Investment opportunities, agency conflicts, contracts, and the demand for audit quality.

Abstract

This paper investigates the relation between a firm's investment opportunity set (IOS) and the demand for audit quality. This paper hypothesizes that a firm's IOS influences the demand for audit quality indirectly through the IOS's influence on the firm's agency costs. A firm's IOS is expected to influence a firm's agency costs through the IOS's influence on the nature of the firm's contracts, and through the IOS'S influence on the relationships between the firm's management and the firm's owners and creditors. The sample is comprised of those firms who were being audited by Laventhol and Horwath (LH) when LH declared bankruptcy in November of 1990. The auditors appointed to replace LH ranged from members of the big six accounting firms to regional and local auditing firms. Because of the variation in the size of the replacement auditors, these auditor-replacement choices provide a good setting to study the factors associated with the demand for audit quality. The demand for audit quality is measured by the size of the replacement auditor. Two measures of this proxy are used. The first is a dichotomous variable representing the selection of a big six/non-big six auditor as the replacement auditor. The second is a continuous variable representing the subsequent auditor's size as measured by the combined sales of the replacement auditor's clients. Results obtained in this study are supportive of quality differentiated audits using both measures of auditor size. Firm-specific factors that are found to be significant in explaining a firm's demand for audit quality are: (1) management ownership, (2) debt, (3) the type of debt (public or private), and (4) risk. Control variables of firm size and the issuance of debt and equity securities are both positively associated with the size of the replacement auditor. The existence of a bonus plan and a direct measure of the firm's IOS are not significant in explaining the size of the replacement auditor. Tests of stock price reactions surrounding the bankruptcy of LH, and to the appointment of a successor auditor provide mixed results regarding the stock market's reaction to the effect of perceived audit quality on firm value.