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Auditor expertise: Evidence from the public sector

01 Sep 2012-Economics Letters (North-Holland)-Vol. 116, Iss: 3, pp 432-435

AbstractThis paper is the first attempt to study the relationship between public auditor expertise and fiscal performance. I find that states requiring the auditor to hold a professional degree feature significantly higher credit ratings and lower expenditures and debt.

Topics: Credit rating (55%), Public sector (54%), Debt (53%)

Summary (1 min read)

Introduction

  • This paper is the first attempt to study the relationship between public auditor expertise and fiscal performance.
  • I find that states requiring the auditor to hold a professional degree feature significantly higher credit ratings and lower expenditures and debt.

1. Auditor expertise

  • In the political process the quality, quantity and timing of information is, to a great extent, determined by transparency and supervision requirements (e.g., Alt and Lassen, 2006).
  • In the corporate auditing literature, one of the main drivers of audit quality is auditor expertise.
  • Due to electoral pressure or career concerns, public decision makers face incentives to misreport.

2. Data on US state auditors

  • I take advantage of the decentralizedUS federal structure.
  • Every state has its own constitution and legal framework defining the details of its auditing institution.
  • The standard approach for studies on the influence of fiscal institutions on government performance adopts fiscal measures such as expenditure or debt as dependent variables.
  • Similar approaches have been used by, e.g., Depken and Lafountain (2006) and Schelker (2012) to study the influence of fiscal institutions and corruption, and by, e.g., Mansi et al. (2004) in the context of corporate auditing quality.
  • The data on state credit ratings are collected from Moody’s Investor Services, Fitch Ratings and Standard & Poor’s.

3. Empirical strategy

  • When estimating the effect of auditor expertise on the normalized credit rating I estimate tobit models that take into account that Rst is censored at −1 and 0.
  • The states without GOB rating are Arizona, Colorado, Iowa, Idaho, Nebraska and South Dakota.
  • When approaching this potential selection problem, I do not find a significant correlation between auditor characteristics and the excluded states.
  • I estimate random effects (RE) as well as fixed effects (FE) models.
  • All regressions include a set of standard state-specific covariates.

4. Empirical results

  • Table 1 presents the regression results of auditor expertise on GOB ratings.
  • The linear fixed effects regressions in columns 5 and 6 show that the coefficients remain statistically significant, while the impact is somewhat higher in magnitude.
  • On average, the states demanding the auditor to hold at least a CPA feature approximately a one notch higher credit rating compared to states without such a requirement.
  • Index capturing various removal procedures for the auditor.

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Economics Letters 116 (2012) 432–435
Contents lists available at SciVerse ScienceDirect
Economics Letters
journal homepage: www.elsevier.com/locate/ecolet
Auditor expertise: Evidence from the public sector
Mark Schelker
Department of Economics and Swiss Institute for International Economics and Applied Economic Research (SIAW), University of St. Gallen, Bodanstrasse 8, 9000 St. Gallen,
Switzerland
CESifo, Germany
Center for Research in Economics, Management and the Arts (CREMA), Switzerland
a r t i c l e i n f o
Article history:
Received 12 November 2009
Received in revised form
7 March 2012
Accepted 20 April 2012
Available online 27 April 2012
JEL classification:
D70
H10
Keywords:
Public auditor
Auditor expertise
Auditor competence
a b s t r a c t
This paper is the first attempt to study the relationship between public auditor expertise and fiscal
performance. I find that states requiring the auditor to hold a professional degree feature significantly
higher credit ratings and lower expenditures and debt. (39 words)
© 2012 Elsevier B.V. All rights reserved.
1. Auditor expertise
In the political process the quality, quantity and timing of
information is, to a great extent, determined by transparency and
supervision requirements (e.g., Alt and Lassen, 2006). Auditors are
a fundamental supervising institutions in the public as well as the
corporate sector to ensure that reported information is accurate.
Without accurate information citizens as well as investors would
find it difficult to make adequate decisions. Since agents face strong
incentives to misreport, independent audits are crucial.
1
The few economic contributions on public auditing so far
emphasize the important functions of auditors in controlling the
government and the bureaucracy by providing information to
policymakers and citizens, and in exposing waste and corruption
(e.g., Frey, 1994, Schelker, 2008). In field experiments Olken (2007)
and Ferraz and Finan (2008) provide evidence that financial audits
reduce wasteful spending and improve the quality of information.
In addition to financial audits some auditing institutions also
Correspondence to: Department of Economics and Swiss Institute for Interna-
tional Economics and Applied Economic Research (SIAW ), University of St. Gallen,
Bodanstrasse 8, 9000 St. Gallen, Switzerland. Tel.: +41 71 224 2578.
E-mail address: mark.schelker@unisg.ch.
1
Recent experiences (e.g., EURO Area) as well as academic research shows that
there is ample evidence for ‘creative accounting’ in the public sector (e.g., von Hagen
and Wolff, 2006).
conduct performance audits, which tend to improve policy
outcomes (Schelker, 2008). Schelker and Eichenberger (2010)
analyze the influence of extending the audit mandate to include
ex ante audits of the budget draft and individual policy proposals
and find significantly lower taxes and expenditures. Research
on auditor independence shows that limiting auditor tenure by
binding term limits improves credit ratings, while there seems to
be no clear effect of auditor appointment and removal procedures
(Schelker, 2008, 2012).
In the corporate auditing literature, one of the main drivers
of audit quality is auditor expertise. So far however, there is
no evidence on the influence of auditor expertise in the public
sector. Due to electoral pressure or career concerns, public
decision makers face incentives to misreport. Audit expertise is
likely to influence these incentives. If more competent auditors
detect inaccurate reporting and fiscal data management with a
higher probability, the informational content of fiscal information
improves, which enables citizens and investors to make more
appropriate electoral and investment decisions.
The public auditing institution is typically a large bureaucracy
and it would be very difficult to assess the overall expertise within
such a complex structure. This study focuses on the influence
of professional expertise of the chief auditor. He enjoys a high
degree of autonomy within the legal and regulatory framework
and defines the audit mandate, strategy and policy, which includes
the focus of the conducted audits, its timing, priorities and
thoroughness.
0165-1765/$ see front matter © 2012 Elsevier B.V. All rights reserved.
doi:10.1016/j.econlet.2012.04.051

M. Schelker / Economics Letters 116 (2012) 432–435 433
Table 1
The influence of auditor expertise on state GOB rating.
US states: 1992–1999
Dependent variable Normalized state general obligation bond ratings (GOB rating)
Estimation method Random effects tobit Linear fixed effects
(1) (2) (3) (4) (5) (6)
Auditor expertise
0.040
***
0.040
***
0.045
***
0.040
***
0.059
***
0.065
***
(0.014) (0.014) (0.014) (0.014) (0.005) (0.006)
Auditor election
0.015 0.028 0.025
(0.024) (0.024) (0.021)
Performance audit
0.001 0.004
*
0.004
*
0.002 0.005
(0.002) (0.002) (0.002) (0.003) (0.003)
Auditor removal
0.006 0.014 0.016
(0.012) (0.012) (0.011)
State population
3.22e09
**
3.14e09
**
3.13e09
**
2.80e09
**
2.06e08
*
1.66e08
(1.50e09) (1.53e09) (1.53e09) (1.36e09) (1.03e08) (1.03e08)
State r.p.c. income
3.01e06 3.34e06 1.10e05
***
1.28e05
***
3.28e06 1.33e05
(2.22e06) (2.27e06) (3.33e06) (3.30e06) (4.93e06) (1.08e05)
Unemployment
0.005
***
0.005
***
0.012
***
0.012
***
0.005 0.011**
(0.002) (0.002) (0.002) (0.002) (0.003) (0.005)
Aged
0.761
*
0.733
*
0.637 1.018
***
0.078 0.060
(0.400) (0.403) (0.398) (0.395) (0.719) (0.643)
Kids
0.263 0.258 0.207 0.237 0.161 0.188
(0.188) (0.191) (0.184) (0.184) (0.199) (0.144)
State r.p.c. debt
2.87e06 2.91e06 5.52e06 4.51e06 8.60e07 5.95e07
(3.76e06) (3.76e06) (3.71e06) (3.65e06) (7.85e06) (6.98e06)
State r.p.c. expenditures
3.01e06 9.22e07 2.87e05
*
2.80e05
*
2.10e05 4.41e05
(1.46e05) (1.48e05) (1.52e05) (1.51e05) (2.78e05) (2.69e05)
Balanced budget law
0.055
***
(0.017)
Initiative
0.001
(0.017)
Year effects Included Included Included
Observations 309 309 309 309 309 309
(pseudo) R-squared 0.179 0.185 0.202 0.372 0.220 0.287
Notes: Cluster-robust standard errors in brackets. Constant term and term for southern states omitted. Time-invariant variables (auditor election, auditor removal, balanced
budget law, initiative) dropped in fixed effects regression.
*
Denotes significance level: 0.05 < p < 0.1.
**
Denotes significance level: 0.01 < p < 0.05.
***
Denotes significance level: p < 0.01.
Hence, the hypothesis is that more competent auditors improve
the quality and reliance of reported information, which results in
improved government performance.
2. Data on US state auditors
I take advantage of the decentralized US federal structure. Every
state has its own constitution and legal framework defining the
details of its auditing institution. Variation can be observed in
many different dimensions, notably in the minimum educational
requirements imposed on the state auditor. Some states require
the state auditor to hold at least a diploma as a Certified Public
Accountant (CPA). Based on NASACT (1992) I construct a unique
dataset for the period 1992–1999 containing information on a
variety of institutional details of US state auditing institutions. In
addition to the information on various characteristics of the US
state audit offices, the dataset contains a whole range of state-
specific standard control variables (Alt et al., 2006), for which
summary statistics can be found in Table A.1 in the Appendix.
The standard approach for studies on the influence of fiscal
institutions on government performance adopts fiscal measures
such as expenditure or debt as dependent variables. In research
on transparency and auditing, this strategy features several
drawbacks: (1) fiscal variables might be biased due to misreporting
and (2) fiscal levels might not be informative about government
efficiency. First, officially reported fiscal information might be
unreliable, because the quality of fiscal information itself depends
on audit quality and transparency (Schelker, 2008, 2012). Hence,
data quality might be endogenous to auditor characteristics.
Second, high as well as low levels of expenditures and debts might
be the outcomes of good as well as bad governance. E.g., especially
efficient governments might face a higher demand for public goods
relative to inefficient governments, which might result in higher
expenditures or debts (e.g., Ferejohn, 1999).
Hence, I present evidence based on an alternative identification
strategy: I adopt state General Obligation Bond (GOB) ratings that
reflect a market evaluation of state fiscal performance. Similar
approaches have been used by, e.g., Depken and Lafountain (2006)
and Schelker (2012) to study the influence of fiscal institutions
and corruption, and by, e.g., Mansi et al. (2004) in the context
of corporate auditing quality. To obtain the market evaluation of
anticipated audit quality I control for the influence of the reported
state of public finance and I include real per capita debt and
expenditures in the regression framework. In line with the general
practice I focus on the 48 mainland states and exclude Alaska and
Hawaii from the analysis.
The data on state credit ratings are collected from Moody’s
Investor Services, Fitch Ratings and Standard & Poor’s. State GOB
ratings are available for a maximum of 42 US states for some
or the entire period 1992–1999, but do not include states that

434 M. Schelker / Economics Letters 116 (2012) 432–435
Table 2
The influence of auditor expertise on state real per capita debt and expenditure.
US states: 1992–1999
Dependent variable PANELA: log state real per capita debt
Estimation method Linear random effects Linear fixed effects
(1) (2) (3) (4) (5) (6)
Auditor expertise
0.099
**
0.099
**
0.118
***
0.107
**
0.114
**
0.139
***
(0.044) (0.044) (0.043) (0.050) (0.044) (0.043)
Auditor controls Included Included Included Included Included
Further controls Included
Year fixed effects Included Included Included
State fixed effects - Included Included
Observations 384 384 384 384 384 384
R-squared 0.261 0.285 0.202 0.360 0.152 0.227
LM (Breusch/Pagan) 1057 1011 1020 1006
Dependent variable PANELB: log state real per capita expenditure
Linear random effects Linear fixed effects
(1) (2) (3) (4) (5) (6)
Auditor expertise
0.059
**
0.051
**
0.050
*
0.044 0.035 0.035
(0.023) (0.022) (0.027) (0.028) (0.026) (0.033)
Auditor controls Included Included Included Included Included
Further controls Included
Year fixed effects Included Included Included
State fixed effects Included Included
Observations 384 384 384 384 384 384
R-squared 0.144 0.184 0.310 0.397 0.558 0.595
LM (Breusch/Pagan) 857.3 842.3 967.7 922.9
Notes: Cluster-robust standard errors in brackets. Information on ‘Auditor controls’ and ‘Further controls’ see Table 1.
*
Denotes significance level: 0.05 < p < 0.1.
**
Denotes significance level: 0.01 < p < 0.05.
***
Denotes significance level: p < 0.01.
have no GOB.
2
The construction of the variable follows Depken
and Lafountain (2006). The three principal agencies use very
similar though not identical rating scales. Therefore, I construct a
normalized overall rating R
st
for each state s in year t. The rating
of state s in year t by agency j = 1, . . . , n is R
stj
{−1, . . . , N
j
},
where 1 corresponds to the highest and N
j
to the lowest GOB
rating.
3
The normalized state-year rating then is R
st
=
1
n
n
j=1
R
stj
n
j
and it varies between 1 and 0.
3. Empirical strategy
In the empirical exercise I estimate the following basic regres-
sion equation:
y
it
= α + β AuditorExpertise
it
+ ζ
A
it
+ λ
X
it
+ ε
it
where y
it
is either the state GOB rating (R
st
), public debt or expen-
ditures, AuditorExpertise
it
is a dummy variable taking 1 if a CPA is
required and 0 otherwise, A
it
are additional characteristics of pub-
lic auditing institutions, X
it
is a vector of state characteristics, β is
the parameter of interest, ζ and λ are parameter vectors and ε is
the error term.
When estimating the effect of auditor expertise on the
normalized credit rating I estimate tobit models that take into
account that R
st
is censored at 1 and 0. For the debt and
2
The states without GOB rating are Arizona, Colorado, Iowa, Idaho, Nebraska and
South Dakota. When observing states without GOB ratings selection bias might
be a concern. When approaching this potential selection problem, I do not find
a significant correlation between auditor characteristics and the excluded states.
Furthermore, I cannot explain any of this selection with the auditing or institutional
variables in a regression framework.
3
The ratings are categorized as follows: AAA = 1 to C = 21 (lowest rating
for Moody’s) and D = 22 (S&P and Fitch). The negative sign is chosen to make it
more intuitive for the reader to interpret the regression results.
expenditure regressions I rely on linear models. I estimate random
effects (RE) as well as fixed effects (FE) models. However, fixed
effects tobit is hard to implement due to the incidental parameter
problem (e.g., Greene, 2003). Therefore, I present linear fixed
effects estimates, which are typically good approximations, and
allow a straightforward interpretation of the effects. However, due
to the high time persistence of institutional variables I prefer the
random effect estimates, which reflect a long-term perspective of
the effects.
Since audit offices differ in various respects, I control for
the different auditor selection and removal mechanisms and for
differences in the audit mandate. All regressions include a set of
standard state-specific covariates. Note that all regressions on state
credit ratings also include real per capita expenditures and debt in
order to control for data quality and fiscal level effects.
4. Empirical results
Table 1 presents the regression results of auditor expertise on
GOB ratings. Columns 1–4 report the random effects estimates.
The results show that states demanding the state auditor to hold
at least a CPA feature significantly higher credit ratings. Including
year fixed effects (columns 3 and 4) and further fiscal controls
(column 4) do not challenge the results. The linear fixed effects
regressions in columns 5 and 6 show that the coefficients remain
statistically significant, while the impact is somewhat higher in
magnitude. On average, the states demanding the auditor to hold at
least a CPA feature approximately a one notch higher credit rating
compared to states without such a requirement. The estimated
coefficients of the control variables are widely in line with previous
research using the same or similar covariates (e.g., Depken and
Lafountain, 2006).
Table 2, Panels A and B present the results on the log of real
per capita debt and expenditures respectively. All random effects

M. Schelker / Economics Letters 116 (2012) 432–435 435
Table A.1
Summary statistics.
Variable Min.–Max. Sample mean (std. dev.) Description
GOB rating (0.381)–(0.046) 0.133 (0.069) Normalized general obligation bond ratings by S&P, Moodys and
Fitch (highest rating Aaa = 1, Aa1 = 2, Aa2 = 3, etc.)
Government expenditures 1298.31–2968.72 1843.54 (293.76) Real per capita government expenditures
Government debt 2088.36–9376.47 4539.76 (1456.23) Real per capita government debt
Auditor expertise 0/1 0.219 (0.414) Minimum education requirement: Auditor has to hold a CPA (1), no
minimum requirement (0)
Auditor election 0/1 0.354 (0.479) Auditor is elected by the citizens (1), auditor is appointed by the
legislature or the executive (0). Details see Schelker (2008)
Performance audits 0–3 1.815 (1.119) Index adding 3 types of performance audits: Economy & efficiency,
program, and compliance audits. Details see Schelker (2008)
Removal procedures 0–3 1.146 (0.914) Index capturing various removal procedures for the auditor. Removal
by single committee or public official (0), simple majority vote in
both legislative chambers required (1), supermajority required in
both chambers or if special procedures (2), agency head cannot be
removed during official term (3). Details see Schelker (2008)
State population 466 251–3.31e+07 5 491 734 (5 794 756) Total state population
State income 10 397.11–22 913.70 14 702.42 (2213.26) Real per capita state income in USD
Unemployment 2.5–11.3 5.211 (1.494) Unemployment rate
Aged 0.087–0.186 0.129 (0.017) Fraction of the aged population (65+)
Kids 0.071–0.264 0.189 (0.017) Fraction of school-aged population (5–17)
Balanced budget rule 0/1 0.542 (0.499) Balanced budget requirement (no carry-over rule)
Voter initiative 0/1 0.458 (0.499) Voter initiative available (1), otherwise (0)
estimates in columns 1–4 of both panels indicate a negative and
statistically significant effect of auditor expertise on debt and
expenditures. States demanding the state auditor to hold at least
a CPA feature roughly 10% lower debt and 5% lower expenditures.
The fixed effects regressions shown in columns 5 and 6 in both
panels point to the same conclusion. The coefficients of the debt
regressions in Panel A confirm the random effects results, while the
coefficients of the expenditure regressions in Panel B are slightly
lower and do not reach statistical significance. Note that these
results are difficult to interpret since fiscal information might be
systematically biased and pure fiscal level effects might not be very
informative on government performance.
To assess the robustness of the results I follow up on two main
strands of arguments. First, expertise could primarily be a matter
of experience. One might worry that states requiring minimum
professional education standards could also be the states that
feature longer auditor tenure. Therefore, I also include variables
on auditor term length and term limits, since they co-determine
auditor tenure (Schelker, 2012). Second, I follow up on two main
concerns of endogeneity: (1) a CPA requirement might be the
result of a more general preference for higher education. Therefore,
I include the share of population holding at least a high school
diploma. (2) The installation of a CPA requirement might reflect
fiscal preferences of citizens, which determine the institutional
design and actual policy outcomes simultaneously. To proxy for
state fiscal preferences I include ADA scores, which rate state
legislators’ ideology on a conservative–liberal scale (Anderson and
Habel, 2009). All results on the influence of auditor expertise
remain robust.
Overall I find that minimum professional education require-
ments for the state auditor are positively correlated with credit
ratings and negatively with public debt and expenditures. An inter-
pretation is that more competent auditors improve the reliability
of released information.
Acknowledgments
I would like to thank Martin Besfamille, Reiner Eichenberger
and an anonymous referee as well as the participants of the annual
meetings of the European Public Choice Society, the International
Society of New Institutional Economics, the Western Economic
Association and the International Institute of Public Finance for
feedback and comments.
Appendix
See Table A.1.
References
Alt, J.E., Lassen, D. Dreyer, 2006. Fiscal transparency, political parties, and debt in
OECD countries. European Economic Review 50, 1403–1439.
Alt, J.E., Lassen, D. Dreyer, Rose, Shanna, 2006. The causes of fiscal transparency:
evidence from the American States. IMF Staff Papers.
Anderson, S., Habel, P., 2009. Revisiting adjusted ADA scores for the US congress,
1947–2007. Political Analysis 17, 83–88.
Depken, C.A., Lafountain, C.L., 2006. Fiscal consequences of public corruption:
empirical evidence from state bond ratings. Public Choice 126, 75–85.
Ferejohn, J., 1999. Accountability and authority: toward a theory of political
accountability. In: Przeworski, A., Stokes, S.C., Manin, B. (Eds.), Democracy,
Accountability, and Representation. Cambridge University Press, Cambridge,
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Ferraz, C., Finan, F., 2008. Exposing corrupt politicians: the effect of Brazil’s publicly
released audits on electoral outcomes. Quarterly Journal of Economics 123 (2),
703–745.
Frey, B.S., 1994. Supreme auditing institutions: a politico-economic analysis.
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Greene, W., 2003. Fixed effects and bias due to the incidental parameters problem
in the tobit model. Working Paper. New York University.
Mansi, S.A., Maxwell, W.F., Miller, D.P., 2004. Does auditor quality and tenure matter
to investors? evidence from the bond market. Journal of Accounting Research
42 (4), 755–793.
NASACT, 1992, 1996, 2000. Auditing in the states: a summary. National Association
of State Auditors. Comptrollers and Treasurers, NASACT. Lexington.
Olken, B.A., 2007. Monitoring corruption: evidence from a field experiment in
Indonesia. Journal of Political Economy 115 (2), 200–249.
Schelker, M., 2008. Making Auditors Effective: Theory, Evidence, Perspectives.
Nomos, Baden-Baden.
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general obligation bond ratings. Public Choice 150 (1), 27–49.
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von Hagen, J., Wolff, G.B., 2006. What do deficits tell us about debt? empirical
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7 citations


Journal ArticleDOI
Abstract: Public Audit Offices are the guardian of the national purse and the pivot of the system of parliamentary control over finance. They help to institutionalize and nurture a culture of accountability, integrity, legitimacy and value for money in the conduct of public business. This in the long term serves as antidotes against institutional corruption. Study findings indicate that Zimbabwe’s audit systems are in the main consistent with regional and global experiences. Efforts are being undertaken to reconstitute and strengthen legal frameworks governing public auditing. Notwithstanding this, legal frameworks did not go deep enough to strengthen the independence of supreme audit institutions. Appointment, funding and reporting frameworks still have peeling effects on the operational independence of the Comptroller and Auditor General. Scenarios aground also suggest that the political will to comply with extant frameworks is low note. Audit recommendations are not seriously taken by Treasury, Accounting Officers and government ministers. There is need to update legal and regulatory frameworks to strengthen the operational independence of the C&AG and also to give it sanction powers to compel Ministries and departments to observe and comply with the Treasury Instructions and other regulations regarding submissions of returns. Efforts should also be directed towards capacitating the C&AG in term of attracting and retaining skilled and experienced staff in the legal and accounting field .

7 citations


Journal ArticleDOI
Abstract: The declining financial health of public pension systems is increasingly becoming a budgetary concern for many state and local governments. While the academic literature has identified several factors behind the growth in unfunded state and local public pension liabilities, there is mixed evidence on how the composition of a pension system’s board of trustees affects a pension’s financial health. This article contributes to this literature by measuring how public pension board composition affects fund financial health as measured by state bond ratings. With a panel dataset of state pensions between 2001 and 2014 our results indicate that elected board members are consistently associated with lower bond ratings (and thus higher borrowing costs) while appointed and ex-officio board members are associated with higher bond ratings. These results are robust to a number of specifications.

6 citations


References
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Journal ArticleDOI
Abstract: Regulators and small audit firms allege that audit firm size does not affect audit quality and therefore should be irrelevant in the selection of an auditor. Contrary to this view, the current paper argues that audit quality is not independent of audit firm size, even when auditors initially possesses identical technological capabilities. In particular, when incumbent auditors earn client-specific quasi-rents, auditors with a greater number of clients have ‘more to lose’ by failing to report a discovered breach in a particular client's records. This collateral aspect increases the audit quality supplied by larger audit firms. The implications for some recent recommendations of the AICPA Special Committee on Small and Medium Sized Firms are developed.

4,563 citations


Journal ArticleDOI
Abstract: This paper examines systematic differences in earnings management across 31 countries. We propose an explanation for these differences based on the notion that insiders, in an attempt to protect their private control benefits, use earnings management to conceal firm performance from outsiders. Thus, earnings management is expected to decrease in investor protection because strong protection limits insiders’ ability to acquire private control benefits, which reduces their incentives to mask firm performance. Our findings are consistent with this prediction and suggest an endogenous link between corporate governance and the quality of reported earnings.

3,362 citations


Journal ArticleDOI
Abstract: This study examines the relation between audit quality and earnings management. Consistent with prior research, we treat audit quality as a dichotomous variable and assume that Big Six auditors are of higher quality than non-Big Six auditors. Earnings management is captured by discretionary accruals that are estimated using a cross-sectional version of the Jones 1991 model. Prior literature suggests that auditors are more likely to object to management's accounting choices that increase earnings (as opposed to decrease earnings) and that auditors are more likely to be sued when they are associated with financial statements that overstate earnings (as compared to understate earnings). Therefore, we hypothesize that clients of non-Big Six auditors report discretionary accruals that increase income relatively more than the discretionary accruals reported by clients of Big Six auditors. This hypothesis is supported by evidence from a sample of 10,379 Big Six and 2,179 non-Big Six firm years. Specifically, clients of non-Big Six auditors report discretionary accruals that are, on average, 1.5-2.1 percent of total assets higher than the discretionary accruals reported by clients of Big Six auditors. Also, consistent with earnings management, we find that the mean and median of the absolute value of discretionary accruals are greater for firms with non-Big Six auditors. This result also indicates that lower audit quality is associated with more “accounting flexibility”.

2,905 citations


Journal ArticleDOI
Abstract: In this study, we document evidence on the relation between auditor tenure and earnings quality using the dispersion and sign of both absolute Jones‐model abnormal accruals and absolute current acc...

1,342 citations


Journal ArticleDOI
Abstract: This study examines whether the length of the relationship between a company and an audit firm (audit-firm tenure) is associated with financial-reporting quality. Using two proxies for financial-reporting quality and a sample of Big 6 clients matched on industry and size, we find that relative to medium audit-firm tenures of four to eight years, short audit-firm tenures of two to three years are associated with lower-quality financial reports. In contrast, we find no evidence of reduced financial-reporting quality for longer audit-firm tenures of nine or more years. Overall, our results provide empirical evidence pertinent to the recurring debate regarding mandatory audit-firm rotation — a debate that has, to date, relied on anecdotal evidence and isolated cases.

917 citations


Frequently Asked Questions (1)
Q1. What are the contributions in "Auditor expertise: evidence from the public sector" ?

This paper is the first attempt to study the relationship between public auditor expertise and fiscal performance. Auditors are a fundamental supervising institutions in the public as well as the corporate sector to ensure that reported information is accurate. This study focuses on the influence of professional expertise of the chief auditor. Hence, the hypothesis is thatmore competent auditors improve the quality and reliance of reported information, which results in improved government performance. In research on transparency and auditing, this strategy features several drawbacks: ( 1 ) fiscal variablesmight be biased due tomisreporting and ( 2 ) fiscal levels might not be informative about government efficiency. To obtain the market evaluation of anticipated audit quality I control for the influence of the reported state of public finance and I include real per capita debt and expenditures in the regression framework. 099 * * −0. 099 * * −0. 118 * * * −0. 107 * * −0. 114 * * −0. 139 * * * ( 0. 044 ) ( 0. 044 ) ( 0. 043 ) ( 0. 050 ) ( 0. 044 ) ( 0. 043 ) Auditor controls – Included Included Included Included Included Further controls – – – Included – – Year fixed effects – – Included Included – Included State fixed effects – – – Included Included Observations 384 384 384 384 384 384 R-squared 0. 261 0. 285 0. 202 0. 360 0. 152 0. 227 LM