Review Of The General Aspects Of Audit Quality
Introduction
This essay reviews the work of Jere R. Francis produced in 2004. It focuses on the assessment of audit quality. Post financial crisis, audit quality has been questioned and has been the subject of high-level inquiries in several fields. With mounting concerns and debates about audit quality, I implicitly assume that audit quality is one of the fundamental features of the audit profession. Therefore, I will discuss the two general aspects of audit quality which I find most appealing – differential audit quality and audit failure. Then, I continue with a further discussion on high-quality audits, litigation and business failures. The following essay starts with an introduction, followed by a discussion and ends with a conclusion for each theme.
Differential Audit Quality
The existence of differential audit quality (DAQ) cannot be doubted as there is a supply of audit that involves a different level of hours and effort in auditing. Furthermore, the availability of different kinds of audits firms proves the supply of differential auditing. Therefore, in order to gain an in-depth understanding of DAQ, research focuses on big firm-small firm dichotomy.
High-Quality Audits by Big 4
The division of audit firms proves that there are indeed different levels of audit quality. Collective evidence finds that larger firms produce high-quality audits (HQA). Firstly, the well-known term “Big 4” has built up reputations of four big accounting firms. This brand-name reputation has provided sufficient incentives for Big 4 to produce HQA. Other empirical evidence can be identified from two observable outcomes – auditor’s report and client’s financial statement. Lennox (1999) finds that Big 4 auditors in the UK report with greater accuracy. Moreover, Weber and Willenborg (2003) find that the pre-IPO audit reports of Big 4 have more predictive accuracy than smaller accounting firms relating to future stock returns and subsequent delistings. These are due to their ability to develop more industry-specific knowledge and expertise, thereby enabling them to provide HQA.
Francis and Yu (2009) also find that Big 4 are competent to offer higher quality audits as they have greater internal experience in conducting such audits. Based on clients’ financial statements, evidence finds that auditors from one of the Big 4 have discovered attempts of earnings management. They then require clients to make appropriate adjustments. This professionalism proves that they are on track in producing HQA. Despite all the cumulative evidence above, Francis (2004) states that it may be a coincidence that these outcomes occur when a Big 4 firm is the auditor. He also adds that it may be that clients are less likely to manage earnings, and more likely to have higher quality earnings in general. In addition, there was not much discussion on small firms in articles regarding HQA. Hence, omitted variables and other explanations could be the cause of the high-quality audits, and not exclusively because the auditors are from Big 4.
Audit Failure
Audit failure has become a more controversial issue following the accounting scandals, and the financial crisis happened about a decade ago. Francis (2004) asserts that audit quality can be conceived as a theoretical continuum. Logically, audit failures happen on the low-end of the quality range. Hence, we could relate audit quality to audit failure. We can observe audit failure based on a few cases. These include auditor litigation and business failures. Moreover, there are two conditions where audit failure can befall. First, is when an auditor does not implement GAAP. Second, is when an auditor fails to issue a modified audit report. These are considered as audit failures because the audited outcomes are potentially misleading to users. There are not many pieces of evidence provided in Francis (2004) about litigation against auditors and business failures. Nevertheless, with the support of other articles, I managed to grasp the relation of the above cases to audit failure.
Auditor Litigation
Carcello and Palmrose (1994) find in their study that accounting issues are one of the reasons to litigations. The auditors are charged as they are unable to reveal misrepresentation of financial statements in the audit reports. Thus, indicating audit failure. Frost (1994) and Kinney and Smith (1992) assert that the presence of modified reports could protect auditors from legal liability. Modified reports can signal client difficulties earlier to bankruptcy, thus reducing the likelihood that business failure surprises users. Nevertheless, research by the latter article finds a small percentage that modified reports precede litigation. I implicitly assume that this occurs because the modified report are incomprehensive. Therefore, resulting in the litigations. However, these reports reveal the merits of claims and results in dismissals. Hence, though modified reports do not prevent the occurrence of lawsuits, they may reduce its severity. In short, auditors’ negligence in auditing give rise to litigations. This carelessness thereby implies audit failure. There is also evidences that business failure leads to litigations. This will be discussed below.
Business failure
Business failures in the savings and loan industry had created a potential litigation crisis for auditors. The president of the Lincoln Asset Management Company, David Gleeson claims that auditors fail to exercise their fiduciary responsibilities as the auditors did not warn of problems in the savings and loan industry. The company thereupon filed a lawsuit against its auditors. Again, this dereliction of duty has led to business failure and ultimately induce litigation. Other than that, Carcello and Palmrose (1994) claim that stakeholders will be less surprised by a business failure if it is preceded by a going concern audit report warning of this possibility. This shows the significance of audit reports as they may help stakeholders to prepare ahead of a business crisis. Nevertheless, it may be wrong to presume an audit failure has occurred just because a business failure occurs.
Carcello and Palmrose (1994) reveal that the majority of failed businesses in their sample have no litigation against auditors, hence no audit-related issues. These imply that audit failure is not always the reason behind business failures. In conclusion, all the above-stated evidence reveal that audit failure eventuates litigation and business failures. Evidence also shows that in some cases, business failure is followed by litigation. Therefore, audit failure can lead to both business failure and litigation. Nevertheless, it has yet to be found that litigation precedes business failure. Finally, some articles provide proposals to reduce the likelihood of audit failure. Jagan Krishnan & Francis J. R. (2002) recommend auditors to do client screening and implement greater reporting conservatism while Tacket, Wolf and Claypool (2004) suggest stricter regulations on the accounting profession.
Conclusion
Based on all the discussions above, research has proven the relatability of differential audit quality and audit failure to the assessment of audit quality. By looking at different sizes of audit firms, differential audit quality can be distinguished. Moreover, pieces of evidence show that larger firms are capable of producing high-quality audits (HQA). Additionally, with respect to DeAngelo’s (1981) definition of audit quality that describes audit quality in terms of audit risk, it can be implied that the higher the quality of audit, the lesser the possibility of audit failure. Hence, the significance of HQA. Furthermore, it can be deduced that auditor litigation and business failures are possible indications of audit failure. Despite the existence of the above events, the audit outcomes can still be associated with a certain level of audit quality. Regardless of the approaches to assessing audit quality, we have still yet to find the optimal level of audit quality. Hence, we are not guaranteed if an audit gives a sufficient level of assurance. On top of that, we must endeavour in ensuring all variables and other explanations are considered in future research. This is to produce valid and fair theories about auditing. All in all, this literature review has helped me comprehend about audit quality more assuredly.
Self-Evaluation
For personal task-management, I have created a table of goals where I make ticks once they are accomplished. I also made a list of priorities for this task. Therefore, I was able to finish it in time. As for the review, I begin with reading the abstract and continue with the heading, sub-headings and conclusion, to get a hint of what is discussed. After identifying the themes, I start reading the paragraphs carefully. Then, I use DiscoverEd, Google Scholar and other platforms to search for related articles. Hence, I use the main article and other works of literature to write this review.
Areas for Improvement
I am grateful to be able to review a straightforward essay like Francis’s (2004). Nevertheless, I had difficulties when choosing relevant articles for the review. Therefore, I hope to improve my research skills. Moreover, I hope to improve my note-taking skills so I could highlight main ideas and take notes orderly. Furthermore, I discovered new terms while doing the review which has led me to investigate the topic. Thus, this widens my knowledge and increases my vocabulary. Critical thinking is anticipated too as this will help me discuss and evaluate more accurately.
