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Determinants of Audit Quality in the Public Sector


  • Determinants of Audit Quality in the Public SectorAuthor(s): Donald R. Deis, Jr. and Gary A. GirouxSource: The Accounting Review, Vol. 67, No. 3 (Jul., 1992), pp. 462-479Published by: American Accounting AssociationStable URL: .Accessed: 20/04/2013 21:42

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  • THE ACCOUNTING REVIEW Vol. 67, No. 3 July 1992 pp. 462-479

    Determinants of Audit Quality in the Public Sector

    Donald R. Deis, Jr. Louisiana State University

    Gary A. Giroux Texas A&M University

    SYNOPSIS AND INTRODUCTION: Previous research demonstrates that "brand name" (e.g., Big Eight versus non-Big Eight) is a factor affecting audit prices and auditor selection.1 As a quality surrogate, brand name re- flects differences between auditor size categories in concern for reputation (DeAngelo 1981b) and the ability to withstand client pressure (Goldman and Barlev 1974). It has not, however, been demonstrated that these fea- tures characterize quality differences within an auditor size category. Although tests are difficult without a direct measure of quality, recent an- nouncements by the General Accounting Office on CPA quality in govern- mental audits indicate a need to determine the factors that affect quality differences within auditor size categories, which is the subject of this study.

    Audit quality is defined as the probability that the auditor will both dis- cover and report a breach in the client's accounting system (DeAngelo 1981a). Two explanations for variations in audit quality involve reputation and power conflict. Because an incumbent auditor captures client-specific quasi-rents, there is incentive to lower audit quality to retain the client. However, audit firm size is a moderating effect since a large client base allows a concern for reputation to remain more important than retention of any given client. The expectations are that (1) audit quality decreases as auditor tenure increases and (2) audit quality increases with the number of

    ' Several studies have addressed this issue, from the perspective of both the private sector (Danos and Eichenseher 1982; Eichenseher and Danos 1981; Francis 1984; Francis and Stokes 1986;Francis and Wilson 1988; Palmrose 1986, 1989; Simon 1985; Simunic 1980) and the public sector (Baber et al. 1987; Copley 1989; O'Keefe et al. 1990; Roberts et al. 1990; Rubin 1988).

    We received valuable comments from Earl Wilson, Kris Raman, Linda Ruchala, one anonymous referee, participants in an accounting workshop at Louisiana State University, the ad hoc associate editor, and the editor. The first author gratefully acknowledges the Corpus Christi State University Grant Program for funding this research. We are also grateful for the cooperation of Tom Canby and Ed Randall at the Texas Education Agency.

    Submitted April 1989. Accepted December 1991.


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  • Deis, Jr. and Giroux-Determinants of Audit Quality 463

    clients. In power conflicts, the client can exert pressure on the auditor to violate professional standards, and a large, financially healthy client can exert greater pressure with a threat of replacing the auditor. However, the established review of audit results or audit working papers by third parties can increase the auditor's ability to withstand client pressure. The expecta- tions are that (3) audit quality is negatively related to the size and financial health of the firm and (4) audit quality improves when the auditor knows work will be subject to review by third parties and that sanctions for poor quality work will occur.

    This article presents the results of an investigation into the determi- nants of audit quality provided by small, independent CPA firms in Texas on audits of independent school districts. The study analyzes quality control review (QCR) findings to obtain a relatively more direct measure of audit quality. Between 1984 and 1989 the Audit Division of the Texas Education Agency (TEA) conducted 308 QCRs. Numerical scoring of 232 QCR letters of findings represents the measure of minimum audit quality and the dependent variable in the regression analysis. Explanatory variables associated with reputation effects, power conflict effects, report timeliness, audit hours, and reported breaches were obtained from TEA sources. The major finding of the study is that audit quality definitions (DeAngelo 1981b; Goldman and Barlev 1974) considered descriptive among audit size cate- gories are sufficiently robust to explain quality variations within an audit size group. The results also confirm earlier studies relating audit quality to audit report timeliness (Dwyer and Wilson 1989) and actual audit hours (Palmrose 1986, 1989). We conclude that audit hours is a suitable surrogate for audit quality when direct measures are unavailable. Key Words: Audit quality, Reputation, Power conflict, Public sector. Data Availability: The data for this study is available on a 3.5" low density

    diskette from the first author. To maintain confiden- tiality, neither the CPA firm nor the school district is identified in the data.

    rT HE following section describes the theoretical framework for this study and pre- sents hypotheses for testing. The next section describes the empirical method, including the measurement of audit quality by using QCR results. The last two

    sections cover empirical results and conclusions.

    I. Theoretical Framework and Hypotheses Audit quality is a continuing issue in the profession (AICPA 1987; GAO 1985). A

    credibility gap in governmental financial reports arose following discovery that poor accounting practices contributed to the fiscal crises of New York and other cities in the 1970s.2 In response, the federal government issued OMB Circular A-102 in 1979 and

    2 Besides the absence of an annual audit, Goldin (1985, 270-71) reports that New York City capitalized op- erating expenses, balanced budgets with uncollectible receivables, consistently overestimated revenues and underestimated expenses, recognized revenues on an accrual basis and expenses on the cash basis, did not

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  • 464 The Accounting Review, July 1992

    OMB Circular A-128 in 1984, seeking to improve financial reporting practices, increase auditor reporting responsibilities, and establish programs to monitor audit quality.3 Since then, the financial reporting practices of local governments have improved (Ingram and Robbins 1987). QCRs, however, find audit quality lacking in many CPA- prepared audits (GAO 1985, 1986, 1989; TSBPA 1987), and recent research suggests that audit quality may affect the public sector audit market in unique ways (Copley 1989; Roberts et al. 1990). Like audit failures in the private sector, audit quality deficiencies in the public sector threaten the public's confidence in the profession.

    Aside from Dwyer and Wilson (1989), audit quality has not been the explicit focus of public sector audit research. Nonetheless, Rubin (1988) and other recent studies dem- onstrate that private sector research is generalizable to the public sector. The theoreti- cal framework developed in this study is based primarily on private sector research and will be empirically tested to determine the merits of generalizing various conclusions about private sector audit quality to the public sector.

    DeAngelo (1981a) defines audit quality as the probability that an auditor will both discover and report a breach in the client's accounting system. The probability of dis- covering a breach depends on the auditor's technical capabilities and the probability of reporting the error depends on the auditor's independence. Prior studies (DeAngelo 1981a; Goldman and Barlev 1974; Nichols and Price 1976) generally assume that the probability of discovering a breach is positive and fixed (i.e., that all auditors are technically capable) and that auditor independence is the key issue. However, without information about technical capabilities (e.g., auditor experience, education, profes- sionalism, and firm audit structure), capability and independence are difficult to disentangle. Although this study also adopts the independence framework to evaluate the audit quality issue, the importance of technical capabilities is addressed. Two explanations for variations in audit quality vis-a-vis the independence issue are found in the literature. These involve (1) auditor reputation (DeAngelo 1981b) and (2) power conflict (Goldman and Barlev 1974; Nichols and Price 1976). These explanations are adopted as a general theoretical framework for this study. The Auditor-Reputation Explanation

    Incumbent auditors capture client-specific quasi-rents and have incentives to lower quality in future periods to retain the client (DeAngelo 1981b, 189). Audit firm size can militate against such opportunistic beh