Audit-Firm Portfolio Characteristics and Client Financial Reporting Quality

Ann Gaeremynck, Sofie Van Der Meulen and Marleen Willekens

European Accounting Review, 2008, vol. 17, issue 2, 243-270

Abstract: This paper contributes to the audit quality literature by defining continuous measures of expected future audit-firm losses and testing their association with proxies of financial reporting quality. In prior studies audit-firm size has been used as a proxy for expected future audit-firm losses and hence - following theoretical arguments in DeAngelo (Journal of Accounting and Economics, 3(3), pp. 183-199, 1981) and Dye (Journal of Political Economy, 101(5), pp. 887-914, 1993) - for audit quality. In particular, the Big 8/6/5/4 indicator variable has been tested empirically against various measures of client financial reporting quality. In this paper, we focus on testing various characteristics of an audit firm's client portfolio as drivers of audit quality (and therefore subsequently also client financial reporting quality), including measures to proxy size, visibility and financial health characteristics of an audit-firm portfolio. We test both a disclosure and earnings quality model for that purpose, and find for a sample of Belgian companies in financial distress, that audit-firm portfolio characteristics better explain variations in client financial reporting quality than the traditionally used Big N indicator variable. In particular, we find that - ceteris paribus - the size of an audit-firm portfolio is irrelevant in explaining the variation in financial reporting quality amongst companies. Next, we find that client visibility characteristics of an audit-firm portfolio have a constraining impact on earnings management, but no impact on the disclosure quality in the notes. Third, we find that solvency characteristics of an audit-firm portfolio (but not liquidity and profitability characteristics), are positively associated with the financial reporting quality. Taken together, the evidence suggests that not so much the size of an audit-firm portfolio (and the audit firm) but other portfolio and client characteristics drive audit and financial reporting quality.

Date: 2008
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Citations: View citations in EconPapers (10)

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DOI: 10.1080/09638180701705932

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