quality. For example, Walmart does not have the highest-quality clothes. Instead, some much smaller specialty stores have the highest-quality clothes. Third, an auditor does not necessarily provide the same quality to all their clients. For example, auditors provide a higher-quality audit service to riskier and more consequential clients, and vice versa.

Auditor tenure

Audit tenure is the length of the auditor—client relationship, which can potentially impact the quality of audits. However, the direction of the impact is not clear since there are two competing arguments: (1) short tenure means an auditor has less knowledge of a client vs. (2) long tenure may mean that an auditor’s objectivity is potentially impaired. It is then theoretically very hard to argue that auditor tenure can be a good proxy for audit quality.

Summary

In this chapter, we discussed the validity of some important proxies for audit quality. All these proxies are correlated with at least one of the three factors determining audit quality: competence, objectivity, and due care. These proxies are related to either inputs (e.g., audit fees), processes (e.g., PCAOB inspections), output (e.g., auditor reports), or quality control (e.g., PCAOB inspection, auditor size). Many studies in the literature often use one proxy to validate another. For example, researchers might investigate the relationship between the quality of post-audit financial statements (such as discretionary accruals) and the market share of an auditor to study whether the market share of an auditor is a proxy for audit quality. By taking this approach, the researcher must accept that the quality of post-audit financial statements is a valid proxy for audit quality. To a certain extent, this is a convoluted situation and the conclusion of the study is not reliable if the validity of both measures is questionable.

End-of- chapter question

Why is information on audit quality important to users of financial statements? How do we obtain such information?

Notes

• 1. It is important to note that, if the quality of the financial statements is determined by their ability to predict the future value of the reporting entity, sometimes compliance with GAAP may not imply high quality for the financial statements. For simplicity, we assume in this chapter that GAAP are always proper standards for truthful preparation of financial statements.
• 2. Statistical power refers to the consistency (accuracy) of the projected value by the estimated model and the actual value of the dependent variable.