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1、Audit Office Size, Audit Quality, and Audit PricingJong-Hag Choi, Chansog (Francis) Kim,Jeong-Bon Kim, and Yoonseok ZangSUMMARY: Using a large sample of U.S. audit client firms over the period 20002005,this paper investigates whether and how the size of a local practice office within an audit firmhe
2、reafter, office size is a significant, engagement-specific factor determining audit quality and audit fees over and beyond audit firm size at the national level and auditor industry leadership at the city or office level. For our empirical tests, audit quality is measured by unsigned abnormal accrua
3、ls, and the office size is measured in two different ways: one based on the number of audit clients in each office and the other based on a total of audit fees earned by each office. Our results show that the office size has significantly positive relations with both audit quality and audit fees, ev
4、en after controlling for national-level audit firm size and office-level industry expertise. These positive relations support the view that large local offices provide higher-quality audits compared with small local offices, and that such quality differences are priced in the market for audit servic
5、es.Keywords: audit office; office size; audit quality; audit pricing.Data Availability: Data are publicly available from sources identified in the paper.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
6、 specific city-based offices within a firm. In terms of DeAngelos 1981b argument, a Big 4 accounting firm is not so big when we shift to the officelevel of analysis. For example, while Enron represented less than 2 percent of Arthur Ander-sens national revenues from publicly listed clients, it was m
7、ore than 35 percent of such revenuesin the Houston office.INTRODUCTIONAs alluded to in the above quote, the size of a city-based audit engagement office could be a more crucial determinant of audit quality and thus audit feesthan the size of a national-level audit firm because the city-based office
8、is a semi-autonomous unit within an audit firm with its own client base. It is an office-based engagement partner or audit team, not national headquarters, who actually administers and implements individual audit engagement con-tracts, including the delivery of audit services and the issuance of an
9、audit opinion. In this regard, Wallman (1996) and Francis (2004) argue that the assessment of auditor independence needs to focus more on the individual office level rather than the entire firm level because most of the audit decisions with respect to a particular client are made within each individ
10、ual office. The anecdotal evidence on the collapse of Enron, which was audited by the Houston office of Arthur Andersen, is a good example that demonstrates the importance of office-level audit quality. However, muchof extant audit research has focused its attention on two national-level audit firm
11、characteristics as fundamental determinants of audit quality, namely: audit firm size (e.g., Simunic and Stein 1987 ; Becker et al. 1998 ; Francis and Krishnan 1999; Kim et al. 2003; Choi and Doogar 2005), and auditor industry leadership (e.g., DeFond et al. 2000 ; Balsam et al. 2003 ; Krishnan 2005
12、). These studies find, in general, that large audit firms with international brand names (i.e., Big 4 auditors ) or industry expertise provide higher-quality audit services than small audit firms whichlack such brand names or industry expertise. Implicit in this line of research is the assumption th
13、at audit quality is homogeneous across offices of various sizes located in different cities within the same audit firm. As a result, we have little evidence on cross-office differences in audit quality, and in particular, whether and how the size of a local engagement office has an impact on audit q
14、uality and/or audit pricing. A natural question to ask is: Is the office size an additional engagement-specific factor determining audit quality and thus audit pricing over and beyond audit firm size and industry leadership? We aim to provide direct evidence on this unexplored question.Several recen
15、t studies provide indirect evidence suggesting that audit quality may differ across different engagement offices within an audit firm. For example, in the first U.S. study that uses each engagement office as the unit of analysis, Reynolds and Francis (2000, 375) find that when client size is measure
16、d at the office level using office-specific clienteles, “Big 5 auditors report more conservatively for larger clients.” Further,Ferguson et al.(2003) and Francis et al. (2005) find that city-specific, office-level industry leadership, when combined with the national-level leadership, generates the h
17、ighest audit fee premiums and thus, by inference, higher audit quality in the Australian and U.S. audit markets, respectively, while national-level industry lead-ership alone has no effect. Subsequently, Francis et al. (2006) document that client earnings quality proxied by abnormal accruals is high
18、er when auditors are city-level industry leaders alone, or they are both city-level and national-level industry leaders. Put differently, their results indicate that national-level industry leadership alone has no significant impact on audit quality. More recently, Choi et al. (2007) show that the g
19、eographical proximity of the city-based engagement office to clients headquarters is positively associated with the accrual quality of clients, suggest-ing that the geographical location of the auditors office is an important engagement-specific determinant of audit quality. The above findings, take
20、n together, suggest that city-based, office-level characteristics may play an important role in determining audit quality and thus audit pricing.It should be pointed out, however, that none of these studies has paid attention to the question of whether the size of a local engagement office is system
21、atically associated with audit quality and fees paid to auditors.To bridge this gap in our knowledge, we investigate a hitherto under-researched question of whether, and how, the size of a local engagement office hereafter, office sizeis associated with audit quality and audit pricing. We first hypo
22、thesize that office size is systematically associated with audit quality even after controlling for audit firm size at the national level and auditor industry expertise at the office level. As will be further elaborated in the next section, one wouldobserve a positive association if the audits by la
23、rge offices are of higher quality than the audits by small offices. Second, we also examine the association between the office size and audit fees. Previous research shows that audit quality is priced in the market (Choi et al. 2008; Craswell et al. 1995; Ferguson et al. 2003 ; Francis et al. 2005 )
24、. To the extent that the office size is positively associated with audit quality, one can predict that the larger is the office size, the higher is the audit quality, and thus the greater is the audit fee. Therefore, a positive association between the office size and audit fees could be viewed as ev
25、idence corroborating the positive association between the office size and audit quality.In testing our hypotheses, we assert that biased earnings reporting can be used to draw inferences about audit quality, and we use the magnitude of abnormal accruals as a proxy for audit quality. To measure abnor
26、mal accruals, we rely on two alternative models developed by Ball and Shivakumar (2006)and Kothari et al.(2005). In addition, we estimate the size of a local engage-ment office using the Audit Analytics database, which provides the identity of audit engagement offices for all SEC registrant clients.
27、 We measure office size in two different ways: one based on the number of audit clients in each office, and the other based on a total of audit fees earned by each office.Briefly, our results reveal that in the U.S. audit market, both audit quality and audit fees are positively associated with offic
28、e size after controlling for audit firm size at the national level proxied by a Big 4 dummy variable , industry leadership at the local office level proxied by an industry specialist dummy variable), and other relevant factors. These results are robust to a battery of sensitivity checks we perform.
29、Our study contributes to the existing literature in several ways. First, our paper is one of few studies which document that audit quality is not homogeneous across local offices within an audit firm. To our knowledge, our paper is one of the first studies that provide direct evidence that the size
30、of an audit engagement office is an important engagement-specific determinant of audit quality in the U.S. The results of our study suggest that future research on audit quality differentiation needs to pay more attention to office-level auditor behavior as the unit of analysis and to the size of a
31、local engagement office. Second, this paper is the first to consider office size as a critical factor in audit pricing. Given that no previous research has examined whether audit fees are influenced by the size of a local office, our evidence helps us better understand the nature of auditor-client r
32、elationships in the context of audit pricing.Finally, the findings in this study provide both regulators and practitioners with useful insights into what determines audit quality and thus audit fees. Our results suggest that regulators would have a better assessment of audit quality if they shift th
33、e level of quality comparison to small versus large auditors at the office level, and away from Big 4 versus non-Big 4 auditors at the national level. Economic theory on quality premiums claims that producing goods and services of a uniform quality for various markets and consumers over time is cruc
34、ial for maintaining quality premiums(e.g., Klein and Leffler 1981; Kreps and Wilson 1982 ; Shapiro 1983). Similarly, our evidence suggests that large, Big 4 auditors should take care to maintain a similar level of audit quality across offices of different sizes because a systematically poor-quality
35、audit service per-formed by a local office could potentially cause damage to the reputation for the entire audit firm.HYPOTHESIS DEVELOPMENTOffice Size and Audit QualityA growing body of audit research emphasizes the importance of analyzing the behavior of auditors in city-based, local engagement of
36、fices. However, none of these studies has paid atten-tion to the size of a local office in the context of audit quality. Why does the office size matter in audit quality over and beyond two well-known audit firm characteristics, i.e., audit firm size or brand name(Big 4 versus non-Big 4) and industr
37、y expertise?In DeAngelos(1981b) framework, an auditors incentive to compromise audit quality with respect to a particular client depends on the economic importance of the client relative to the auditors client portfolio. Her analysis indicates that large auditors are likely to provide higher-quality
38、 audit services to a particular client than small auditors because an auditors economic dependence on that client is negligible for large auditors, and large auditors have more to lose (i.e., bear higher reputation loss ) in case of audit failures, compared with small auditors.DeAngelos (1981b) theo
39、ry can also be applied to the analysis of audit quality differentiation between large versus small offices, because a local engagement office can be viewed as a semi-autonomous unit in terms of its audit decisions, client base, revenue sources, and other factors(Francis 2004; Francis et al. 2006; Wa
40、llman 1996) . Large local offices are less likely to depend on a particular client than small local offices because the former have deeper office-level clienteles and thus are less economically dependent on a particular client. In other words, large offices are less likely to acquiesce to client pre
41、ssure for substandard reporting than small offices.Further, local offices, whether small or large, may not bear the full amount of reputation losses associated with an audit failure because a substantial portion of the reputation losses are likely borne by the national-level audit firm itself. While
42、 the reputation losses in the event of audit failures are likely to be greater for large audit firms (DeAngelo 1981b ) , the losses are not necessarily greater for large local offices than for small local offices, because these costs are more firm-wide in nature rather than office-specific. This mea
43、ns that local offices may be more concerned with the economic importance of a particular client than a potential litigation risk from audit failures, in particular, when the offices are small in size. The above arguments lead us to predict that large local offices with relatively deep local clientel
44、es are less likely to compromiseaudit quality with respect to a particular client, and thus that they are likely to provide higher-quality audit services, ceteris paribus, compared with small local offices with relatively thin local clienteles. In such a case, one would observe a positive associatio
45、n between office size and audit quality. We call this prediction the economic dependence perspective .SUMMARY AND CONCLUDING REMARKSWhile previous auditing research has examined whether and how audit fees and audit quality are influenced by audit firm size at the national level and auditor industry
46、leadership at both the national level and the city level, this line of research has paid little attention to the effect of the size of a local engagement office within an audit firm (i.e., office size) in the context of audit quality and audit pricing. Unlike previous research, the focus of this pap
47、er is on whether the office size is an additional, engagement-specific factor determining audit quality and audit pricing over and beyond national-level audit firm size and office-level industry leadership. Our results can be summarized as follows.First, we find that the office size is positively as
48、sociated with audit quality proxied by un-signed abnormal accruals. Our finding is consistent with what we call the economic dependence perspective: large (small) local offices with deep office-level clienteles are less (more) likely todepend on a particular client, and thus are better (less) able t
49、o resist client pressure on substandard or biased reporting. Second, we find that large local offices are able to charge higher audit fees to their clients than small ones, which is consistent with the view that large offices provide higher-quality audits than small offices, and this quality differential is priced as a fee premium in the market for audit services. However, the above finding is at odds with the view that large offices have a cost advantage in producing audit services of similar quality and thus are abl
