Auditing Quality

  • Benito Arruñada


As with any other goods or services it is appropriate to examine the quality of auditing services from the point of view of their value to those who make use of them. These are both direct users-those who purchase them-and indirect but perhaps the more important users-those for whom audited accounts are destined. This latter group includes the shareholders in and creditors of organizations whose accounts are audited as well as their customers, employees and the public bodies with whom they deal.1 In some cases such users employ the accounts to monitor the conduct or performance of those taking decisions in the organizations being audited. In other cases, however, they use the accounts in a prospective manner as an instrument to assist them in taking decisions, whether direct investment, lending, purchasing or employment.


Agency Cost Audit Committee Audit Firm Audit Quality Professional Judgement 
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  1. 1.
    In this respect the classification made by the Auditing Practices Board is interesting in establishing decreasing degrees of auditor liability in relation to three sets of stakeholders: primary (shareholders and regulators), secondary (creditors and employees) and tertiary (potential investors, intermediaries, tax authorities, etc. not included as primary stakeholders). See APB (1994, pp. 25–6).Google Scholar
  2. 2.
    Despite the difficulties inherent in observing this type of variable, the effect of audit quality in improving contractual terms has been quantified in some specific situations. For example, Balvers, McDonald and Miller (1988) and Beatty (1989) found that the discount typically associated with public share offers granted by companies seeking a stock exchange listing for the first time was lower when their accounts had been audited by prestigious firms. Balvers et al. (1988) also reveal that the effect is complementary to that produced by the fact that the operation is handled by a merchant bank of high standing. In a more recent study, Hogan (1997) shows that the owners of businesses must choose between accepting greater underpricing—i.e., a higher discount on the share price—and providing increased guarantees by means of an auditor of higher standing.Google Scholar
  3. 3.
    In order to facilitate the study of contractual relationships Agency Theory makes an abstraction by considering a single relationship between two individuals in which, moreover, only one of them, the “agent”, is obliged to provide some service to the other, who is usually referred to as the “principal”. In this type of abstract contractual relationship it is appropriate to classify the contractual costs and safeguards on the basis of which of the respective parties initiates and pays for them. In an agency relationship all the costs aimed at reducing a deviation in the agent’s performance from the interests of the principal are referred to as “agency costs”. Three categories are usually distinguished: (1) “monitoring costs”, which are those paid for by the principal, (2) “bonding costs”, paid for by the agent, and (3) a certain “residual loss”, which is the result, even with optimum levels of monitoring and bonding, of the fact that it is usually preferable that a certain deviation persists in the conduct of the agents from what would be optimum in the hypothetical or ideal case in which there are no contractual costs. For an introduction to the theory, see the classic work of Jensen and Meckling (1976).Google Scholar
  4. 4.
    Auditors were appointed by a government body in Korea until the 1980 reforms (Park, 1990 ). In many countries a similar mechanism is used for appointments by the courts and the Companies’ Registry. A lottery mechanism has also been proposed on some occasions (see, for example, Cinco Dias, 17 October, 1995 ).Google Scholar
  5. 5.
    It has nevertheless been argued that companies may create audit committees purely for image purposes (Bradbury, 1990 ). The study by Menon and Williams (1994) shows that audit committees voluntarily created by US companies have in general had a very inactive life, although their activities increase with the presence of extemal (non-management) members on the board of directors. This outcome seems logical; the audit committee can operate as a body which assists the board in its monitoring work but this function only makes sense if the board itself also acts as a monitoring body and is to some extent independent of management. ( There is another explanation, however, related to the desire of external directors to be seen to be independent, particularly in relation to any possible liability suits).Google Scholar
  6. 6.
    This view of auditing is derived from Jensen and Meckling (1976, pp. 338–9). Auditing is obviously not the only safeguard nor perhaps the most important. Auditing services can in fact be replaced by other monitoring mechanisms. Anderson, Francis and Stokes (1993) examined such replacement by empirically analyzing the relationships which exist in Australian companies between external audit fees, salaries paid to internal auditors and the overall remuneration of the board of directors. One of their results shows that as the percentage of the value of a company of a less tangible and therefore more conflictive nature increases so also does the cost of auditing in relation to board remuneration.Google Scholar
  7. 7.
    One of the principal creators of modern organizational economics views thus the role of auditing as hiring reputation with the safeguard of the reputation of the auditor himself: “owners win the confidence of investors by renting the reputation of auditors for accuracy and fairness. Auditors earn a market rate of retum on their investment, via the costs of quality audits, in building a reputation among investors” (Wilson, 1983, p. 305). This rental of reputation is valuable because the client only needs it occasionally (particularly when having recourse to capital markets) whilst the auditor is permanently present as a supplier of contractual safeguards. The auditor’s role as specialist who stakes his reputation when backing part of the activities of his clients is similar to that of other specialists, such as merchant banks (Gilson and Kraakman, 1984), underwriters of security issues (Downes and Heinkel, 1982; Booth and Smith, 1986), debt rating agencies (Wakeman, 1981) and insurance companies to the extent that they also monitor certain assets (Mayers and Smith, 1982 ).Google Scholar
  8. 8.
    In the economics of contracts moral hazard problems arise as a consequence of post-contractual information asymmetries leading to performance failures.Google Scholar
  9. 9.
    See, for example, Titman and Trueman (1986).Google Scholar
  10. 10.
    Mandatory auditing has been established by the domestic legislation of EU member states on the basis of different Community directives (mainly the Fourth Directive, 78/660/EEC, of 25 July 1978, which has already been implemented in all member states). (See in this respect Buijink, Maijoor, Meuwissen and Witteloostuijn, 1996, pp. 25–31). Except for some countries in which all companies are obliged to have their accounts independently audited (Finland, Ireland, Norway [not a member of the EU] and Sweden), in the remainder the rules only make it obligatory when they reach a certain size. Mandatory auditing and a more detailed disclosure of financial statements by listed companies was adopted in the United States by the Securities Act of 1933. The adoption of mandatory auditing in the US was explicitly supported by the auditing profession and not opposed by firms, with scant discussion by the legislature (SEC, 1994, pp. 5–6). This has also been the case in many European countries. The effects of the rule are not clear, however. For empirical attempts to assess the consequences of the Securities Act, mostly focusing on stock exchange prices, see Simon (1989), Chow (1983), Jarrell (1981), Benston (1973) and Stigler (1964).Google Scholar
  11. 11.
    The birth and historical evolution of the profession is testimony to the extent of voluntary demand for auditing, which in greater part took place outside the framework of legal obligations. This was particularly the case in Britain where much nineteenth century company legislation did not make it obligatory to carry out audits or make it necessary for them to be carried out by professionals. At the end of the nineteenth century, when the 1900 Companies Act made auditing generally mandatory for companies listed on the stock exchange, virtually all accounts of such companies were already being audited by professional chartered accountants. For a discussion and several historical references, see Watts and Zimmerman (1983, pp. 628–9), who demonstrate how the auditing of accounts came about a long time before any type of legal or regulatory obligation and appears as far back as the thirteenth century.Google Scholar
  12. 12.
    For instance, after six years of mandatory audits of large and medium-sized companies, voluntary audits accounted for 23.01 percent of the total audits carried out in Spain in 1995 (Boletin Oficial del ICAC,no. 25, 1996, p. 38). Moreover, this voluntary demand has been growing since 1992.Google Scholar
  13. 13.
    This was the case in Spain, for example, where financial institutions were obliged to audit their accounts a long time before a general obligation was laid down by Act 19/1989.Google Scholar
  14. 14.
    Empirical works in this respect particularly include that of Craswell, Francis and Taylor (1995), which restates and improves on several preceding works, showing that part of the price differential previously considered as a “reputation premium” (see Section 2.1.3 in this respect, below) should in fact be attributed to the investment required to produce specialized auditing. The interested reader will find references to these works in Craswell et al. ( 1995, p. 298, n. 2 ).Google Scholar
  15. 15.
    See, in particular, Francis and Wilson (1988), as well as Defond (1992).Google Scholar
  16. 16.
    Section 1.2.2 deals with a more complex scenario in which the auditor can use a more or less exten- sive series of variables on which to base his opinion, in which event the regulatory system can have a decisive effect by favoring or preventing the use of qualitative indications which are not verifiable by third parties or, on the other hand, restrict the auditor to just using indicators which can be verified (in what can be known as “defensive auditing”), which safeguards him from any potential liability in the event of future litigation.Google Scholar
  17. 17.
    It should be pointed out that this definition of auditing quality in terms of technical competence and independence provides a useful breakdown for analysis since it defines two relatively distinct problems and therefore enables specialized rules and practices to be designed to support each of them. The two dimensions are not totally independent, however, as emphasized by the fact that a lack of independence can be shown by decisions which reduce effective technical competence. This would happen when the auditor decides not to make an effort to discover problems which he does not wish to report on.Google Scholar
  18. 18.
    This definition of quality was developed from the so-called Positive Accounting Theory. See, in particular, Watts and Zimmerman (1980, p$18; 1986, pp. 314–5) and DeAngelo ( 1981b, p. 186 ).Google Scholar
  19. 19.
    The concepts of “search” goods and “experience” goods were formulated by Nelson (1970) and that of “credence” goods by Darby and Kami (1973).Google Scholar
  20. 20.
    Defensive medicine“ is understood to be the administration of all types of treatments with very low expected benefits but which are administered in any event to avoid possible legal liability.Google Scholar
  21. 21.
    Such consequences of the liability system are far from trivial, as shown by the results of research by the National Bureau of Economic Research which in 1996 reliably quantified its effects on “defensive medicine” in the United States (Kessler and McCellan, 1996). Various direct reforms of the professional liability system (maximum limits, abolition of punitive damages, calculating interest from the date of judgement only, reducing compensation by sums obtained from other sources) enabled medical expenses to fall by between 5% and 9% without adverse consequences in terms of mortality or medical complications. Another indication of the importance of the matter is provided by the fact that the benefits obtainable by reducing liability are estimated at 600 million dollars per year simply in relation to myocardial infarction costs.Google Scholar
  22. 22.
    This requirement is highlighted in the report on good government of companies prepared by the Centre for European Policy Studies (CEPS, 1995, pp. 44–5).Google Scholar
  23. 23.
    Grossman and Hart were pioneers in differentiating between observable and verifiable information in their article on vertical integration (1986).Google Scholar
  24. 24.
    Evidence regarding auditor switching provides some indirect indication that different economic agents have access to and can verify varying types of information. Krishnan (1994) found that a change of auditor is more likely when the auditor gives a qualified opinion applying apparently conservative criteria in relation to the observable financial position of the business. The results of another study (Krishnan and Stephens, 1995) are consistent with the following explanation: the first auditor has private information which leads him to be conservative and the second also has access to this information and therefore does not modify his opinion compared with that of the former auditor. Obviously, he also cannot previously commit himself to issuing an unqualified opinion given his lack of knowledge of the client. Although the set of information which is verifiable by a judge probably includes all the information observable by researchers carrying out this type of empirical study, a comparison of the two situations has at least an indicative value to the effect that those participating in economic activities use sets of information with different properties in terms of its observability.Google Scholar
  25. 25.
    This contextual interpretation of financial statements also accounts for possible systematic bias, if any, as modeled by Antle, Nalebuff and Baiman (1991).Google Scholar
  26. 26.
    This was the situation in the Royal Mail case, dealt with by Grout et al. (1994, pp. 333–4).Google Scholar
  27. 27.
    The report from the Centre for European Policy Studies on the proper govemment of companies shared this view in relation to the regulation of accounting information by statutory rules in continental Westem Europe (CEPS, 1995, p. 18).Google Scholar
  28. 28.
    As do Grout et al. for example (1994, p. 336).Google Scholar
  29. 29.
    See Smith and Warner (1979).Google Scholar
  30. 30.
    This compensation may also be excessive in those countries in which the auditor is subject to a system of joint and several liability, including several European countries (Buijink et al.,1996, p. 96). This matter will be considered again in Section 3.4.3.Google Scholar
  31. 31.
    Readers familiar with management practices and the economic literature of franchises will recognize a structure in this conflict very similar to that often arising between franchisees of the same franchisor. Franchisee establishments tend to reduce the quality of their services to the prejudice of the reputation of the brand name and the network of establishments of which they form part. For this reason, an essential function of the franchisor is to safeguard quality and take disciplinary measures against those who do not fulfil minimum standards. When taking disciplinary measures such as expulsion the franchisor does so to the benefit not only of himself but, and perhaps principally, to the benefit of the other franchisees. It is believed that the periodic collection of fees of a variable nature (which incurs a cost in lessening the incentives of franchisees) is precisely aimed at giving the franchisor an incentive to carry out this disciplinary function effectively. See, in relation to this aspect, principally the works of Rubin (1978, p. 227), Brickley and Dark (1987, p. 410) and Lafontaine (1992, p. 279). Moreover, litigation brought by franchisees against their franchisors as a result of inadequate control of members of the network is commonplace. A famous case in the United States was Creel Enterprises vs. Mr. Gatti’s, in which the former sued the franchisor as it was harmed by the repeated breach by another member of the chain of obligations imposed on all the franchisees (Johnson, 1992, p. 18 ).Google Scholar
  32. 32.
    For European companies, data from Ridyard and de Bolle (1992, pp. 89–91) enable the average rotation period to be estimated at between 30 and 40 years. Large companies seem to have a lower change rate. Thus, in a study of 3,500 audits carried out between 1980 and 1988 in England it was estimated that the average length of each relationship was 40 years (“Auditors Too Cosy with Clients?” [Accountancy, January 1995, p. 11]). Ridyard and de Bolle provide similar data for Great Britain: in a sample of 137 large companies the rotation rate was lower than 1% between 1987 and 1990 (1992, p. 89). The figures are similar in the United States. There, rotation affects a percentage of between 1% of large companies and 6% of small companies each year. See, on this, the studies cited by DeAngelo (198 lb, pp. 188–9) and Beck, Frecka and Salomon ( 1988b, pp. 68–9 ).Google Scholar

Copyright information

© Springer Science+Business Media New York 1999

Authors and Affiliations

  • Benito Arruñada
    • 1
  1. 1.Pompeu Fabra UniversityBarcelonaSpain

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