Financial reporting is reckoned as the most significant medium of communication between the firm and the stakeholders. Financial reporting has its roots in agency theory by Jensen and Meckling (1976)¹. It postulates that agency relationship is the result of separation of ownership and management, and managers may not always act in the best interests of owners. Financial reporting is a means to reduce agency costs and its independent external audit aids in monitoring actions of managers.

External audit certifies that financial reporting information portrays a true and fair view of fundamental economics of firm thereby providing an independent assurance about the credibility of financial reporting information (Francis, 2004)². Client’s or companies demand for audit quality because of agency costs. The firms where agency costs are high would like to have higher audit quality in order to reduce information risk. Moreover, regulations with respect to the role of audit committee and internal audit function also leads to demand for higher audit quality. It is, therefore, considered as an integral part of corporate governance mosaic which is responsible for overseeing the financial reporting process (Cohen, Krishnamoorthy and Wright, 2004)³. Moreover, the auditors themselves are interested to supply higher audit quality because of litigation risk and reputation risk. Owing to the significance of external audit in assuring financial reporting quality, the academic accounting research has tried to probe into the measurement of audit quality and its impact on financial reporting quality. The academic accounting research conjectures that the quality of audit has an impact on financial reporting quality and as such it is one of the components of financial reporting quality (DeFond and Zhang, 2014)⁴. In the light of this supposition, the advocates of empiricism have made an attempt to assess audit quality using various proxies like auditor size, fees, non-audit services and industry specialization. This review endeavors to understand audit quality, its role in financial reporting, take a stock of proxies used to assess the audit quality and suggest the direction for future research.

Audit Quality:

Auditors play a very important role in the financial reporting process as they give assurance about the credibility of financial reporting information. The onus of detecting and reporting any material error or violation of Generally Accepted Accounting Principles (GAAP), carried out intentionally or unintentionally, by the client is on the auditor. Thus, audit quality is the ability of auditor to detect GAAP violations and report that violations (DeAngelo, 1981)⁵. Failure to give a qualified opinion is this regard leads to audit failure and in some instances litigation against the auditor. Thus, litigation against the auditor is an evidence of audit failure and impairment of audit quality (Francis, 2004)². This conceptualization is however episodic in nature and can be known only when a litigation is initiated against auditor. Therefore, viewing audit quality as a gamut of various events/activities can aid in better conceptualization of audit quality. Francis (2004)² conceptualizes audit quality as continuum of low quality to high quality. Audit failure and litigation due to such failure falls in the low end of continuum, meaning thereby that audit is of low quality. The prospective source of ascertaining audit failure, apart from litigation, is earnings restatements and Accounting and Auditing Enforcement Releases (AAER’s). Auditor – client alignments and audit outcomes fall in the rest part of the continuum (Francis, 2004)². This conceptualization though takes a step further than mere detection of GAAP violations, does not consider pre-audited financial statements which is the main input to the audit process. These financial statements are result of the internal financial reporting system designed to map the fundamental performance of firm, which in turn depends on fundamental characteristics of firm. DeFond and Zhang (2014)⁴ acknowledges this broader idea by arguing that the responsibility of auditor is not mere detection of GAAP violations but to provide assurance of quality of financial reporting. They define higher audit quality as ‘greater assurance that the financial statements faithfully reflect the firm’s underlying economics, conditioned on its financial reporting system and innate characteristics.’ Thus, audit quality is considered as the important ingredient of financial reporting quality.

Proxies to Measure Audit Quality:

Extant literature has documented various proxies to measure audit quality. These proxies can be divided into two categories, namely, output based measures and input based measures (DeFond and Zhang, 2014)⁴. The output based measures include material misstatements (restatements, AAERs), auditor communications (Going concern opinions), financial reporting quality (discretionary accruals, meet/beat targets, accrual quality and conservatism) and perception based measures (market reaction, cost of capital, change in market share and PCAOB inspections). The input measures include auditor characteristics (Big N and industry specialization) and audit-client contracting features (audit fees, change in fees, non-audit fees). The output based measures are captured in earnings quality. Thus, the focus is on input based measures because clients demand for audit quality depends on observable inputs (DeFond and Zhang, 2014)⁴. The input based proxies are discussed below:

a) Size of Audit Firm:

The size of audit firm is generally measured as a dichotomous variable indicating the presence or absence of a Big 4 auditor. It is argued that firms having Big 4 as an auditor will have higher audit quality as they have stronger incentives, reputation and greater competencies than other auditors. For a large auditor, a single client is not very important and in case of misreporting there is a greater loss of reputation. However, a small auditor, with lesser number of clients, may prefer to misreport rather than losing clients. Moreover, firms with higher agency cost and information asymmetry try to make their communication more credible by appointing a Big 4 as auditor. Thus, the size of audit firm can be used as a proxy for audit quality (DeAngelo, 1981)⁵. Studies like Becker et al. (1998)⁶; Zhang et al. (2007)⁷; Palmer (2008)⁸; Chen et al. (2011)⁹ have used auditor size as a proxy for audit quality.

b) Audit Fees:

Audit fees are the measure of auditor’s effort. Higher audit fees means higher audit effort (more hours) or more expertise (higher billing rates) (Francis, 2004). So, it is used as a proxy for audit quality. Audit fees scaled by total assets or total sales or total audit fees is used as a proxy for audit quality. Studies like Frankel et al. (2002)¹⁰; Zhang et al. (2007)⁷; Stanley et al. (2007)¹¹; Tang et al. (2012)¹² have used audit fees as a proxy for audit quality.

c) Non-Audit Services:

Non-audit services are services provided by auditor other than the audit service. By providing non audit services, the auditing firms enter into a commercial relationship with the company. This may influence the independence, objectivity and skepticism of auditors, which may impair audit quality (Tepalagul and Lin, 2015)¹³. Non-audit service is negatively associated with audit quality. Studies like Frankel et al. (2002)¹⁰; Kinney, Palmrose and Scholz (2004)¹⁴; Stanley et al. (2007)¹¹ have used non-audit services as a proxy for audit quality.

d) Industry Specialization:

Industry specialization is a means of creating differentiation for audit firms (Francis, 2004)². It is measured using client industry concentration. Industry specialist auditors are expected to have greater audit quality because of more competency and reputation and also command higher audit fees. In an experimental study conducted on sample of 70 auditors, Hegazy, Sabagh and Hamdy (2015)¹⁵, found that industry specialist auditors are better than non-specialist auditors in detecting frauds and misstatements. Studies like Dunn and Mayhew (2004)¹⁶ and Stanley et al. (2007)¹¹ have used industry specialization as a proxy for audit quality.

e) Cross City Differences:

Office level analysis of accounting firms rather than firm level analysis renders a different perspective to the understanding of audit quality. Generally, individual audit contracts are executed by the office of the firm located in the city of client’s headquarters. As quoted by Francis (2004)², ‘Enron represented less than 2% of Arthur Andersen’s national revenues from publicly listed clients, it was more than 35% of such revenues in the Houston office.’

f) Auditor Liability Exposure:

Auditor’s incentives to misreport are affected by potential legal liability and other punitive actions for negligence and misconduct (Francis, 2004)². The legal system were auditor liability is more, audit quality of higher level can be expected.

g) Auditor Tenure:

The tenure of auditor and client relationship can also impact audit quality and auditor incentives. In case of long tenure, auditor can become captive to clients. However, mandatory rotation of auditors and cooling period has been initiated to reduce auditor tenure. Zhang et al. (2007)⁷ has used tenure of auditor as a proxy for audit quality.

Audit Quality and Financial Reporting:

The fundamental objective of financial reporting is to provide information that is useful for the purpose of making investment and credit decisions (ICAI, 2000)¹⁷. This objective of decision usefulness is achieved when financial statements reflect the true underlying economics of the firm and adequate disclosure of other information that can aid in decision making. This is consistent with decision based approach to accounting research which focuses on decision usefulness of information (Wolk, Dodd and Rozycki, 2008)¹⁸. However, this objective is marred when manager’s make opportunistic use of the discretion, referred to as earnings management. In this scenario, an independent assurance from auditors with respect to the credibility of such information becomes vital. Auditors bring out the discrepancy in financial reporting by giving qualified opinions, earnings restatements and disclosure of internal control weaknesses. Thus, audit quality plays an important role in ensuring quality of financial reporting. Literature has documented the impact of audit quality on earnings management, earnings restatements, disclosure of internal control weakness and disclosure level. The respective studies are summarized below.

Earnings Management:

Becker et al. (1998)⁶ used Big 6 auditors as a proxy for audit quality and found that non Big 6 auditor firms have higher discretionary accruals than Big 6 auditor firms by an average of 1.5-2.1 % of total assets. The discretionary accruals were estimated using Jones (1991)¹⁹ model. The study by Chen et al. (2011)⁹ used Big 4’s and 4 big auditors in China as a proxy for audit quality. They found lower level of earnings management and cost of equity capital for firms audited by Big 4’s and 4 big auditors in China. Thus, it can be inferred that auditor size helps in controlling earnings management incentives. Audit fees and non-audit fees are also used as a proxy for studying earnings management activities of firms. Frankel et al. (2002)¹⁰ used audit fees and non-audit fees as a proxy for audit quality. They found a positive association between non audit fees and magnitude of discretionary accruals. However, audit fees are found to be negatively associated with earnings management indicators.

Earnings Restatements:

Stanley et al. (2007)¹¹ examined the relationship between the tenure of auditor and likelihood of earnings restatements using a matched sample of 382 companies with and without restatements for 2001-04. The short tenure expertise and independence was proxied by industry specialization and audit fees whereas the long tenure independence was proxied by non-audit fees. They found a negative relationship between length of auditor-client relationship and likelihood of restatement. This implies that industry specialization and audit fees are effective in improving financial reporting quality whereas non-audit service placing auditors in business relationship with client is not effective in improving financial reporting quality.

Disclosure of Internal Control Weakness:

Zhang et al. (2007)⁷ examined the relationship between auditor independence and disclosure of internal control weakness. The auditor independence was measured as ratio of audit fees to total fees. The indicator variables for presence of Big 4 as auditor and change in auditor was also used in the study. The matched sample of 208 firms was based on the indicator variable. They found that if auditors are independent, there is more likelihood of detecting internal control weakness.

Disclosure Quality:

Dunn and Mayhew (2004)¹⁶ studied the relationship between industry specialization of auditor and disclosure quality. Industry specialization of auditor is measured by total sales audited by an audit firm within an industry and disclosure quality is proxied by Association for Investment Management and Research (AIMR) rankings. They found positive association between auditor industry specialization and analyst ranking of disclosure quality in unregulated industry, but found no relation in regulated industry.

Audit Quality in India:

The studies referred earlier are with respect to western countries. In India, the litigation risk and liability for auditor is lower in comparison to US or UK (Wingate, 1997)²⁰. This will impact auditor independence and thereby audit quality. Thus, it becomes important to validate the use of proxies relevant in western context for India. The existence of majority of family groups have made corporate governance mechanism legalese and compliance oriented. Meagre work has been done in the context of audit quality in India. With respect to the presence of Big 3 auditors, Jaiswall and Banerjee (2012)²¹ note that Big 3 are effective in curbing managerial discretion in smaller firms only. This may mean that bigger firms may engage in higher earnings management, even with the presence of Big 3. Joshy, Desai and Agarwalla (2015)²² found no difference in the quality of earnings (estimated using discretionary accruals) between the clients of Big 4 and Non Big 4 audit firms. Thus, Big 3/4 are used by firms just to indicate superior quality of reported information. This corroborates with the findings of Kaushik and Kamboj (2012)²³. They conclude that BSE 500 companies do not consider size of audit firm as proxy for audit quality. These evidences provide a case for exploring other proxies for measuring audit quality in India.

Scope of Future Research:

The role of auditor has been primarily important in financial reporting process as it provides independent assurance about the credibility of financial reporting information. The agency costs arising out of the separation of ownership and management, and use of financial reporting information for investment and credit decisions, has aggravated the assurance role an auditor has to play. The users of financial reporting information place a higher trust in information content of financial reports when it is certified by auditors to be true. However, financial reporting frauds like Enron and Satyam has made investors skeptical about the skepticism and objectivity of auditors. In this scenario, it becomes important to measure audit quality, in order to restore the confidence of investors in financial reporting quality. There has been a flurry of research with respect to audit quality in western countries, especially the USA. The extant literature has identified many proxies to measure audit quality and examined its impact on earnings management and disclosure quality. However, the cross country differences in the legal environment prevents the researchers from using the same proxies in Indian context. As the litigation risk for auditors is lower in India in comparison to the USA, there is a probability of leniency on the part of auditors in issuing qualified opinions. Also, the audit reports are of generic template and number of clean audit reports is quite overwhelming. Moreover, the listed companies are more or less equally distributed among Big 4 auditors and Non-Big 4 auditors, which casts a doubt on the use of size as proxy for audit quality. The further research needs to look at newer dimensions or a modification in already existing dimensions of measuring audit quality. For example, Satyam paid more fees to the auditor in the year of fraud. It also paid more fees to the auditors in comparison of its peer companies. Thus, looking at the year-on-year percentage change in audit fees and also a comparison with audit fees paid by peers can give better picture of audit quality. Moreover, other parameters like the amount of penalty and big pockets of auditors, number of branches of audit firm, international presence of audit firm and the number of partners in audit firm can be considered for empirical research on audit quality. The regulations in India, though quite comprehensive, can come up with a composite measure or index which ranks the audit firms in terms of their quality. An action in this direction has been initiated by the Public Company Accounting Oversight Board (PCAOB), USA. The board has issued a concept release in 2015 which contains a portfolio of indicators to evaluate audit quality. Such an action can also be initiated by the regulators in India.

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Received on 20.03.2017 Modified on 10.04.2017

Asian J. Management; 2017; 8(2):262-266.

DOI: 10.5958/2321-5763.2017.00040.3