A Review of

Archival
Auditing
Research

Determinants of Audit Quality

Client Demand
Client Incentives (e.g. agency cost)
Client Competency (e.g. IAF)
Auditor Supply
Auditor Incentives for Independency (e.g.
reputation, litigation)
Auditor Competency (e.g. expertise, inputs to audit
process)

Regulation intervention shapes both incentives and

competency.

Definition of Audit Quality

Old: Probability that an auditor both detect and report

the breach. (understates high AQ benefits)

New: Assure that financial statements faithfully reflect

the firm's underlying economics.

Substance over form: There will be litigation risks even

statements comply with GAAP. Audit opinion only
reflects form, not AQ.

Financial Reporting Quality

1. Audit Quality
2. Financial Reporting System: maps underlying
economics into reports.
3. Inner Characteristics: characterized by its underlying
economics.
.

R and I constrain FRQ.

Financial Reporting Quality (reflect underlying

economics)
1. Audit Quality (High AQ increases FRQ)
2. Financial Reporting System (pre-audited statements):
maps underlying economics into reports.
3. Inner Characteristics: characterized by its underlying
economics.
. R & I constrain FRQ.
. Conflicts b/w auditors and managers in choosing FRS.
. Relation b/w AQ, R and I.

AQ Proxies

Supply Side - Output-based proxies (Constrained by the R

and I).

Demand Side - Input-based proxies (Observable noisy

inputs).

Output-based proxies

Material Misstatement: auditors erroneously issued an

unqualified opinion on materially misstated financial
statements.
E.g. Restatement and AAERs
Limitation: only detect large material errors.

Auditor communication
E.g. GC modified audit opinion, which is client's
ability to continue as a going concern.
Limitation: issued to financially distressed firms, lose
generalizability; excessive conservatism.

Output-based proxies

Financial reporting quality characteristics: use earnings

quality to detect opportunistic earnings management
E.g. DAC, Accrual Quality, Meat/Beat
Advantage: their continuous captures variations in
AQ
Limitation: measurement error and bias.

Perception-based measures
E.g. ERC, Cost of Capital, Stock Market Reaction
Limitation: endogeneity

Input-based proxies

Auditor characteristics: examine clients demand for AQ

E.g. Auditor Size, Industry Specialization
Limitation: fail to capture subtle variation.

Auditor client contracting features

E.g. Audit Fee (both demand and supply factors)
Limitation: endogeneity

Choose Best AQ Measure

Most appropriate for research setting

Since proxies have complementary strength, can more

than one proxies be used in one research?

Further research: inferences from proxies based on their

weaknesses or strengths.

AQ Models

Problems:
Some control variables are correlated with I and R.
Omitted correlated variables

Client Demand for AQ

Research on value of auditing

Compare audited versus unaudited financial
information
Usefulness of GC to predict bankruptcy
Market does not react to Section 404 ICMWs
Auditor change conveys information

Critique: Lack generalizability

Future research: beyond traditional financial

statements (environmental concerns)

Client Demand for AQ

Factors Driving Client Demand for AQ

Client Incentive
Agency conflicts (management ownership or
leverage)
Higher AC demand higher AQ (auditor
characteristics)

Client Competency
Corporate governance Strength
Specific Governance Mechanisms: IAF

Critique
Rely on input measures of AQ
Endogeneity

Auditor Supply for AQ

Reputation
Market-based incentives for independence
Litigation

Inputs to audit process

Competency
Expertise

Auditor Incentives
Regulation

Engagement Risk:

Reputation
Litigation
(Self-fulfilling prophecy?)

Client Business Risk & Auditor Business Risk (Litigation

Risk)

Auditor Incentives: Reputation Risk

Reputation: upside and downside; Litigation: only
downside.
Litigation risk is subject to legal environment
changes(PSLRA).
Critique: limited US evidence; rely on extreme cases;
confounded by litigation risk.
Reputation
AQ
Increase AQ to improve reputation (no evidence)

Auditor Incentives: Litigation Risk

Auditor effort (reduce risk) and fees (bear risk)

Higher litigation risk
Higher fees
Fees also reflect risk premium (transfer risk)
Disentangle effort (actual hours) and premia (billing
rates)
why not just control one variable?
Effort cant eliminate all litigation risks
Client satisfaction & fees (positive association)
Non-fee studies
Shifts in litigation risk (e.g. PSLRA)
Misstatement risk (e.g. accruals)

Auditor Incentives: Litigation Risk

Client acceptance and retention (avoid risk)

Avoid risky clients (not afraid of affecting market
share)
High quality auditor choose low quality client is
possible
Lobbying activities
PSLRA: reduced auditor liability, litigation relief
Determinants of litigation risk
Auditor characteristics (large, shorter tenure etc.)
Client characteristics (large, distressed, high growth
etc.)
Engagement characteristics

Auditor Incentives: Auditor size associated with

AQD

Material misstatements
Big N fewer restatements (weak evidence)
Auditor communication
Disentangle incentive effects from competency
FRQ
Lower DAC, timely management forecast, lower
forecast error, greater conservatism(?)
Perceptions of AQ
Larger ERC, higher analyst forecast accuracy
Auditor changes; IPO
Audit fees
Fee premium: higher AQ, monopoly pricing or risk
premium (which one?)

Auditor Competency

Competency
Incentive
Industry specialization (Big N auditors)
Motivation: increase fees and market share,
economies of scale
Greater knowledge of industry
Higher reputational capital, higher incentive
Measurement: industry market share
Approaches: audit quality proxies; market reaction
to auditor switches; fee premia
Self-selection problem
Distance between competitors
Geographic proximity
Auditor office size
Greater in-house expertise
Audit process
Materiality level; audit adjustments; audit partner
compensation

Critique

Limited research on reputation risk

Reputation risk is confounded by litigation risk
Fee study: tease audit effort form risk premia
Non-fee study: conservatism
Big-N: endogeneity and self selection; mixes incentives
and competency
Measurement of specialization

Future research

Auditor competency (e.g. ownership structure,

compensation scheme)
Individual auditor characteristic (e.g. education
background)
Audit process (black box)