Assessing actual audit quality

123 Pages·2004·1.57 MB·English

by  Dang, Li

Assessing Actual Audit Quality

A Thesis
Submitted to the Faculty
of
Drexel University
by
Li Dang
in partial fulfillment of the
requirements for the degree
of
Doctor of Philosophy
May 2004
© Copyright 2004
Li Dang. All Rights Reserved.
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TABLE OF CONTENTS
LIST OF TABLES.........................................................................................................vi
LIST OF FIGURES.......................................................................................................vii
ABSTRACT................................................................................................................viii
CHAPTER 1: INTRODUCTION...................................................................................1
1.1 Introduction.......................................................................................................1
1.2 Perceived Audit Quality, Actual Audit Quality, and the Size Proxy................4
1.3 Audit Quality and Earnings Management.........................................................8
1.4 Audit Quality and Analysts’ Forecast Errors..................................................10
1.5 Research Questions.........................................................................................11
1.6 Overview of the Study.....................................................................................12
1.7 Contribution of the Study................................................................................12
1.8 Organization of the Study................................................................................13
CHAPTER 2: LITERATURE REVIEW AND DEVELOPMENT OF
HYPOTHESES.............................................................................................................14
2. 1 Introduction....................................................................................................14
2.2 Review of Audit Quality and Actual Audit Quality........................................14
2.2.1 Definition of Audit Quality..................................................................14
2.2.2 Audit Quality Measures and the Size Proxy........................................18
2.3 Audit Quality and Earnings Management.......................................................22
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2.3.1 Earnings Management Research..........................................................23
2.3.1.1 Definition of Earnings Management.........................................24
2.3.1.2 Estimation of Earnings Management........................................25
2.4 Audit Quality and Analysts’ Earnings Forecast Errors...................................26
2.5 Development of Hypotheses ...........................................................................28
2.5.1 Introduction.........................................................................................28
2.5.2 Perceived Audit Quality and Actual Audit Quality..............................29
2.5.3 Audit Quality and Earnings Management............................................31
2.5.4 Audit Quality and Analysts’ Earnings Forecast Errors........................32
2.6 Conclusion.......................................................................................................33
CHAPTER 3: METHODOLOGY.................................................................................34
3.1 Introduction.....................................................................................................34
3.2 Sample Selection.............................................................................................34
3.2.1 Cases of Apparent Audit Failures ........................................................34
3.2.2 Accounting, Prices, and Earnings Forecast Data.................................35
3.2.3 Matching of Companies to a Control Group........................................35
3.3 Models and Approach to Testing....................................................................35
3.3.1 Hypothesis 1.........................................................................................35
3.3.1.1 Model Specification ..................................................................36
3.3.1.2 Testing of Hypothesis 1.............................................................37
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3.3.2 Hypothesis 2.........................................................................................39
3.3.2.1 Estimation of Earnings Management........................................39
3.3.2.2 Model Specification ..................................................................40
3.3.2.3 Testing of Hypothesis 2.............................................................41
3.3.3 Hypothesis 3.........................................................................................42
3.3.3.1 Model Specification ..................................................................42
3.3.3.2 Testing of Hypothesis 3.............................................................44
3.4 Conclusion.......................................................................................................44
CHATPER 4: ANALYSIS AND RESULTS................................................................45
4.1 Introduction.....................................................................................................45
4.2 Sample Characteristics....................................................................................45
4.3 Testing Hypothesis 1.......................................................................................46
4.3.1 Overview..............................................................................................46
4.3.2 Descriptive Statistics............................................................................49
4.3.3 Testing H1 Using Cramer (1987) Procedure........................................50
4.3.3.1 Description of Cramer (1987) Procedure.................................50
4.3.3.2 Cramer z-test............................................................................52
4.3.3.3 Cramer Confidence Intervals.....................................................53
4.3.3.4 Special Problems with Cramer Procedure.................................54
4.3.4 Testing H1 Using Bootstrap Confidence Intervals...............................56
4.3.4.1 Introduction of Bootstrap Methods..........................................56
4.3.4.2 Bootstrap Percentile Confidence Intervals................................57
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4.3.4.3 Bootstrap Percentile t Confidence Intervals..............................59
4.3.5 Summary..............................................................................................60
4.4 Testing Hypothesis 2.......................................................................................61
4.4.1 Descriptive Statistics............................................................................61
4.4.2 Testing Results.....................................................................................61
4.4.3 Summary..............................................................................................63
4.5 Testing Hypothesis 3...............................................................................63
4.5.1 Descriptive Statistics............................................................................63
4.5.2 Testing Results.....................................................................................64
4.5.3 Summary..............................................................................................65
CHAPTER 5: CONCLUSIONS....................................................................................67
5.1 Overview.........................................................................................................67
5.2 Conclusions.....................................................................................................67
5.2.1 Perceived Audit Quality and Actual Audit Quality..............................67
5.2.2 Actual Audit Quality and Earnings Management................................68
5.2.3 Actual Audit Quality and Financial Analysts’ Forecast Errors............69
5.3 Limitations of the Study..................................................................................70
5.4 Contributions and Implications for Future Research ......................................71
REFERENCES..............................................................................................................74
APPENDIX: TABLES AND FIGURES.......................................................................84
VITA...........................................................................................................................111
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LIST OF TABLES
1. Sample Size and Industry Distribution………………………………………84
2. Observations in Each Comparison……………………………………….….87
3. Descriptive Statistics for Observations Included in Testing H1…………….88
4. Comparison of R2s Using z-test Based on Cramer Procedure………………89
5. Comparisons of Confidence Intervals for R2s Based on Cramer Procedure...91
6. Comparisons of Bootstrap Percentile Confidence Intervals for R2s…………92
7. Comparisons of Bootstrap Percentile Confidence Intervals for R2s…………93
8. Descriptive Statistics for Observations Included in Testing H2……………..94
9. Correlation Matrix for Variables in Testing H2…………………………….95
10. Results for Testing H2……………………………………………………….96
11. Descriptive Statistics for Observations Included in Testing H3……………..97
12. Correlation Matrix for Variables in Testing H3……………………………..98
13. Results for Testing H3……………………………………………………….99
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LIST OF FIGURES
1. Histograms and Q-Q Plots for Comparison 1…………………………100
2. Histograms and Q-Q Plots for Comparison 2…………………………102
3. Histograms and Q-Q Plots for Comparison 3…………………………104
4. Histograms and Q-Q Plots for Comparison 4…………………………106
5. Histograms and Q-Q Plots for Comparison 5…………………………108
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ABSTRACT
Assessing Actual Audit Quality
Li Dang
Kevin F. Brown, Ph.D.

Prior audit quality research has adopted a variety of measures for audit quality.
Since actual audit quality is unobservable before and when the audit is conducted,
market-perceived audit quality proxies have been widely used. However, no research
has examined whether market-perceived audit quality can appropriately proxy for
actual audit quality. This study addresses the research question “does market-
perceived audit quality capture actual audit quality?” Using a post hoc identification of
“apparent audit failures” as cases of poor actual audit quality, this study examines
whether poor actual audit quality is related to higher levels of earnings management
and to smaller analysts’ forecast errors.
This study uses a matched-pair design, matching each audit failure company with a
similar non-audit failure company. In investigating the first research question, value
relevance of accounting information is used as the measure of market-perceived audit
quality. By comparing value-relevance of accounting information across audit failure
and non-audit failure groups, this study documents that accounting information is less
value-relevance for audit failure group. This result suggests that the market appears to
assess actual audit quality accurately and, therefore, market-perceived audit quality
can be used as the proxy for actual audit quality.
Consistent with prior studies, discretionary accruals are estimated to measure
earnings management. Compared with the non-audit failure group, the audit failure
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group exhibits higher levels of discretionary accruals. The result supports my
hypothesis that poor actual audit quality is associated with higher levels of earnings
management. The results of this study do not reveal any statistically significant
relationship between actual audit quality and financial analysts’ forecast errors.