In this study, we investigate the association between audit quality and information asymmetry between informed and uninformed traders. We employ three proxies for information asymmetry – absolute price differences, absolute volatility differences, and absolute differences in the long/short ratio of trades – between US stock and options markets and represent audit quality through the appointment of Big n and industry specialist auditors. For a sample of 4062 firm-years between 2002 to 2005, our results indicate that the appointment of Big n and industry specialist auditors is associated with lower information asymmetry measures. Our results are consistent with audit quality playing a role in the quality of financial reporting information and flowing through to the allocation of information among traders.

In the presence of illiquid markets the reliability of fair value is an open question (Laux and Leuz, 2009). We contribute to this debate by investigating whether voluntary valuation-related disclosures and audit effort can help alleviate the reliability concerns. Using hand-collected data on 21 voluntary valuation-related disclosure items from 281 financial statements of European real estate firms over the period 2007 to 2009, we find consistent evidence that more audit effort decreases the bid-ask spread when model inputs are used to value investment property in the balance sheet. However, we find no evidence that valuation-related disclosures increase the reliability of fair value estimates. To shed light on this unexpected result, in additional analysis we link the valuation-related disclosures to the fair value estimation accuracy of the assets sold. Results indicate that disclosures are used to overcome less accurate estimates rather than to decrease information asymmetry. Overall, results suggest that the capital market values additional audit effort when the measurement choices that are made provide more accounting discretion and are more relevant for stakeholders’ decisions, but perceives valuation-related disclosures as insufficient.

We examine the value of higher audit quality in enforcing and implementing International Financial Reporting Standards (IFRS) using the recent changes in goodwill accounting regulation. IFRS requires management to test for goodwill impairment and write off impairment losses against income. Accounting regulators claim that the IFRS impairment regime better reflects the underlying economic attributes of goodwill. Our results indicate that this claim depends on the enforcement and implementation of IFRS standards by higher quality assurance providers. We develop arguments as to why choosing a Big 4 auditor gives greater assurance of IFRS enforcement and implementation. We find support for this proposition by showing that goodwill impairment charges under IFRS better reflect the underlying economic value of the goodwill only in the presence of high quality auditing and that this is most apparent in ensuring that no goodwill impairment charges are made against income where this supported by the firm’s circumstances.

We argue that audit quality has direct and indirect effects on the cost of equity capital. Direct effects are consistent with auditor reputation effects reflecting insurance and/or assurance roles. However, if audit quality is at least in part a reflection of expected assurance levels, then we also expect recognized indicators of audit quality to have an indirect mitigating effect on the relation between the cost of equity capital and what would otherwise be viewed as aggressive accounting. That is, we expect that in addition to any insurance role, there is at least one component of an auditor’s assurance role that is valued for the mitigation of aggressive accounting. Our results support this prediction using two audit quality dimensions based on a measure of auditor industry specialization and a measure of unexpected audit fees. We find that in addition to higher audit quality being associated with a direct reduction in the cost of equity capital, for the unexpected audit fee-based measure of audit quality, there is also a significant mitigation of the positive impact of high accruals on the cost of equity capital. Additional analysis of instances of switching to higher quality auditors and audit qualifications provides further evidence of auditor reputation playing a mitigating role on the effect of aggressive accounting on the cost of equity capital. We therefore conclude that markets recognize the importance of both the insurance and assurance dimensions of audit quality.

This study investigates whether audit markets remain competitive in the wake of Arthur Andersen's demise and merger with Ernst & Young to create the Big Four. We conduct the study estimating audit fee models using Australian audit market data from both 2000 and 2003 to determine whether there is any evidence of cartel pricing either before, or subsequent to, the merger. In both years, we find evidence of a Big N price premium when estimating an audit fee model across all clients, and when we estimate the model separately across large and small client market segments. This evidence is consistent with product differentiation by Big N auditors and competitive markets.

This study investigates if a quality auditor is more likely to be appointed in circumstances where financial reports have greater relevance for bonding and monitoring and whether the choice of a high quality auditor in these circumstances provides benefits to the firm through increasing the value relevance of the earnings and book value of assets of the firm. Using a sample of Australian companies and conditioning the analyses on firm characteristics where financial reports have greater relevance for contracting, we find these conditions are conducive to a greater likelihood of choosing a high quality auditor and more value relevant accounting numbers as a consequence.

This paper proposes a new method of incorporating prior domain knowledge into a kernel based feature selection algorithm. The proposed feature selection algorithm combines the Fast Correlation-Based Filter (FCBF) and the kernel methods in order to uncover an optimal subset of features for the support vector regression. In the proposed algorithm, the Kernel Canonical Correlation Analysis (KCCA) is employed as a measurement of mutual information between feature candidates. Domain knowledge in forms of constraints is used to guide the tuning of the KCCA. In the second experiments, the audit quality research carried by Yang Li and Donald Stokes [1] provides the domain knowledge, and the result extends the original subset of features.

Ferguson et al. (2003) report that audit industry fee premia primarily reside with joint national and city-specific industry leadership as opposed to merely firm-wide (national) industry expertise, suggesting auditor choice among the Big 5 is best conceptualized on joint industry specialization in city-specific markets and nationally. The present study examines whether the prior results could be confounded by the presence of city-specific overall market leadership effects. Our findings reaffirm that joint local and national auditor industry expertise is valued by audit clients. Furthermore, overall city-specific leadership, by itself, also matters in fee determination and results in higher fees, although at a slightly weaker level of statistical significance.

We provide evidence of an association between audit partner rotation and the quality of earnings. It is a requirement for Australian firms that the engagement partner be identified by name in the annual report. Using a sample of 3,621 firm-years between 1998 and 2003, we show that audit partner changes most likely reflecting partner rotation (i.e., they are not due to a switch of audit firm) are associated with lower signed unexpected accruals, and that for Big 5 clients this relation is driven by smaller positive unexpected accruals following partner changes. This result is consistent with more conservative reporting following a rotation of audit partner, and this interpretation is further supported by evidence suggesting a significant increase in the asymmetrically timely recognition of economic losses when firms have a change of audit partner. Our tests also show that these effects occur predominantly among clients of Big 5 audit firms, and that any effect is concentrated in the latter part of our sample period, when partner rotation was a professional requirement. We therefore conclude that audit partner rotation is associated with incrementally greater conservatism in financial reporting, but only in circumstances where the ability of client firms to resist partner rotation is reduced by mandatory partner rotation requirements.

The current institutional regulatory framework for auditing is a product of the philosophy that individual property rights exist and are to be protected. These notions of property rights create the tension to which auditing is a partial solution.In this chapter, we describe the institutional regulatory framework for auditing and its relationship to markets, corporations and professional associations. Our thesis is that all the institutional arrangements are incentivised as contracting cost-reducing mechanisms to deliver 'audit reform' but residual losses are to be expected. Ethics is viewed as central to the contracting process, facilitating functional completion of contracts and helping to reduce residual losses in contracting. Auditing is also demanded (ex ante) to reduce the expected contracting residual economic loss resulting from attempts to protect individual property rights. Market participants have incentives to minimise contracting residual losses, and regulatory intervention is valued to the extent that the reforms are more efficient contracting solutions to minimise those losses.We review fallacies in the market failure arguments used as rationales for regulatory intervention and suggest that the costs of regulation could be underestimated and the benefits could be overstated. The result is that regulatory intervention could increase future bonding and monitoring costs beyond what is optimal, and thus contribute to inefficient allocation of the costs of property rights.In the same way that ethical behaviour by contracting parties can reduce contracting residual losses, ethical behaviour by politician-regulators in the political process could contribute to lowering the political residual losses and enhancing society's well-being through facilitating the economic outcomes sought by contracting parties.

The Australian Stock Exchange's Principles of Good Corporate Governance and Best Practice Recommendations require all listed companies that do not have a majority of independent directors to explain their reasons. We show that independent (outside) directors seem to add value only where their firms have substantial amounts invested in growth options. In these circumstances, outside directors add significant value in their first year on the board and where they have at least three other board positions.

In an environment where expected litigation costs were relatively low and the provision of forward-looking accounting information was voluntary (Australia), we show that IPO firms voluntarily providing an earnings forecast within the offer document are significantly more likely to use a high quality auditor, consistent with the signaling role of auditor attestation being at least partially dependent on the extent of voluntary, audited disclosures. Any trade-off between auditor choice with either firm risk or retained ownership is confined to smaller IPOs and/or those using less prestigious underwriters, which are also those where support for the signaling role of auditors (and voluntary disclosure) is evident using a valuation model. Our results highlight the failure of “stylised” signaling models such as [Datar et al. (1991); Hughes (1986)] to recognize extensive interaction between various mechanisms, resulting in multiple signaling equilibria.

The Ramsay Report on the Independence of Australian Company Auditors, released in October 2001, contains a review of the current Australian requirements and proposals for reform of the rules and regulations governing auditor independence. In this paper we provide a critical examination of these proposals, in conjunction with any underlying rationale offered in the report. Assuming the onus of proof rests with the proponents of change, we argue that the justification for regulatory change is not well made. We pose a series of questions about the proposals and their potential economic consequences. Many of these questions are empirical and provide opportunities for further research.

Financial reporting has been likened to an information highway that should serve the needs of those who use it The consequences of failing to satisfy these needs include the inability to raise and/or allocate capital efficiently (Ienklns, 1994). A major challenge in an environment of globalisation and accelerating technological innovation is ensuring that relevant information is provided, through both internal management reports and external financial reports. Failure to develop relevant reporting practices will at best make reports irrelevant, at worst misleading. This paper aims, through a survey of major Australian firms, to provide insights into the nature of intangible assets, the management and accounting practices adopted with respect to such assets, and the potential relevance of such information for both internal and external users. Evidence is presented of identifiable intangible assets arising from strategies to develop competitive advantage, and increasingly representing the value created within the firm by management. Accordingly, information on the development of such assets will be critical internally for evaluating managerial performance and externally for determining the level and persistence of earnings by financial analysts.

This paper reports on capitalisation practices of Australian managers for a large sample of firms in the 1993–97 period, and on accounting regulatory issues in relation to intangibles during and after this period. The data show diversity in capitalisation practices in 1993–97, which we suggest is a consequence of abstract conceptual bases for capitalisation decisions under the Australian regulatory framework. The analysis indicates the framework retains traditional emphasis on conservatism and reliable measurement while providing managers with substantial accounting discretion to capitalise intangible assets. We conclude there is an imperative for research investigating capitalisation decisions for intangibles to guide any further regulation.

In an environment where expected litigation costs are relatively low (Australia), we provide evidence strongly consistent with signaling considerations influencing the choice of auditor by initial public offering (IPO) firms. When our analysis is confined to smaller IPOs and/or IPOs using less prestigous underwriters (i.e., those IPOs where the use of a high quality auditor is less "routine"), we find that the probability of selecting a high quality auditor is positively related to IPO firms' riskiness, negatively related to the level of retained ownership by the initial owners and positively related to the decision to voluntarily provide information about expected earnings. these results jointly provide support for the signaling models of Datar, Feltham and Hughes (1991) and Hughes (1986), whereby the choice of a high quality auditor represents a trade-off with the level of retained ownership, but is complimentary to the extent of direct disclosure.