The Chain Reaction Of Low-quality Audits

Since the end of last century, the accounting firm has experienced three times of merger wave through the creation of a branch by newly established or absorption and the scale of the accounting firm has grew stronger. However with the growing size of the accounting firms, a series of accounting fraud scandal challenge the quality of audit work by certified accounting firms. For example the PengCheng accounting firm suffering severe punishment because of the Green Earth Event in2011and the broken up of ZhongLei accounting firm last year. Therefore the most prominent problem in the current audit industry development is that the the headquarter offices and its branches is a legal entity in form but failed to achieve substantial unity in fact. The internal operation of the audit firm is still a "black box" unopened. The incidence of low-quality audit would affect the credibility of the company and the accounting firm. And the existence of low-quality audit in an audit firm may indicate two possibilities. Firstly, the low-quality audit was just due to accidental reasons. The second possibility is that one low-quality audit may indicate a more systematic problem in an audit firm. The chain reaction we investigate is based on the second possibility.Based on the above, we investigate whether the low-quality audits of the accounting firm indicates the presence of a chain reaction on the quality of concurrent audits conducted by the firm. A low-quality audit is defined as the presence of one or more financial restatement of clients. And a chain reaction of low-quality audits could occur in an audit firm due to firm-specific characteristics including personnel and quality control procedures. In our article, chain reaction occurs if the presence of one or more low-quality audit in an audit firm conveys negative information on the quality of other concurrent audits conducted by the firm and then affect the audit fees. And prior research provides evidence that differences in characteristics of accounting firms and enterprises are an important determinant of audit quality. So our article divides our sample to larger big10 audit firms and small big10audit firms to compares their different degree of chain reaction. In addition, because the special characteristic of our country’s enterprise, we also take the government factor into consider.We draw some conclusions after our testing. Firstly we find that in audit firm where a low-quality audit occurred, the other concurrent clients of that firm have a higher level of abnormal discretionary accruals compared to firms with zero low-quality audit. That is to say the low-quality audits of the accounting firm have a chain reaction on the quality of concurrent audits conducted by the firm. Secondly we find there is less chain reaction in large10audit firms than in small big10audit firms. This result suggest that in large audit firm an low-quality audit is more likely to be accidental rather than symptomatic of widespread problems. Thirdly we find that if the low-quality audit happened to the state-owned enterprise, the chain reaction would be bigger.Our findings should be of interest of accounting firms, audit standard setters, investors and regulators because we provide a new method to infer the overall quality of an audit firm through the use of easily obtainable and publicly available information on restatements. Accounting firms can benefit from this method because those in charge of quality control processes can use it to identify offices and employees that may not be implementing the firm’s quality control procedures appropriately. Audit standard setters can use this information to develop some standards that emphasize the potential for quality control problems in the audit firms. In addition, investors can use it as additional information to infer something about the company’s earnings quality based on the history of the audit firm that performs the audit. Finally, regulators can use this information to identify audit firms where audits are more likely to be of lower quality.Our study also has some limitations. Firstly our measure of low-quality audit within an audit firm relies on the assumption that each company that should restate its earnings actually does so. This is not likely to be the case. Secondly besides financial restatement there are indicators can be used to measure low-quality audit. However our study did not consider it. Finally, our sample is limited to publicly traded companies. In fact an audit firm also performs audits for smaller, private clients, so our study cannot be generalized to this client base.