Michael T. Stein

The Production of Audit Services: Evidence from a Major Public Accounting Firm

In this research, we examine the empirical relation between client characteristics and the nature and mix of labor resources used by an international CPA firm to obtain a desired level of assurance that clients financial statements are free of material misstatement. The level of assurance is the output of an audit, while the input resources measure the effort required to produce that output, under varying client circumstances. We use disaggregated labor hours by rank within the firm (partner, manager, senior, and staff) as the measure of inputs, in order to examine how client characteristics affect both the amount and mix of labor used. To the extent that client characteristics have differential effects on the various types of labor, only disaggregated data can reveal changes in labor mix and may also provide a more powerful test (relative to tests

Voluntary Audits and the Cost of Debt Capital for Privately Held Firms: Korean Evidence

Using a large sample of privately held Korean companies that are not required to obtain an external audit, this paper examines the informational value of voluntary external audits of financial statements with respect to the cost of debt. We find that private companies with an external audit pay a significantly lower interest rate on their debt than do private companies without an audit. Further, the interest rate on borrowing is significantly lower for Big 4-audited companies than for non-Big 4-audited companies. Finally, we find that a change in a companys status from no audit to being audited - either voluntarily or because the audit became mandatory - leads to significant savings in the cost of borrowing.

Client Characteristics, Abnormal Accruals, and Auditor Switches: An Empirical Study

Abstract This paper investigates the associations among client characteristics, abnormal accruals and auditor switches. Working within a framework that categorises switches as resulting from auditor-client realignments, disagreements over accounting decisions, or dissatisfaction with auditor/client service quality, we find that auditor switches are associated with smaller, higher risk clients. Several other factors such as the issuance of securities and the existence of a modified opinion also increase the probability of an auditor switch. Notably, testing a subsequent time period to DeFond and Subramanyam (1998), we do not replicate their findings that clients with negative prior year abnormal accruals are more likely to switch auditors once other controls are in place. Further, our evidence suggests that clients that switch auditors move closer to the industry norm abnormal accruals in the subsequent period than non-switching clients, regardless of the sign of the prior period abnormal accruals. This result differs from DeFond and Subramanyam (1998) who report larger income increasing abnormal accruals for switchers. In general, we find that abnormal accruals add little explanatory power to models of auditor switching in our sample.

The association between human resource investment by audit firms and their audit quality

Abstract Utilizing unique data available only in Korea, we examine the association between investment in human resources and audit quality provided by audit firms. While human resources investment is important in improving audit quality, few studies have examined this association mainly because public data about human resources investment and financial statements of audit firms are unavailable. Using two proxies for audit quality (i.e. discretionary accruals and accounting conservatism), we provide evidence that higher compensation in audit firms improves audit quality. In addition, we find higher audit quality in audit firms with higher education expenses, when audit quality is measured by the level of conservatism of clients’ financial statements. These results support regulators’ stance that quality control through human resources investment in audit firms can effectively improve audit quality and therefore the quality of clients’ financial reporting. However, we find no association between education expenses and the average absolute value of discretionary accruals of audit clients. These results generally suggest that direct investment in human capital (i.e. compensation) is more effective in improving audit quality than indirect investment in human capital (i.e. education expenses).

An Economic Analysis of Audit and Nonaudit Services: The Trade-off between Competition Crossovers and Knowledge Spillovers Discussion of "An Economic Analysis of Audit and Nonaudit Services: The Trade-off between Competition Crossovers and Knowledge Spillovers"

In this paper, I present a model in which both markets for audit services and nonaudit services (NAS) are oligopolistic. Accounting firms providing both audit services and NAS will employ oligopolistic competition in each of these markets. In addition to auditors gaining “knowledge spillovers†from auditing to consulting or vice versa, oligopolistic competition in one market will influence the counterpart in the other market †what I call “competition crossovers†. Although scope economies due to knowledge spillovers (for example, cost savings) are always beneficial to auditors, such benefits can entice accounting firms to adopt strategies (for example, price reductions) to compete aggressively in the audit market so that some, or all, firms become worse off. A trade†off arises between these two economic forces in the two oligopolistic markets. Given the trade†off between competition crossovers and knowledge spillovers, accounting firms may not reduce their audit prices, even though supplying NAS enables firms to decrease auditing costs — a nontrivial impact of oligopolistic competition in two markets on audit pricing. The empirical implication of my results is that because of competition†crossover effects between the auditing and consulting service markets, finding empirical evidence for knowledge†spillover benefits is likely to be difficult. Control variables for “audit†market concentration†concerned with competition†crossover effects and “auditor expertise†concerned with knowledge†spillover benefits should be included in audit†fee regressions to increase the power of empirical tests. With regard to policy implications, my analyses help explain the impact of the Sarbanes†Oxley Act on “market segmentation†and, hence, the profitability of accounting firms.