Evidence on the Impact of Audit-Firm Portfolio Characteristics on Client Financial Reporting Quality

Abstract

The aim of this study is to test the impact of some new measures of expected future audit-firm losses on client financial reporting quality. In prior studies audit-firm size has been used as a proxy for expected future audit-firm losses and hence - following DeAngelo's (1981) argument's - for audit quality. In particular, a big 6 indicator variable has been tested empirically against various measures of client financial reporting quality. This is however a very rough measure that does not distinguish between the likelihood and the size of future audit-firm losses. In this study, we define and measure various audit-firm portfolio characteristics that relate to both the likelihood as well as the size of future audit-firm losses. We find, for a large sample of Belgian companies, that audit-firm portfolio characteristics better explain variations in client financial reporting quality than the traditionally used big 6 indicator variable. In particular, we find that - ceteris paribus - client financial reporting quality is positively associated with the incumbent auditor's percentage of distressed audit clients and the size characteristics of its audit client portfolio.

Keywords: audit-firm portfolio characteristics, financial reporting quality, factor analysis

JEL Classification: M41, M49