As recent accounting scandals at Enron, Worldcom, Parmalat, and others make clear, high quality external auditing is one of the central components of sound corporate governance. We study the Japanese audit market, where recent events provide a potentially powerful setting for studying the effect of auditor reputation on audit quality.
An important but largely unresolved issue in both the academic and policy arenas is what determines audit quality. The literature focuses on two principal forces that motivate auditors to deliver quality a litigation/insurance incentive and a reputation incentive. Under the first motive, if auditors are legally liable for audit failures to an economically significant degree (which includes regimes under which they are liable for more than their proportionate share of damages), they have an incentive to deliver quality to avoid litigation. Under the second, auditors have reputational incentives to avoid audit failures because audit quality is valuable to clients and so priced in the market for audit services.
The audit profession argues that reputation effects are sufficient to ensure quality, and that their legal liability for corporate failures should be limited. Regulators in several important jurisdictions, including Europe and the U.S., are currently considering rules that limit auditor liability. Arguments in favor of this include: current liability claims against the major audit networks are substantial, exceeding the total capitalization of these networks, as a result, it is possible that one or more of these firms could be subject to “catastrophic” liability claims that put them out of business, resulting in even greater audit market concentration than currently exists, some type of limit to audit firm liability would allow these firms to insure against liability claims, further reducing the likelihood a large claim would put them out of business.
We study recent events in the Japanese audit market. With the increasing globalization of capital markets, Japanese financial regulators are seeking to convince regulators in other countries that Japan’s financial reporting infrastructure, including its accounting rules and auditing, is of “high quality” and so equivalent to those in other large capital markets, most notably in Europe and the U.S. This means that the Japanese audit profession is changing rapidly, away from the traditional Japanese model of “cozy” relationships between auditors and clients (that worked well in an era when much economic activity was relationship-based and centered around “main bank” group of companies), to one more like the western model that emphasizes auditor independence and a more adversarial monitoring relationship.
Download
PDF Ebook Audit Quality and Auditor Reputation: Evidence from Japan
