Audit Firm Characteristics and their Relations with Value Relevance of Audited Accounting Information
Asian Tax Journal Vol. 15 No. 2 (2014), pp. 9-46
Abstract
Recent regulatory changes in accounting and audit practice are attending to audit qualityimprovements and investors’ perceptions thereon, which is now moving to identification of auditquality indicators and their disclosures to assist the investors’ evaluation of audit quality. Traditionalaudit researches and practice literature provide discussions on audit firm characteristics to be usedas possible audit quality indicators. Specifically, Big 4 firm, auditor’s industry expertise, (abnormal)audit hours and audit fees could be included as representative audit quality indicators covered bythe previous literature. Audit firm characteristics are comparable to client characteristics alsocovered by other audit researches (Hermanson et al. 2007；Lawrence et al. 2011, etc.). Morerecently, Hermanson et al. (2007), Kim and Cheon (2010), and Lee (2012), among others, focusedon audit firm characteristics identified by the regulator’s inspection reports or quality control reviewresults. Furthermore, the European Union (EU)(Article 40 of the EU 8th Company DirectiveDirector) has already established a registration to require audit firms auditing public companieslisted in the EU jurisdictions to file and disclose transparency reports to provide the investors withinformation about the audit firm’s quality controls, operation results and various audit qualityinformation. Similar regulations for Korean audit firms are established in 2003 from when Koreanaccounting firms should file annual reports with the Financial Supervisory Service (“FSS”). Subjects underlying all these discussions and development is related to a traditional controversyabout definition of audit quality；recent literature and academic researches are beginning to covervarious aspects of audit quality. e.g. the Advisory Committee on the Auditing Profession(ACAP)(2008), the International Organization of Securities Commission；IOSCO)(2009), Bedardet al. (2010), and Francis(2011) discuss feasibility of such audit quality indicators. They alsopresented various examples of audit quality indicators classified in terms of input vs. outputmeasures or audit firm－level vs. engagement－level indicators. Specifically, the IOSCO illustratedvarious audit quality indicators and the related groupings of categories. With regard to the auditquality indicators, Francis (2011) explained that there is insufficient research to know if this kind of aggregated information can tell us something about audit quality, and said that the IOSCOreport is just a list which are not rigorously investigated. We are to fill this gap. We identify ten audit firm characteristics for the experimental variablesbased on the previous studies (Hermanson et al. 2007；Kim and Cheon 2010；Lee 2012), andinvestigate their relationship with value relevance of earnings focusing on two aspects. First, wesee whether value relevance of audited accounting information are different according to auditfirm characteristics which the previous studies reported they are associated with good (or bad)audit quality. Second, the investors are likely to consider the auditor characteristics more seriouslyin their investment decisions after regulatory changes that the FSS began to attend to thecharacteristics during its review of audit firm’s quality control systems in 2007；we examinewhether such regulatory change has impacts on value relevance of earnings according to the auditfirm characteristics. We used Ohlson (1995) model to investigate the effects of the audit firmcharacteristics on value relevance of audited accounting information. In the model, controlvariables of size, leverage, return on assets, and year, industry and audit firm dummies areincluded in the models to mitigate potential effects of selection bias. Our results generally indicate that investors perceive positively (negatively) incremental valuerelevance of audited earnings information according to audit firm characteristics generally relatedto good (bad) audit quality as reported by the previous studies, however significance and directionof such relationship varies across the characteristics. Specifically, the higher measures indicatinghuman resource leverage and audit expertise are positively perceived by the investors；the higherworkload measures are negatively perceived. However, average experienced years of professionalsare negatively perceived by the investors contrary to Lee (2012) who find no significantrelationship between average experience and audit quality. Such patterns according to the auditfirm characteristics are reinforced similarly after the FSS implemented its regulatory reviews onthe audit firm’s quality control systems；however their significance vary across the experimentalvariables. As an additional analysis, we repeated the same examination (1) for the samples dividedinto Big 4 and Non－Big 4 firm clients, (2) using variable values of changes in price, net bookvalue and earnings, and (3) using variable values of price, net book value and earnings valuedeflated by outstanding shares (in the main table, variable values are deflated by lagged totalassets). Such additional analyses support the findings in the main tables. This result is consistentwith the hypotheses of this study；however, hypothesis 1 is statistically strong, but hypothesis 2is not strong enough for every experimental variables. Overall, our findings support that audit firm characteristics indicating good (bad) audit qualityare generally associated with the investor’s positive (negative) perceptions on audit quality. However, the investor’s perceptions vary across the audit firm characteristics which is alsosupporting Bedard et al. (2010) and Francis(2011) who explained that a single indicator is notdesirable；rather, it is necessary to require reporting of a number of different audit qualityindicators so that the combination gives a multi－dimensional picture of audit quality.
Keywords
- value relevance
- audit firm characteristics
- audit quality indicators
- reviews on the auditor’s quality control systems
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