Audit quality following the Public Company Accounting Oversight Board’s operation

• DOI: https://doi.org/10.1108/CG-02-2017-0026
• Published date: 02 October 2017
• Pages: 927-946
• Date: 02 October 2017
• Author: She-Chih Chiu,Chin-Chen Chien,Hsuan-Chu Lin
• Subject Matter: Strategy,Corporate governance

Audit quality following the Public

Company Accounting Oversight

Board’s operation

She-Chih Chiu, Chin-Chen Chien and Hsuan-Chu Lin

She-Chih Chiu is based

at the Department of

Accountancy, National

Taipei University, New

Taipei City, Taiwan.

Chin-Chen Chien is

based at National Cheng

Kung University, Tainan,

Taiwan. Hsuan-Chu Lin is

Associate Professor at

National Cheng Kung

University, Tainan,

Taiwan.

Abstract

Purpose –The purpose of this paper is to investigate the extent to which the transition from

self-regulation to heteronomy has changed the gap in audit quality between Big Four and non-Big Four

auditors.

Design/methodology/approach –This study analyzes publicly held companies in the USA between

1999 and 2012 using univariate analysis, multivariate analysis and quantile regression analysis. Audit

quality is measured with discretionary accruals.

Findings –This study shows an insignificant difference in audit quality between the clients of Big Four

and non-Big Four auditors after Public Company Accounting Oversight Board (hereafter, PCAOB)

began its operations. In the analysis of the effects of PCAOB inspections on the audit quality of audit

firms that are inspected annually and triennially, the findings show that the inspections have more

positive effects when carried out annually. This suggests that the frequency of inspection is positively

associated with audit quality. Overall, these results provide evidence that recent improvements in audit

quality have been caused by changes in regulatory standards.

Originality/value –The paper provides three major original contributions. First, the authors add to the

literature on audit quality by further demonstrating a reduced gap in audit quality between Big Four and

non-Big Four audit firms due to heteronomy. Secondly, this study contributes to the debate as to whether

independent inspections on audit firms are beneficial or not and suggests that the PCAOB inspections

help increase audit quality. Finally, the results of this work contribute to the growing literature examining

discretionary accruals.

Keywords Audit quality, PCAOB, Auditor size, Sarbanes-Oxley Act of 2002

Paper type Research paper

1. Introduction

The purpose of the study is to investigate the extent to which the transition from

self-regulation to heteronomy has reduced the gap in audit quality between Big Four and

non-Big Four auditors. We address whether the Public Company Accounting Oversight

Board (hereafter, PCAOB) has reduced the gap in audit quality between Big Four and

non-Big Four auditors. Specifically, we shed light on the audit quality in reducing accruals

management. Although auditor reporting decisions, ex ante cost-of-equity capital and

analyst forecast accuracy are arguably cleaner measures of audit quality than are

discretionary accruals, we consider discretionary accruals an appropriate measure

because they are most relevant to PCAOB inspections.

This work fills a gap in the current literature on audit quality. The quality of the work of

external auditors was criticized sharply after Enron bankruptcy in 2001 and the collapse of

Arthur Andersen in 2002. This criticism motivated regulatory changes in the USA and led

to the implementation of Sarbanes-Oxley Act of 2002 (hereafter, SOX) (Francis, 2004). The

main provisions of this Act regarding auditors include the prohibition of certain consulting

Received 3 February 2017

Revised 8 June 2017

Accepted 27 June 2017

DOI 10.1108/CG-02-2017-0026 VOL. 17 NO. 5 2017, pp. 927-946, © Emerald Publishing Limited, ISSN 1472-0701 CORPORATE GOVERNANCE PAGE 927

engagements for audit clients and the establishment of the PCAOB. The PCAOB performs

inspections annually for firms that audit at least 100 public companies and triennially for

those auditing 100 or fewer public companies. In March, 2008, the Center for Audit

Quality (CAQ) conducted a survey of the audit committee members[1]. The results of this

survey showed that 82 per cent of the subjects felt that audit quality had been improved in

recent years, and 58 per cent felt that SOX had a positive influence on audit quality. Using

different proxies for audit quality, the academic literature has also made great efforts to

determine whether or not SOX has had any positive effects. To the best of our knowledge,

however, little of prior studies have investigated whether SOX has different effects on the

audit quality of Big Four and non-Big Four auditors, and it is this gap in the literature that

the current work seeks to address.

Our study is potentially relevant to recent calls for research on whether changes to the

institutions responsible for monitoring audit firms have proven beneficial (DeFond and

Francis, 2005;Nelson, 2006). Many academic studies have found that larger accounting

firms provide higher-quality audits[2]. The primary argument made by these studies to

explain these results is based on the idea that big audit firms have more valuable

reputations that they need to protect, are more independent, and have access to more

skills capacity and technical expertise. However, while big audit firms dominate the audit

market, there are still a surprisingly large number of publicly held companies that choose

to be audited by domestic and regional audit firms. A survey conducted by GAO (2008)

revealed the important role played by smaller audit firms in the audit market, especially with

regard to smaller companies. The results of this survey showed that the largest audit firms

audited 98 per cent of 1,500 largest publicly held companies – those with annual revenues

of more than US$1bn. In contrast, mid-size and smaller audit firms audited almost 80 per

cent of the 3,600 smallest companies – those with annual revenues of less than US$100m,

a finding that was echoed by the PCAOB (2008). However, there is as yet no conclusion in

the literature as to whether or not SOX has narrowed the gap in audit quality between big

and smaller audit firms, and this is the issue the current study addresses.

We use discretionary accruals, as developed by Jones (1991), as the proxy for audit

quality. Because income-increasing earnings manipulations are likely to be reversed in

future years and to yield a high absolute value, the use of the absolute value reduces the

power of the test. Following Dechow et al. (2011), we studentize the discretionary accruals

to mitigate potential effects from the revision of income-increasing earnings management.

In addition to income-increasing accruals, we examine the variations in discretionary

accruals and conduct both univariate analysis and multivariate analysis. We also perform

quantile regression analysis to estimate the median coefficients, because these are more

robust against outliers compared to the ordinary least squares regression (Koenker and

Bassett, 1978;Koenker, 2004).

Using a sample of US firms between 1999 and 2012, we find an insignificant difference in

discretionary accruals between the clients of Big Four and non-Big Four auditors after

PCAOB began its operations. In addition, examining the impact of the PCAOB inspections

on the audit quality of audit firms that are inspected annually and triennially, we find that the

inspections have more positive effects when carried out annually, suggesting that the

frequency of inspection is positively associated with audit quality. In the robustness

analysis, we show that our findings are not driven by different discretionary accrual proxies

and client portfolios. Overall, these results provide evidence that recent improvements in

audit quality have been caused by changes in regulatory standards.

We add to the literature on audit quality (DeAngelo, 1981;Simunic and Stein, 1987;Francis

and Wilson, 1988;Palmrose, 1988;DeFond, 1992;Teoh and Wong, 1993;Becker et al.,

1998) by further demonstrating a reduced gap in audit quality between Big Four and

non-Big Four audit firms due to heteronomy. In addition, we contribute to the debate as to

whether independent inspections on audit firms are beneficial or not and conclude that

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