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Asian Review of Accounting
Audit quality within adverse selection markets

Bharat Sarath,
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Vol. 24 Issue: 1, pp.2-18, https://doi.org/10.1108/ARA-12-2015-0127
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ARA
24,1
Audit quality within adverse
selection markets
Bharat Sarath
2 Rutgers Business School, Rutgers University, Piscataway, New Jersey, USA
Received 7 December 2015

Accepted 7 December 2015
Abstract
Purpose – Auditing may be viewed as an arrangement for reducing inefficiencies arising from the
fundamental market conflict between a seller who wants as high a price as possible and a buyer who
wants to pay as low a price as possible. In more general terms, sellers prefer policies that boost the
stock price in the short run whereas buyers would prefer the price to peak when they are ready to sell
some time in the future. By framing audited financial reports within this context, the purpose of this
paper is to provide some insights regarding both audit institutions and audit regulation.
Design/methodology/approach – This paper relies on conceptual arguments and a simple
analytical model.
Findings – The basic findings are that a unique definition of audit quality is not compatible with the
economics of a market where there are conflicts across traders as well a possibility that some traders
hold superior information to others. Even an identification of quality with accuracy fails in this setting
of conflict. The inference is that audit quality should be approached from a multi-dimensional
perspective rather than a unique measure.
Research limitations/implications – While the paper points out difficulties in constructing
measures of audit quality extant in the literature, it does not provide any clear empirical suggestions
for better measures.
Originality/value – The paper brings back into focus issues from information economics that form
the bedrock for the study of audited financial statements in equity markets. While the paper is partially
a survey and synthesis of some of the latest empirical findings, it describes them within the context of a
rational economic market where traders may possess private information. Within such a market, the
paper outlines both the conflicts and the benefits inherent to the current institutional arrangements
where auditors are paid by incumbent shareholders and overseen by regulators.
Keywords Quality, Audit
Paper type Research paper
1. Introduction: the role of audits in markets with adverse selection

Measuring the quality of a product is seldom a simple exercise. High quality audio
equipment, for example, is tested for its electronic properties but these scientific
measures may differ from consumer perceptions about how the equipment sounds in
usage. Analogously, audit quality can be measured in several different ways. The goal
of this paper is to argue that audit quality should primarily be defined from a user
perspective and to indicate why a unique measure of audit quality that is accepted by
all types of users may not exist.
Auditors play a central role in the efficient functioning of public markets through
their certification of financial reports. However, users of financial statements
(say, investors in the stock market) are not in a position to gather information on the
details of the verification procedures used by the auditor. Even assuming that all
Asian Review of Accounting the details of audit process were to be made public, it is unlikely that investors would
Vol. 24 No. 1, 2016
pp. 2-18
have the training to judge the quality of the audit[1]. This fundamental limitation of
© Emerald Group Publishing Limited
1321-7348
quality assessment from the consumer side creates theoretical difficulties for direct
DOI 10.1108/ARA-12-2015-0127 measures of audit quality. In this paper, I argue that any approach to determining the
“quality” of audits has to begin more generally with the value of financial reports to Audit quality
market participants. Since the value of the audit process to end users is through within adverse
accurate financial reports, audit quality measures cannot be treated independently
from accounting rules[2].
selection
The first step in developing a value for financial reporting is to provide markets
a description of how information, in the abstract, plays a role in a pure exchange
market (such as the New York Stock Exchange). Pure exchange economies are the 3
original framework for general equilibrium asset pricing models (Arrow-Debreu,
1954). Another landmark paper by Miller-Modigliani asserts the irrelevance of capital
structure in a general equilibrium under an assumption of perfect and complete
markets. Further developments in finance through the 1970s led to the Capital Asset
Pricing Model (CAPM) where the relationship between risk and return is formalized.
The main implication for financial reporting in this classical framework is a negative
one: in perfect and complete markets the role of accounting information in
predicting the future (and by implication, of audit quality) vanishes. Indeed, under
CAPM, the use of past market data suffices to predict future expected returns,
and audited financial statements do not play a meaningful role in predicting future
asset prices[3].
The central role of information in a pure exchange market resurfaces powerfully in
the adverse selection model described by Akerlof (1970), and this paradigm is the
foundation for the theory of audit quality developed in this paper. The primary conflict
in a pure exchange economy is between the buyer and the seller where the seller would
prefer to obtain a high price whereas the buyer wishes to pay as low a price as possible
for the asset that is being traded. However, this conflict is essentially trivial in the
absence of asymmetric information, that is, if neither the buyer nor the seller has any
informational advantage (a maintained assumption in the traditional derivation of the
CAPM). In contrast, the presence of an informational advantage on the part of the seller
leads to the “lemons” equilibrium of Akerlof (1970) where only the worst asset is traded.
The first formal model in this paper developed in Section 1 illustrates Akerlof’s idea in a
very simple setting of an asset with two future outcome realizations. Nevertheless, this
simplest model illustrates an important principle – the market failure associated with
information asymmetry involves the collapse of trade rather than a loss to either
buyers or sellers. This leads to the natural question of how the public disclosure of
audited information facilitates trading, and how the “quality” of this information
benefits market efficiency.
While collapse of trade is clearly harmful from an intuitive perspective, it requires
some additional feature to convert it to a formal measure of loss within an adverse
selection model. In this paper, I will assume that the buyer values the asset more than
the seller. Perhaps the simplest justification for this assumption is one of differential
time preferences, that is, when sellers weight future payoffs less than buyers[4]. If an
asset fails to trade, the (utility) gains resulting from the exchange of current and future
consumption between sellers and buyers is lost. While this simple idea suffices for
a systematic development of audit quality measures in markets, a more complex and
realistic assumption would be to move away from a pure exchange economy to one that
involves production. I stay within the structure of a pure exchange economy with gains
to trade as this structure is very simple and approximates some of the effects of
introducing production which we briefly discuss next.
Efficient capital markets direct funding to projects that have high future returns.
When presented with misleading information about future prospects of projects
ARA (i.e. low quality information), investors react by refusing to fund projects. As a consequence,
24,1 high quality projects do not get funded resulting in a social loss. This is just
a restatement of market failure due to adverse selection but the social loss is correctly
identified as arising from the lack of funding for good projects. The approach of
allocating a(n) (exogenous) loss whenever there is a failure to trade functions as
a short-cut for the (endogenous) losses arising from the failure to fund higher value
4 projects as a consequence of informational asymmetries.
To summarize the discussion so far, the foundation for discussing public
information quality is an adverse selection market with gains to trade. The seller
(owner of the asset) is viewed as having an informational advantage. Due to this
informational advantage, buyers are reluctant to trade and there is an associated social
loss whenever trade fails to take place. The value of public information is measured in
terms of reducing the potential loss in trading arising from the seller’s informational
advantage. The next step is to adapt this general market framework to the setting of
financial reports that are certified by an outside auditor.
In adapting the adverse selection model outlined above to analyze audit quality, two
preliminary remarks are in order. The first pertains to the informational advantage of
the seller, and the second to assumptions about how auditors respond to economic
incentives. While the idea that the seller has superior information goes back to ancient
markets, (the rule in the Roman Forum was summarized as Caveat Emptor – let the
buyer beware) it requires some elaboration within equity markets where buyers and
sellers trade fractional claims rather than assets. It is here that the conflict between
seller and buyer re-enters the analysis. Typically, owners of shares have a shorter
horizon than buyers who are yet to purchase the shares. To the extent that managers
are hired and fired by incumbent shareholders, they also face pressure to increase
prices in the short-run as opposed to the long-run[5]. So while incumbent investors may
not possess private information about the stock that they are trading, potential
investors fear that the information on which market prices are based may be biased in
favor of the incumbent investor. In effect, this potential bias functions in the same way
as private information for the seller in a lemons market. The second feature pertains to
the fact that for the purposes of economic analysis, it is necessary to treat auditors as
acting in their own self-interests. Ethics manuals for auditors suggest that this may not
be a valid assumption so it is worth clarifying at the outset that within this paper, all
participants, whether they are investors, auditors or regulators, are assumed to act in
a manner consistent with maximizing their own utilities. The auditor is hired by the
firm and will lose the client if there is dissatisfaction over the auditor’s services.
The interaction between a utility-maximizing auditor and the client-firm has been studied
in a number of prior studies.
One of the first papers that discusses the role of an auditor acting as an independent
economic agent is Antle. As clearly spelt out in that paper, earlier literature had ignored
the fact that auditors need to be incentivized to perform their tasks adequately.
An immediate consequence of viewing auditors as economic agents is that audit
quality and financial statements have to be assessed within a “second-best” framework
where incentive costs for auditors cannot be dismissed. Other papers following this
approach include Antle (1984) and Baiman et al. These papers make the basic point that
when auditors are hired and paid for by firms, there are unavoidable questions about
the degree of auditor independence (Antle, 1984). However, it must be stressed that the
papers discussed above involve a principal, manager and auditor, and are not
structured around a financial market.
Wilson (1983) explicitly analyzes the economic forces acting on auditors within a Audit quality
financial market. This paper makes the crucial point that the viability of auditors as a within adverse
financial intermediary depends on reputation formation. The observation that auditor
reputation acts as a surrogate for audit quality is a critical insight that has motivated
selection
several theory papers (e.g. Alles and Datar, 1999). Given the lack of knowledge about markets
audit quality, the credibility of financial reports issued by firms depends heavily on the
reputation of the audit firm as a whole rather than the circumstances surrounding 5
specific audits. Therefore, public companies that engage high reputation audit firms
are able to secure better market outcomes, be it the trading price of stock, cost of bank
or corporate debt, or the ability acquire or merge with other firms. This observation
also provides a link between theory and empirics as many empirical studies have
documented favorable market outcomes for BIG-n clients[6].
Another potential proxy for the credibility of audited financial statements stems
from the “deep pockets” of BIG-4 auditors (Sarath and Wolfson, 1991; Bar-Yosef and
Sarath, 2005). Deep pockets imply greater payouts from litigation (if the plaintiffs
succeed in showing that the audit reports were deficient). For example, over the period
1992-2011, all but two settlements that exceeded $10 million in auditor payout were
made by BIG-n firms. These potentially greater payouts should result in BIG-n auditors
taking more due care while auditing financial statements. Therefore, the level of
penalty that can be imposed on auditors for errors in financial statements functions as
an implicit warranty for the reliability of these statements. The interaction of deep
pockets with reputation sets up a self-sustaining cycle of reputation and profitability.
As high reputation auditors obtain better financial terms for their clients, it also allows
them to charge higher fees for their services (commonly termed as the BIG-n “premium”).
Therefore, the overall economic consequences of the unobservability of audit quality lead
to a theoretical prediction of reputation proxies matched by reputational rents. More
specifically, the audit market fee and reputation equilibrium involves the following
process: first, greater market benefits for client-firms that engage auditors with a high
reputation; (second, greater profitability for reputable audit firms through the (partial)
recapture of these market benefits through a fee “premium”; third, greater wealth
accumulating through the fee premium (even after greater litigation payouts); fourth,
investor beliefs that the greater litigation exposure leads to better audits sustaining the
high reputation of these reputable wealthy auditors[7].
While reputation and potential litigation payouts serve as indirect warranties about
the reliability of financial information, the fact that auditors are hired and paid by the
client-firms cannot be ignored in analyzing audit quality. As noted earlier, the
economics of market trading generates pressure on managers to focus on stock prices
over a shorter horizon than the one that may be desired by potential buyers of
a security. The fact that under current arrangements, auditors are hired and paid
by the client-firms management raises the possibility that auditors would try to please
management rather than act as neutral evaluators of financial information.
The possibility that auditors become too lenient with their clients motivated the
provision in the Sarbanes-Oxley Act (SOX) banning external auditors from supplying
certain types of consulting services. The viewpoint I adopt in most of this paper is to
analyze how audit quality functions under the current regulatory structure in the USA
where an external auditor hired by the manager must certify the financial report,
although I will briefly discuss radical alternatives such as making independent audits
voluntary (Ronnen, 1996), allowing firms to choose across different audit standards or
delegating auditor choice to an insurer.
ARA The last part of this introduction discusses the empirical literature on audit quality.
24,1 Adopting the perspective that audit quality is measured through its ability to help
mitigate informational frictions implies that audit quality and GAAP rules must be
treated together. An audit report attests to the fact that financial statements conform to
GAAP and sometimes adds other items such as a going-concern qualification. Since the
vast majority of reports simply attest to GAAP conformity, audit quality measures
6 cannot be separated from accounting rules. Following from this observation, there are
three approaches to measure audit quality:
(1) through the effects of financial reporting in improving the efficiency of trade;
(2) through direct measures of audit failure rates; and
(3) through measures of how auditing moves reported values closer to “true
values.”
Method 1 is the preferred approach suggested in this paper. I shall argue that Method 2,
while clearly useful in its own right, has to be linked to Method 1 if it is to provide valid
measures of audit quality. Method 3 appears to be flawed and I will argue against it.
A good example of the use of Method 2 is provided in Francis. The different measures
of failure include lawsuits, client-firm bankruptcy or Accounting and Audit Enforcement
Releases (AAER) issued by the SEC. Francis goes on to observe that these failure rates
are low and that the cost of audits as a percentage of client-firm sales dollars are very
small. However, as documented in Francis and Krishnan, auditors are poor at predicting
bankruptcy through their going concern reports. So while the low failure rate suggests
that audit quality is high, the high error rate in bankruptcy prediction may suggest that
they are not serving the needs of the market. While failure measures are certainly
important for understanding audit quality, the information based approach used here
would lead to a different interpretation of the findings documented in Francis. The main
role of the auditor is to alert investors in situations of information asymmetry. If there is
no adverse selection problem, that is, a struggling firm’s problems are already reflected in
the market price, a going-concern opinion is of no value. Therefore, measuring error rates
without conditioning on the underlying market conditions makes them hard to interpret.
Similarly, a small number of class-action lawsuits against auditors may suffice to
maintain an optimal cost-quality balance for financial reports even though the majority
of low quality audits go unpunished. In summary, the observed failure rate of audits is
based on equilibrium strategies of users and regulators in order to make auditing as
valuable as possible. Measures of audit failures are clearly important in understanding
the quality of audits but a simple identification of failure rate with quality may not be
warranted (see Section 2, Example 2).
Method 3 where high audit quality moves reported values are close to “true values”
is intuitively appealing but does not stand up to close scrutiny. Accounting
measurements involve judgment and are different from scientific measurements.
Fundamental quantities such as “value” or “income” are defined only in perfect capital
markets where accounting has little informational value. If we step out of the classical
paradigm, for example, to a situation where the market is incomplete, unique values for
assets can no longer be defined. If there is no unique definition for value or income, any
attempt to measure deviations from this value is futile. Demski makes a further point in
demonstrating that an optimal accounting standard may not exist given heterogeneous
preferences across users of financial reports. Even if “true values” can be determined,
users will not agree on the optimal rule for reporting these values. The main result in
Demski is that different standards are optimal depending on the decision problem faced Audit quality
by the investor. This same point applies to audits as well: the definition of quality within adverse
cannot be based simply on accuracy with regard to underlying values in even very
simple decision contexts (see Example 2).
selection
The arguments of the previous paragraph should not be interpreted as saying that markets
audit quality cannot be measured through its effect on accounting – only that it cannot be
measured through (unquantifiable) constructs such as deviation from “true earnings.” 7
Many empirical studies link audit quality to other types of market outcomes and their
findings are consistent with the information driven framework outlined in this
introduction. One of the first studies to link audit quality with auditor reputation and audit
fees is the path breaking study of Simunic (1980). While results about audit quality and
fees have been refined in later papers, a summary of the essential findings are as follows:
(1) BIG-n auditors charge higher fees and get better market terms for their clients; and
(2) auditing methods within any given audit firm, or, for the same client-firm and
auditor across time, vary substantially.
I first present briefly, the empirical evidence confirming these points.
A brief sample of empirical papers that test the association between fees and
auditor size (reputation) include Palmrose (1986), Ireland and Lennox (2002) and Simon.
The market benefits of using a BIG-n auditor include better IPO pricing (Beatty, 1989);
lower debt costs (Pittman and Fortin, 2004); lower equity costs (Khurana and Raman,
2004). The within-audit-firm variances in quality are alluded to in Simunic (1980) and
analyzed in recent studies such a Kallapur and Chung. The fact that audit quality
changes over time has been documented in other studies such as Geiger and
Raghunandan (2002) and underlies the decision to mandate auditor rotation in some
countries and partner rotation in the USA (see Section 4 for a further discussion).
The empirical findings are consistent with the equilibrium predictions arising from
informational frictions in a pure exchange market alongside the unobservability of
audit quality for users. BIG-n firms have higher reputation and earn higher rents.
Investors’ beliefs about audits are based on the audit-firm reputation and not at the
level of the individual audit and the market value of audits depends on these beliefs.
Therefore, proceeding from empirical observations about market outcomes to
definitions of audit quality involves two steps: how does audit quality, which is
measured at the level of an individual audit, translate into investor beliefs at the audit
firm level; and how do these beliefs affect market outcomes in a pure exchange market
where “better” for one participant typically means “worse” for another. In other words,
when comparing two different audits through their effect on the market, it is quite
conceivable that different participants would rank their quality in opposite ways based
on the nature of the way they use it. As a simple example, shareholders with a short-
term horizon may classify a good audit as one that uses a higher threshold for a going
concern qualification (so they will have a greater probability of selling at a high price)
whereas those with a longer term perspective may prefer to be alerted early regarding
going concern risks (as they have no intention of selling their shares and are not
worried about a short-term drop in the share price).
The rest of this paper is laid out as follows. Section 2 provides some simple
theoretical models to illustrate the issues raised in this introduction. Section 3 discusses
further empirical evidence and the contrast between market mechanisms and
regulation as tools to improve audit quality. Section 4 discusses more speculative ideas
and Section 5 provides conclusions.
ARA 2. Two models of information value
24,1 In this section, I construct some simple models to illustrate and clarify the market
structure discussed in the introduction, and the role of auditors and audit quality
within this framework. The market is a simple adverse selection market where asset
values have two discrete outcomes. The seller is perfectly informed about the value of
the asset and the buyer obtains information from a financial report. The seller captures
8 all the gains from trade and the buyer breaks-even[8]. The relationship between the
financial report and the true value (i.e. known to the seller) depends on the nature of the
audit. I shall discuss this in more detail after setting up the example.
Example 1:
Future asset value to seller 8 2

Future asset value to buyer 10 4

Financial report θH θL
Each of the asset values is assumed to occur with probability 0.5. The difference
between the valuation of the buyer and seller represents gains to trade. So if the asset
fails to trade, a social value of 2 is lost. The next step is to define the quality of the
reporting system (Table I).
Here, p denotes the quality of the reporting system and p A 1=2; 1 . If p ¼ 1=2 the
financial reporting system is useless as the buyer learns nothing from the financial report.
If p ¼ 1, the true value is revealed to the buyer and the seller has no informational
advantage. I calculate the equilibrium trading in this model for different values of p.
The equilibrium hinges around the values E [Buyer Value∣θi, p] where i ¼ H, L. These
values are seen to be:

E Buyer V alue9 yL ; p ¼ 4pþ 10ð1pÞ ¼ 106p

E Buyer V alue9 yH ; p ¼ 10p þ 4ð1pÞ ¼ 4 þ 6p
The buyer will not bid above this value (assuming they know p: I will discuss this later).
Now consider the seller’s strategy. If the price is below their private value, they will not
sell. When θH is reported, the seller will offer at most the expected value 4 + 6p. So for
example, if p ¼ 3=5, the buyer will offer at most 7.6 and the seller with an asset worth 8
will not trade. Knowing that only the seller with asset worth 2 (to the seller) will trade in
the market, the buyer will bid at most 4 (the price at which they break even). The same
logic shows that the equilibrium price is given by:

Price yH 9p ¼ 4 Price yL 9p ¼ 4 for p o 2=3; Price yH 9p

¼ 4 þ 6p Price yL 9p ¼ 4 for p X 2=3
The last price follows from the fact that if p X 2=3, on the report θL the seller will bid at
most 10 − 6p ⩽ 6 and only the low asset will trade which means the equilibrium price
will drop to 4.
True seller value ¼ 8 True seller value ¼ 2
Financial report θH p (1 p)

Table I. Financial report θL (1 p) p
Further, if p X 2=3, the expected value to the buyer on observing θH is 8 or more and at Audit quality
this price, both types of assets will trade and the buyer will obtain their expected value, within adverse
that is, the price 4 + 6p ensures that both assets trade on the report θH and the buyer
breaks-even.
selection
Simple though it is, the model above captures all the fundamental characteristics markets
needed to characterize the social value of audits. The social loss comes from two
sources. First, the high asset may fail to trade due to the adverse selection problem 9
unless the reporting system is sufficiently accurate. Second, the high asset may fail to
trade if the auditor is overly conservative and issues a low report to the high asset.
If p o2=3, the high asset never trades. As the asset is of high type with probability 0.5
and the gains from trade are 2, this means that the social loss is 0.5 × 2 ¼ 1 for p o2=3.
If p X 2=3, the social loss occurs when the asset is of high type but obtains a low report
(see equilibrium price solution above), which happens with probability 0.5 × (1−p)
(probability of high type asset × probability of misclassification). The social loss is
therefore: 2 × 0.5 × (1−p) ¼ (1−p). To summarize, the social loss function ‘ ( p) is given
by: ‘ ð pÞ ¼ 1 for p o 2=3 and ‘ ð pÞ ¼ ð1pÞ for p X 2=3. When p ¼ 1, all social loss
is eliminated.
A number of intuitive inferences can be drawn from the model. First, buyers protect
themselves by bidding low and never lose money. However, there is a social loss due to
foregone gains from trade. Second, if the financial reports are not sufficiently reliable, they
do not ameliorate the social loss. Last, if audits are costly, the optimally accurate system
(from the point of view of the seller) is when the sum (cost of the audit + foregone gains
from trade) is minimized. However, this optimal value is different for sellers of different
types. The low type seller will want the cheapest audit because they always manage to
trade (the lemon always trades) and capture the resulting gains. This motivates the result
that different seller types will not agree on the optimal properties of the reporting system.
Notice that the equilibrium is calculated assuming that the properties of the
reporting system (represented by the parameter p) is known to the buyer. As observed
in the introduction, the accuracy of the financial reporting system depends on both
GAAP and audit quality. So the stylization that p is known to all is inconsistent with
the underlying economics of market trading. So p should be interpreted as the buyers’
beliefs regarding the reliability of financial reports. This raises the question of how
these beliefs are formed and whether they are accurate. Assuming a rational
expectations equilibrium where investors’ beliefs are confirmed in equilibrium, the
social loss will go down if the seller hires an auditor with a higher reputation. For a full
rational expectations equilibrium where all these issues are formalized, see Bar-Yosef
and Sarath (2005).
The social loss function derived in the previous example is decreasing in the
reporting accuracy parameter p. It is therefore tempting to classify this as audit quality,
that is, higher quality is associated with lower probability of misclassification. The next
example shows that unfortunately, this intuitive idea is not fully justified.
Example 2:
Future asset value to seller 8 4

Future asset value to buyer 12 6
Financial report θH θL
The relationship between financial reports and underlying values is the same as in
Example 1. The difference comes from the fact that there are proportional gains to
ARA trade in this model making the seller “more eager” to trade high value asset. As in
24,1 Example 1, I first compute expectations:

E Buyer V alue9yL ; p ¼ 6p þ 12ð1pÞ ¼ 126p

E Buyer V alue9yH ; p ¼ 12p þ 6ð1pÞ ¼ 6 þ 6p
10
It follows that the equilibrium yL 9p ¼ 1=2 ¼ 9 and both assets trade at this
price.
Arguing in the same fashion, Price yH 9p ¼ 126p X 9 recall that p X 1=2 so both
assets trade on both reports and there is no social loss when p X 1=2.
However, if p 4 2=3, E [Buyer Value∣θL, p] ¼ 12 − 6p o 8 and since the buyer will not
offer a price higher than the expected value, the high asset holder will not trade
(given financial report yL andaccuracy p 4 2=3), so the equilibrium market price is

given by 6 and only the low asset will trade. Therefore, the social loss function from
forgone trade is given by: Price yL 9p 4 2=3 ¼ 6. Therefore, the social loss function is
given by: ‘ðpÞ ¼ 0 for p p 2=3 and ‘ðpÞ ¼ 4 0:5 ð1pÞ ¼ 2ð1pÞ for p 4 2=3.
So, for example, increasing the accuracy of the reporting system from p ¼ 3=5 o 2=3
to p ¼ 3=4 X 2=3 results in an increase in social loss from 0 to 1=2.
This result is not very surprising from a theoretical perspective. As the parameters
of the problem change, all participants adjust their strategies and these strategy
changes affect the payoff from the game. The interaction between parameter change
(i.e. the increase in accuracy) and the strategy change can lead to unintended
consequences. Perhaps a good practical example is the use of sale accounting for
transactions with qualifies special purpose entities (QSPE’s). While the transfer of
ownership rights to QSPE’s was accurately treated as a sale for assets such as cargo
ships, firms started using the same accounting for transfer of cash-flow rights where
the sales treatment was inappropriate resulting in many problems.
2.1 Discussion of the models

Contrasting Examples 1 and 2, the main difference is the greater profit from trade for the
high type asset holder. When the reporting system if inaccurate, the buyer is more likely
to get “lucky” on the low report and as there are high gains from trade, both asset holder
types are willing to trade. As the report precision improves, the buyers probability of
getting “lucky” and the bid price come down and if it drops below the threshold value of 8,
the high-type seller does not trade on the low report and the social loss increases.
The first example shows how informational value can be measured from a theoretical
perspective and the second shows that the change in informational value does not map
neatly into the failure rate of the information system. When applied to audited financial
reports, the inference is that the identification between greater market benefits and lower
failure rates may not be justified. Any attempt to define or measure audit quality has to
take both aspects into account. In particular, the fact that BIG-n auditors get better
outcomes for their clients does not mean that the financial statements they audit are of
“higher quality.” To avoid any confusion on this point, I emphasize that greater market
benefits may go together with higher audit quality – but this should not be assumed
ex-ante and should be tested independently by checking audit failure rates (as in Francis).
3. Audit quality, market incentives and regulation

There is a large literature of empirical studies that try to measure audit quality and to
document changes in quality due to regulatory or other effects. Some aspects of this
literature, particularly the market effects of perceived BIG-n quality were discussed in the Audit quality
introduction – higher audit quality may be inferred from better market outcomes at least within adverse
in some instances. I return now to a discussion of other strands of the literature and to the
measure of audit quality implicit in these papers. At the risk of being repetitive, the main
selection
assumption through which I base my analysis is that investors do not have direct markets
knowledge about the soundness of a specific financial report and rely on beliefs about the
system in general. For example, though the financial reports of Enron were of poor 11
quality and supplied misleading financial information to investors, the general reputation
of Enron’s auditor, Arthur Andersen (AA), led investors to treat these reports as credible
and sustained a high stock price for Enron over many years. Therefore, any definition of
audit quality based on user benefits has to take into account the fact that investor beliefs
about audit quality are at the audit-firm level or a system level.
Prior to 1933, independent audits were voluntary. The first and most basic question
is how information quality was affected by a decision to mandate financial reports.
Ronen suggests that mandating audits could lead to a reduction in overall information
quality. When audits are voluntary, differences in financial report quality are more
apparent. In particular, if a firm decided not to use a certified external auditor, investors
will be able to treat this firm’s financial reports with greater skepticism. In contrast, if all
firms hire a reputable auditor but there is substantial within firm variance in quality
(as has been documented by many empirical papers such as Chung and Kallapur, 2003;
Francis and Yu, 2009), investors may assume that all audits are of decent quality and
reach faulty decisions (as in the case of Enron). On the other hand, much criticism has
been leveled at recent regulatory actions such as SOX (which was partially motivated at
avoiding future “Enrons”) on the grounds that the social costs of this regulation outweigh
the social benefits. In its essence, this is a debate about the efficiency of market forces, that
is, would the market for audits have reformed on its own without the pressure of
legislation? The next three sections discuss some significant recent and proposed changes
in the audit process comparing market mechanisms with regulatory mechanisms and
comparing their potential for raising audit quality from the perspective of social value.
The three issues (and the related empirical literature) I will discuss are: first, the
limitations on external auditors providing consulting services; second, mandatory
partner/auditor rotation; and third, PCAOB inspections of audit firms. All these regulations
relate to ineffective policing of quality by both professional organizations and the market.
The limitation on consulting services provided by the external auditor (referred to under
the acronym NAS (Non-Auditing Services)) and mandatory rotation involve the same
economic tradeoff. Both NAS and a longer auditor-client relationship increase the auditor’s
knowledge regarding the firm; on the other hand, both lead to a potential erosion of
independence. The issue that needs to be resolved is whether the benefits accruing from
greater knowledge of the firm are less important than the costs arising from lack of
independence when viewed from the perspective of end users of financial reports. Several
empirical studies have analyzed these issues and I discuss their findings.
3.1 NAS and auditor independence

The SEC’s first reaction to the potential problem arising from NAS (in 2000) was to
follow the traditional logic by requiring firms to disclose the fees for these services in
proxy statements. The SEC’s motivation was summed up as:
[…] investors armed with these new disclosures will be better able to evaluate the
independence of the auditors of the companies in which they invest.
ARA However, SOX, enacted in 2002 contained within it a provision that the SEC come up
24,1 with a list of activities that would compromise independence. Ultimately, in 2003, the
SEC banned the independent auditor from virtually all business services except tax
consultancy[9].
The decision to ban these consulting services was controversial. The now defunct
accounting firm, AA, had been a pioneer in providing consulting services. In 1989, AA
12 spun off their consulting services (Andersen Consulting) as a separate unit. However,
within a few years, they had regrown a consulting division (AA Business Consulting).
In 1998, the two consulting arms were in conflict and the resolution was that Andersen
Consulting became completely independent under the new name of Accenture just in
time to avoid the disaster that led to the dissolution of AA.
The rapid regrowth of a consulting division in AA suggests there are natural
synergies for accounting firms to provide consulting services. It was in recognition of

this possible synergy that the SEC initially chose the disclosure route. As in our very
simple Example 1, investors can always protect themselves against lack of auditor
independence by “bidding low.” If client-firms find that using the same accounting
firm for both NAS and audits creates more damage to their market price than the
benefits of joint service, they will unbundle the services to two different accounting
firms. If on the other hand, investors are not concerned about the lack of
independence arising from NAS and the market outcomes do not worsen, the
potential synergies from bundled audit and NAS will result in greater efficiency.
In other words, permitting NAS with rules on disclosing the associated fees should be
a viable market solution.
A thorough survey of the empirical literature relating to NAS is provided in
Beattie and Fearnley (2002), chapter 8. The end conclusion in that paper is that there
seems to be little evidence for impairment of independence arising from the provision
of NAS. Unfortunately, the idea of spillover benefits from NAS to audits is also weak.
Another study finds that the bundling of tax consultancy and audits may be viewed
favorably by the market suggesting that at least in this one case, the bundling of
services by the auditor is efficient. Against this evidence, the decision to ban many
types of NAS is probably due to a focus on systemic concerns. If Investor trust in
auditors is eroded, the negative consequences would outweigh any narrow gains
resulting from the bundling of services at an individual client level. Such systemic
hypothesis is not easy to test and the debate over NAS is difficult to resolve through
empirical analysis.
3.2 Mandatory auditor rotation

As in the discussion concerning NAS, papers studying the desirability of mandatory
rotation of auditors try to measure the same tradeoff between greater expertise and lower
independence. A number of studies have hypothesized an inverted U-shaped relationship
between audit quality and the length of the audit engagement. In initial years, audit
quality rises because of expertise but it erodes in later years because of lack of
independence. Therefore, there is an “optimal auditor engagement term” after which the
auditor should be changed. SOX did not mandate auditor rotation but required partner
rotation. The benefit of this arrangement is that expertise is maintained but the erosion of
independence may be halted. Nevertheless, several countries have mandated auditor
rotation and the issue is still being discussed within the USA.
In contrast to the discussion on NAS, the case of mandatory rotation is simpler from
an empirical perspective for two reasons. First, it is reasonable to assume that investors
are aware of the length of the audit engagement (as opposed to knowledge of the Audit quality
erosion in independence due to the provision of NAS) and consequently, market within adverse
reactions reflect this information. Second, there are countries that mandate auditor
rotation so the effects of this rule can be directly evaluated. The empirical evidence in
selection
current literature on the benefits (or drawbacks) of auditor rotation are, to my mind, not markets
convincing. The reason is that many of these papers rely on some measure of abnormal
earnings or accruals to infer increases or decreases in audit quality. The impossibility 13
of defining “abnormal earnings” (see introduction) makes linking the quality of audits
to abnormal accruals (or the earnings response coefficient) very problematic. For
example, the measure of abnormal accruals (signed or unsigned) is typically the
deviation from a time-series prediction. Such a divergence may indicate either more
transparency (less smoothing) or noise[10].
A different approach is adopted in Gunny et al. (2007) where audit quality is

measured through the use of PCAOB inspection reports. These reports provide direct
evidence on whether PCAOB experts deemed that the audits were deficient in some
regard. If independence is eroded over time, the number of deficiencies should be
greater with longer term engagements. Perhaps the best way to study the effects of
mandatory auditor rotation is to jointly analyze market-wide effects in countries where
mandatory auditor rotation has been adopted with intrinsic measures of audit failures
as a function of the length of the audit engagement in countries where mandatory
rotation has not been adopted.
3.3 PCAOB inspection reports

The PCAOB tries to maintain the integrity of audits in a manner similar to that of the
SEC in maintaining information quality. Analogous to the SEC’s triennial review of
corporate financial statements, the PCAOB inspects large audit firms (those with more
than a hundred clients) on an annual basis. The inspection process is two-fold –
checking conformity with GAAP and checking the quality control systems in
place – that is, both the factors that influence the information value of financial reports.
Quality control is along a firm-wide dimension evaluating aspects such as training
policies or the procedures for client acceptance and retention. These inspection reports
are made available to the public on the PCAOB website.
The PCAOB inspections provide an interesting situation in comparison with the
earlier system of peer reviews by other audit firms or the AICPA. This issue is
examined in two recent papers Anantharaman and Gunny and Zhang (2013). The point
I want to focus on is that the debate over the value of PCAOB deficiency reports also
involves a tradeoff between knowledge and independence. Peer review is conducted
by fellow auditors who are more knowledgeable about the practical issues associated
with designing effective audits as compared to the PCAOB (Glover et al., 2009).
On the other hand, both Coffee; Russell and Armitage argue that peer review is
ineffective because of the failure to be critical about professional colleagues.
Nevertheless, Hillary and Lennox find that firms peer review opinions are taken
seriously by client-firms and affect market share. The inference (as in the case of
NAS), is that peer review has lower credibility as a system, but may have value for
client-firms trying to select an auditor.
From the other side, PCAOB inspections are not viewed as helpful particularly by
smaller firms (survey by Daugherty and Tervo). In addition, Lennox and Pittman find
that PCAOB inspection outcomes do not lead to gains and losses of clients. About
60 percent of inspected audits for small firms were classified as deficient (Hermanson
ARA et al., 2007). In addition, the same paper notes that audit firms with more deficiencies
24,1 typically have a mix of clients that are more risky and a higher ratio of clients to
personnel suggesting over extension into the audit market with insufficient investment.
The implication is that PCAOB inspection reports are focussing their efforts in the
right place.
Both peer reviews and PCAOB inspections are aimed at convincing users that
14 audited financial reports are reliable. However, the decision context is different for each
of these approaches. Peer reviews are unlikely to be taken as effective from the market
side given the ease with which the review system can be manipulated. However, from
the client-firms side, it provides valuable information for selecting an auditor who is
likely to deliver an efficient service. The PCAOB’s approach is aimed at the users of
financial information. By inspecting firms and reporting the deficiencies at the audit
firm level, they are providing information in a way that allows investors to judge the
quality of financial statement. Deficiencies recorded by the PCAOB occur with such a
high frequency that making it less useful for a client-firm. However, the fact that the
PCAOB is pressuring auditors, both small and large, will help lend credibility to
financial reporting as a means of levelling the “informational biases” inherent to a
system where auditors are hired and paid by the client-firm.
4. Two modest proposals for structural reform

In this last section, I examine two proposals for changing the entire structure of
financial reporting in markets. The proposals are interesting in their own right but I use
them here to illustrate some of the ideas advanced in this paper. The first proposal is to
allow multiple versions of GAAP (Sunder, 2002); the second is to entrust the choice of
independent auditor to an insurance firm that pays for financial statement errors
(Ronen, 2002; Dontoh et al., 2013). Sunder (2002) views the current structure where
rule-making authority is monopolized by FASB as inferior to one where there are
multiple rule-making bodies. Client-firms (and auditors) can choose which set of rules
they wish to follow. Allowing such flexibility will incentivize the rule makers to monitor
stock market consequences more effectively[11]. A second advantage for this approach
arises from the difficulties in constructing an “optimal” accounting framework that
applies to all users. Sunder’s suggestion will allow firms with different business models
to choose the set of standards that are most appropriate for their operations.
Ronen (2002) argues that the system where client-firms hire and pay for auditors is
incompatible with auditor independence. Instead, he suggests that the auditor be hired
by an insurance company that is required to compensate investors for damages caused
by errors in the financial statement. The premium paid to the insurer will be disclosed
in the financial statements. The advantage here is that there is information ex-ante
about information quality made to the insurers. Assuming competitiveness in the
insurance industry, the premium will accurately reveal the quality of the financial
statements allowing investors to factor financial statement quality into their
investment decisions. Disclosing the premium will lead to more accurate inferences
regarding audit quality than the disclosure of audit fees. High audit fees can arise from
greater audit quality or from greater audit risk (i.e. lower audit quality) and the two
effects cannot be separated (Dontoh et al., 2013).
5. Conclusions
Since the primary role of audited information is to mitigate informational failures in the
market, the definition of audit quality must be related to the market benefits (or losses
avoided) through corporate financial reports. For this reason, audit quality and Audit quality
financial report quality cannot be neatly separated as concepts. Audit quality is within adverse
difficult to communicate to users on a firm-by-firm basis because of its inherent
complexity. For example, a disclosure of high audit fees can reflect either greater levels
selection
of verification (high quality) or a favorable relationship with the client-firm (lack of markets
independence). Consequently, investors rely more on audit firm reputation as a proxy
for the quality of the financial reports issued by all of their client-firms. 15
Empirical literature corresponds quite closely with economic theory in some areas
such as the effects of BIG-n reputation but not in others such as those that try to link
earnings quality to audit quality. The market settings in which audited information
plays an interesting role are also those in which concepts such as “economic earnings”
cannot be validated through simple time-series analysis. Therefore, it is conceptually
better to use other measures of audit quality such as the likelihood of restatements or
the issuance of AAER’s by the SEC.
As has been argued with regard to accounting rules (Sunder, 2002), it is unlikely that
there is a unique definition of audit quality that will be acceptable to all users.
Therefore, it might be best to offer measures along three different dimensions: first,
intrinsic measures such as actual audit failures or PCAOB deficiency reports; second,
measures of client-firm reactions reflected in fees or auditor choice; and third, market
outcomes such as better IPO pricing for auditors who are believed to deliver higher
quality. Disclosing all three measures to end-users and allowing them to form their
own inferences would be preferable to trying to construct an integrated measure of
audit quality.
Notes
1. In economic terminology, products whose quality cannot easily be verified by users are
known as credence goods; Emons (1997).
2. A recent article with a similar economic focus is Frantz.
3. Accounting can play a different role in these markets – allowing effective financial contracts
to be written and executed. Specifically, financial contracts require verifiable measures that
can be used to settle-up agreements and accounting numbers can play a role here even if
they do not add any information about the future above that available from market data.
Perhaps one could also argue that the commonly held beliefs about the variance-covariance
structure of asset returns necessary for deriving the CAPM requires common information
sources such as financial statements but this is not discussed in any explicit fashion during
the derivation of the CAPM.
4. An extreme version of this are overlapping generation models where the seller places zero
weight on future payoffs and the asset has to pass to the buyer.
5. This is not an assertion that all shareholders are myopic. Rather, it is a recognition of the
fact that sellers would prefer the share price to peak at the time they sell whereas the buyers
would prefer the share price to peak after they buy. Consequently, sellers have a preference
for the stock price to peak earlier than do buyers.
6. This link is discussed in much greater detail later in this introduction.
7. Formal models involving all these aspects are quite complicated and one possible approach
can be found in Bar-Yosef and Sarath (2005).
8. All these assumptions can be generalized considerably and I refer the interested reader to
Sarath and Wolfson.
ARA 9. The banned services include: bookkeeping or other services related to the accounting
records or financial statements of the audit client; Financial information systems design and
24,1 implementation; appraisal or valuation services, fairness opinions, or contribution-in-kind
reports; Actuarial services; Internal audit outsourcing services; Management functions or
human resources; broker or dealer, investment adviser, or investment banking services;
legal services and expert services unrelated to the audit; and any other service that the
PCAOB determines, by regulation, is impermissible.
16
10. Equally, the very low predictive powers of accounting earnings with regard to short-term
returns does not generate confidence in the earnings response coefficient as a useful
empirical measure.
11. Sunder (2002) eloquently states that: “A competitive regulatory regime helps create more
efficient rules by feeding information about the stock market consequences back to the
makers and users of the rules. No comparative feedback is possible under the current
monopoly.”
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No. 3, pp. 269-307.
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ssrn.com/abstract¼1015089
Gunny, K. and Zhang, T.C. (2013), “PCAOB inspection reports and audit quality”, Journal of Audit quality
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within adverse
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markets
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of audit partners, preparers, and financial statement users”, Auditing, Vol. 11 No. 1, pp. 1-15.
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quality on the valuation of new issues”, Journal of Accounting and Economics, Vol. 14 No. 4,
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investment”, The American Economic Review, Vol. 48 No. 3, pp. 261-297.
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Vol. 1, pp. 1-5. doi: 10.1002/9781118785317.weom010078.
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services”, Journal of International Accounting, Auditing and Taxation, Vol. 8 No. 2,
pp. 215-240.
ARA Krishnan, G., Visvanathan, G. and Yu, W. (2013), “Do auditor-provided tax services enhance or
impair the value relevance of earnings?”, The Journal of the American Taxation
24,1 Association, Vol. 35 No. 1, pp. 1-19.
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determination of audit and non-audit fees”, Journal of Accounting Research, Vol. 41 No. 4,
pp. 721-744.
18
Corresponding author
Professor Bharat Sarath can be contacted at: bsarath@andromeda.rutgers.edu
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Audit quality within adverse selection markets

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Received 7 December 2015

1. Introduction: the role of audits in markets with adverse selection

Future asset value to seller 8 2

Future asset value to buyer 10 4

True seller value ¼ 8 True seller value ¼ 2

Financial report θH p (1 p)

Future asset value to seller 8 4

(given financial report yL andaccuracy p 4 2=3), so the equilibrium market price is

2.1 Discussion of the models

3. Audit quality, market incentives and regulation

3.1 NAS and auditor independence

synergies for accounting firms to provide consulting services. It was in recognition of

3.2 Mandatory auditor rotation

A different approach is adopted in Gunny et al. (2007) where audit quality is

3.3 PCAOB inspection reports

4. Two modest proposals for structural reform

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