Audit Quality and Auditor Size: An Evaluation of Reputation and Deep Pockets Hypotheses

There is now a great deal of evidence that large audit firms provide higher quality audits and offer greater credibility to clients' financial statements than small audit firms. The stock market reacts more favourably when a company switches to a large auditor rather than to a small auditor (Nichols and Smith, 1983; and Eichenseher et al., 1989); large audit firms give more accurate signals of financial distress in their audit opinions (Lennox, 1999); companies with higher agency costs are more likely to hire large audit firms (Francis and Wilson, 1988; Johnson and Lys, 1990; DeFond, 1992; and Firth and Smith, 1992); large audit firms charge higher fees than small audit firms (Simunic and Stein, 1987; Beatty, 1989; Chan et al., 1993; and Craswell et al., 1995); and companies involved in IPOs experience less under-pricing when they hire large audit firms (Balvers et al., 1988; and Firth and Smith, 1992). Two explanations for the positive correlation between auditor size and audit quality have been provided by theoretical research ± these relate to auditors' reputations and the depth of auditors' Journal of Business Finance & Accounting, 26(7) & (8), Sept./Oct. 1999, 0306-686X