pike - 2003 - studies on audit quality [aq]

Studies on Audit Quality
Joel E. Pike
A dissertation submitted in partial fulfillment of
the requirements for the degree of
Doctor of Philosophy
(Business)
at the
UNIVERSITY OF WISCONSIN - MADISON
2003
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Committee’s Page. This page is not to be hand-written except for the signatures Committee’s Page. This page is not to be hand-written except for the
A dissertation entitled
STUDIES ON AUDIT QUALITY
submitted to the Graduate School of the
University of Wisconsin-Madison
in partial fulfillment of the requirements for the
degree of Doctor of Philosophy
by
Joel E. Pike
Date of Final Ora! Examination: June 12,2003

M o nth & Y ear D eg re e to b e a w ard e d : December May August 2003
* * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * *
Approval Signatures of Dissertation Committee
Signature, Dean of Graduate School
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For my wife Nadine Mercil and my father Gilmour J. Pike
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Acknowledgements
I would like to thank my dissertation advisor, Ella Mae Matsumura, for her support and
guidance over the last six years. I also want to express my deep gratitude to my co-chair, Brian
Mayhew, for his generous sharing of his time and expertise. I hope that I can be to others in the
future the colleagues they have been to me. I would also like to thank the remaining members of
my dissertation committee, Mark Covaleski, John Eichenseher, and Robert B. M iller for their
time and suggestions.
Several other members of the accounting community at the University of Wisconsin -
Madison also deserve special mention. Terry Warfield has been particularly generous with his
time and willingness to offer help and suggestions. Kathy Hurtt has also offered insightful
comments on sections of this dissertation. My fellow Ph.D. students have also profoundly
affected me, making this time one of intellectual exploration and joy. I would like to especially
recognize Changling Chen and Helen Brown for their helpful comments and shared interests, and
Qiang Cheng for his sense of humor and inspiration. In addition, I would like to thank Matt
Magilke for many stimulating discussions, the University of Wisconsin - Madison Department
of Accounting and the School of Business for their financial support, and my wife Nadine for her
support and her hours of assistance with data collection.
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i i i
Table of Contents
Acknowledgments ii
Figures and Tables viii
Chapter 1 Introduction 1

1. Independence and Audit Quality 1
2. The Demand for Auditing, Independence, and Quality 3
3. Levels of Analysis, Methodological Issues in Prior Literature,
and Proposed Resolutions 4
3.1 Levels of Analysis 4
3.2 Methodological Issues in the Prior Literature and
Proposed Resolutions 6
3.2.1 Archival Studies 6
3.2.2. Analytical Models 8
3.2.3 Experimental Studies 10
4. Summary of Remaining Chapters 11
Chapter 2 Reputation in Auditing 13
1. Introduction 13
2. Theories of Reputation 16
2.1 Reputation Formation and Depletion 18
Chapter 3 Reliable Reputation Formation 21
1. Hypotheses 21
2. Experiment 24
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2.1 Game Description and Player Choices
2.2 Experimental Design
2.3 Subject Pool
3. Results
3.1 Reputation Formation; Sensitivity to Cost and Expected Life
4. Discussion and Conclusions
Chapter 4 The Value of a Reputation for Audit Quality: Experimental
Evidence from Buying and Selling Reputations
1. Buying and Selling Reputations
2. Hypotheses Development
3. Experiment

3.1 Game Description and Player Choices
3.2 Experimental Design
3.2.1 Treatments: Buying and Selling Reputations
3.2.2 Subject Pool
4. Results
4.1 Buying and Selling Reputations
4.1.1 Competent Auditors Buying Preferences
4.1.2 Competent Auditors Selling Preferences
4.1.3 Inept Auditors Selling Preferences
4.1.4 Other Analysis - Purchase Price Effects
4.1.1a Effects on Buyer-Seller Combination
4.1.1b Effects of Treatments on Purchase Prices
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V
4.2 Summary 57
5. Discussion and Conclusions 57
Chapter 5 Audit Quality and the Provision of Non-Audit Services:
Evidence from the Property-Casualty Insurance Industry: Overview 66
1. Introduction 66
2. Review of Prior Research and Industry Background 68
2.1 Audit Quality 68
2.2 Non-Audit Services and Independence 70
2.3 Insurance Industry Background and Accounting 72
2.4 Loss Reserves and Managerial Incentives 76
Chapter 6 Audit Quality and the Provision of Non-Audit Services: Evidence
from the Property-Casualty Insurance Industry: Replication 79
1. Introduction 79
2. Hypotheses Development 79
3. Research Methodology and Results 81
3.1 Sample Selection 81

3.2 Sample Descriptive Statistics 85
3.3 Model Development 85
3.4 Multivariate Analysis 86
4. Conclusion 99
Chapter 7 Audit Quality and the Provision of Non-Audit Services: Evidence
from the Property-Casualty Insurance Industry:
Industry Specialization 101
1. Industry Specialization 101
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Chapter 8
Appendix
Appendix
2. Hypotheses Development
102
3. Research Methodology and Results
105
3.1 Sample Selection
105
3.2 Sample Descriptive Statistics
105
3.3 Model Development
105
3.4 Multivariate Analysis
106
4. Conclusion
114
Conclusion
116
1. Summary and Contribution
116

2. Future Research
119
A. Parameter Definitions, Updating, Value, and Cost
Constraint Functions and an Excerpt from Mailath
and Samuelson (2001)
121
B Experimental Materials 126
1. Instructions for Baseline Short Expected Life 126
2. Instructions for Baseline Long Expected Life 131
3. Instructions for Treatment 1
136
4. Instructions for Treatment 2 143
5. Instructions for Treatment 3 150
6. Instructions for Treatment 4 157
7. Quiz for Baseline Sessions 164
8. Quiz for Treatment Sessions 165
9. Post Experiment Questionnaire
166
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10. Background Information Request Form
Appendix C Example of Loss Reserve Reporting and Development
References
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v iii
FIGURES
Figure 1-1
Figure 1-2
Figure 1-3
Figure 1-4
Figure 3-1

Figure 3-2
Figure 3-3
Figure 7-1
Figure 7-2
Figure 7-3
TABLES
Table 3-1
Table 3-2
Table 3-3
Table 3-4
Table 3-5
Table 4-1
Table 4-2
Table 4-3
Table 4-4
Table 4-5
Table 4-6
Table 6-1
Table 6-2
Table 6-3
Figures and Tables
Demand for Auditing 4
Role of Information Asymmetry in Perceived Auditor
Independence and Quality 5
Characteristics and Relationships to Independence and Quality 7
Three Player Multi-Period Game Example 9
Period t Timeline and Player Moves 25
Screenshot of Player Screen 27
Percentage of Periods Subjects Invested by Cost Level 38
Industry Specialization by Auditors 102

Industry Concentration in Actuarial Services 103
Industry Concentration in Actuarial Services Provided by
Outside Consultants 104
Sixteen High Quality Outcomes and Four Low Quality Outcomes 29
Demographics of Subject Pool 32
Number and Percentage of Subjects at Equilibrium 34
Number and Percentage of Subjects Near Equilibrium 35
Percentage of Costly Investments 37
Summary of Buying and Selling Treatments 49
Demographics of Subject Pool 52
Estimated Coefficients, Z-Statistics, and p-Values from
probit of Buyer Type on Consumer Bid and (Consumer Bid)2
overall and by Treatment 54
Estimated Coefficients, t-Statistics, and p-Values from
Regressing Buyer and Seller Type Combinations on
Consumer Bid, Purchase Price and Treatment 58-62
Purchase Price by Treatment, Buyer Type, and Seller Type 63
Estimated Coefficients, t-Statistics, and p-Values from
Regressing Purchase Price on Treatment, Consumer Bid,
Buyer Type and Seller Type 65
Sample Selection Criteria and Descriptive Statistics 82
Descriptive Statistics for 1,836 Property-Casualty Insurers
across Auditor and Actuary Type 83-84
Estimated Coefficients, t-Statistics, and p-Values from
Regressing the Absolute Value of Loss Reserve Errors
scaled by Total Admitted Assets (Materiality Units) on
Auditor Type Interactions and Control Variables:
Replication of Petroni and Beasley (1996) Model 88-89
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ix

Table 6-4
Table 6-5
Table 7-1
Estimated Coefficients, t-Statistics, and p-Values from
Regressing the Signed Value of Loss Reserve Errors
scaled by Total Admitted Assets (Materiality Units) on
Auditor Type, Actuary Type, Interaction and Control
Variable: Replication of Gaver and Paterson (2001) Model 92
Estimated Coefficients, t-Statistics, and p-Values from
Regressing the Transformed Absolute Value of Loss
Reserve Errors, scaled by Total Admitted Assets on
Auditor Type, Actuary Type and Control Variables 95-97
Estimated Coefficients, t-Statistics, and p-Values from
Regressing the Transformed Absolute Value of Loss
Reserve Errors, scaled by Total Admitted Assets on
Industry Specialist Auditor Type, Actuary Type and
Control Variables 109-112
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Chapter 1
1
Introduction
1. Independence and Audit Quality
Concern over the independence of auditors and the quality of audits has grown in recent
years. The SEC, the AICPA, academic researchers and practitioners have all emphasized the
importance of independent auditors and high quality audits to the proper functioning of the
capital market system. During the 1990’s, the relative importance of non-audit service revenue
to audit firms grew, litigation reform reduced audit firm liability exposure, and the ability to
organize as limited liability entities also decreased auditor liability, and some of the largest audit
firms merged. All of these factors contributed to increasing concern over the auditor
independence and audit quality. This concern is evident in comments by SEC regulators

(Wallman 1996; Saul 1996; Schuetze 1994; Levitt 1998; Turner 1999, 2000) and continuing
efforts of the profession to allay fears of increasingly impaired independence and resulting
decreased audit quality. Unfortunately, it is difficult to disentangle independence and quality
since if the auditor is not independent, the incentive to do a high quality audit is weakened, as
misstatements will not be reported even if found.
Regulatory bodies such as the AICPA and SEC generally define independence as a state of
mind that results in unbiased and objective judgment about financial reporting matters.
Unfortunately, research on the psychology of judgment and decision-making suggests that a lack
of bias is impossible for boundedly rational human beings (Bazerman et al. 1997). A behavioral
definition that is consistent with economic incentives defines independence as the probability of
disclosing a material misstatement given that it is discovered (DeAngelo 1981a). This
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2
conditional probability also takes into account the role of audit quality, which determines the
probability of discovering the breach. Audit quality is a function of several variables, one of
which is independence. Theory suggests that characteristics of both the auditor and the client as
well as of the relationship between them are expected to influence both auditor independence and
audit quality.
One major problem with this conditional probability definition is the difficulty of observing
independence. Because we only observe breaches that are disclosed, we are unable to determine
what the conditional probability might be. Another approach might be to start with something
that can in certain circumstances be observed - such as audit quality - and use that to make
inferences. If we observe high quality in the presence of incentives to impair independence, we
can infer that the auditors were likely independent, and other incentives, perhaps auditor
investment in a reputation for quality, are dominant. Because audit quality is not observable in
many circumstances, the role of a reputation for quality is also important. These reputations
develop based upon signals of the firms’ commitment to quality (Ippolito 1990, Gallouj 1997)
and upon the relatively few instances where quality is observable, such as litigation, audit failure,
or regulatory filings which report on the precision of prior periods’ estimates. The relative
scarcity of these observations of quality or the lack of quality makes them even more important.

This dissertation extends prior literature on the conditions and characteristics that affect the
likelihood of high-quality audit outcomes by using two complementary methodologies: 1)
experimental economics to test a new analytical model of reputation formation and transfer and
2) archival data analysis to directly examine audit quality. Together these provide evidence of
associations with quality at two levels of analysis - individuals (experimental) and firms
(archival). The explicit use of the individual as the unit of analysis is also an important
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3
contribution, as much o f the prior literature is not at all clear whether they are referring to an
audit firm or to an individual auditor when they discuss auditor behavior and decision-making.
By using individuals as the unit of analysis, I begin to develop insight about how individual
decisions may aggregate into observed firm behavior or corporate culture (Kreps 1996).
The remainder of this chapter is organized as follows: section 2 discusses the development
of the demand for auditing and the demand for independence and quality, section 3 briefly covers
some methodological issues and contains a short literature review, and section 4 summarizes and
links the remaining chapters.
2. The Demand for Auditing, Independence, and Quality
The history of the development of auditing (DeAngelo 1981c; Watts and Zimmerman
1983; Gaa 1994) in the English-based market systems (Canada, the U.K. and the U.S.) supports
the view, articulated in much of the principal-agent literature, that the demand for auditing arises
from information asymmetries, as shown in Figure 1-1.
These asymmetries were the result of the increasing separation of ownership and control.
Auditor independence and audit quality were not an issue as the early auditors were not
specialists, but were a subset or representative of the owners. The principal purpose of the audits
was to report on managements’ stewardship of assets owned by others.
When auditors became specialized, the additional information asymmetry between auditors
and owners began to cause problems. Independence was an early solution to the perceived
problem. To the extent that auditors were independent of management, it was assumed that they
would provide an objective assessment of management’s reported numbers. The quality of the
audit and the effort expended by the auditor, both generally unobservable, were unfortunately not

affected by requiring independence.
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DE M AN D FOR A UD ITING
4
Separation of capital providers
and control of resources
r
Information asymmetry
Demand for monitoring
r
Audits as monitor of managers'
stewardship and effort.
Figure 1-1
Figure 1-2 illustrates the role of the information asymmetry between auditors and investors
(owners). The two links not addressed by independence are the use of costly signaling by audit
firms and the incentives for investing in forming a reputation for high quality audits. Investing
in a reputation for high quality could also be considered as one method of trying to signal both a
commitment to providing high quality audits and to using high effort in performing the audit. It
is the formation of a reputation and the relation of a proxy for audit quality with firms considered
to have a high reputation that I address in this dissertation.
3. Levels of Analysis, Methodological Issues in Prior Literature, and Proposed Resolutions
3.1 Levels of Analysis
Issues of independence and quality can be examined at three levels: the profession as a
whole, audit firms, and individual auditors. In much of the prior literature, the difference
between examining audit firms and individual auditors is ambiguous. For example, several
models (Magee and Tseng 1990; Matsumura et al. 1997; Antle 1982, 1984; DeAngelo 1981a,
1981b) use individual auditor and manager interaction, with possible implications for firm
behavior.
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5

ROLE OF INFORMATION ASYMMETRY IN PERCEIVED AUDITOR INDEPENDENCE
AND QUALITY
| Information Asymmetry |
Incentives for Costly
Reputation Formation
Incentives for Costly
Signaling
Demand for
Credible
Monitoring
(Independence)
Audit Quality and
Auditor Effort
Unobservable
Figure 1-2
This dissertation focuses explicitly on behavior and implications regarding individual
auditors in Chapter 2, 3, and 4, and on audit firms in Chapter 5, 6, and 7. As discussed further
below, there appear to be few incentives for firms to impair their independence, and many
incentives for them to maintain it, while the opposite is more often the case for individual
auditors. Although firms provide oversight, audit results are based on the individual and group
decisions of a subset of unobservable individuals whose incentives may differ from those of the
firm overall. The effectiveness of firm oversight and the resulting reputation for quality may
differ by industry specialization as well as other characteristics, such as size. While there is no
specific entity that is a “firm” and can be said to have made a decision or acted, there is a role for
using firms as the level of analysis.
Particularly in audit firms, observed firm behavior regarding audit quality is actually an
aggregation of individual actions. This individual behavior is influenced by: 1) other members
of the firm, 2) the firms’ culture and norms, and 3) the systems of controls that are established
and followed to enforce the explicit organization norms and provide oversight. When I examine
what firms “do” I am using observations about many unseen individuals who have decision

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6
making ability within the audit partnership to make inferences about the internal corporate
culture, norms, and controls. In this dissertation I examine decisions at both this aggregate firm
level and explicitly at the individual level.
3.2 Methodological Issues in the Prior Literature, and Proposed Resolutions
3.2.1 Archival Studies
One stream of empirical research dealing directly with independence and quality has used
the appearance or perception of independence, as that can be observed (Dykxhoom and Sinning
1981, 1982; Firth 1980; Lavin 1976; Lowe and Pany 1994; Pany and Reckers 1980; Pearson
1985; Shockley 1981; Farmer et al. 1987). Although the use of investor perceptions may help
auditors more effectively signal their quality and effort choices, the investor perceptions may not
be correct, and thus these studies tell us little about actual quality and effort.
Another stream of prior research uses litigation, which is also observable, to proxy for audit
failure - a lack of quality - and examines the relationship of client and audit firm characteristics
to litigation. Stice (1991), Lys and Watts (1994), Krishnan and Krishnan (1997) and Bonner et
al. (1998) all take this approach.
Kleinman et al. (1998) summarize the literature on independence and discuss a variety of
characteristics of the audit firm, the client, and the nature of the auditor-client relationship that
are theoretically related to auditor independence. These are summarized in Figure 1-3.
The major drawback to prior archival studies of auditor independence and quality, as
Bonner et al. (1998) point out, is the lack of evidence that their proxy for quality or
independence is in fact a valid construct. This criticism motivates my study in Chapters 5, 6, and
7, which uses a directly observable measure of the precision of an important management
estimate of an account balance included in the audited financial statements as a more direct
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CHARACTERISTICS AND RELATIONSHIPS TO INDEPENDENCE AND QUALITY
Panel A: AUDIT FIRM CHARACTERISTICS AND THE RELATIONSHIP TO INDEPENDENCE AND QUALITY
Audit Q uality
Panel B: CLIENT FIRM CHARACTERISTICS AND THE RELATIONSHIP TO INDEPENDENCE AND QUALITY

[F inancial Health of C lient
|Client^Firm^ize_^J ~__^^
[C lient Industry ~ |

? -
JU tigatioi^
[M an a g e m e n t O w n ersh ip Level'
Panel C: AUDITOR CLIENT RELATIONSHIP CHARACTERISTICS AND INDEPENDENCE AND QUALITY
[L£ngthof_Relationshi|D
[Client Ince n tives
|A u d ito M n c e n t^
A uditor I n d e p e n d e n c e |»
[Conflict o v e r N on-A m big u o u s Is s u e
[Conflict o v e r A m big uo u s l s s u ~
[Prior Conflicts H istory
Figure 1-3
| Level of A lternativ e M onitoring |
A uditor I n de p e n de n c e >

► £ ! Audit Q uality ]
[P rovision_of_N o n -A u ^ ^
|A udit Firm O rganiz a tio n al F orm |
[Audit Firm S iz e
Auditor In d e p e n d e n c e U
[P ro fessio n al S o c iety M em b ersh ip
P e e r Review R esults
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measure of audit quality.
3.2.2. Analytical Models

Antle (1982, 1984) develops analytical models based on game theory that demonstrate
equilibrium conditions for independence, while Magee and Tseng (1990), Matsumura and
Tucker (1995), and Dye (1991, 1995) develop models which examine the effects of audit pricing,
second partner review, auditor replacement, and the organizational form of the audit firm on
independence and quality. Matsumura et al. (1997) model the decision of issuing an unqualified
vs. going-concern report in a model which develops incentives of auditors. If instead we
substitute any report that does not include some important information the auditor is aware of,
this model also develops implications for independence and quality. Yost (1995) shows that by
allowing managers to hire and set auditors’ compensation, independence may actually increase.
Antle (1982) attempts to determine optimal contracting arrangements between a utility
maximizing, strictly risk averse owner and a utility maximizing, strictly risk averse manager and
a utility maximizing, strictly risk averse auditor by modeling the non-cooperative strategic game
they play. While this paper is still often cited, he notes in his conclusion:
modeling the auditor as a strategic player introduces two complexities. First, the mathematical
program formulated may yield solutions that are not reasonable. This arises because the program
may call for the auditor and manager to play dominated Nash equilibria in some subgames.
Second, the nontrivial nature of the subgames implies that randomized strategies by the auditor
and manager may be of cmcial importance.
Another crucial limitation is that the model is a one-period game. How the outcomes and
implications would change in repeated play is not known.
Antle (1984), in another often-cited paper, looks at the implications of a similar analysis on
auditor independence. His results are that, while owners prefer a strongly independent auditor,
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9
given an incentive plan, auditors are always at least as well off by foregoing independence. He
says:
This raises two issues. First, what are the mechanisms that provide auditors’ incentives to
maintain independence in practice? Second, a partial equilibrium model (such as presented here)
has limited potential for the analysis of all of auditors’ incentives to maintain independence
because many of these develop from the impact of a lack of independence on equilibria in the

market for auditors.
The problem here is not with the methodology. Some important insights can be gained, but
unfortunately these models quickly become intractable. An example of an extensive form game
between only a manager and auditor is shown in Figure 1-4. The choices of managers’
1 M anagers C h o o s e B u sin e ss Stra tegy
2 N ature D eterm ines O u tcom e S tate (High, M edium, Low)
3 M a n agers O b serve O utco m e, Make R eporting D ecision ( Report Low, A ccurate, or High)
4 Auditor O b serv e s Report, C h o o s e s Audit Technology (Quality Low, Medium, High)
5 Auditor O bse rves Testing R e sults an d C h o o s e s Audit R eport (Note: T here is a
stochastic ele m ent here - n a tu re m o v e s to d e term in e if testin g d e te c ts m isstate m ents).
6 A ssu m e that for e a c h testin g result, the aud itor c a n ch o o se: 1) Unqualified, 2) Q ualified, 3) A d verse
or 4) D isclaim er. This gives 80 possib le term inal nodes, and 80 s e ts of payoffs. M anag ers an d audito rs
payoffs d e p e n d on th e p a ram e ters u s e d to m odel their in centiv es, risk attitudes, production a n d cost
functions, and the probabilities of random o u tc o m es (n a tu re 's m oves).
strategies, number of outcome states, and manager’s reporting decisions are all restricted to three
discrete possibilities. The result is still eight possibilities confronting the auditor, and 27
possible paths. Restricting the auditor to three levels of audit technology and four possible
reports, and ignoring the stochastic nature of the auditing process in uncovering misstatements if
they do exist still gives eighty terminal nodes and payoff pairs. Since this is a game of imperfect
THREE PLAYER MULTI-PERIOD GAME EXAMPLE
Figure 1-4
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10
information1 and also, if auditors and managers cannot observe each other’s type and
preferences, determining which of multiple possible equilibria is actually played is difficult or
impossible. This turns out to be the case in many non-cooperative games.
The game becomes even more complex when a three-player game among managers,
investors, and auditors is modeled. If more than a two- or three-period game is modeled, again
the equilibria quickly become very difficult to solve for. In an infinite-period game, which is
required for most models of reputation (Selten 1978), there are an infinite number of mixed

strategy equilibria.
Magee and Tseng (1990) analyze a multi-period dynamic programming model with one
client and many auditors to examine both the audit pricing decision in a multi-period setting and
conditions that may lead to impaired independence. They define independence as reporting
contrary to the auditors’ belief about what GAAP reporting requires, in a setting where auditors
may disagree about GAAP. They find that economically rational auditors will only impair their
independence under certain conditions.
3.2.3 Experimental Studies
Magee and Tseng’s results have been supported in a series of experiments (Caligari,
Schatzberg and Sevcik 1998, Mayhew, Schatzberg and Sevcik 2001, Mayhew and Pike 2003).
Other models have not been supported experimentally. For example, as noted above, Yost
(1995) suggests that managers’ control of auditor hiring and firing may lead to increased auditor
independence. In contrast, Mayhew and Pike (2003) show experimentally that to achieve
1 This is because the auditor only observes the manager’s report, not her actions or the state o f nature. A game o f
perfect information requires that players have the ability to observe states o f nature and the past actions of every
player in the game.
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11
consistently high audit quality, it is crucial to break the link between managers and auditors by
not allowing managers to hire and fire auditors.
This highlights the importance of experimental documentation of analytical predictions.
These experiments also illustrate a method for extending the results of analytical models. By
experimentally testing a model and then, if it is supported, relaxing assumptions and extending
the testing, the authors infer that any deviations in behavior are the results of the treatments
employed. This technique is used in Chapters 3 and 4.
4. Summary of Remaining Chapters
The remainder of the dissertation proceeds as follows: Chapter 2 reviews the literature on
reputation, including the role of reputation in auditing, general theories of reputation, and a
discussion of reputation formation and depletion. Chapters 3 and 4 use an experimental
economics approach to first test, then attempt to extend the implications of a model of reputation

building developed by Mailath and Samuelson (2001). The model has the appealing properties of
a unique equilibrium prediction in an infinite horizon game, and some links to the institutional
features of audit partnerships. The model incorporates individual decisions about whether to
invest in order to increase the probability of a high quality outcome. Investors observe outcomes
over time and make inferences about the type of auditor they are facing. In this game, auditors
may be replaced at any time, but investors cannot observe these replacements. This is similar to
the setting where within the audit firm, which does not change, the actual audit team members,
and indeed the partner in charge, do change. Because the audit opinion is signed in the name of
the firm, and not the actual individual auditor, this model appears especially apt.
A second feature is the predictions Mailath and Samuelson (2001) derive regarding how
firms will be exchanged (bought and sold or, in effect, rented for a period of time) among auditor
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12
types and explicitly how the value of various levels of reputations affects their preferences. The
experiments, based on the model of Mailath and Samuelson, are designed to test the individual
auditor incentives’ link to audit quality in panel C of Figure 1-3. Chapter 3 provides the first
empirical test of Mailath and Samuelson’s (2001) model and a design for reliably generating
reputable behavior in the laboratory. I also explicitly link features of the model to features of the
audit environment. Chapter 4 poses important questions on how the culture within a partnership
may change over time as changing incentives alter the types of replacement partners desired.
Chapters 5 reviews the literature on audit quality, non-audit services, and independence
followed by an overview of accounting practice and issues in the property-casualty insurance
industry. Chapters 6 and 7 use archival data from this setting, where results of managers’
estimates can be reviewed
ex post and the resulting measure of precision used as a proxy for
audit quality. The presence or absence of quality, and the relationship with audit firm type, size,
and incentives is explored. The study specifically tests the audit firm level variables for the
provision of non-audit services, audit firm size, and audit fee links to audit quality in panel A of
Figure 1-3. Chapter 6 replicates prior studies and extends them to a larger sample and a more
precise measure of quality by extending the “look-back” period to include seven years of

ex post
realization. In addition, Chapter 7 looks at the contribution of industry specialization to
increased audit quality.
Chapter 8 concludes with a short discussion and offers suggestions for future research.
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Chapter 2
Reputation in Auditing
1. Introduction
Less than three years ago, the auditors of Arthur Andersen and their former consulting
arm, then known as Andersen Consulting, concluded a bitter separation fight which included
disagreements over the right to use the Andersen name. Andersen Consulting, in arguing for its
right to retain the use of the name reportedly claimed to have spent nearly $7 billion to build its
reputation (Brown 2000), but was forced to relinquish the name. The owners and employees of
Accenture (the former Andersen Consulting) are likely now congratulating themselves on losing
that fight after the collapse of Arthur Andersen in 2002.
What is the value of a reputation? Who or what creates that value? How might that
value be destroyed? What role do incentives and corporate culture2 created by organizational
and institutional features play in the creation or destruction of a reputation’s value? These are all
important questions to the auditing profession, as the value of the profession itself is dependent
upon the reputation of its firms and practitioners for providing high quality audits that enhance
the credibility of financial reporting.
Who partners select as new partners and how they evaluate managers and staff personnel
may change as their incentives and compensation change. Systematic changes in preferences for
the type of new partner and lower level employees could cause the organization to evolve over
2 1 use corporate culture in the sense o f Kreps (1996). Kreps m odels corporate culture as the organizational
evolution resulting from repeated plays o f a multi-period gam e by partners whose incentives and preferences for
ch oosing the type o f fellow partner and replacement partner may change. While I do not test corporate culture as
such, I do test whether changing conditions result in different types o f partners being chosen as replacements, and
hypothesize about how that would affect the evolution o f the organization over time.
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