The Joint Effect of Investor Protection and Big 4/non-Big 4 Auditors on Audit Quality:Evidence from IPOs

• In Event: Continental Breakfast and Research & Education Forum
  In Paper Session: Table 8: Audit Quality II

Abstract

I investigate whether audit quality is jointly affected by the investor protection regime and the firms’ choice of Big 4/non-Big 4 auditors. I use financial restatements as a proxy for a low-quality audit, in a within-country setting of U.S. firms before and after their initial public offering. I find that the likelihood of a client restatement is higher in the Pre-IPO time period, when investor protection is stronger. This result suggests that investor protection does not solely increase audit quality. Rather, it suggests that management’s incentive to report attractive financial performance outweighs investor protection constraints. However, I hypothesize that Big 4 auditors enforce stronger investor protection because Big 4 auditors have deeper pockets and greater reputation capital at risk. I find that Big 4 clients are less likely to issue a restatement than non-Big 4 clients in the Pre-IPO period. Furthermore, I find that clients of non-Big 4 auditors are more likely to have a restatement of the Pre-IPO financial statements than the Post-IPO financial statements, leading to the result that the higher likelihood of a client restatement in the Pre-IPO period is largely driven by non-Big 4 auditors. These results suggest that Non-Big 4 auditors, having less reputation capital at risk, either acquiesce to the issuer’s incentive to report strong financial performance in the Pre-IPO time period, or they are less confident at detecting errors.

Author

• Jungeun Park, Louisiana State University