Public Company Audits and City‐Specific Labor Characteristics

Abstract

Prior research emphasizes the centrality of audit offices in understanding auditing practices, and documents significant interoffice variation in audit outcomes based on industry expertise and office size. Our study examines how two city‐specific labor characteristics also affect audit offices and local audit markets: the city's average educational attainment, and the number of accountants in a city, which proxy for a city's human capital. Our argument draws on the urban economics literature and predicts that the level of human capital in a city is positively associated with an audit office's ability to conduct high‐quality audits. As expected, there is a positive association between audit quality (quality of audited earnings and accuracy of going‐concern reports) and average education level in the city in which the lead engagement office is located. This association is generally significant for both Big 4 and non‐Big 4 offices, but is relatively stronger for non‐Big 4 firms that are more tied to local labor markets. A company is also more likely to choose a non‐Big 4 auditor in cities with higher educational levels and relatively more accountants, and there is evidence of higher non‐Big 4 audit fees as a city's education level increases. Collectively, these results suggest that local labor characteristics affect audit offices, audit quality, and the ability of non‐Big 4 auditors to compete with Big 4 auditors in the audits of public companies.

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“…25. While Dee et al (2015) do not find this to be a significant characteristic in their subset of firms that disclose component auditor use, recent studies find local education levels and professional certifications of relevant individuals to be informative characteristics (e.g., Beck et al 2018;Hoitash et al 2016;Ge et al 2011;Prawitt et al 2009). Nagy et al (2020) find that the number of CPAs in U.S. audit firm offices is positively associated with audit quality, measured by the likelihood of restatements and discretionary accruals.…”

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“…Chung, Cho, Lee, and Son (2017) found that firms with a strong labor union tend to choose high-quality auditors. Beck, Francis, and Gunn (2018) argued that human capital is associated with the supply of audit and found that US firms headquartered in cities with high average educational levels are more likely to choose a non-Big 4 auditor. The migration of wealthy elites is increasingly publicized in China.…”

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“…Examples of characteristics corresponding to improved quality include auditor size (DeAngelo ), office size (Francis et al ; Francis and Yu ), or industry expertise (Balsam et al ; Krishnan ; Reichelt and Wang ). More recently, Beck et al () documented a positive association between audit quality and the average education level in the MSA of the engagement office, and Hoopes et al () linked auditor salaries to audit quality.…”