francis - 2004 - what do we know about audit quality [aq]

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What do we know about audit quality?
*
Jere R. Francis
*
University of Missouri—Columbia, 432 Cornell Hall, Columbia, MO 65211, USA
University of Melbourne, Victoria, Australia
Abstract
This paper reviews empirical research over the past 25 years, mainly from the United States, in
order to assess what we currently know about audit quality with respect to publicly listed companies.
The evidence indicates that outright audit failure rates are infrequent, far less than 1% annually, and
audit fees are quite small, less than 0.1% of aggregate client sales. This suggests there may be an
acceptable level of audit quality at a relatively low cost. There is also evidence of voluntary
differential audit quality (above the legal minimum) along a number of dimensions such as ﬁrm size,
industry specialization, ofﬁce characteristics, and cross-country differences in legal systems and
auditor liability exposure. The evidence is very positive although there is some indication that audit
quality may have declined in the 1990s, in which case there could be merit in recent reforms such as
the Sarbanes-Oxley Act of 2002 in the US. However, we do not know from research the optimal level
of audit quality and therefore whether we currently have ‘too little’ or ‘too much’ auditing? Despite
this lacuna we are entering an era of more mandated auditing in response to high-proﬁle corporate
governance failures including the Enron–Andersen affair. Finally, while recent reforms have scaled
back the scope of non-audit services due to independence concerns, a case can be made that audit
quality will always be somewhat suspect if other services are provided that are perceived to
potentially compromise the auditor’s objectivity and skepticism. For this reason public conﬁdence in
audit quality may be increased by proscribing all non-audit services for audit clients.
Recommendations are also proposed with respect to legal liability reform and changes in partner
compensation arrangements.
q 2004 Elsevier Ltd. All rights reserved.
Keywords: Audit quality; Sarbanes-Oxley Act; Audit failure rates
0890-8389/$ - see front matter q 2004 Elsevier Ltd. All rights reserved.
doi:10.1016/j.bar.2004.09.003
The British Accounting Review 36 (2004) 345–368

www.elsevier.com/locate/bar
*
I appreciate the helpful comments of an anonymous referee and colleagues at University of Missouri—
Columbia and University of Melbourne. The paper is based on the author’s plenary lecture at the 2004 annual
meeting of the British Accounting Association, York University.
* Tel.: C1 573 882 5156; fax: C1 573 882 2437.
E-mail address:
This paper reviews research on audit quality from the past 25 years, with a particular
focus on empirical research from the United States. In the aftermath of the Enron
bankruptcy in 2001 and the related collapse of Arthur Andersen in 2002, it has become
fashionable to criticize auditing and to question the quality of audits being performed by
accounting ﬁrms, especially the large international Big 4 accounting ﬁrms.
1
Indeed this
criticism motivated recent regulatory changes in the United States brought about by the
Sarbanes-Oxley Act of 2002 (Public Law No. 107-204) in which self-regulation by the
accounting profession has been replaced with direct regulation by a new independent
agency, the Public Company Accounting Oversight Board.
My emphasis is on publicly listed companies because the separation of ownership and
management control in listed companies makes the independent external audit especially
important with respect to corporate governance and the oversight of such companies. The
review is not meant to be comprehensive and encyclopedic but is instead a more selective
survey whose purpose is to identify and assess a wide range of evidence on audit quality
from academic research. It turns out that we know quite a bit, and despite Enron and other
high-proﬁle failures, the evidence indicates that the general level of audit quality is
satisfactory with very few outright audit failures, although there is some evidence that both
earnings quality and audit quality may have declined during the 1990s.
1. What are outright audit failure rates?
Audit quality can be conceptualized as a theoretical continuum ranging from very low
to very high audit quality. Audit failures obviously occur on the lower end of the quality

continuum, and so a good starting point in thinking about audit quality is to ask what the
rate of outright audit failure is? An audit failure occurs in two circumstances: when
generally accepted accounting principles are not enforced by the auditor (GAAP failure);
and when an auditor fails to issue a modiﬁed or qualiﬁed audit report in the appropriate
circumstances (audit report failure). In both cases, the audited ﬁnancial statements are
potentially misleading to users.
As a ﬁrst approximation of audit quality, we can think of audits as either meeting or not
meeting minimum legal and professional requirements. Audit quality is inversely related
to audit failures: the higher the failure rate, the lower the quality of auditing. What do we
know about audit failure rates? Outright audit failures are difﬁcult to determine with
certainty but can be inferred from several sources including auditor litigation and business
1
The studies cited in this review date to earlier periods when the dominant group was the Big 8 prior to 1989,
the Big 6 from 1989–1997, Big 5 from 1998 to 2001, and the Big 4 since the collapse of Arthur Andersen in 2002.
For convenience the term ‘Big 4’ will generally be used through the paper to refer to all of these groupings. The
Big 8 ﬁrms were Arthur Andersen, Arthur Young, Coopers and Lybrand, Deloitte Haskins and Sells, Ernst and
Whinney, KPMG, Price Waterhouse, and Touche Ross. The Big 6 came into being in 1989 when Ernst and
Whinney merged with Arthur Young in the US to become Ernst and and Young, and Deloitte Haskins and Sells
merged with Touche Ross to become Deloitte Touche. The Big 5 came into being in 1997 when Coopers and
Lybrand merged with Price Waterhouse in the US to become Pricewaterhousecoopers. Note that in some
countries these mergers played out differently in terms of who merged with whom.
J.R. Francis / The British Accounting Review 36 (2004) 345–368346
failures, investigations by the Securities and Exchange Commission (SEC), and earnings
restatements. Each of these is now reviewed.
Arguably the most convincing evidence of an outright audit failure occurs when there is
litigation against auditors (Palmrose, 1988). It turns out that the number of lawsuits against
auditors in the United States is small, despite the often-heard claim about rampant
litigation (Andersen et al., 1992).
2
Using a comprehensive dataset, Palmrose (2000)

documents around 1000 lawsuits against the large national accounting ﬁrms over the
period 1960–1995, or an average of only 28 lawsuits per year. Given a population of
around 10,000 publicly listed companies in the United States, 28 lawsuits per year imply
an annual audit failure rate of 0.28%, i.e. 28 hundredths of one per cent. The number of
successful lawsuits is even smaller and is generally estimated to be around 50% of total
lawsuits after excluding cases successfully defended by accounting ﬁrms and non-
meritorious cases dismissed by courts (Palmrose, 1997). The bottom line is that the
number of proven audit failures is so small as to approach a rate of zero, and so it is
difﬁcult to imagine what could be done to change auditing practices or the regulatory
environment that would result in a signiﬁcantly lower audit failure rate.
A broader deﬁnition of auditor failure could be based on business failure rates. It turns
out that failures of publicly listed companies in the United States are also small in number,
averaging around 40 per year (Francis and Krishnan, 2002). However, it may be wrong to
presume an audit failure has occurred just because a business failure occurs, and this is
borne out by the fact that auditors of bankrupt companies are sued only 25% of the time
(Palmrose, 1987).
3
Regardless, the audit failure rate implied by bankruptcy rates is very
small and comparable to the low failure rate based on auditor litigation.
Since 1982, the SEC has issued Accounting and Auditing Enforcement Releases
(AAERs) which report outcomes of its investigations against companies and auditors.
AAERs are the result of consent decrees in which companies and/or their auditors do not
formally plead guilty to misdeeds, but instead accept an administrative action such as a
ﬁne, or other reprimand, and agree that they will not engage in the kind of behavior
described in the AAERs which the SEC deems unacceptable (Feroz et al., 1991).
Arguably, these consent decrees could be interpreted as evidence of ‘audit failures’ even
though they are not legally described as such. Dechow et al. (1996) examine the ﬁrst 436
AAERs issued from 1982 to 1993. Over this 12-year period there were 165 actions
describing auditor deﬁciencies representing about 14 actions per year. Given the US
population of approximately 10,000 publicly listed companies which are subject to SEC

regulations, 14 yearly actions against auditors is an annual audit failure rate of 0.14% (i.e.
14 hundredths of one per cent) from 1982 to 1993. More recently, 1485 new AAERs have
been issued from 1994 to 2003, or an average of 149 per year, and this may reﬂect an
2
The concern for litigation is not so much the frequency of lawsuits, but the potential magnitudes of lawsuits
and the possibility that one or a few large lawsuits have the potential to bankrupt an accounting ﬁrm as happened
in 1991 with Laventhol Horwarth, the 7th largest US accounting ﬁrm at the time.
3
An auditor is responsible for issuing a going concern report if the auditor believes a company may not survive
12 months from the balance sheet date. However, the auditor is not responsible for predicting bankruptcy per se,
and it is possible for companies to fail for reasons an auditor could not have reasonably anticipated 12 months in
advance.
J.R. Francis / The British Accounting Review 36 (2004) 345–368 347
increase in questionable ﬁnancial reporting practices during the 1990s. While there has
been no formal study (to date) of these AAERs actions, my informal review based on a
random sample indicates that a majority of these AAERS are not directed toward auditors.
The bottom line is that the annual audit failure rate implied by AAERs is well under 1%
even since the mid-1990s when the number of AAERs began to increase.
Another potential source of audit failure data comes from earnings restatements ﬁled
with the SEC and recently summarized in a report by the Government Accounting Ofﬁce
(GAO, 2003). Arthur Levitt, former SEC Chairman, was concerned by the increase in
earnings restatements in the late 1990s, and was convinced they indicated past accounting
(and auditing) failures due to the kind of aggressive earnings management he warned of in
a 1998 speech entitled ‘The Numbers Game’ (Levitt, 1998).
GAO (2003) covers earnings restatements from 1997–2002, and restatements increased
monotonically over the period from 92 (1997) to 250 (2002), with a sharp increase in 1999
coinciding with Chairman Levitt’s concerns. However, my informal review of these
restatements indicates a majority are straightforward adjustments of accounting
‘estimations’ in prior-year ﬁnancial statements and therefore (arguably) not audit failures.
Indeed in about one-fourth of the cases the auditor identiﬁed the problem and initiated the

re-statement, and in the majority of cases there was no related SEC action against
companies or litigation against auditors, which means that most earnings restatements are
not interpretable as audit failures.
In sum, the ex post evidence of audit failures from SEC sanctions, litigation rates,
business failures and earnings restatements all point to a very low failure rate, much less
than one per cent annually. This may understate the true failure rate if there are undetected
audit failures. However, if an audit failure goes undetected, it most likely means that the
company and its stakeholders have not suffered adverse economic effects such as
bankruptcy or ﬁnancial distress arising from the audit failure. What we can more properly
conclude is that known audit failures with material consequences are relatively infrequent.
While there may be other audit failures with lesser consequences, we have no evidence on
the rate of these occurrences.
2. How costly is auditing?
The evidence reviewed so far indicates that outright audit failures with material
consequences are very infrequent, fewer than 100 per year in a population of over 10,000
listed companies. However, in evaluating audit quality it is important to assess both the
beneﬁts and costs of auditing. For example, while audit failure rates are low, if audit fees
are large it is possible that too much investment is being made in audit quality relative to
the beneﬁts achieved. Audit costs are analyzed using 2002–2003 audit fee disclosure data
in the United States. I made the following calculations for 5500 large US publicly listed
companies, having aggregate sales of $8177 billion and aggregate market value of $9912
billion (note all monetary amounts are in US dollars). Aggregate audit fees for these 5500
companies totalled $3.4 billion which means audit fees represented only 0.04% of sales
and 0.03% of market value. I also analyzed audit fees for each decile of companies from
the smallest decile of ﬁrm size to the largest decile. As expected average fees as
J.R. Francis / The British Accounting Review 36 (2004) 345–368348
a percentage of sales decrease as ﬁrm size becomes larger. For the smallest decile, audit
fees average 2% of sales, but for the largest decile audit fees average less than 1/100 of one
per cent of sales.
So auditing appears to be a relative ‘bargain’ in the sense that audits cost a relatively

small fraction of client sales. However, the low cost of auditing does not necessarily mean
that audit quality is low since the outright audit failure rate is also quite low. While this
data may give some comfort that the social beneﬁt of auditing (as suggested by low failure
rates) is achieved at a reasonable social cost, this kind of cost–beneﬁt analysis does not tell
us anything about audit quality for the vast majority of companies which have ‘legally’
satisfactory audits.
4
Remember, audit quality is conceptualized as a continuum from very
low to very high quality, and outright failures occur on the extreme low end of quality. The
remainder of this paper surveys what we know about audit quality over the remainder of
the quality continuum and focuses primarily on the two empirical observables in auditing:
(1) auditor–client alignments, or who audits whom; and (2) audit outcomes which include
audit reports and the audited ﬁnancial statements which are a joint outcome of auditor–
client negotiations (Antle and Nalebuff, 1991).
3. What do we know from audit report research?
Since 1989 there are effectively two types of audit reports issued in the United States:
the standard clean unmodiﬁed report and a modiﬁed report for going concern uncertainty.
5
Butler et al. (2004) calculate that 6.6% of US listed companies received a going concern
reports during the period 1994–1999. Another study documents yearly going concern
reporting rates ranging from 9 to 5%, with a monotonic decline over the period 1990–1997
(Francis and Krishnan, 2002).
Even though modiﬁed going concern reports represent less than 10% of total audit
reports, one way of determining if audits are of high quality is to determine if investors
respond to going concern reports in a manner consistent with such reports conveying ‘bad
news’ about the client. If auditing is of high quality then going concern audit reports
should convey useful information; however, if auditing is of low quality, then modiﬁed
audit reports would have little or no informational value to investors. Before examining
the empirical evidence, it is useful to ﬁrst consider ‘misreporting’ rates. Misreporting
comes about from false negatives (a type 2 statistical error), i.e. issuing a clean audit report

when in fact a going concern report was appropriate, and from false positives (a type 1
statistical error), i.e. issuing a going concern report for ﬁrms that do not subsequently fail
or otherwise become ﬁnancially distressed. Both false negatives and false positives are
4
A referee points out that individual accounting ﬁrms may be highly proﬁtable and may earn economic rents
due to the accounting profession’s exclusive monopoly over the supply of audits. From this viewpoint it is
possible that audits currently cost more than they would in a more competitive market setting for the existing level
of audit quality. However, absent ﬁrm-level production cost data it is not possible to know if this is the case.
5
Qualiﬁed and adverse opinions cannot be issued for SEC registrants, and disclaimers are rarely issued. There
are other kinds of ‘technical’ modiﬁed opinions such as a change in accounting methods. However, the essential
reporting choice is now between a standard clean opinion and a going concern report.
J.R. Francis / The British Accounting Review 36 (2004) 345–368 349
(arguably) reporting failures in the sense that the right audit report was not issued which
reduces the informational value of audit reports due to noise.
3.1. False negatives and false positives in audit reporting
With regard to false negatives, Carcello and Palmrose (1994) ﬁnd that only 30% of
bankruptcies are preceded by a going concern audit report. In other words, 7 in 10
bankruptcies have a ‘false negative’ or clean audit report. Of course, as already noted,
there are only around 40 bankruptcies of publicly listed companies per year, so the
absolute number of false negatives per year is quite small. Strictly speaking, bankruptcies
not preceded by going concern audit reports are not necessarily audit failures since the
objective of an audit is not the prediction of bankruptcy. However these cases are widely
viewed as audit failures and for this reason false negatives (clean reports) for bankrupt
companies can create potentially signiﬁcant litigation risk for auditors. Carcello and
Palmrose (1994) document that auditors not issuing a going concern report before
bankruptcy are sued twice as often (64 versus 36%), have lower lawsuit dismissal rates,
and higher resolution payments (around $10 million versus $1 million). Settlements can
also increase the cost of future insurance premiums. There may also be a cost to investors
who are less well informed about bankruptcy risks than they might otherwise have been.

Consistent with this, Chen and Church (1996) ﬁnd the market response to a bankruptcy
announcement is less negative (by 13%) when the auditor has previously issued a going
concern report, indicating that bankruptcy is less of a surprise to investors. In general a
large negative stock market reaction is also more likely to trigger an investor lawsuit
against auditors, so this is less likely if auditors give an early warning of bankruptcy risk
by issuing a going concern report.
With regard to false positives, Francis and Krishnan (2002) document that around seven
going concern reports were issued (nZ1003) per bankrupt company (nZ143) in their
sample over the period 1990–1994, which means that on average six out of seven going
concern reports were false positives. This implies that auditors are conservative in the
sense of ‘over issuing’ going concern reports.
6
However, despite over issuing going
concern reports, auditors’ diagnostic skills apparently fail to get it right when it matters
and companies actually fail, i.e. as already indicated most bankruptcies are not preceded
by a going concern report.
The low cost of false positives relative to false negatives may explain why there are so
many going concern audit reports.
7
The largest potential cost of false positives is client
dissatisfaction, and Krishnan (1994) documents a higher rate of auditor switches for ﬁrms
receiving false positives, around 22% compared to a base line switching rate of 6%. There
is also a social cost of auditor switches as the client and new auditor incur transaction and
start-up costs related to the switch. In addition, there is evidence that ‘new audits’ may be
of lower quality due to a learning curve effect (Johnson et al., 2002), in which case
6
The ‘over issuing’ rate is lower if the number of unique ﬁrms receiving one or more going concern reports
(729) is compared to the 143 bankrupt ﬁrms, i.e. about ﬁve reports per bankruptcy.
7
Another explanation is that auditor reporting conservatism is induced by the US legal system and the auditor’s

exposure to litigation risk. This is discussed later in the paper.
J.R. Francis / The British Accounting Review 36 (2004) 345–368350
a reduction in audit quality may occur when false positives induce auditor changes.
Finally, another cost of false positives is the self-fulﬁlling prophecy problem. When
auditors issue a going concern report, it may trigger a sequence of events that has the
unintended consequence of pushing a client into bankruptcy. For example, banks or other
lenders may not extend or renew lines of credit, and suppliers may change their terms in
order to speed up cash payments.
To sum up, auditors are not always accurate in their reporting choices and this can
potentially reduce audit quality. They report conservatively (too many false positives) but
more often than not they fail to get it right when it matters (too many false negatives).
While the existence of false positives and false negatives creates noise and reduces the
informativeness of audit reports, it does not necessarily eliminate their informational value
altogether. I now review research which indicates that modiﬁed audit reports do have
informational value, despite the presence of false positives.
3.2. Do modiﬁed audit reports really matter?
The informativeness of audit reports is difﬁcult to assess for two reasons. First, audit
reports are typically released concurrently with the 10-K annual report ﬁled with the SEC
and therefore it is virtually impossible to separate information in the audit report from the
overall set of information in the 10-K. Second, most going concern reports are repeat
offenders and so there is little or no surprise value in the audit report. For this reason, much
of the going concern literature examines ﬁrst-time report modiﬁcations, and there is
evidence that ﬁrst-time going concern reports which come as a surprise do result in the
expected negative stock market reaction (Dodd et al., 1984; Loudder et al., 1992).
Another approach to informational value examines if modiﬁed audit reports have
predictive power. Raghunandan (1993) investigates the predictive ability of audit reports
modiﬁed for contingent losses arising mainly from lawsuits. These audit reports were
required prior to 1989, and he ﬁnds they were more predictive of actual litigation outcomes
than were ﬁnancial statements having footnote-only disclosures of loss contingencies. In
other words, when auditors commented directly on loss contingencies in the audit report,

there was a signiﬁcantly greater likelihood that a litigation-related loss would be incurred,
which provides evidence that modiﬁed audit reports are informative.
Initial public offerings (IPOs) are a particularly rich setting to investigate audit reports
because less is known about companies due to greater information asymmetry and
therefore the reports of auditors may potentially convey important information to
investors. A study which exploits this setting is Weber and Willenborg (2003). They
examine a sample of small microcap IPOs with market capitalization under $10 million.
Surprisingly they document that around 25% of microcap IPOs go public with an audit
report modiﬁed for going concern, and ﬁnd that the pre-IPO audit reports have predictive
ability with respect to both future stock returns and subsequent delistings.
In sum, there is not a large amount of research on the informativeness of modiﬁed audit
reports, in part because of the difﬁculty in developing a research design that can tease out
the informativeness of such reports. However, there is evidence that modiﬁed audit reports
are informative and have predictive ability, despite the noise created by false positives.
J.R. Francis / The British Accounting Review 36 (2004) 345–368 351
4. Auditor differentiation and audit quality
It is difﬁcult to assess audit quality ex ante because the only observable outcome of the
audit is the audit report which is a generic template and the overwhelming majority of
reports are standard clean opinions. While it is possible to assess audit quality ex post in
the case of outright audit failures, as already noted, these are relatively infrequent
occurrences. An important development in audit quality research is based on the premise
that ‘differences’ in audit quality exist and can be inferred by comparing different groups
or classes of auditors. This research implicitly assumes that all audits meet minimum legal
and professional standards (except of course the cases of outright audit failure), and
therefore the research focuses on differential audit quality above and beyond the legal
minimum. At an intuitive level we observe that there are many different kinds of audit
ﬁrms which suggest there is a supply of differential auditing demanded by different
clienteles.
4.1. The big ﬁrm–small ﬁrm dichotomy
The ﬁrst wave of auditor-differentiation research focused on the dichotomy between

large and small ﬁrms as a basis for differential audit quality. DeAngelo (1981) argues that
accounting ﬁrm size is a proxy for quality (auditor independence) because no single client is
important to a large auditor and the auditor has a greater reputation to lose (their entire
clientele) if they misreport. By contrast, an accounting ﬁrm with only one client may
logically conclude that they have more to gain by going along with their client and
misreporting than by being tough and potentially getting ﬁred. A related line of research
argued that the large ‘Big 8’ international accounting ﬁrms had established brand name
reputations and therefore had incentives to protect their reputation by providing high-
quality audits (Simunic and Stein, 1987; Francis and Wilson, 1988). These arguments do
not necessitate that Big 8 (now Big 4) audits are always superior. Individual audit failures
by Big 4 ﬁrms can and do occur. Rather, the arguments simply mean that audits of Big 4
ﬁrms as a group will, on average, be of higher quality than other (smaller) accounting ﬁrms.
There are several streams of research motivated by the big ﬁrm-small ﬁrm dichotomy.
Many studies document that Big 4 audits around the world carry a premium relative to the
audits of other ﬁrms, after controlling for client characteristics affecting audit fees such as
size, complexity and auditor-client risk sharing (Simunic, 1980). On average the Big 4
premium has been around 20%. Moizer (1997) provides a review of earlier studies, and for
more recent evidence see DeFond et al. (2000), Ferguson et al. (2003). A higher audit fee
implies higher audit quality, ceteris paribus, either through more audit effort (more hours)
or through greater expertise of the auditor (higher billing rates).
8
The question then arises as to whether or not there is a demand for differential audit
quality given that any licensed auditor can legally satisfy the requirement to have an audit.
8
A higher audit fee per se does not necessarily ensure a higher quality audit, particularly if accounting ﬁrms
have pricing power over clients. However, the evidence on audit outcomes reviewed later in the paper provides
conﬁrmatory evidence that accounting ﬁrms charging higher fees (such as the Big 4) also provide higher quality
audits on average.
J.R. Francis / The British Accounting Review 36 (2004) 345–368352
In other words, why do ﬁrms voluntarily pay more for a higher quality audit when lower-

priced and legal alternatives exist? Research has focused on those clienteles that logically
might be expected to demand higher quality audits. Speciﬁcally, the evidence indicates
that ﬁrms with greater monitoring needs due to higher agency costs are more likely to use
Big 4 auditors (Francis and Wilson, 1988; DeFond, 1992; Francis et al., 1999). A second
line of argument is that ﬁrms with greater inherent uncertainty (and greater information
asymmetry between the ﬁrm and outsiders) have an incentive to communicate their
intrinsic quality by hiring a more credible, high-quality auditor. This argument has mostly
been made in the context of IPOs and the evidence indicates there is reduced information
asymmetry (i.e. less underpricing) when going public with larger brand name auditors
(Beatty, 1989; Willenborg, 1999).
Corroborative evidence from other research supports the notion that larger accounting
ﬁrms supply higher quality audits. For example, the Big 4 ﬁrms are sued relatively less
frequently after controlling for clientele size, and Big 4 ﬁrms are sanctioned less
frequently by the Securities and Exchange Commission (Palmrose, 1988; Feroz et al.,
1991). A counter explanation is that the large accounting ﬁrms are not really better, they
just have more resources to ﬁght lawsuits and regulators. However, research on audit
outcomes, which is discussed next, rebuts this view with evidence of higher quality audits
by larger (Big 4) accounting ﬁrms.
There are two observable audit outcomes, audit reports and audited ﬁnancial
statements. Evidence from audit report research supports that Big 4 auditors are of
higher quality. Francis and Krishan (1999) show that Big 4 auditors have lower thresholds
for issuing modiﬁed audit reports, which indicates greater reporting conservatism for a
given set of client characteristics. Lennox (1999) ﬁnds that Big 4 auditors report with
greater accuracy in the United Kingdom, and Weber and Willenborg (2003) ﬁnd that the
pre-IPO audit reports of large national and international (Big 4) accounting ﬁrms have
more predictive accuracy than smaller accounting ﬁrms with respect to future stock returns
and subsequent delistings.
The evidence from ﬁnancial statements also supports that Big 4 audits are of higher
quality. Using the abnormal accruals paradigm (Jones, 1991), the evidence indicates that
clients of Big 4 audited companies have lower abnormal accruals which implies less

aggressive earnings management behavior and therefore higher earnings quality (Becker
et al., 1998; Francis et al., 1999).
9
Consistent with these ﬁndings, Nelson et al. (2002)
report evidence from one Big 4 accounting ﬁrm that auditors detect earnings management
attempts (especially income-increasing attempts) and require clients to make appropriate
adjustments. In addition, Teoh and Wong (1993) document that the earnings surprises of
Big 4 audited companies are valued more highly by the stock market which is consistent
with higher earnings quality when a Big 4 ﬁrm is the auditor.
In sum, despite some recent high-proﬁle cases, the collective evidence is strongly
supportive that audits of large (Big 4) accounting ﬁrms are of higher quality. There is one
9
The accrual paradigm calculates unexpected or abnormal accruals relative to an expectation model of normal
accruals. Abnormal accruals imply that managerial discretion over accounting is used to distort reported earnings
for private beneﬁts, and that managed earnings are different from the outcome of a neutral application of generally
accepted accounting principles (Schipper, 1989).
J.R. Francis / The British Accounting Review 36 (2004) 345–368 353
troubling aspect to this line of research. An alternative explanation may simply be that
‘good’ companies are more likely to select Big 4 auditors, are less likely to manage
earnings, and in general are more likely to have higher quality earnings. In other words,
it’s not high-quality auditing that causes the observed audit outcomes; rather, auditor
choice is endogenous and it may simply be that good ﬁrms with good earnings quality hire
high-quality auditors. Even though prior research has controlled for systematic clientele
differences between Big 4 and non-Big 4 auditors, endogeneity and selection cannot be
entirely ruled out as an alternative explanation and more work is needed on this important
topic. A few studies have examined endogeneity and these studies are generally supportive
of the research results cited above. See Hogan (1997), Ireland and Lennox (2002), and
Weber and Willenborg (2003).
5. Moving beyond the big ﬁrm-small ﬁrm dichotomy
The ﬁrst wave of research described above viewed the Big 4 as a homogenous group of

ﬁrms. The second wave of research relaxes this assumption and has begun examining
potential sources of differentiation in audit quality within the dominant Big 4 group of
accounting ﬁrms.
10
Three primary sources of differentiation have been investigated to
date: differences due to industry specialization, differences across individual practice
ofﬁces (cross-city differences), and institutional differences across countries (cross-
country differences).
5.1. Industry expertise
Big 4 accounting ﬁrms promote their industry expertise and we observe empirically that
industry market shares are not evenly distributed among the large accounting ﬁrms. The
linkage between industry market share and industry expertise is as follows. Solomon et al.
(1999) argue that industry experts have a deeper knowledge than non-experts due to greater
experience in the industry which enables experts to make more accurate audit judgments. If
accounting ﬁrms have more clients/fees in an industry, then they have more opportunities
for their auditors to acquire the kind of deep industry knowledge which leads to industry
expertise. Francis et al. (2005) use the new US audit fee disclosures for 2000–2001 and
calculate industry fee leaders for 63 non-ﬁnancial industries based on two-digit SIC
industry codes. On average they ﬁnd that industry leaders have 50% of industry fees, while
the number two ﬁrm has only 22% of industry fees. Industry leadership in the 63 industries
is widely dispersed among ﬁrms and distributed as follows: Arthur Andersen (14), Deloitte
Touche (5), Ernst and Young (16), KPMG (9), and Pricewaterhousecoopers (19).
The evidence in support of industry expertise parallels the research on Big 4
audit quality. Audit fees are higher for industry leaders implying higher audit quality,
10
Another reason for this development is that Big 4 market shares continue to expand globally and now exceed
90% of publicly listed companies in the US. From a practical viewpoint this means there is low power in research
designs of studies comparing large and small auditors because there is such low variance in the experimental
variable, i.e. most observations are audited by large (Big 4) auditors.
J.R. Francis / The British Accounting Review 36 (2004) 345–368354

and consistent with this there is evidence that earnings are of higher quality when the
auditor is an industry expert. Regarding audit fees, Francis et al. (2005) document that the
industry leader in the US has a fee premium relative to other Big 4 auditors; Ferguson et al.
(2003) ﬁnd that the top two industry leaders in Australia earn a premium relative to other
Big 4 auditors; and DeFond et al. (2000) ﬁnd that the top three industry leaders in Hong
Kong earn a premium relative to other Big 4 auditors. The fee premia in these studies
range from 10 to 30%. There is also evidence that audited ﬁnancial statements are of
higher quality when audited by an industry expert. Balsam et al. (2003) document that
abnormal accruals are smaller for companies audited by industry experts, which implies
less managerial discretion and higher earnings quality, while Balsam et al. (2003) and
Krishnan (2003) document that earnings surprises are valued more highly by the stock
market, which is also consistent with higher earnings quality. There is additional evidence
from Elder and Zhou (2002) who ﬁnd that IPOs having industry experts exhibit less
underpricing and smaller abnormal accruals, and Krishnan (2004a) who ﬁnds that earnings
audited by industry experts are more conservative using the Basu (1997) framework.
5.2. Cross-ofﬁce differences in audit quality
In a series of recent papers I have argued that it may be more insightful to analyze
speciﬁc ofﬁces of large accounting ﬁrms rather than the ﬁrm as a whole (Reynolds and
Francis 2000; Ferguson et al., 2003; Francis et al., 2005). The reason for this view is that
individual audit engagements are administered by an ofﬁce-based engagement partner
who is typically located in the same city as the client’s headquarters. The way we think
about an accounting ﬁrm changes dramatically when we shift the unit of analysis away
from the ﬁrm as a whole, to the analysis of speciﬁc city-based ofﬁces within a ﬁrm. In
terms of DeAngelo’s (1981) argument, a Big 4 accounting ﬁrm is not so big when we shift
to the ofﬁce level of analysis. For example, while Enron represented less than 2% of Arthur
Andersen’s national revenues from publicly listed clients, it was more than 35% of such
revenues in the Houston ofﬁce.
Reynolds and Francis (2000) report the ﬁrst ofﬁce-level of study of US companies and
auditors. They ﬁnd that auditors treat relatively larger clients in ofﬁces more
conservatively than smaller clients. Speciﬁcally, larger clients in ofﬁces have smaller

abnormal accruals (implying less earnings management) and larger clients are also more
likely to receive a going concern audit report. By contrast, when client size is measured at
the ﬁrm level using national clienteles (instead of ofﬁce-level clienteles) there is no
association between client size and auditor behavior. The study demonstrates the
importance of an ofﬁce-level analysis: we see a different picture when decomposing ﬁrms
into practice ofﬁces and analyzing the ofﬁces separately.
The next development in ofﬁce-level research is a re-examination of auditor industry
expertise as an ofﬁce-speciﬁc phenomena rather than a ﬁrm-wide characteristic across all
ofﬁces of accounting ﬁrms. The central issue in the ‘national’ versus ‘city’ perspective on
industry expertise is the degree to which there is a transfer of expertise wherein a Big 4
ﬁrm ‘captures’ the ofﬁce-based industry expertise of its accounting professionals and
distributes it to other ofﬁces in the ﬁrm’s network beyond speciﬁc ofﬁces where the experts
reside and work. The argument for the transfer of expertise is that accounting ﬁrms can
J.R. Francis / The British Accounting Review 36 (2004) 345–368 355
capture industry expertise through knowledge-sharing practices such as internal
benchmarking of best practices, the use of standardized industry-tailored audit programs,
and extending the ‘reach’ of professionals from their primary local-ofﬁce clientele to other
clients through travel and internal consultative practices. The alternative viewpoint is that
auditor expertise is uniquely held by individual professionals through their deep personal
knowledge of clients, and cannot be readily captured and distributed by the ﬁrm to other
ofﬁces and clients. Transfer of expertise would be evidenced if national (ﬁrm-wide)
reputation for industry expertise is priced by the audit market, but would not be supported
if it turns out that only local-ofﬁce (city-speciﬁc) reputation is priced.
Studies using Australian and US data indicate that auditor reputation for industry
expertise is neither strictly national nor strictly local in character (Ferguson et al., 2003;
Francis et al., 2005). Rather, the evidence indicates that auditor industry expertise is most
credible when the auditor is jointly the national industry leader and the city-speciﬁc
industry leader, indicating that there is both a national and local-ofﬁce reputation effect in
the pricing of industry expertise. The premium for joint national–city leaders is around
20–25% higher relative to fees of other Big 4 auditors. This is evidence of the transfer of

expertise since national leadership does affect the audit fee premium. However, the results
do not strongly support the transfer of expertise argument since national leaders alone,
without also being city-speciﬁc industry leaders, never have a signiﬁcant fee premium.
There is also some evidence that city-speciﬁc industry leadership alone (without also
being a national industry leader) may result in a fee premium in the US, although this
result does not hold in all of the sensitivity analyses.
11
Basioudis and Francis (2004) report
an even stronger city reputation effect in the United Kingdom. They report no signiﬁcant
premium for national industry leadership, while city-speciﬁc industry leaders (alone) earn
a premium of around 20% relative to other Big 4 auditors, with no additional premium for
being joint national–city leaders. In sum, these studies demonstrate signiﬁcant cross-city
variation in auditing and support that the ofﬁce-level of analysis is an important
development in research on audit quality.
5.3. Other approaches to the study of audit quality
There are other approaches to the study of auditor quality including research on audit
tenure, non-audit fees, audit committees, accounting ﬁrm alumni, and the effect of legal
systems on auditor incentives. Each of these is now brieﬂy discussed.
Auditor tenure research examines if the length of the auditor-client relationship affects
audit quality, and is motivated in part by calls for mandatory auditor rotation. The
argument for rotation is that auditors can become captive to clients in long tenure
situations. The counter-argument is that auditors have strong economic incentives to
maintain their independence and internal mechanisms such as the rotation of engagement
personnel are sufﬁcient to maintain the skepticism and independence of auditors.
11
In follow-up research-in-progress, the authors ﬁnd that earnings quality also follows the same implied
hierarchical ordering, with clients of joint city–national leaders having the highest earning quality, clients of city
leaders (alone) the next highest earnings quality, and clients of national leaders (alone) being no different than
other (nonleader) auditors.
J.R. Francis / The British Accounting Review 36 (2004) 345–368356

An additional argument against rotation is that audit quality may be lower initially for new
audit engagements while auditors acquire knowledge of the client. Two recent studies
provide evidence on auditor tenure and audit quality by examining the association between
accounting accruals and tenure. Meyers et al. (2003) ﬁnd no evidence that long tenure
impairs audit quality and some (weak) evidence that accruals are of higher quality as
tenure increases (i.e. abnormal accruals are smaller and accruals have more predictive
ability). Johnson et al. (2002) ﬁnd evidence of lower audit quality (larger abnormal
accruals) in the ﬁrst three years following auditor changes relative to ongoing
engagements of four or more years which is consistent with lower initial audit quality
on new engagements. Thus the evidence does not support the need for or the beneﬁt of
mandatory auditor rotation.
There has been a ﬂurry of research on non-audit fees motivated in part by the SEC’s
attempt in 2000 to ban non-audit services for audit clients (SEC, 2000), and facilitated by
newly mandated US disclosures of fees paid to auditors. The most controversial of these
studies is Frankel et al. (2002) who report evidence that companies which pay their
auditors relatively more non-audit fees have larger abnormal accruals and are more likely
to meet or beat analysts’ forecasted earnings. Together these two ﬁndings imply that
auditors treat clients with larger non-audit fees more leniently, and that such clients have
greater scope to manage earnings to meet benchmark targets, which suggests both lower
audit quality and lower earnings quality. At face value, the results offer evidence in
support of the SEC’s proposed ban of non-audit services for audit clients. Frankel et al.
(2002) has spawned a mini-industry and there are at least four published papers that refute
some or all of their ﬁndings (Ashbaugh et al., 2003; Chung and Kallapur, 2003; Larcker
and Richardson, 2004; Reynolds et al., 2004). In related research, DeFond et al. (2002)
ﬁnd no evidence that auditor reporting decisions are affected by the level of non-audit fees.
At this stage one would have to say that the evidence is inconclusive, but there is at least
the possibility that high levels of non-audit services may impair audit quality.
12
See also
Canning and Gwilliam (2003) for a discussion of the general arguments for and against the

provision of non-audit services, and for a more extensive literature review, see Beattie and
Fearnley (2002), particularly of earlier studies and survey research with respect to ‘user’
perceptions of the impact of non-audit services on auditor independence.
Research has linked audit quality with the boards of directors, and the audit committees
of boards of directors. This research shows that audit quality is higher when boards and
audit committees are more independent (more outside directors). Carcello and Neal (2000)
show that auditors are more likely to issue going concern reports in the presence of
more independent boards and are less likely to be ﬁred by the company following the
issuance of a going concern audit report (Carcello and Neal, 2003). Using AAER data,
12
The Frankel et al. (2002) paper hints at some political dimensions to accounting research. The accounting
establishment was upset by the Frankel et al. study, and I believe there was some sympathy within the academic
community to publish papers refuting their ﬁndings. Top-level accounting research journals do not generally
publish replications or ‘no results’ studies, yet that is what has occurred in the non-audit services area. A more
generous view is that the policy implications are very important in this area and there was a genuine appreciation
of the need for multiple studies to determine if there really is a potential audit quality problem from the joint
provision of audit and non-audit services.
J.R. Francis / The British Accounting Review 36 (2004) 345–368 357
Dechow et al. (1996) report that auditors are more likely to have detected accounting
problems and Klein (2002) ﬁnds that abnormal accruals are smaller (implying less
earnings management) when boards are more independent. Abbott et al. (2001) report
evidence that more independent boards are less likely to hire auditors for non-audit
services. Collectively the evidence indicates there is an endogeneity of corporate
governance since companies with more independent boards also have auditors that are
more likely to detect and report accounting problems and constrain earnings management
behavior, and independent boards are also more likely to restrain the scope of non-audit
services which may have the potential to impair audit quality (or at least the appearance of
such).
Another line of recent research has investigated if accounting ﬁrm ‘alumni’ in senior
management positions of audit clients can potentially compromise audit quality. The

concern is that the ‘cozy’ relationship between accounting ﬁrms and their former
employees may impair auditor skepticism and objectivity. In addition, because alumni
have a good understanding of their former accounting ﬁrm’s audit methodology, they
could more easily deceive auditors. These concerns have led to some restrictions in
Sarbanes-Oxley on the so-called revolving door or ‘outplacement’ of accounting ﬁrm
personnel to clients. What do we know about this phenomenon from empirical studies?
Lennox (2004) ﬁnds that auditors are less likely to issue modiﬁed audit reports for clients
with accounting ﬁrm alumni in top-level management positions, and Menon and Williams
(2004) document that abnormal accruals are larger for clients with former accounting ﬁrm
partners as employees. Together these two studies provide evidence that auditor behavior
is more lenient toward clients with highly placed alumni. While this provides evidence of
lower audit quality, Lennox (2004) reports that only 10% of audits in his sample involve
alumni in senior management positions, and only 7% of the sample in Menon and
Williams (2004) have former audit partners, so the outplacement phenomena may be less
widespread than is commonly thought.
Recent research has also begun investigating how a country’s legal system affects
auditor behavior through the standard of care auditors must meet to legally satisfy their
statutory audit responsibilities. In other words, auditor incentives are affected by potential
legal liability and other punishment for negligence and misconduct. Francis and Wang
(2004) draw on recent research in ﬁnancial economics to measure differences in legal
systems and to investigate if these differences affect auditor incentives (e.g. La Porta et al.,
1998 and 2003). Speciﬁcally, they test if Big 4 auditors treat their clients consistently
around the world or, alternatively, if Big 4 behavior is systematically related to a country’s
legal system. Francis and Wang (2004) document that Big 4 auditors treat their clients
more conservatively in countries having a legal system that gives investors greater
protection, including the ability to sue auditors. More speciﬁcally, they show that accruals
(both total and abnormal) of Big 4 clients are smaller in countries with greater investor
protection, which is consistent with auditor conservatism being induced by differences in
legal systems with respect to investor protection. These results show that auditor behavior
is affected by legal incentives, and are consistent with Seetharaman et al. (2002) who

report that audit fees are higher for UK companies that cross-list in US markets, a ﬁnding
which is interpreted as a risk-premium for the auditors due to increased litigation risk
exposure in the US legal system.
J.R. Francis / The British Accounting Review 36 (2004) 345–368358
5.4. Did earnings quality and audit quality decline in the 1990s?
Cohen et al. (2004) document that earnings management behavior increased steadily
from 1987 until the passage of Sarbanes-Oxley in 2002, and that this had the effect of
reducing both the quality of accounting earnings and the informativeness of earnings to the
stock market. They further show that earnings management was greatest in poorly
performing industries and in companies whose managers had large stock options.
Was there corresponding erosion in audit quality over this same time period? In the
wake of the Enron collapse, The Private Securities Litigation Reform Act of 1995 in
particular was widely criticized as having fostered a more lenient and less skeptical
approach to audits in the late 1990s that led to reduced audit quality and contributed to the
collapse of Enron and other companies. Two recent studies examine if auditor behavior in
the US was affected by The Private Securities Litigation Reform Act of 1995. Both studies
provide evidence that the reduction in legal liability may have led to increased leniency by
Big 4 auditors toward their clients and arguably lower audit quality since the mid-1990s.
Lee and Mande (2003) document that abnormal accruals of Big 4 clients increased after
1995, which is consistent with greater earnings management behavior, and Francis and
Krishnan (2002) ﬁnd that Big 4 auditors were less likely to issue going concern audit
reports after 1995, ceteris paribus. Of course it is also possible that the auditor
conservatism documented in other research using pre-1995 data was driven by
‘unreasonable’ and excessive litigation-risk exposure, and that the observed auditor
behavior following The Private Securities Litigation Reform Act of 1995 simply reﬂects a
more appropriate level of risk (see Krishnan and Krishnan, 1997; Shu, 2000 for additional
evidence of risk-management behavior induced by litigation risk). Regardless of the
interpretation, the evidence indicates that auditor behavior is directly affected by legal
incentives.
6. Policy making and the role of audit research

In the United States, audit research has had little impact on audit regulations or the
policy making process. Two recent examples underscore this. In 2000, the Securities and
Exchange Commission proposed a ban on the auditor’s provision of non-audit services for
audit clients (SEC, 2000). This was done with little input from the academic community.
The initiative was undertaken because the (then) SEC Chairman, Arthur Levitt, was
convinced the ban was needed to improve audit quality, despite the absence of compelling
evidence that audit quality was compromised by non-audit services. A second example is
the hasty passage of the Sarbanes-Oxley Act of 2002 following the Enron and Arthur
Andersen collapses. Again there was no serious academic input as both Democrats and
Republicans fell over themselves in their haste to pass the legislation and seek political
advantage in a highly charged election year.
Why has academic research had so little impact on regulation and policy making? The
fault lies on both sides. For our part, academics often eschew research with explicitly
normative policy implications, or at least fail to directly address potential policy
implications in their research. Part of the blame for this may lie in arguments advocating
J.R. Francis / The British Accounting Review 36 (2004) 345–368 359
so-called ‘positive’ research over more explicitly ‘normative’ accounting research.
However, all accounting research is fundamentally normative and deeply ideological in
terms of the particular research question that is asked in a research study, how the research
question is framed, preferences for certain research methods relative to others, and the
interpretation of research ﬁndings (Arrington and Francis, 1989). Another reason why
academic accounting research is ignored by policy makers is that many leading accounting
academics so clearly adhere to the Chicago school of economics which is generally hostile
to government regulation. In addition, academic accountants are often viewed as
apologists for the accounting profession and in particular for the Big 4 accounting ﬁrms.
This view is reinforced by numerous Big 4 professorships and donations to accounting
departments of US universities, and the general lack of critical reﬂection in accounting
scholarship published in leading US research journals.
Policy makers and regulators also share in the blame, however. For example,
accounting regulation lacks a tradition of using scientiﬁc-based research as input to policy

deliberations. While we may lament this state of the world, the fact is that policy making is
inherently a political rather than scientiﬁc process, especially in those ﬁelds where the
underlying research domain is in the social sciences and which are perceived to be ‘less
scientiﬁc’ and more subjective than the natural sciences. For this reason I believe the most
we can hope for is that policy makers will at least consider extant accounting research in
their policy deliberations. The good news is that this appears to occur more often in some
countries outside the United States based on my discussions with academic colleagues in
Australia, Canada, and the United Kingdom (e.g. see Fearnley and Beattie).
7. What do we know about audit quality?
Summing up, it turns out that we know more about audit quality than we might have
originally suspected:
† Auditing is relative inexpensive, less than 1/10 of one percent of aggregate client sales;
† Outright audit failures with material economic consequences are very infrequent;
† Audit reports are informative, despite the presence of false positive and negatives;
† Audit quality is positively associated with earnings quality;
† Audit quality is affected by legal regimes and the incentives they create;
† There is evidence of differential audit quality by Big 4 ﬁrms and industry experts, and
differential audit quality across individual ofﬁces of Big 4 ﬁrms and across different
legal regimes;
† Academic research has had little impact on regulations and policy-making in the US,
although it may have had more inﬂuence in other countries such as the United
Kingdom.
While these ﬁndings collectively suggest that audit quality may be at a socially desirable
level, there are some fundamental and important things we do not know about audit quality.
First, we do not know if the US evidence on audit quality generalizes to audits in other
countries that have different legal systems and in particular to non-common law countries
J.R. Francis / The British Accounting Review 36 (2004) 345–368360
with weaker investor protection and less ability to sue auditors for negligence and
misconduct. Second, we do not know how much auditing is optimal or if requiring ‘more’
or ‘better’ auditing to reduce the risk of an audit failure is a good cost–beneﬁt trade-off.

While audits are relatively inexpensive and the outright audit failure rate is low, when a
corporate failure like Enron occurs there are enormous social and economic consequences.
Despite this lack of knowledge, the new US audit requirements in Sarbanes-Oxley are
expected to have a large impact on audit fees with expected increases of 50% or more; yet,
we have no compelling reason to believe that audit quality will necessarily be improved or
that audit failures will be signiﬁcantly reduced by these more costly audits. Third, we do not
know what the optimal social arrangement is for auditing. Is it a private sector function with
public oversight (the old SEC model and current UK model)? Or would it be better to have
direct regulation as in the case of Sarbanes-Oxley and the Public Company Accounting
Oversight Board which has replaced self-regulation by the accounting profession? And, the
ultimate question of course is whether it would be better to have a public sector audit
function under direct government auspices rather than some kind of private sector
arrangement that currently prevails around the world. While I suspect most academics (at
least in the US) would prefer a private sector solution on ideological grounds, there is no
compelling scientiﬁc evidence for holding strongly to such a belief.
8. Some ﬁnal thoughts
Assuming that auditing is best left as a private sector activity, a very important but
answered question is the level of ‘legal risk’ that will achieve optimal audit quality. The
US is a global outlier in terms of the auditor’s exposure to legal liability. Even though the
number of lawsuits is relatively small in the US, nevertheless there are more lawsuits
annually in the US than in the rest of the world combined. As noted earlier, it is the
potential magnitude of a lawsuit that creates litigation risk more so than the frequency of
lawsuits, and the risk of an audit ﬁrm failure arising from a large lawsuit is very real in the
US and indeed happened in 1991 with the collapse of Laventhol Horwath, the 7th largest
US accounting ﬁrm at the time. Outside the US, audit ﬁrm failures are highly unlikely.
13
While the US legal regime may create a strong incentive for good auditing, it obviously
does not prevent audit failures altogether and it did not prevent the Enron–Andersen
collapse in particular.
And so this begs the question of whether extreme legal risk is really necessary to

achieve an optimal or even satisfactory level of audit quality. The post-Enron reforms of
the accounting profession have failed to address the auditor liability question. Each Big 4
accounting ﬁrm is currently facing serious legal problems in the US and any one of these
ﬁrms could conceivably collapse. Is a ‘Big Three’ or ‘Big Two’ or ‘Big One’ viable if
auditing is to remain a private sector activity? A challenge then for regulators is to create
13
Although a referee notes that the Big 4 accounting ﬁrms are actively lobbying for litigation reform in the
United Kingdom on the grounds that the current legal environment in the UK could lead to an accounting ﬁrm
failure.
J.R. Francis / The British Accounting Review 36 (2004) 345–368 361
a credible mechanism to punish substandard audit work without creating an accounting
ﬁrm meltdown. Again the Enron–Andersen case is instructive. A single client in a single
ofﬁce brought down the global ﬁrm, and a recent study documents that Andersen’s
Houston ofﬁce seems to have been out of line relative to other Andersen ofﬁces (Krishnan,
2004b). Indeed, given the decentralized ofﬁce-based structure of accounting ﬁrms, it does
not make sense to hold the entire ﬁrm accountable for the misdeeds of one ofﬁce or even a
few individuals. Interestingly, other common law countries such as Canada and the UK
seem to achieve high-quality auditing without the kind of extreme legal risk that exists in
the US. While the issue here seemingly involves only the US, it actually is a global issue
because accounting ﬁrms are global businesses. The US Big 4 accounting ﬁrms are also
the global Big 4 ﬁrms, with US operations now representing slightly less than half of total
global revenues. As the Andersen case illustrates, a US accounting ﬁrm failure is de facto a
global failure. And so liability reform in the US is important for the global survival of
private sector auditing, not just the US practices.
14
I have concluded in this essay that audit quality seems to be at an acceptable level based
on the very low incidence of outright audit failures. However, there is also some nascent
evidence that audit quality may have eroded in the 1990s, coinciding with changes in the
organizational culture of the large accounting ﬁrms that emphasized growth and the cross-
marketing of other (non-audit) services. I conclude with proposals for two low-cost

reforms that I believe have the potential to signiﬁcantly address the erosion of audit quality
that may have occurred and, equally important, to improve the public perception of audit
quality in the wake of the high-proﬁle corporate failures of the past few years.
The ﬁrst reform concerns the incentive problems created by partner compensation plans.
Partner compensation has moved away from a model in which partner income sharing was
relatively equal, to more of a performance-based model in which there is greater variation
in partner income (Burrows and Black, 1998). The problem with the incentive approach is
that it personally rewards partners for risk-seeking behavior, while the entire ﬁrm (because
of legal liability) bears the risk of taking on risky audit clients. Audit quality in turn may be
affected if compensation incentives undermine the engagement partner’s skepticism and
objectivity toward high-risk clients. There is some suggestion that this may have occurred
in the Arthur Andersen audit of Enron. Sarbanes-Oxley addresses this problem, in part, by
prohibiting the use of non-audit fees in performance-based contracts. Apparently it was
common to reward audit partners based on the amount of non-audit services purchased by
audit clients. While non-audit fees are off the table for compensation purposes, partners are
still rewarded for the audit revenues they generate and this creates a strong personal
incentive to take on risky clients. Further, it is clear that auditors do not have the diagnostic
ability to correctly identify ex ante those particular clients that will create subsequent audit
14
The social cost of an accounting ﬁrm failure might appear to be small since the primary asset of an accounting
ﬁrm is the human capital of its employees, and the human capital would be efﬁciently redeployed to other (or
new) accounting ﬁrms as occurred with the collapse of Arthur Andersen. However, there may be a social cost in
terms of increased market concentration by the remaining (Big 3?) ﬁrms and transaction costs arising from
involuntary auditor switches. In addition, there could be a more general market disruption as remaining
accounting ﬁrms expand and reorganize internally, and time is required to establish auditor reputations for these
reorganized ﬁrms.
J.R. Francis / The British Accounting Review 36 (2004) 345–368362
litigation problems (recall that most bankruptcies are not preceded by a going concern
report). The asymmetry between partners who are rewarded for risk-seeking behavior
versus the ﬁrm which bears the business risk is not a sustainable business model in auditing,

and accounting ﬁrms need to restructure partner compensation and return to an arrangement
in which partners share relatively more equally in ﬁrm income. Given the increased partner
rotation requirements under Sarbanes-Oxley, it also makes more sense for accounting ﬁrms
to reward partners more equally because increasingly they are sharing equally in the ﬁrm’s
overall work load. And, while this may create incentives for some partners to free-ride and
under-perform, there are other monitoring mechanisms ﬁrms can adopt to ensure that
partners perform satisfactorily but which are de-coupled from compensation.
I have argued that the evidence suggests that actual audit quality is high. However, there
continues to be a widely held perception, rightly or wrongly, that audit quality is impaired
by non-audit services and this suspicion has deepened post-Enron. These concerns led to
restrictions on non-audit services by the SEC in 2000 and further restrictions by Sarbanes-
Oxley in 2002; however, companies continue to buy large amounts of non-audit services.
15
The profession has long argued that non-audit services are not a problem, that clients
demand such services, and that auditors have legal and economic incentives to maintain
their independence and protect their reputation (AICPA, 1997). In my view this is a losing
public-relations battle and I believe the time has come for the accounting profession to stop
providing non-audit services for audit clients. Even if there is no ‘smoking gun’ or direct
evidence that non-audit services impair actual audit quality, there will always be at least the
suspicion that auditors are not completely objective if they provide signiﬁcant other
services that put the auditor in a commercial business relationship with the client.
Ironically, a ban on non-audit services need not create practice disruptions for the
accounting ﬁrms because each of the ﬁrms would be in the position of providing non-audit
services for the clients of all other accounting ﬁrms. Clients might also beneﬁt from this
‘unbundling’ because the evidence from other industries is that unbundled goods and
services are generally cheaper due to increased competition. While increased competition
might hurt accounting ﬁrms, the argument to sustain the current arrangements simply so
that accounting ﬁrms can earn economic rents is hardly defensible.
16
While arguments can be made both for and against the provision of non-audit services,

the fundamental beneﬁt of banning non-audit services is getting auditors focused on their
franchise and raison d’etre, which is the independent attestation of ﬁnancial statements
(Zeff, 2003; Wyatt, 2004). It may not be glamorous work, but as Enron and other cases show,
15
For example, in the 2003 ﬁscal year AT&T Corporation paid fees of $29.7 million to their auditors of which
less than half ($12.7 million) was related to the annual ﬁnancial statement audit.
16
Accounting ﬁrms argue that ‘bundled’ audit and non-audit services are cheaper due to positive knowledge
spillovers (Simunic, 1984). However, this argument is dubious because the audit team does not provide non-audit
services for large publicly listed companies. Instead, the specialization and division of labor in Big 4 accounting
ﬁrms means that different personnel in different divisions of the ﬁrm provide non-audit services, which makes the
spillover/synergies argument highly suspect. One area where knowledge spillover does seem plausible is the joint
preparation of tax returns and the audit of tax-related accounts in the ﬁnancial statements (which requires
knowledge of taxes payable). So a case could be made for allowing auditors to prepare corporate tax returns, but
not tax planning which puts the auditor in an advisory role and also puts auditors in the problematic role of
auditing their own work, i.e. the consequences of tax planning advice.
J.R. Francis / The British Accounting Review 36 (2004) 345–368 363
corporate governance and independent external audits are important institutional practices
that we tend to take for granted until a failure occurs. While the empirical evidence is
supportive that outright audit failure rates are very low, this does not mean we have achieved
nirvana with respect to audit quality. Further, there is a public perception that audit quality
may have declined in the 1990s, a view that is supported by some recent research. To restore
public conﬁdence in auditing, and to possibly increase actual audit quality as well the
public’s perception of quality, accounting ﬁrms can signal their unambiguous commitment
to audit quality by voluntarily stopping the provision of other (non-audit) services to audit
clients in order to convey in the clearest possible manner that independent auditing is the
core value and the core business of public accounting ﬁrms.
9. Postscript
Two developments at the Public Company Accounting Oversight Board (PCAOB)
occurred shortly before this paper was to be submitted for publication. First, the PCAOB is

currently reviewing the right of accounting ﬁrms to offer tax services to audit clients. The
Sarbanes-Oxley Act of 2002 authorizes the PCAOB to determine the list of
‘impermissible’ non-audit services. At a day-long roundtable discussion on July 14,
2004, PCAOB Chairman William J. McDonough stated ‘new concerns relating to auditor
independence have come to the public’s attention These concerns relate to tax services
and products that audit ﬁrms provide to their clients and the senior executives of those
clients, including extremely aggressive, if not abusive, tax strategies that may, by their
nature, impair the objectivity of the auditor’ (as reported in Accounting Today, August
9–22, 2004, pp. 1 and 38). With the elimination of many other non-audit services, taxation
is now one of largest sources of non-audit service revenues. It is clear from the recent
PCAOB roundtable discussion that the appropriateness of non-audit services—even those
services such as taxation that are closely related to accounting—are being viewed with
increasing skepticism in terms of their impact on both actual and perceived auditor
independence.
The second development is the August 26, 2004 release of the initial inspection reports
of the Big 4 accounting ﬁrms. These independent inspections replaced the old peer review
system administered by the Public Oversight Board which, while nominally independent,
was nevertheless under the auspices of the American Institute of Certiﬁed Public
Accountants and therefore under control of the accounting profession. The PCAOB
inspection reports document deﬁciencies at all four ﬁrms, including the failure to correctly
apply an accounting rule relating to the classiﬁcation of current debt due within one year.
Edited versions of reports are publicly available at the PCAOB web site at http://www.
pcaobus.org. Under the Sarbanes-Oxley Act of 2002, full reports are not immediately
available and accounting ﬁrms are given one year to correct deﬁciencies before details of
negative assessments are made public. In a press release by the PCAOB which is available
on their web site, PCAOB Chairman William J. McDonough says “As our reports state,
their emphasis on criticisms do not reﬂect any broad negative assessment of the ﬁrms’
audit practices. The Board’s inspections are unprecedented, and in this ﬁrst year, our
ﬁndings say more about the beneﬁts of the robust, independent inspection process
J.R. Francis / The British Accounting Review 36 (2004) 345–368364

envisioned in the Sarbanes-Oxley Act of 2002 than they do about any inﬁrmities in these
ﬁrms’ audit practices.” While these initial inspection reports do not necessarily mean that
audit quality is poor, or that it has declined in recent years, the reports do indicate that the
PCAOB inspection process is going to be far more rigorous the old peer review system,
and this may bode well for the future of audit quality. Of course it remains an open
question whether or not the new regulations are cost effective in terms of improving actual
audit quality and whether the new regulations are necessary given the relatively small
number of documented audit failures. On the other hand ‘perceptions’ are very important
with respect to auditor credibility, particularly since audit quality is difﬁcult to observe
directly, and these new regulations may be just as important with respect to the public
perception of audit quality as they are for the actual improvement of audit quality. Along
these lines James S. Turley, Ernst and Young Chairman and Chief Executive Ofﬁcer,
responded to the PCAOB inspection report by saying, “When I am asked about the
PCAOB’s role, I consistently say that a tough, but fair and independent regulator, will
make our ﬁrm and the entire profession better, while helping both to regain the conﬁdence
of the investing public.”
17
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