The Emergence of Second‐Tier Auditors in the US: Evidence from Investor Perceptions of Financial Reporting Credibility

Abstract

Abstract:We examine changes in the association between auditor type (Big 4, Second-Tier, and Other non-Big 4) and perceived financial reporting credibility in the wake of events (e.g., Andersen's failure, the implementation of SOX, creation of the PCAOB, etc.) which led to significant growth in Second-Tier client portfolios and increased scrutiny of Second-Tier audit practices. Our results reveal that financial reporting credibility of Second-Tier clients was lower than that of Big 4 clients and was indistinguishable from that of Other non-Big 4 clients preAndersen. However, post-Andersen, we find that financial reporting credibility of Second-Tier clients is higher than that of Other non-Big 4 clients and is indistinguishable from that of Big 4 clients. We expect that our results will be of interest to regulators, both in the United States and in the European Union, who have expressed concerns about the current state of competition in the audit market, management and boards of directors that are contemplating switching to a Second-Tier audit firm, and academics investigating quality differences among audit firm types.

Big N Auditors and Earnings Response Coefficients – A Comparison Study between the US and China*

“…The results based on the post-SOX sample show that Big N clients' financial reports do not exhibit significantly higher ERC compared with non-Big N clients' financial reports. Our results are consistent with previous findings (Boone et al, 2010;Chang et al, 2010;Cassell et al, 2013) and suggest that industry structure and regulations are important factors that affect investors' perception of audit quality.…”

“…The statistical summary is helpful to understanding audit industry structure in both the US and China markets and how audit industry and institutional reforms affect investors' perception of audit quality. Our results are generally consistent with recent studies (Boone et al, 2010;Chang et al, 2010;Cassell et al, 2013) and support the notion that audit market competition and regulation environment are two important forces that affect perceived audit quality. The comparison results are also likely to provide additional evidence to support the argument that institutional factors are one of the important factors that affect perceived audit quality internationally (Khurana and Raman, 2004;Francis and Wang, 2008) .…”

“…Second, the Public Company Accounting Oversight Board (PCAOB) inspects public company audit firms annually. The inspection results show that the Big N auditors and some second-tier auditors met the criteria during the period from 2004 to 2011 (Cassell et al, 2013), suggesting that second-tier auditors are likely to provide comparable audit quality to Big N auditors. These two factors are likely to contribute toward reducing the financial reporting credibility gap between Big N and non-Big N auditors.…”

“…First, the size and the client portfolios of second-tier auditors grew rapidly after 2002 (GAO, 2006;Rama and Read, 2006;Cassell et al, 2013). With their greater firm size, these auditors have a stronger incentive to protect their reputation capital (DeAngelo, 1981).…”

“…Recent studies (e.g. Boone, Khurana, and Raman, 2010;Chang, Cheng, and Reichelt, 2010;Cassell et al, 2013) provide evidence to show that the quality (or perceived quality) difference between Big N and second-tier auditors becomes indistinguishable after the Sarbanes-Oxley Act (hereinafter, SOX) came into effect.…”