This paper explores broad trends in regulation of the auditing profession from 1981–2005, the first 25 years of Auditing: A Journal of Practice & Theory. It begins with a sketch of the 1980 regulatory environment, three constants over the next 25 years, and three external developments or “shocks” that dramatically affected audit regulation activity. The initial conditions, constants, and shocks are then related to audit regulation beginning with the audit risk model in the 1980s as the basis for selfregulated auditing standards, continuing with a vision of unregulated, non-mandated value-adding assurance services in the 1990s, and finally, the 2002 statutory adoption of independent regulation of registered accounting firms and a government-sanctioned corporate governance role for auditors. I close with some implications of the 2005 audit regulation environment for future auditing scholars and practitioners.

This paper examines how partners in an audit firm can use profit-sharing rules to induce optimal partner behavior from the firm's point of view, taking into account the strategic competition of firms in an auditing oligopoly. We use a linear contracting framework to investigate the effects of profit-sharing rules on individual partners' various decisions, including their pricing strategies and effort choices.We assume that efficient audits of different types of clients require different effort profiles with respect to degree of partner cooperation. For example, the audit of a complex company requires different amounts of partner collaboration than does the audit of a simple company. Moreover, since it is too costly for an enforcement party, such as the head office of an audit firm or a court, to verify each client's type in order to resolve compensation disputes among the firm's partners, it is reasonable to assume that client type cannot be contracted upon for partner compensation purposes. Given this assumption, we derive conditions under which there exists an equilibrium in which audit firms strategically choose different profit-sharing rules to specialize in different types of clients, thereby earning positive economic profits. Our analysis provides insights into the strategic competition among the big audit firms, and helps to explain the observed differences in the compensation plans of these firms and in the nature of their client portfolios.

In this paper, we examine the relative efficiency of audit production by one of the then Big 6 public accounting firms for a sample of 247 geographically dispersed audits of U.S. companies performed in 1989. To test the relative efficiency of audit production, we use both stochastic frontier estimation (SFE) and data envelopment analysis (DEA). A feature of our research is that we also test whether any apparent inefficiencies in production, identified using SFE and DEA, are correlated with audit pricing. That is, do apparent inefficiencies cause the public accounting firm to reduce its unit price (billing rate) per hour of labor utilized on an engagement?With respect to results, we do not find any evidence of relative (within-sample) inefficiencies in the use of partner, manager, senior, or staff labor hours using SFE. This suggests that the SFE model may not be sufficiently powerful to detect inefficiencies, even with our reasonably large sample size. However, we do find apparent inefficiencies using the DEA model. Audits range from about 74 percent to 100 percent relative efficiency in production, while the average audit is produced at about an 88 percent efficiency level, relative to the most efficient audits in the sample. Moreover, the inefficiencies identified using DEA are correlated with the firm's realization rate. That is, average billing rates per hour fall as the amount of inefficiency increases. Our results suggest that there are moderate inefficiencies in the production of many of the subject public accounting firm's audits, and that such inefficiencies are economically costly to the firm.

This study investigates the planning materiality values used by auditors in The Netherlands for a sample of engagements performed by Big 5 and non-Big 5 firms in 1998–99. We find that, consistent with archival evidence from KPMG in Elliott (1983), planning materiality is not a constant percentage of a base, but increases at a decreasing rate with client size. In addition, we find that planning materiality values increase with the quality of the client's control environment and the magnitude of the client's rate of return on assets, while decreasing with the complexity of the client. We also find that Big 5 firms use lower planning materiality values than non-Big 5 firms, ceteris paribus, which is consistent with the production of relatively higher audit quality levels by the Big 5. Finally, we find that auditors use lower materiality values in situations where earnings might be managed to show a small profit or a small loss.

This study investigates the relationship between audit pricing and litigation risk. The main question posed in the research is: Are audit fees adequate to compensate auditors for litigation risk? The answer to this question is an essential element in assessing the severity and implications of the liability crisis in auditing.The paper approaches the question in several stages. First, there is an economic analysis of audit pricing. Second, there is a review and reinterpretation of the empirical literature related to audit pricing. Lastly, new evidence is provided from a sample of 249 audits done by a Big 6 auditor. The main results from these analyses are: increased litigation is likely to result in a demand displacement from high-quality to low-quality auditors; the archival evidence suggests that audit fees do reflect variations in litigation risk and that there is some evidence of the predicted demand displacement; and the evidence from the audits included in the sample suggests the incremental contribution margin from the change in audit fees attributable to litigation risk factors appeared to be adequate to cover the costs of litigation for the audit firm performing the audits during the period studied.

This study tests for across-industry differences in the client characteristics which drive the number of hours of various grades of professional labor (partners, managers, seniors, and staff) used in audit service production. When auditing a client's financial statements, we assume that an audit firm uses a least cost combination of labor resources to produce a constant level of assurance.The data for the tests were collected by questionnaire from partners-in-charge of 108 financial services client audits and 249 industrial client audits performed in the U.S. by a major public accounting firm in 1989.We find that client size and complexity of operations are the major determinants of audit hours in both industries. However, the appropriate measure of clients' cash flow risk varies across industries. While leverage and the fact that equity and/or debt securities are publicly held are the best risk measures for industrial clients, the incidence of operating losses is the best measure for financial clients. Also, industrial clients' internal controls have negligible effects on audit production, while the strength of internal controls for financial services clients has significant effects on labor hours utilized. Finally, reliance on the internal auditors of financial clients results in the use of fewer staff hours but more higher-level hours, with no net effect on audit fees.

In this research, we examine the empirical relation between client characteristics and the nature and mix of labor resources used by an international CPA firm to obtain a desired level of assurance that clients' financial statements are free of material misstatement. The level of assurance is the output of an audit, while the input resources measure the effort required to produce that output, under varying client circumstances. We use disaggregated labor hours by rank within the firm (partner, manager, senior, and staff) as the measure of inputs, in order to examine how client characteristics affect both the amount and mix of labor used. To the extent that client characteristics have differential effects on the various types of labor, only disaggregated data can reveal changes in labor mix and may also provide a more powerful test (relative to tests

This paper tests the demand-side prediction of Datar, Feltham, and Hughes (1991) that new issuers of securities are more likely to choose a high-quality auditor and retain a lower level of ownership as the firm-specific riskiness of future cash flows increases. Previous tests of this hypothesis using U.S. data have generally been inconclusive, perhaps because an increase in the riskiness of client cash flows simultaneously increases an auditor's litigation risk and supply price. Our results using data from a significantly different legal environment (Canada) are consistent with the predictions of Datar, Feltham, and Hughes.

This paper reports empirical tests of an hypothesized positive relation between audit quality and firm-specific risk that is predicted by Datar, Feltham, and Hughes' (1991) theoretical analysis of auditor choice when firms go public. Three types of proxies for ex ante firm-specific risk are used to test this relation: regression coefficients that theory relates to the firm-specific risk, ex ante proxies available from prospecti, and ex post variances in returns. Results from the first are moderately consistent with our hypothesis, while those from the latter two are either mixed or contrary.

The question of whether an auditor should also provide management advisory services (MAS) to an audit client has been extensively debated. On the one hand, the Metcalf Committee Staff Study [1976, pp. 50-52] suggested that supplying both services can create a conflict of interests, particularly when a CPA firm recruits a client's executives and is interested in assuring their success, or when it installs a management information system and subsequently audits the reliability and accuracy of its own work. In these situations, a CPA firm acting as both auditor and consultant may be motivated not to report consulting deficiencies observed during the audit, thereby avoiding erosion of its consulting brand name. In general, any situation which increases the probability that an auditor will not truthfully report the results of his audit investigation can be viewed as a threat to independence.1 An opposing view of potential threats to truthful reporting by auditors engaged in MAS was taken by the Cohen Commission [1978, p. 97],

The question of the existence of competition among auditors has been the subject of considerable discussion in recent years. More specifically, the firms as a group have been accused of monopolizing the market for audits {Staff Study of the Subcommittee on Reports, Accounting and Management of the Senate Committee on Government Operations [1977]). However, evidence on the issue is scanty and typically anecdotal (e.g., Bernstein [1978]). The evidence of the Staff Study itself is limited to statistics, with the allegations relying on what has come to be called the concentration doctrine (Demsetz [1973]). According to this doctrine, supplier is a reliable indicator of supplier behavior and performance. In this paper, I provide evidence from a test of the hypothesis that price competition prevails throughout the market for the audits of publicly held companies, irrespective of the share of a market segment which is serviced by the Big Eight firms. The evidence is based on an examination of a sample cross-section of audit fees.