kong - 2005 - an empirical study of audit quality in china

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AN EMPIRICAL STUDY OF AUDIT QUALITY IN CHINA
FROM THE PERSPECTIVES OF REGULATORS
AND THE ACCOUNTING PROFESSION
by
Wong Man Kong, Raymond
A thesis
submitted in partial fulfillment
of the requirements for the Degree of
Doctor of Philosophy
School of Accounting and Finance
The Hong Kong Polytechnic University
September 2005
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CERTIFICATE OF ORIGINALITY
I hereby declare that this thesis is my own work and that, to the best of my
knowledge and belief, it reproduces no material previously published or written, nor
material that has been accepted for the award of any other degree or diploma, except
where due acknowledgement has been made in the text.
-/ , (si«ned)
WONG Man Kon£ (Name of student)
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Abstract
An Empirical Study of Audit Quality in China From the Perspectives of
Regulators and the Accounting Profession
by
Wong Man Kong, Raymond
Doctor of Philosophy
The effective functioning of securities markets depends on the quality of audits
and the integrity of auditors. However, the recent tide of corporate scandals and audit
failures has shocked the public, and both audit quality and auditor independence have
been questioned. It is therefore in the interests of both auditors and regulators to
understand the main causes of audit failure, and to investigate the factors that drive
audit quality. While much of the focus in the accounting literature has been on audit
quality in the U.S. and other developed countries, a comprehensive study of the audit
quality in developing countries is of equal significance given the increasing
importance of international investment. The increasingly vital role that is played by
China in the world economy and its unique institutional setting provide a motivation
for the examination of the specific factors that drive audit quality.
In this thesis, I first evaluate audit quality directly through an examination of the
cases of audit failure that have been discovered by the Chinese regulator, the China

Securities Regulatory Commission (CSRC). I attempt to show the extent to which the
regulator perceives auditors to be responsible for their failure to detect fraud. Then I
use auditor independence as a measure of audit quality to investigate two specific
factors that drive auditor independence from the perspective of the accounting
profession. I hypothesize that regulatory sanctions serve as an incentive to improve
auditor independence, and further posit that the organizational form of CPA firms
affects the independence level of auditors.
The empirical results indicate that audit failures that involve material
misstatements by clients are more likely to lead to enforcement actions against
auditors than disclosure fraud. Misstatement fraud that involves accounting earnings
is more likely to lead to enforcement actions against auditors than misstatement fraud
that involves balance sheet figures. The results reveal a strong association between
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several types of fraud and audit failures from the regulator’s perspective. To examine
the factors that drive auditor independence, I use the issuance of modified audit
opinions as a proxy for auditor independence, and demonstrate that sanctioned
auditors act more independently after being subject to regulatory sanctions and that
CPA firms that are registered as partnership firms are more independent than firms
that are registered as limited liability firms. This implies that formal regulatory
sanctions and the organizational form of CPA firms are important drivers of auditor
independence and audit quality in China.
Overall, the results make several contributions to regulators, the accounting
profession, and academia. First, the analyses on audit failures provide direct and
useful information for the improvement of audit quality. In particular, regulators and
the accounting profession can make use of my findings in their policy making.
Regulators and policy makers may consider devising new accounting and auditing
standards to govern substandard audits to detect specific types of fraud. The
accounting profession may also consider providing technical training for staff to
identify various prominent types of fraud. Second, the evidence of an improvement
in auditor independence that is motivated by regulatory sanctions implies that formal

sanctions serve as an effective deterrent to the unethical behavior of auditors. This
result supports the view that more resources should be devoted to regulatory
supervision to improve audit quality and auditor independence. Finally, the results on
the organizational form of CPA firms contribute to the literature by empirically
demonstrating the link between auditor independence and the organizational form of
CPA firms. This finding is also useful for regulators and the accounting profession as
they attempt to evaluate the optimal balance in implementing a limited liability
regime without diminishing audit quality and auditor independence.
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ACKNOWLEDGEMENTS
I wish to acknowledge the help of many people during my study. The first and
foremost thanks go to my two supervisors, Professor Phyllis L. L. Mo and Professor
Michael A. Firth. This dissertation would not have been possible without their
supports and encouragements throughout my study. I owe my great deal to my chief
supervisor, Professor Phyllis Mo, to her dedication in offering me direction and
penetrating criticism, as well as guiding me through draft after draft over the past
several years. My gracious thanks also go to my co-supervisor, Professor Michael
Firth, who has been so generous with his time in providing valuable comments on
my thesis and is a wonderful coach in guiding me throughout this dissertation. Their
advice on both substance and style are palpable on every page of this dissertation.
Thanks are also due to many faculty members at The Hong Kong Polytechnic
University. I am greatly indebted to Professor Ferdinand Gul, Dr. Peter Cheng, Dr.
Thomas Lau, Dr. Ben Bao, and Dr. Sandra Ho, for their insightful comments on
various chapters of my thesis. I also thank many academic colleagues and
professionals in Hong Kong, China, and the United States who provided valuable
suggestions, comments, and insights on audit quality and auditors’ practices in
China.
Last but not least, I would like to thank my family members whose constant
love and encouragement enable me to persist throughout my study. Especially, my
wife, Agnes, is my source of inspiration and impetus for pursing my study and

finishing this dissertation.
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An Empirical Study of Audit Quality in China From the Perspectives of
Regulators and the Accounting Profession
Certificate of Originality
Abstract
Acknowledgements
Table of Contents i
List of Tables iv
Chapter 1 Introduction
1.1 Motivation for the Research 1
1.1.1 Importance of Audit Quality 1
1.1.2 Importance of Audit Quality in China 2
1.2 Objectives of the Thesis 5
1.3 Contributions of the Thesis 7
1.4 Organization of the Thesis 9
Chapter 2 Literature Review
2.1 Introduction 10
2.2 Various Measures of Audit Quality 11
2.2.1 A Direct Measure of Audit Quality 11
2.2.2 Auditor Size 12
2.2.3 Brand Name Reputation 14
2.2.4 Industry Specialization 15
2.2.5 Modified Audit Opinions 15
2.2.6 Auditor Economic Dependence on Clients 17
2.3 Previous Research on Audit Quality 18
2.3.1 Audit Quality in Developed Economies 18
2.3.2 Audit Quality in China 23
Chapter 3 Audit Quality from the Perspective of Regulators
Chapter Summary 29

3.1 Introduction 30
3.2 China Securities Regulatory Commission (CSRC) Enforcement
Actions 33
3.3 Hypotheses Development 35
3.3.1 Material Misstatement Fraud versus Disclosure Fraud 35
3.3.2 Revenue-related Fraud versus Assets-related Fraud 39
3.4 Research Methodology 42
3.4.1 Sample Selection 42
3.4.2 Empirical Models 43
i
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3.5 Empirical Results 46
3.5.1 Sanctions on CPA Firms and Audit Partners 46
3.5.2 Fraud Characteristics and Univariate Tests 47
3.5.3 Multivariate Tests 49
3.6 Chapter Conclusion 50
Chapter 4 Audit Quality from the Perspective of the Accounting
Profession - Formal Sanctions as an Effective Incentive for
Auditor Independence
Chapter Summary 55
4.1 Introduction 56
4.2 Formal Sanctions on Auditors in China 60
4.2.1 Chinese Institute of Certified Public Accountants (CICPA)
Disciplinary Actions 61
4.2.2 China Securities Regulatory Commission (CSRC)
Enforcement Actions 62
4.3 Hypothesis Development 63
4.4 Research Methodology 67
4.4.1 Sample Collection 67
4.4.2 Empirical Model 69

4.5 Empirical Results 72
4.5.1 Stock Market Responses to Sanctioned Clients with
Sanctioned Auditors 72
4.5.2 Consequences for Sanctioned CPA Firms and Audit Partners 75
4.5.3 Market Share of Auditors after Sanctions 76
4.5.4 Effectiveness of the Regulatory Sanctions 78
4.6 Chapter Conclusion 81
Chapter 5 Audit Quality from the Perspective of the Accounting
Profession - An Empirical Examination of the
Organizational Form of CPA Firms and Auditor
Independence
Chapter Summary 84
5.1 Introduction 85
5.2 Development of the Legal Forms of CPA Firms in China 90
5.3 Hypotheses Development 93
5.4 Research Methodology 100
5.4.1 Sample Description 100
5.4.2 Empirical Models 102
5.4.3 Control Variables 104
5.5 Empirical Results 107
5.5.1 Descriptive Statistics of the Sample Firms 107
5.5.2 Results for Testing the Association between the Legal Form of
CPA Firms and Audit Opinions (Hypothesis H I) 107
5.5.2a Univariate Tests and Correlation Matrix 108
5.5.2b Multivariate Tests 109
5.5.3 Results for Testing the Association between Auditor Switch
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and Audit Opinions (Hypothesis H2) 109
5.5.3a Univariate Tests and Correlation Matrix 109

5.5.3b Multivariate Tests 110
5.5.4 Results for Testing the Association between Incorporation of
Partnerships and Audit Opinions (Hypothesis H3) 111
5.5.4a Univariate Tests and Correlation Matrix 111
5.5.4b Multivariate Tests 112
5.6 Robustness Tests 112
5.7 Chapter Conclusion 114
Chapter 6 Conclusion and Discussion
6.1 Summary of the Results 117
6.2 Implications 119
6.3 Limitations 121
6.4 Future Extensions of this Research 122
Tables 123
References 151
iii
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LIST OF TABLES
Table 1-1
Table 1-2
Table 2-1
Table 3-1
Table 3-2
Table 3-3
Table 3-4
Table 3-5
Table 3-6
Table 4-1
Table 4-2
Table 4-3
Table 4-4

Table 4-5
Table 4-6
Table 5-1
Table 5-2
Table 5-3
Table 5-4
Table 5-5
Average Annual Percentage Growth of Real GDP
Development of the Chinese Stock Market
Development of the Accounting Profession for the Audits of
Listed Companies
Sample Collection Procedure for the CSRC Enforcement
Releases
Descriptive Statistics of Enforcement Releases
Analysis of the Punishments Enforced in the Enforcement
Actions
Detailed Description of Fraud
Descriptive Statistics and Univariate Tests for Financial
Statement Fraud and Auditor Sanctions
Multivariate Analysis Results for Financial Statement
Fraud and Auditor Sanctions
Sample Descriptions for Testing the Effectiveness of Auditor
Sanctions
Market Reaction to Sanctioned Clients with Sanctioned
Auditors versus Sanctioned Clients with Non-sanctioned
Auditors
Consequences for Sanctioned CPA Firms and Audit
Partners after Enforcement Action
Univariate Tests for Sanctioned CPA Firms’ Market Share,
Audit Partners’ Share of the Client Portfolio, and the

Percentage of Modified Opinions Issued before and after the
Enforcement Actions
Descriptive Statistics of Auditor and Client Characteristics
Multivariate Results for the Effectiveness of Auditor
Sanctions
Sample Descriptions for Testing the Association between the
Legal Form of CPA Firms and Audit Opinions
Descriptive Statistics of the Sample Firms
Univariate Tests for the Association between the Legal Form
of CPA Firms and Audit Opinions (full sample)
Pearson (Spearman’s rho) Correlations for the Association
between the Legal Form of CPA Firms and Audit Opinions
(full sample)
Multivariate Tests for the Association between the Legal
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123
124
125
126
127
128
129
130
131
133
134
135
136
137
138

139
140
141
142
Table 5-6
Table 5-7
Table 5-8
Table 5-9
Table 5-10
Table 5-11
Table 5-12
Form of CPA Firms and Audit Opinions (full sample)
Univariate Tests for the Association between Auditor Switch
and Audit Opinions (auditor-switch subsample)
Pearson (Spearman’s rho) Correlations for the Association
between Auditor Switch and Audit Opinions (auditor-switch
subsample)
Multivariate Tests for the Association between Auditor
Switch and Audit Opinions (auditor-switch subsample)
Univariate Tests for the Association between Incorporation
of Partnerships and Audit Opinions (incorporation
subsample)
Pearson (Spearman’s rho) Correlations for the Association
between Incorporation of Partnerships and Audit Opinions
(incorporation subsample)
Multivariate Tests for the Association between
Incorporation of Partnerships and Audit Opinions
(incorporation subsample)
Sensitivity Tests for the Association between the Legal Form
of CPA Firms and Audit Opinions

143
144
145
146
147
148
149
150
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CHAPTER 1
INTRODUCTION
1.1 MOTIVATION FOR THE RESEARCH
1.1.1 Importance of Audit Quality
The demand for auditing services arises from a desire to reduce the divergence
of interests and information asymmetry between the owners (the principal) and
managers (the agent) in a principal-agent relationship (Jensen and Meckling 1976;
Watts and Zimmerman 1986). Managers can voluntarily increase the transparency of
their actions by hiring independent auditors to monitor their behavior.
Recent research provides empirical evidence that high-quality, independent
audits are used as monitoring and bonding mechanisms to alleviate agency costs
(DeFond 1992; Fan and Wong 2005; Francis and Wilson 1988). In addition,
high-quality auditors give greater credibility and better quality to financial statements
(Khurana and Raman 2004; Teoh and Wong 1993), are more likely to constrain the
opportunistic behavior of management (Becker et al. 1998; Francis et al. 1999; Kim
et al. 2003), experience a higher incidence of auditor-client disagreement over
income-increasing accounting methods (DeFond and Jiambalvo 1993), report more
conservatively by issuing more modified audit reports (Francis and Krishnan 1999;
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DeFond et al. 2000; Chen et al. 2001), and have a greater efficiency in

technologically specialized industries (Craswell et al. 1995) than low-quality auditors.
As a consequence, high-quality auditing services are of particular importance in
lending credibility to financial statements and increasing investor confidence.
Auditors specialize in the supply of various levels of quality (product differentiation),
and clients demand different levels of audit quality because of the differential agency
costs across firms (DeAngelo 1981; DeFond 1992). Understanding the factors that
are associated with audit quality is a vital concern for investors, policy makers,
regulators, the accounting profession, and the general public alike.
1.1.2 Importance of Audit Quality in China
Table 1-1 reports the annual growth in GDP for the world and selected
developed and developing economies. According to the International Monetary Fund
(IMF) (2003; 2005), the ten-year average growth in GDP for the period of 1995 to
2004 for China is 9.5 percent, which is significantly greater than the growth of the
United States (3.7 percent), the Euro area (2.2 percent), Japan (1.3 percent), and
India (6.8 percent), and is double that of the world average (4.2 percent). With the
rapid growth in its economy, China is playing an increasingly important role in world
economic trade. Some analysts are predicting that China’s GDP will surpass that of
Germany by 2010 and Japan by 2015, and will equal the GDP of the United States by
2
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around 2040 (see, for example, Kren 2005). In addition, the expansion of the
domestic stock market has aroused the interest of foreign investors to invest in China.
Table 1-2 documents the development of the Chinese domestic stock market. Since
the establishment of the two stock exchanges in the early 1990s, the stock market has
grown rapidly (Haw et al. 2003). In 1991, thirteen firms were listed on the two stock
exchanges (eight on the Shanghai Stock Exchange and five on the Shenzhen Stock
Exchange). By the end of 2004, 1,373 firms were listed on the exchanges, and the
total market capitalization of the listed firms reached RMB3,706 billion, which is
equivalent to approximately US$440 billion. China is increasingly seen as an
interesting country for foreigners who want to make portfolio investments, and to

facilitate this demand the authorities have opened up avenues for foreigners to invest
in Chinese firms. For example, the recent Qualified Foreign Institutional Investors
(QFII) initiative allows foreigners to directly invest in Chinese domestic equity
stocks, and many U.S., European, and other international funds have taken advantage
of this opportunity. Furthermore, the Chinese authorities have granted more domestic
firms permission to raise funds from abroad and to list their securities in Hong Kong
and in foreign markets. Many Chinese firms have taken up these opportunities.
[Insert Tables 1-1 and 1-2 About Here]
China is undergoing a transition from a planned economy to a market economy,
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in which various market segments (including insurance, banking, and auditing
markets) are opening up to foreign investors. Although the lower economic costs of
production attract substantial capital inflows to the economy, the quality of financial
statements is an impediment to foreign investment in, and transactions with, Chinese
firms. The absence of an efficient legal environment and corporate governance
regimes, which are characteristics of many transitional and developing economies,
means that the quality of audit services plays an important role in ensuring the proper
functioning of the financial reporting systems, and helps safeguard the assets of
investors (Fan and Wong 2005). It is therefore highly instructive for foreign and
domestic investors and the government to learn more about the quality of financial
statements and the mechanisms that are used to ensure quality in such a fast growing
emerging economy. Previous literature affirms the role of audit quality and auditor
independence in China (Chen et al. 2001; Gul et al. 2003), and provides some
evidence of improved auditor independence following regulatory changes (DeFond
et al. 2000; Yang et al. 2001). However, there is limited research that examines other
factors that drive audit quality and auditor independence in China. Given the
importance of quality auditing services in the Chinese economy, this study hopes to
shed some light on these issues.
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1.2 OBJECTIVES OF THE THESIS
The primary objective of my thesis is to provide a comprehensive study to
understand audit quality in China from the perspectives of regulators and the
accounting profession. Recently, the rising tide of fraudulent financial reporting in
major corporations has shocked the public and tarnished the reputation of the
auditing profession. The first aim of my thesis is therefore to directly measure audit
quality by studying audit failures in listed companies. Through an in-depth
examination of formal regulatory sanctions against auditors, I attempt to show the
types of fraud that are more likely to lead to poor audit quality (audit failures), and
investigate the extent to which the regulators perceive auditors to be responsible for
the detection of these types of fraud.
Second, recent policy debates on the regulatory supervision of the accounting
profession have raised the concern of the profession, policy makers, and the general
public alike. There is a growing consensus that regulatory intervention in audit
practices, such as the promulgation of the Sarbanes-Oxley Act in the U.S., is
necessary to improve auditor independence and audit quality, and, in particular, to
restore investor confidence in financial statements. Previous studies suggest that
auditors that have been criticized by regulators have experienced economic losses in
terms of market share, audit fees, and the market value of their client firms (see
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Davis and Simon 1992; Dopuch and Simunic 1982; Firth 1990; Moreland 1995;
Wilson and Grimlund 1990). Therefore, auditors that suffer economic losses should
be motivated to act more independently to repair their tarnished reputation. Recent
research suggests that formal sanctions are an effective incentive to improve auditor
independence (Shafer et al. 1999), but these studies use surveys or experiments to
examine the perceived risk of sanctions, and, though they provide some insight, are
no substitute for the measurement of the actual effects of formal sanctions on audit
quality and auditor independence. Thus, the second objective of my study is to

investigate whether regulatory supervision through the execution of formal
regulatory sanctions helps to improve auditor independence and audit quality in the
Chinese securities market.
Finally, there are theoretical models that demonstrate that increased liability
protection for auditors results in reduced audit quality (Dye 1995; Chan and Pae
1998). To date, however, there has been little or no research to empirically test this
theory. In the late 1990s, China underwent an accounting reform that required all
accounting firms to disaffiliate themselves from their government-sponsoring agents
and form independent CPA firms. Independent CPA firms can be registered as
unlimited liability partnerships' or as limited liability firms if certain requirements
1 H ereafter, I use the term s “partnership” , "audit partnership”, or “partnership firm ” for an unlimited
liability partnership firm.
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are met. Since the reform, the levels of auditors’ risk and liability exposure have
substantially increased, and the liabilities are not covered or guaranteed by the
government. This unique institutional characteristic provides an excellent setting in
which to empirically investigate whether an auditor’s intrinsic liability exposure that
is dependent on the legal organizational form of the CPA firm affects that auditor’s
propensity to issue modified audit reports (which is a proxy for auditor independence
and audit quality).
1.3 CONTRIBUTIONS OF THE THESIS
My thesis contributes to the literature in the following ways. Previous studies
show some evidence of the motivation effect of formal sanctions on audit quality, but
their results are largely based on analyses of survey responses in experimental
settings. My study presents empirical results that are based on the effectiveness of the
actual regulatory sanctions on auditor independence and audit quality. Second, my
research is the first to empirically demonstrate the association between the
organizational form of a CPA firm and auditor independence.
Based on an analysis of audit deficiencies, the results of my study provide a

direct measure of poor audit quality, and provide some useful information for the
profession to develop various auditing procedures for the detection of egregious
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fraud. For example, CPA firms could design more comprehensive audit procedures to
verify eamings-related items. The analysis also gives some insights into the
regulator’s views on the responsibility of auditors in detecting fraud. This knowledge
will be helpful to the accounting profession and policy makers when they devise new
accounting and auditing standards that will help uncover these specific types of
fraud.
My thesis also has significant implications for policy makers, regulators, and the
accounting profession in their continuous effort to structure accounting reforms in
China. The results on the effectiveness of regulatory sanctions as incentives for
auditor independence suggest that more resources should be allocated to regulatory
supervision. Without effective regulatory supervision, auditors are likely to act less
independently, and clients thus have more power over auditors (DeFond et al. 2000).
My research also provides some directions for the design of regulatory procedures in
other transitional economies. Furthermore, the evaluation of the impact of the
organizational form of a CPA firm on auditor independence suggests that partnership
firms are more independent and report more conservatively than limited liability
firms. Regulators and policy makers could consider more stringent regulations on the
establishment of limited liability audit firms to better control audit quality.
Accounting professional bodies could also consider the setting up of a peer review
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regime to self-reguiate the behavior of auditors in China.
1.4 ORGANIZATION OF THE THESIS
Chapter 2 provides a literature review of audit quality measures and presents the
research to date on audit quality in developed countries and in China. An
investigation into audit quality from the regulator’s perspective is presented in

Chapter 3, and an investigation into audit quality from the perspective of the
accounting profession is documented in Chapters 4 and 5. Specifically, Chapter 4
examines the effectiveness of formal sanctions as incentives for auditor
independence, and Chapter 5 empirically investigates the impacts of the legal form of
CPA firms on auditor independence and audit quality. Finally, Chapter 6 concludes
the thesis, documents the implications of the study, and discusses future research
opportunities.
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CHAPTER 2
LITERATURE REVIEW
2.1 INTRODUCTION
According to DeAngelo (1981), audit quality can be defined as an auditor’s
ability to detect and report errors and irregularities in financial statements. The
ability of auditors to detect irregularities in financial statements depends on their
technical capabilities, whereas the ability of auditors to report breaches in financial
statements depends on the extent of their independence from their clients. In another
words, the higher an auditor’s technical competence and independence, the higher
the quality of the auditing service.
As audit quality cannot be observed directly except in ex-post audit failures,
previous studies use different proxies as measures of audit quality and investigate the
impact of various economic and environmental factors that are associated with audit
quality. Some examples of these measures are auditor size (DeAngelo 1981; Francis
1984; Francis and Wilson 1988; Johnson and Lys 1990), auditor’s brand name
reputation or industry specialization (Francis and Simon 1987; Davidson and Neu
1993; Craswell et al. 1995), the issuance of modified audit opinions (Francis and
Krishnan 1999; Chen et al. 2000), and auditor economic dependence on clients
10
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(Abbott et al. 2003; Ashbaugh et al. 2003; Frankel et al. 2002). Recent research also

reveals that audit quality is strongly associated with the credibility of reported
earnings (Teoh and Wong 1993), audit price premiums (Francis 1984; Baber et al.
1987; Francis and Simon 1987), the resolution of agency costs (DeFond 1992; Fan
and Wong 2005), the constraint of earnings management (Becker et al. 1998; Francis
et al. 1999; Kim et al. 2003), the threat of sanction risk (Shafer et al. 1999), the
propensity of auditors to issue modified reports (Morris and Strawser 1999), and the
protection of auditor reputation over economic fee dependence (Reynolds and
Francis 2001).
This chapter provides a literature review of audit quality and the various factors
that affect audit quality in developed countries and in China. The organization of the
chapter is as follows. Section 2.2 describes some of the common measures of audit
quality in the literature, and section 2.3 provides a review of the literature that studies
audit quality in developed countries and in China.
2.2 VARIOUS MEASURES OF AUDIT QUALITY
2.2.1 A Direct Measure of Audit Quality
A direct measure of audit quality is the ex-post audit failures that reveal “bad”
or poor-quality audits that are supplied by auditors during an audit engagement. A
U
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number of studies that examine audit failures involve direct investigations of
regulatory enforcement actions (Feroz et al. 1991; Rollins and Bremser 1997; Bonner
et al. 1998; Carcello and Nagy 2004) and litigation against auditors (St. Pierre and
Anderson 1984; Palmrose 1988). By and large, these studies reveal a positive
association between poor audit quality and audit failures (Palmrose 1988), and report
the main problems that result in poor-quality audits (St. Pierre and Anderson 1984;
Rollins and Bremser 1997; Bonner et al. 1998). A common limitation of these
analyses is the small numbers of audit failure cases that are examined. For example,
Palmrose (1988) examines a sample of 472 U.S. legal cases that were brought against
auditors between 1960 and 1985, which represents just 18 litigation cases per year
approximately. Feroz et al. (1991) summarize 188 firms that were subject to the U.S.

SEC enforcement actions between 1982 and 1989. Of the 188 enforcement action
cases, there were 85 cases where the auditors were sanctioned by the SEC, which
represents around 10 enforcement cases against auditors per year.
Due to the limited observations of audit failures, researchers have developed
various indirect measures of audit quality that are based on technical competence and
auditor independence.
2.2.2 Auditor Size
Auditor size is one of the most common proxies for audit quality. Auditor size
12
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can be measured as the audit fees that are charged to clients, the total number of
clients, total client assets or sales, which are continuous measures, and Big N versus
non-Big N auditors, which is a dichotomous measure. DeAngelo (1981) argues that
larger auditors (as measured by number of clients) have more client-specific
quasi-rents that serve as collateral against losses that are incurred through the
discovery of a lower quality audit than was promised. This collateral motivates larger
auditors to behave less opportunistically, and thus to supply a perceived higher
quality audit and to display a higher level of independence. Subsequently, many
researchers have used auditor size as a measure of audit quality (Francis 1984;
Francis and Wilson 1988; Johnson and Lys 1990; DeFond 1992; DeFond et al. 2000;
Chen et al. 2001; Gul et al. 2003). Francis and Wilson (1988), Johnson and Lys
(1990), and DeFond (1992) use the sales of clients as a proxy for audit quality,
because client sales revenues should be highly correlated with client-specific
quasi-rents, and greater client sales signify a larger auditor size. DeFond et al. (2000),
Chen et al. (2001), and Gul et al. (2003) also use the measure of the financial
situation of clients as a surrogate for auditor size in China. They use the total assets
of clients as a surrogate of quasi-rents, and employ a dummy variable of TOP 10 to
indicate whether an auditor is a top ten auditor (large auditor) according to the total
assets of its clients.
13

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Another example of a measure of auditor size is that of the Big Eight (or Big
7/6/5/4) versus non-Big Eight firms, in which researchers generally argue that Big
Eight audit Firms have “more to lose” from discovery of substandard audits, in terms
of loss of reputation or loss of future economic rents from clients (Francis 1984;
Baber et al. 1987).
2.2.3 Brand Name Reputation
Based on the quality differentiation argument of DeAngelo (1981), auditors
voluntarily specialize in different (albeit uniform) quality levels for the purpose of
capturing higher fees (product differentiation). Big Eight auditors generally have a
brand name reputation to the extent that they charge a higher price premium for
higher quality audits (Francis 1984; Francis and Simon 1987; Simon and Francis
1988; Davidson and Neu 1993). The brand name reputation effect also motivates
auditors to supply high-quality auditing services, as they are subject to the threat of
loss of reputation if they provide substandard audits. Francis and Simon (1987)
analyze the small client segment of the U.S. audit market for publicly traded
companies, and find that a Big Eight price premium exists relative to non-Big Eight
auditors, which are characterized by national firms or local/regional firms. Other
research studies similarly report that Big N auditors charge higher premiums. These
findings imply the existence of Big N product differentiation in the market for audit
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