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The effect of audit structure on the audit market
The Effect of Audit Structure on the Audit Market Steven E. Kaplan, Krishnagopal Menon, and David D. Williams
One way in which audit firms have begun structure employed in the audit approach. affects the relative competitiveness of the No single audit structure represents an attractiveness of each category of audit
to differentiate themselves is in the degree of In this paper we argue that audit structure auditor in different client-market segments. optimal choice for all clients. Rather, the structure is contingent upon the degree of
stability in the client’s environment. Trends in intra-Big Eight market shares over the period 1976 to 1986 show that the auditor preferences of consumers of audit services are consistent with the environment in which the clients operate. The client’s preference for a structured auditor increases with increased stability in the client’s operating environment. Clients in unstable environments seem to have a preference for unstructured auditors. We attribute these changes to cost advantages that structured auditors have in stable environments, and that unstructured auditors have in unstable environments.
Introduction The competitive structure of the market for audit services in the United States is an important issue for policy makers and practitioners alike. Competition among public accounting firms seems to have intensified in recent years. Clients are becoming more conscious of differences in audit quality and public accounting firms are becoming more aggressive in seeking new clients (Amett and Danos 1979, p. 50; Berton 1985, p. 33; Cushing and Loebbecke 1986, p. 41). Danos and Eichenseher (1986), who analyzed long-term trends in market share patterns, found increasing intra-Big Eight competition (p. 646), although the overall share of Big Eight firms increased over the period studied (p. 643). The increased competition has been accompanied by changes in the way in which the public accounting profession conducts its business. For example,
Address Xpitlt r~Ut%tS to Professor Krishmgopd Menon, School of Management, Boston University, 685 Commonwedth Avenue, Boston. MA 02215. Journalof Accounting
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significant changes have taken place in the public accounting profession’s ethical standards. Kinney (1988, p. 420) described the past 15 years as a “period of substantial relaxation of the AICPA’s ethical rules.” Major changes in advertising, solicitation, and competitive bidding, among other areas, have contributed to a more competitive climate. In this new competitive climate there is a high incidence of auditor switching. The Public Accounting Report (PAR) indicated that a record 737 publicly traded companies changed auditors in 1986, a 147% increase from 1981 (PAR 1987, p. l), while as many as 719 firms changed auditors in 1987 (PAR 1988, p. 2). Audit firms have sought to differentiate themselves in this competitive market in a number of ways. Several researchers (e.g., Simunic and Stein 1987, pp. 8-10) have suggested that the audit product itself is differentiated. Some firms have developed notable strengths in nonaudit accounting services, information systems, and general management consulting services. This paper focuses on another important change occurring among suppliers of auditing services, namely the degree to which the audit approach is structured. Cushing and Loebbecke (1986, p. 35) reported significant variation across audit firms in terms of the audit structure employed. While audit structure has been of interest to researchers (e.g., Kinney 1986; Bamber and Snowball 1988; Morris and Nichols 1988; Williams and Dirsmith 1988; Bamber et al. 1989), to date there has been little research on the effect of audit structure on competitiveness. Newton and Ashton (1989) did address this issue in their study. Newton and Ashton contended that a structured approach has inherent efficiencies (1989, p. 24) and that over time, clients would prefer structured auditors over unstructured ones (p. 34). However, their examination of the Canadian market did not show evidence of such a shift in client preferences (p. 34). Like Newton and Ashton, we believe that audit structure is directly related to the auditor’s competitiveness. We disagree with Newton and Ashton in that we argue that no single audit structure provides audit efficiences across all market segments. Rather, the type of audit structure adopted by a firm may give it a competitive edge in some segments of the audit market but not in others. In advancing this contingency perspective we focus primarily on expected differences in auditor production costs. However, audit structure may affect competitiveness in other ways, such as through its influence on the working relationships between auditor and client. In this paper, we report the results of a study which examined the association between a client’s environment and the audit structure employed by the client’s auditor. First, we examined auditors’ client portfolios over the period 1976 to 1986. Differences in audit structure were only just beginning to emerge in the early part of this period, but had become more pronounced by 1986. Thus, we hypothesized a positive association between audit structure and the client environment for 1986, but not for 1976. Next, we examined the displacement of auditors over the same period. It was expected that the
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selection of the successor auditor would follow a trend towards the matching of the client with the auditor whose structure corresponds with the client’s environment. Finally, we examined a sample of fee-driven auditor changes, to see if the expected relationship between auditor choice and client environment holds for this sample. In the next section we review relevant literature and discuss the research questions explored in this study. The third section describes the research methods employed and the results obtained. Implications of the study are presented in the final section.
Audit Structure and Competitiveness Audit Structure Cushing and Loebbecke (1986, p. 32) define a structured audit methodology as “a systematic approach to auditing characterized by a prescribed, logical sequence of procedures, decisions, and documentation steps, and by a comprehensive and integrated set of audit policies and tools to assist the auditor in completing the audit. ’ ’ ’ More broadly, Bamber and Snowball (1988, p. 492) defined a structured audit as “the extent to which auditors’ task related behaviors are subject to formalized prescriptions and restraints.” In their view (p. 492), the structured audit approach provides a “blueprint” for the performance of an audit that specifies the steps to be followed in carrying out audit t&S.* The field auditor’s discretion to ignore template specifications is restricted. On the other hand, an unstructured audit approach may be characterized by the relative absence of a template and the need for the audit team to exercise greater discretion during the conduct of the audit (Bamber and Snowball 1988, p. 492). Cushing and Loebbecke (1986, p. 35) ranked 12 national CPA firms according to the degree of structure they employed in an audit. In order to arrive at this ranking, they examined audit firms’ materials and assessed the nature and level of guidance provided by each firm. Firms classified as most structured laid greater stress on initial audit planning, used preprinted standardized materials more extensively, and relied more on quantitative audit techniques and decision aids. Several other recent studies have examined questions relating audit structure to auditor behavior. Morris and Nichols (1988, pp. 251-253) found an association between audit judgment consensus and the audit structure. Bamber
‘As Cusbittg and Loebbecke (1986, p. 32) note in their study, their concept of structure in the audit approach is similar to concepts proposed in an earlier study by Dirsmitb and McAllister (1982). Dirsmitb and McAllister (1982, p. 215) used the terms “organic” and “mechanistic,” rather than “unstructured” and “structored.” 2We prefer the term “template,” first suggested to us by a reviewer of this paper, to “blueprint” in describing the structured method, and use this term in the remainder of tie paper.
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and Snowball (1988) did not find a similar association (p. 499). However, they did find that members of unstructured firms tended to view their tasks as less analyzable and less routine (p. 497). Kinney (1986, p. 84) found that the voting pattern of the Auditing Standards Board appeared to be influenced by the structure of the firms with which the Board members were associated. Williams and Dirsmith (1988, pp. 501-503) found that clients employing unstructured audit firms took longer to release their earnings when earnings fell below expectations. Finally, Bamber et al. (1989, p. 293) found that audit seniors’ perceptions of their role stress differed systematically across firms with different degrees of audit structure.
Audit Structure and Client-Auditor
Fit
One of the espoused benefits of using a structured audit approach is the control of audit costs (Cushing and Loebbecke 1986, p. 42). Grobstein and Craig (1984, p. 16) and Mullarkey (1984, p. 82), among others, have also contended that structured approaches contribute to efficiencies in audits. Sullivan (1984, p. 64), on the other hand, suggested ways in which structured audits are inefficient, such as their disregard for qualitative evidence. Cushing and Loebbecke (1986, p. 43) also indicated that while it may help to control costs in “typical” audit environments, a structured approach designed to anticipate features of the typical audit environment may be more difficult to apply to the “atypical” environment. Newton and Ashton (1989, p. 24) posited a positive relationship between structure and efficiency. This led them to expect that structured auditors would tend to displace unstructured auditors over time (p. 34). They examined (p. 34) auditor changes in the Canadian market, expecting to observe a general change away from unstructured auditors to more structured ones. Their evidence showed that unstructured auditors actually increased their share of the firms in the sample, rather than losing share (p. 34). Our analysis of the cost efficiencies of audit structure builds upon the contingent perspective suggested by Cushing and Loebbecke (1986, p. 43). We argue that the selection of an audit approach affects the auditor’s production cost function, making it possible for the auditor to supply a lower cost audit for certain types of consumers while increasing the relative cost to the auditor of providing services to other types of consumers. One important determinant of the effect of audit structure on costs is the task environment of the individual auditor. If the auditor is operating in a stable task environment, then few deviations from programmed procedures may be Audit staff members would be able to accomplish their tasks necessary. expeditiously by following firm-supplied program aids. In the event of an unexpected contingency, staff members would resort to what Bamber and Snowball (1988, p. 493) term “coordination and control” mechanisms. These are mechanisms used to overcome inflexibility and achieve a fit between
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structured audit approaches and uncertain tasks. An example of such a mechanism is consultation with managers or supervisors. In a stable task environment, uncertainties may be few, and may require only minimal use of coordination and control mechanisms. While a structured approach would allow the systematic selection of audit procedures to meet specific objectives, the unstructured methodology may result in more unnecessary procedures being performed. The relative absence of firm-supplied decision aids requires the unstructured firm auditor to rely on individual discretion in making decisions that would be routinized in a structured approach. Inefficient choices may be made in such decisions as sample size selection. In a stable task environment, then, an unstructured audit may be more time consuming and inefficient. However, as the task environment becomes less certain, the relative cost advantages should shift. Bamber and Snowball (1988, p. 501) found that auditors from structured firms tended to rely more extensively on coordination and control mechanisms than unstructured firm auditors, in response to increasing task uncertainty. In making less use of these costly mechanisms, auditors from unstructured firms may be able to accomplish their tasks more efficiently. Additionally, if structured firm auditors are limited in their discretion to depart from procedures prescribed in the audit manual, they may perform unnecessary procedures only because of a need to comply with the standardized instructions. In a dynamic task environment, a structured audit may be more time consuming and inefficient than an unstructured audit. The stability of the auditor’s task environment is likely to be related to the stability of the client’s environment. The organizational theory literature has consistently posited a relationship between an organization’s structure and the stability of its environment, suggesting that “mechanistic” structures “fit” stable environments, while “organic” structures fit dynamic environments (e.g., Bums and Stalker 1961; Mintzberg 1979). According to Mintzberg (1983, p. 137), for example, in a stable environment the organization can easily protect its operating core and standardize its activities, establishing rules and formalizing procedures. Dynamic environments pose uncertainties that require more flexible and less formal coordination and control mechanisms, as well as more responsive decision-making systems.3 Audit clients operating in a stable environment are likely to have standardized systems, routinized procedures, and relatively formal and elaborate organizational structures. This leads to a stable task environment for the auditor. The use of a template in these circumstances should reduce the amount of judgment and time required to conduct the audit. The relative stability of the environment also makes it more likely that a template used in one year can be
3Contingency researchers have exploredthe relationship between the environment and internal accounting and information systems. For a summary of this research, see Macintosh (1985).
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modified easily for use in subsequent years, as well as allow for the use of similar templates in firms from the same industry. Unstructured audits are likely to be more costly for clients in such environments because of their reliance on the discretionary judgments of audit staff. On the other hand, an unstructured audit approach may have production cost efficiencies for consumers operating in a dynamic environment. A firm that faces a rapidly changing environment is generally unable to standardize procedures or establish a formal organizational structure to the same extent as a firm in a stable environment. The auditor’s task environment will be more uncertain. This makes the use of a template more difficult. Because the environment is changing quickly and unexpectedly, a template will be able to provide only limited guidance to the auditor without significant and costly changes being made to it during the audit. Audits for firms in dynamic environments are likely to involve substantially more unexpected contingencies that call for discretionary judgments. The lower cost suppliers are likely to be those who routinely employ judgment intensive methods and are experienced in responding to unstructured situations. Thus, we would expect unstructured auditors to be better placed to deliver cost-efficient services to consumers in a dynamic environment. Relative production cost advantages should be reflected in audit product pricing over the long term. The increasing competition in the audit market has resulted in the competitive pricing of services (Berton 1985, p. 33). Prior research has provided evidence of the importance of price in auditor selection and retention decisions (Bedingfield and Loeb 1974, p. 68; Eichenseher and Shields 1983, p. 30; Simon and Francis 1988, p. 263). A recent survey reported that 37% of the firms that changed auditors in 1987 claimed to be replacing their existing Big Eight auditor because of excessive fees (PAR 1988, p. 3). We expect that the differentiation of audit firms along the lines of audit structure has led to unstructured firms having a competitive edge in certain market segments and structured firms the edge in others, through relative cost advantages. However, cost differentials may not be the only, nor indeed the principal effect of audit structure on the competitiveness of the auditor. The presence of a fit between the auditor’s structure and the client’s environment may convey other kinds of benefits. For example, it is plausible that auditor structure may affect the working relationships between auditor and client. A good working relationship was found to be a critical factor in auditor retention decisions in a survey conducted by Eichenseher and Shields (1983, pp. 29-30). A structured audit may be more congruent with the organizational culture of a client in a stable environment. That is, both the auditor and the client may prefer structured approaches to organizational control issues. Clients in stable environments may believe that the structured audit would be a more effective approach for their firm. On the other hand, an unstructured audit approach may be congruent with the organizational culture of dynamic clients, who tend to use less structured and more informal control systems.
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Audit structure differentiation is likely to have begun to make its impact on the relative market positions of the major suppliers only in recent years. Differences in audit structure only began to emerge in the mid-1970s (Cushing and Loebbecke 1986, p. 1). It has taken a number of years for each firm to formulate an approach that is consistent with its strategy and capabilities, and to develop the necessary technology and expertise to implement the approach. Now that developments in audit structure are more than a decade old, their effect on auditor selection decisions should be discernible. Our analysis was restricted to Big Eight auditors.4 The differences between Big Eight and non-Big Eight auditors in terms of such product characteristics as credibility and product line scope are likely to have been substantial enough to confound our findings. Restricting the sample in this manner has the consequence of limiting the insights obtained from the study to the Big Eight sector of the audit market. However, Big Eight firms are so dominant in the audits of publicly traded companies as to make the understanding of this market sector important in its own right. The primary emphasis of the empirical part of this study was the analysis of the relationship between audit structure and client environmental stability over the period 1976 to 1986. This analysis was conducted on two different sets of firms: the first a set representing all firms, and the second a set of firms making auditor changes over the period. We expected that the client portfolios of the audit firms would change in a manner consistent with the firms’ audit structure. On a cross-sectional basis, the stability of the client’s environment should be positively correlated with the audit structure employed by its auditor. Firms changing auditors should show a marginal preference for the matching type of auditor. A secondary analysis was conducted to see whether there is any support for attributing clients’ auditor preferences to cost advantages conveyed by structure. In this analysis, we tested the hypothesized audit-structure environmental-stability relationship on a sample of companies whose motivation for changing auditors was to reduce audit fees. In the next section, we describe the research methods employed and the results obtained.
Method and Results The analyses performed in this study required the use of surrogate measures for audit structure and client environmental stability. The measure used to represent the degree of audit structure (AS) adopted by each Big Eight firm is the one developed by Kinney (1986). While Kinney (1986) does not report the rating for each firm, these ratings are disclosed in Morris and Nichols (1988, p. 241). Kinney reports (p. 83) that his rankings are consistent with those
4T~o mergers between Big Eight firms have taken place in the period since the study was conducted, reducingto six the numberof independentfirms in this class of auditors.
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Table 1. Audit Firm Structure (AS) Ratings“ Firm
AS Rating
Deloitte Ha&ins & Sells Peat Mat-wick Mitchell Touche Ross Arthur Andersen Arthur Young Ernst & Wbinney Coopers & Lybrand F’rice Waterhouse
15 15 13 11 10 10 5 5
Classification Structured Structured StNCtURd
Intermediate Intermediate Intermediate Unstructured Unstructured
“These ratings were developed by Kinney (1986) and subsequently reported in Morris and Nichols (1988, p. 241). The classification of firms into structured/intermediate/unsuuctured types is also taken from Kinney (1986, p. 84).
developed by Cushing and Loebbecke (1986). The AS ratings are presented in Table 1. Kinney classified the eight firms into three groups: structured, intermediate, and unstructured. This classification is also presented in Table 1. A measure for environmental stability (ES) was developed for each client by computing the coefficient of variation for the first difference in sales in the industry in which the firm operates. This metric was first proposed by Bourgeois (1985, pp. 555-556). Other objective measures of environmental stability/volatility have been proposed by organizational theorists (e.g., Tosi et al. 1973). Bourgeois argued that a measure based on first differences of sales is free of influences from major trends and is a true indicator of discontinuities.’ The metric suggested by Bourgeois (1985, p. 556) is presented in equation 1.
ES, = xj
(1)
where: ES, = the environmental stability measure for industry j, Xti = the first difference in sales for industry j for year i, Xj = the mean Xti for industry j, t is an index for year, with a maximum value of 5, and j is an index for the industry. Following Bourgeois’ method, ES,s were computed for each industry using six consecutive years of sales, ending in the year of interest (which yielded five first differences). The three-digit SIC code was used as the basis for grouping
sEnvironmental stability has often been operationalized by organizational theorists using perceptual measures taken from organizational members (Duncan 1972; Downey and Slocum 1975; Pennings 1975). Because of the large number of firms in this study and need for measures of stability for a prior period, it was not feasible to use a perceptual measure. We chose to rely on an objective measure.
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firms into industries. Using Bourgeois’ measure results in clients in the same industry being assigned the same value for environmental stability. The environmental stability measure for each client i is denoted ES, in this paper. Bourgeois’ use of industry sales in computing environmental stability is based on the assumption that the uncertainty faced by a firm is largely related to the rate of change in the industry. It equally could be contended that firm-specific environmental uncertainty is more likely to be related to the volatility of the firm’s own sales, which should reflect both industry-related and firm-specific factors. We tested the sensitivity of our results to this assumption by using two different ES, metrics, one computed at the industry level and the other specific to the firm. The results obtained for the two sets of analyses were very similar. However, sample sizes for the analyses using the firm-specific metric were significantly smaller than for analyses using the industry-level metric. Results obtained for the analyses using the firm-specific metric are reported in footnotes.
Incumbent Auditor Analysis The incumbent auditor analyses employed a cross-sectional data set representing all publicly traded firms. The set was drawn from the expanded COMPUSTAT II database.6 In order to be included in the set, the firm had to have a Big Eight auditor. Additionally, we restricted our analysis to industries that had a minimum of 20 firms listed on COMPUSTAT II. The set included samples for 1976 and 1986. The 1976 sample consisted of 3939 firms, while the 1986 sample contained 5 119 firms. Data to compute ES,s were obtained from COMPUSTAT II. Information on the client’s incumbent auditor also was obtained mainly from COMPUSTAT II, supplemented where necessary by reference to Who Audits America (1976- 1986).’ First, we examined the client portfolio of each Big Eight auditor, to see if there is a correlation between the audit structure adopted by the auditor and the environmental stability faced by its clients. The stability of the portfolio of clients held by each Big Eight firm was measured as the average client stability, weighted by the size (and thereby presumably the importance) of the client. The formula used to compute average client stability is presented in equation 2. ACS” = C(ESi”(Si” / CSin))
(2)
%OMPUSTAT II contains financial and auditor data for approximately 10,000 publicly traded coypanies that are registered with the Securities and Exchange Commission (SEC). In computing ACS (see p. 10) for each audit firm, clients who received a disclaimer of opinion from their auditors were excluded (31 in 1976, 19 in 1986) on tbe grounds that the auditor did not provide a complete audit of the financial statements.
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Table 2. Audit Structure (AS) Rating and Average Client Stability (ACS) Firm Deloitte Haskins & Sells Peat Marwick Mitchell Touche Ross Arthur Andersen Arthur Young Ernst & Whinney Coopers & Lybrand Price Waterhouse
AS Rating
1976 ACS
(n)
1986 ACS
(n)
15 15 13 11 10 10 5 5
1.22 1.20 1.23 1.29 1.32 1.19 1.36 1.16
(390) (583) (366) (738) (362) (517) (481) (502)
1.58 1.53 1.45 1.61 1.54 1.70 1.70 1.78
(495) (786) (512) (923) (488) (702) (644) (569)
where: ACS, = average client stability measure for auditor n, ES,, = environmental stability for client i (equal to ES,, where client i belongs to industry j) of auditor n, Si, = log of sales for client i of auditor n, and i, j, and n are indices for client, industry, and audit firm, respectively. If there is a tendency for client firms to be attracted to cost-efficient auditors, and if audit structure affects supplier production costs as described in the previous section, then the client portfolio of the CPA firms should show different characteristics. Independent auditors with higher AS ratings (indicating more structured approaches) can be expected to have lower ACS values (indicating more stable environments) than those with lower AS ratings. We computed ACS for each Big Eight auditor for 1976 (the first year of the period we examined) and for 1986 (the last year). Table 2 shows ACS for each of these years, along with the auditor structure (AS) rating. Limiting the number of observations to the eight CPA firms considered in the study weakens any statistical test for association. However, a test for rank correlation shows no evidence of association between AS and ACS in 1976 (Spearman’s correlation coefficient = -0.27, p = 0.51), but a significant association in 1986 (Spearman’s correlation coefficient = -0.78, p = 0.02).8
sThe metric used here to represent an auditor’s client portfolio gives greater weight to larger clients. Alternative metrics could have been used. For example, an unweighted portfolio metric could have been employed; i.e., ACS, = XES,,/k, (where k, = the number of clients belonging to auditor n). We correlated these unweighted AC.3 measures for the Big Eight auditors with audit structure. The results were similar to those for the weighted portfolio metric. There was no significant association between average client stability and audit structure in 1976 (Spearman’s correlation = - 0.17, p = 0.69). ACS and AS were statistically correlated in 1986 (Spearman’s correlation = - 0.68, p = 0.06). A series of pairwise comparisons (using Tukey’s test) showed statistically significant differences between mean ES, values in three cases in 1986 (Price Waterhouse-Deloitte Haskins & Sells, Price Waterhouse-Peat Marwick Mitchell, and Price Waterhouse-Touche Ross) and two cases in 1976 (Coopers & Lybrand-Price Waterhouse and Coopers & Lybrand-Arthur Young). The 1986 differences are consistent with our expectation, but the 1976 difference between Coopers & Lybrand and Price Waterhouse, two unstructured firms, is difficult to interpret.
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The change in the relationship between audit structure and average client stability of the Big Eight firms from 1976 to 1986 is consistent with our expectation. According to Cushing and Loebbecke (1986, p. 1) and others, major changes in the auditing methodologies of the large accounting firms were introduced in the period following the mid-1970s. There was only limited differentiation in firms’ audit structure in the mid-1970s. Our analysis shows little relationship between audit structure and average client stability at that time. However, audit structure and the environmental stability of clients appear to be related in 1986, by which time significant differences in audit structure are known to have existed. If client stability is associated with auditor selection, we would expect to find a positive cross-sectional correlation between the client’s environmental stability measure (ES,) and the audit structure measure of its CPA firm (AS). We computed the correlation coefficient for these two variables, for each of the years 1976 and 1986. There was no correlation at all between AS and ES, for the 1976 sample (Pearson’s correlation coefficient = -0.01, p = 0.65). A small, but statistically significant, negative correlation was observable for the 1986 sample (Pearson’s correlation coefficient = -0.08, p = 0.04).9 The absence of a correlation in 1976 is not surprising. The recency of the development of audit structure differentiation leads to the expectation that there should indeed be no association between AS and ES, in 1976. This would be consistent with the results of the analysis in the previous section. The existence of a statistically significant correlation in 1986 may be an indication that audit structure is beginning to emerge as an important factor in audit market dynamics. However, the observed correlation is very small.”
Auditor Change Analysis Prior researchers have documented a number of reasons for firms to change auditors. ‘I This paper suggests that the fit between audit structure and environmental stability is another factor influencing a firm’s selection of an auditor. A
‘In order to control for the effect of client size in this analysis, two regressions were run, one each for 1976 and 1986, using AS as the dependent variable and ES, and the log of the client firm’s sales as independent variables. The regression results were consistent with the reported correlations. While statisticaUy significant models were obtained, the R-squared values were very low (less than 1%). The coefficient for the independent variable ES, was negative in each case, but significant (p c 0.01) only in 1986. The cocfficiene for the size was negative and significant in both models. “The incumbent auditor analysis was repeated using a firm-specific environmental stability metric. ESi was recomputed by substituting firm sales data for industry data in equation (1). Average client stability (ACS) was then computed for each auditor. Again, ACS was significantly correlated with AS only in 1986 (1986: S pearman’s correlation = -0.81, p = 0.01; 1976: Spearman’s correlation = 0.1, p = 0.82). A cross-sectional correlation between firm-specific ESj measures and AS was also conducted. As with the industry level analysis, a small but significant negative correlation was detected for 1986 (1986: Pearson’s correlation = -0.04, p = 0.04; 1976: Pearson’s correlation = -0.01, p = 0.77). “Chow et al. (1988) and Knapp and Elikai (1988) identify many of the important contributions to the auditor changes literature.
ma
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et al.
sample of firms making auditor changes should show, in aggregate, a tendency to select an auditor who employs an approach that matches the firm’s environment. Clients in relatively stable environments should show a tendency to displace unstructured auditors with more structured ones, while clients in relatively unstable environments should tend to prefer unstructured auditors. The sample of firms used in this analysis consisted of 950 clients who changed from one Big Eight auditor to another over the period 1977 to 1986. Again, data on auditor changes were obtained from COMPUSTAT II, supplemented where necessary by data from Who Audits America. Two related tests were performed. The first test examined the characteristics of the Big Eight firms’ new client pool. Clients making auditor changes were partitioned into two sets: 1976- 1981 changes and 1982-1986 changes. Client environmental stability measures (ES,) were used to compute a measure of new client stability for each auditor, NCS, for each of the two periods examined. NCS, for each auditor n, was defined as the mean of the ES, values for the new clients acquired by auditor n. NCS values for the first period were computed using 1981 ES, values, while NCS values for the second period were computed using 1986 ES, values. More structured auditors were expected, on average, to be more attractive to clients in relatively stable environments, while unstructured auditors were expected to attract clients in more volatile environments. This would then result in NCS decreasing as the auditor structure increased. However, this relationship was only expected to exist in the more recent period, in view of the recent differentiation of firms’ audit structure. Table 3 shows the NCS for each Big Eight auditor, along with the auditor’s structure (AS) rating, for each of the two periods examined. The analysis showed that clients switching auditors appear to have a preference for an auditor that matches the client’s environment. As expected, this preference is evident only in the later period examined. The correlation between NCS and AS was not significant in 1977 to 1981 (Spearman’s
Table 3.
Audit Structure (AS) Rating and New Client Stability (NCS)
FirIll Deloitte Haskins 8c Sells Peat Marwick Mitchell Touche Ross Arthur Andersen Arthur Young Ernst & Whinney Coopers & Lybrand Price Waterhouse
AS Rating 15 15 13 11 10 10 5 5
1977- 1981 NCS (n)
1982- 1986 NCS (n)
1977- 1986 NCS 00
1.60 1.62 1.19 1.70 1.93 1.75 1.58 1.90
1.47 1.13 1.38 1.79 1.65 1.49 2.07 1.64
1.50 1.28 1.29 1.75 1.75 1.59 1.86 1.76
(24) (44) (47) (86) (31) (54) (59) (44)
(59) (99) (54) (86) (60) (89) (76) (47)
(83) (143) (101) (163) (91) (143) (135) (91)
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Effect of Audit Structure on Audit Market
Table 4.
Direction of Auditor Changes
A. Auditor
Changes During
1977-1981 Successor
Predecessor
Auditor
Unstructured Intermediate Stmctwxl Total B.
Unstructured
Auditor
Intermediate
Total
StlUCtUred
18 45 40
47 47 68
28 50 37
93 142 145
103
162
115
380
AuditorChangesDuring 1982-1986 Successor
predecessor
auditor
Unstructured Intermediate Structured Total
Unstructured
Intermediate
Auditor Structured
Total
18 62 43
69 80 86
64 88 60
151 230 189
123
235
212
570
correlation coefficient = -0.39, p = 0.34). It was significant in the 1982 to 1986 period (Spearman’s correlation coefficient = -0.77, p = 0.04). However, while the ordering of NCS and AS were negatively correlated in this period, a series of pairwise comparisons, using Tukey’s test, showed a statistically significant difference between mean ESi values for only one pair of CPA firms (Peat Marwick Mitchell and Coopers & Lybrand). When auditor changes for the two periods were combined, NCS and AS were negatively correlated (Spearman’s correlation coefficient = -0.89, p = O.Ol).‘* A second test was conducted to see whether the direction of the auditor change made by client firms was consistent with the hypothesized auditor-structure environment-stability relationship. For this test, we grouped auditors into the three classes identified by Kinney (1986, p. 84), that is, structured, intermediate, and unstructured (see Table 1). Table 4 shows the number of firms changing from and to each of these three classes. If the arguments made in this paper are valid, firms changing to a more structured auditor than their incumbent auditor should be in more stable environments, on average, then those seeking a less structured auditor. In order to test this, the sample of firms changing auditors for each of the two periods, 1977-1981 and 1982-1986, were classified into two groups: those changing to an auditor with a more structured approach (MS), and those
‘*An alternative way of assessing this association between the client tim’ environmental stability and the successor auditors’ struchlre is simply to correlate AS and ES,. For the firms which changed auditors in the 1977 to 1981 period the correlation between AS and ES, was not significant (Pearson’s correlation = -0.05, p = 0.33). However, a significant correlation was obtained for the sample of firms changing auditors in the 1982 to 1986 period (Pearson’s correlation = - 0.11,
p=
0.01).
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choosing a less structured auditor than the incumbent (LS). Firms making changes within the same audit structure class were omitted.i3 In the 1977-1981 period, the MS group contained 125 firms, while the LS group had 153 firms. The MS group had 221 firms in the 1982 to 1986 period, while the LS group consisted of 191 firms. Mean ES, values were significantly different between these groups for the 1982 to 1986 period (MS group mean ES, = 1.38, LS group mean = 1.90, t value = 2.53, p = O.Ol), with clients selecting more structured auditors tending to belong in more stable environments. The difference in stability between the groups for the 1977 to 1981 period was not significant (MS group mean ES, = 1.45, LS group mean ES, = 1.75, t value = 1.11, p = 0.27).14
Analysis of Fee-Motivated Auditor Changes While the prior analyses provide some evidence that auditor-client pairings are influenced by the match between the auditor’s structure and the client’s environment, they do not shed light on the reasons for this relationship. Earlier in this paper, we had offered as one potential explanation the argument that each type of audit approach conveys cost advantages for certain types of clients. The reflection of these cost advantages in prices could result in auditors and clients being matched in the manner observed. A direct test of this hypothesis requires audit cost information, which, unfortunately, is not publicly available. However, the Public Accounting Report annually identifies firms that cited audit fees as a reason for changing auditors. If cost advantages flow from audit structure differentiation, this should be reflected in a sample of firms that have been motivated by price to change auditors. A sample of 153 firms that changed from one Big Eight auditor to another over the period 1984 to 1986, citing reduced fees as a motivation, was obtained from the Public Accounting Report. Table 5 shows the direction of the changes, using the unstructured-intermediate-structured trichotomy to classify both the old and new auditors.
‘sFirms making changes within an audit structure class were omitted because the focus of this analysis is the client’s attraction for a new auditor with a different structure. that more closely matches the client’s environment. Changes between firms of equivalent structure simply cannot be explained within the framework proposed in this paper. Indeed, the ES, values for the firms in this category did not show any detectable pattern. 14The analyses for the sample of firms changing auditors were repeated using the firm-specific metric of client stability rather than the industry-level metric. Insufficient data for ES, calculations for a number of these firms resulted in the sample size being reduced to 306 firms. However, the results were consistent with those repotted for the industry-level metric. NCS (new client stability) was computed for each auditor as the mean of its new clients’ ES,s, where ESi was based on the client firm’s sales volatility. These NCS measures were correlated with AS at statistically significant levels in the 1982 to 1986 period but not in the 1977 to 1981 period (1982 to 1986: Spearman ‘S correlation = -0.84, p = 0.01; 1977-1981: Spearman’s correlation = 0.40, p = 0.33). t tests showed that mean ES, values of the MS group were less than mean ESi values of the LS group only for the 1982 to 1986 period (1982-1986: MS group mean = 1.94, LS group mean = 2.65, t value = 2.16, p = 0.03; 1977-1981: MS group mean = 2.17, LS group mean = 2.40, t value = 0.64, p = 0.52).
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Effect of Audit Structure on Audit Market
Table 5. Direction of Price-Motivated
Auditor Changes (1984- 1986) Successor Auditor
Predecessor Auditor
Unstructured
Intermediate
StNCtUd
Total
Unstructured Interndiate Structured
4 18 9
13 12 35
17 35 10
34 65 54
Total
31
60
62
153
ES, measures were computed for these firms for 1986. Three firms had missing data. Omitting these firms resulted in a sample of 150 firms at this stage. Clients’ ES, measures were associated with the successor auditors’ AS ratings at a statistically significant level (Pearson’s correlation coefficient = -0.20, p = 0.01). However, this correlation by itself does not reveal whether the direction of the auditor change was consistent with the audit structure, environmental-stability hypothesis. In order to assess this, the sample was divided into firms changing to a more structured auditor (MS) and firms moving to a less structured auditor (LS). There were 65 firms in the MS group and 62 in the LS group. Firms making changes within an audit structure class were omitted. Mean ES, values for the MS and LS groups were then compared. As expected, firms selecting more structured auditors tended to belong in more stable environments (MS group mean ES, = 1.53, LS group mean = 2.53, t value = 2.08, p = 0.04).15 While this result provides some support for the argument that certain audit approaches have cost advantages for clients in certain types of environments, it is by no means unambiguous. Disconfirming results from this test would have been a clear rejection of the cost advantages argument, but confirmatory results obtained could be explained by factors other than audit costs. It is plausible that some omitted variable could explain why clients in more volatile environments are attracted to unstructured auditors and clients in relatively stable environments are attracted to structured auditors in both the entire population of auditor switching firms and the sample of fee-motivated switchers.
Conclusion This study has been motivated by the tendency for many major CPA firms to develop more structure in their audit approaches. Previous researchers have documented these changes and demonstrated their importance in audit practice
“Using a firm-specific Es, metric rather than an industry-level metric provided similar results. The additional data rqtdrements resulted in the sample of fee-motivated changes shrinking to 52. The mean ES, for the LS group (3.50) was higher than the mean for the MS group (2.17). The difference was significant (t-value = 2.03, p = 0.05).
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(see, for example, Cushing and Loebbecke 1986; Grobstein and Craig 1984). There has also been recognition that the cost structure of audit services is likely to be affected by these changes. Some authors have suggested that structured audits inevitably result in lower audit costs. We maintain that a structured audit approach conveys benefits in some situations, but an unstructured approach may have advantages in others. Specifically, the relative advantage of a structured approach may be contingent upon the stability of the client’s environment. For example, a relatively unstructured audit is likely to be cost efficient for clients in unstable environments, while a structured approach is likely to be more efficient for clients in stable environments. While there has been some increase in the audit structure in the industry as a whole in recent years, the major CPA firms have increasingly differentiated themselves in terms of the extent of structure employed. Any ensuing differences in attractiveness to clients should translate into changes in the market positions of these firms. We examined the client portfolios held by different Big Eight auditors and changes in these portfolios to see if there is any evidence of an audit structure effect. A number of tests were performed with consistent results. The evidence supported the principal thesis of this paper. Irma-Big Eight market shares in different client market segments have changed in recent years in a manner consistent with the audit structure the firm has adopted. There has been a tendency for the more structured firms in the Big Eight to increase their share of clients in stable environments, while more unstructured firms have increased their share of client firms in unstable environments. Client firms changing their auditor have shown a preference for a successor auditor whose approach is more consistent with the client’s environment. It is not our intention, in this paper, to empirically explain why audit firms prefer one type of audit approach over another. A number of potential explanations exist. However, one potential explanation that is implicitly rejected by our results is that audit structure differentiation emerged as a consequence of the dominant presence in structured auditors’ portfolios of clients in more stable environments. There is no evidence that the audit structure rating of the firms is associated with their client bases, as they existed in the mid-1970s. The reasons for the observed audit-structure environmental-stability relationship are also somewhat speculative at this stage. While we believe tbat this relationship is driven primarily by the cost advantages conveyed by different types of audit structure in different types of client environments, none of the analyses directly tested tbe role of audit costs. We did examine a sample of firms that cited lower fees as a motivation for changing their auditor. Firms choosing an auditor belonging to a different structure class tended to make a choice consistent with their environment. However, alternative explanations other than relative cost advantages could explain the observed results. For
Effect of Audit Structure on Audit Market
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example, the structured (unstructured) auditors in our sample may have chosen to specialize in industries that would be classified in this study as having stable (volatile) environments for reasons other than cost advantages. Since audit firms have sought to differentiate their product by differentiating themselves along lines of audit structure, it should not be surprising that audit structure has an effect on the relative market positions of these firms. The structure employed by a firm is an integral part of the way it conducts its business. The attention paid to this issue by the audit community is indicative of its importance. Our study has been exploratory in nature, and only examined broad trends in the audit market. The evidence we have provided, while consistently supporting a relationship between audit structure and client stability, should be viewed as being preliminary rather than conclusive. The results of this study point to a need for additional research in this area. An important direction for further research would be to explore in detail the linkages between audit methods, audit costs, and auditors’ market positions. We acknowledge the helpful comments and suggestions of Jane Mutchler and Kenneth B. Schwartz. This research was supportediu part by The Committee of 100, College of Business at Arizona State University, the Institute for Accounting Research and Education at Boston University, and the Peat Marwick Foundation.
References Amett, H. E. and Danos, P. 1979. CPA Firm Viability. AM Arbor, MI: Graduate School of Business Administration, The University of Michigan. Bamber, E. M., Snowball, D., and Tubbs, R. M. April 1989. Audit structure and its relation to role conilict and role ambiguity: An empirical investigation. The Ac-
counting Review 64(2):285-299. Bambex, E. M., Snowball, D., and Tubbs, R. M. April 1989. Audit structure and its relation to role conflict and role ambiguity: An empirical investigation. The Ac-
counting Review 54(2):285-299. Bedingfield, J. P. and Loeb, S. E. March 1974. Auditor changes-an
examination. The
Journal of Accountancy 137(3):66-69. Berton, L. January 28, 1985. Audit fees fall as CPA firms jockey for bids. The Wall Street Journal p. 33. Bourgeois, L. J. September 1985. Strategic goals, perceived uncertainty, and economic performance in volatile environments. Academy of Management Journal
28(3):548-573. Bums, T. and Stalker, G. M. l%l. Tavistock.
The Management
Chow,
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Research Opportunities in Auditing: The Second Decade (A. R. Abdel-khalik and I. Solomon, 4s.).
Sarasota, FL: American Accounting Association, pp. 155-183.
Cushing, B. E. and Loebbecke, J. K. 1986. Comparison of Audit Methodologies Large Accounting Firms. Sarasota, FL: American Accounting Association.
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Danos, P. and Eichenseher, J. W. October 1986. Long-term trends toward seller concentration in the U.S. audit market. The Accounting Review 61(4):633-650. Dirsmith, M. W. and McAllister, J. P. Spring 1982. The organic vs the mechanistic audit. Journal of Accounting, Auditing & Finance 5(3):214-228. Downey, H. K. and Slocum, J. W. September 1975. Uncertainty: Measures, research, and sources of variation. Academy of Management Journal 18(3):562-577. Duncan, R. B. September 1972. Characteristics of organizational environments and perceived environmental uncertainty. Administrative Science Quarterly
17(3):313-327. Eichenseher, J. W. and Shields, D. Spring 1983. The correlates of CPA-firm change for publicly-held corporations. Auditing: A Journal of Practice and Theory
2(2):23-37. Grobstein,
M. and Craig, P. W. Spring
1984. A risk analysis approach
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Auditing: A Journal of Practice and Theory 3(2): 1- 16. Kinney, W. R. March 1986. Audit technology and preferences for auditing standards. Journal of Accounting and Economics 8(1):73-89. Kinney, W. R. Spring 1988. Attestation research opportunities: 1987. Contemporary Accounting Research 4(2):416-425. Knapp, M. C. and Elikai, F. Winter 1988. Auditor changes: A note on the policy implications of recent analytical and empirical research. Journal of Accounting, Auditing & Finance 3(l) (new series) 78-86. Macintosh, N. 1985. The Social Software of Accounting and Information Systems. New York: Wiley. Mintzberg, H. 1979. The Structure of Organizations. tice-Hall . Mintzberg,
H. 1983. Structuring in Fives. Englewood
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Morris, M. H. and Nichols, W. D. April 1988. Consistency exceptions: Materiality judgments and audit firm structure. The Accounting Review 63(2):237-254. Mullarkey, J. F. 1984. The case for the structured audit. In Auditing Symposium I/II (H. F. Kettler, and N. A. Ford, eds.). Lawrence: University of Kansas Press, pp. 73-84. Newton, J. D. and Ashton, R. H. 1989. The association between audit technology and audit delay. Auditing: A Journal of Practice and Theory 8(supplement):22-37. Pennings, J. M. September 1975. The relevance of the structural-contingency model for organizational effectiveness. Administrative Science Quarterfy 20(3):393-410.
Public Accounting Report (PAR). February Public Accounting Report (PAR). February
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Simon, D. T. and Francis, J. R. April 1988. The effect of auditor change on audit fees: Tests of price cutting and price recovery. The Accounting Review 63(2):255-269.
Simunic, D. A. and Stein, M. T. 1987. Product Dz-rentiation in Auditing: Auditor Choice in the Market for Unseasoned New Issues. Vancouver, BC: Canadian Certified General Accountants’ Sullivan,
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J. D. 1984. The case for the unstructured audit approach. Symposium VZZ (H. F. Kettler and N. A. Ford, eds.). Lawrence: Kansas Press, pp. 61-68.
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Tosi, H., Aldag, R., and Storey, R. March 1973. On the measurement of the environment: An assessment of the Lawrence and Lorsch environmental uncertainty subscale. Administrative Science Quarterly 18(1):27-36. Who Audits America (1976 through 1986). Menlo Park, CA: The Data Financial Press. Williams, D. D. and Dirsmith, M. W. 1988. The effect of audit technology on auditor efficiency: Auditing and the timeliness of client earnings announcements. Accounting, Organizations and Society 13(5):487-508.
One way in which audit firms have begun structure employed in the audit approach. affects the relative competitiveness of the No single audit structure represents an attractiveness of each category of audit
to differentiate themselves is in the degree of In this paper we argue that audit structure auditor in different client-market segments. optimal choice for all clients. Rather, the structure is contingent upon the degree of
stability in the client’s environment. Trends in intra-Big Eight market shares over the period 1976 to 1986 show that the auditor preferences of consumers of audit services are consistent with the environment in which the clients operate. The client’s preference for a structured auditor increases with increased stability in the client’s operating environment. Clients in unstable environments seem to have a preference for unstructured auditors. We attribute these changes to cost advantages that structured auditors have in stable environments, and that unstructured auditors have in unstable environments.
Introduction The competitive structure of the market for audit services in the United States is an important issue for policy makers and practitioners alike. Competition among public accounting firms seems to have intensified in recent years. Clients are becoming more conscious of differences in audit quality and public accounting firms are becoming more aggressive in seeking new clients (Amett and Danos 1979, p. 50; Berton 1985, p. 33; Cushing and Loebbecke 1986, p. 41). Danos and Eichenseher (1986), who analyzed long-term trends in market share patterns, found increasing intra-Big Eight competition (p. 646), although the overall share of Big Eight firms increased over the period studied (p. 643). The increased competition has been accompanied by changes in the way in which the public accounting profession conducts its business. For example,
Address Xpitlt r~Ut%tS to Professor Krishmgopd Menon, School of Management, Boston University, 685 Commonwedth Avenue, Boston. MA 02215. Journalof Accounting
0 1990Elsevier
and Public
Science
Policy.
Publishing
CO.,
9, 197-215
Inc.
197
(1990) 02784254
/9Q/SO3.50
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significant changes have taken place in the public accounting profession’s ethical standards. Kinney (1988, p. 420) described the past 15 years as a “period of substantial relaxation of the AICPA’s ethical rules.” Major changes in advertising, solicitation, and competitive bidding, among other areas, have contributed to a more competitive climate. In this new competitive climate there is a high incidence of auditor switching. The Public Accounting Report (PAR) indicated that a record 737 publicly traded companies changed auditors in 1986, a 147% increase from 1981 (PAR 1987, p. l), while as many as 719 firms changed auditors in 1987 (PAR 1988, p. 2). Audit firms have sought to differentiate themselves in this competitive market in a number of ways. Several researchers (e.g., Simunic and Stein 1987, pp. 8-10) have suggested that the audit product itself is differentiated. Some firms have developed notable strengths in nonaudit accounting services, information systems, and general management consulting services. This paper focuses on another important change occurring among suppliers of auditing services, namely the degree to which the audit approach is structured. Cushing and Loebbecke (1986, p. 35) reported significant variation across audit firms in terms of the audit structure employed. While audit structure has been of interest to researchers (e.g., Kinney 1986; Bamber and Snowball 1988; Morris and Nichols 1988; Williams and Dirsmith 1988; Bamber et al. 1989), to date there has been little research on the effect of audit structure on competitiveness. Newton and Ashton (1989) did address this issue in their study. Newton and Ashton contended that a structured approach has inherent efficiencies (1989, p. 24) and that over time, clients would prefer structured auditors over unstructured ones (p. 34). However, their examination of the Canadian market did not show evidence of such a shift in client preferences (p. 34). Like Newton and Ashton, we believe that audit structure is directly related to the auditor’s competitiveness. We disagree with Newton and Ashton in that we argue that no single audit structure provides audit efficiences across all market segments. Rather, the type of audit structure adopted by a firm may give it a competitive edge in some segments of the audit market but not in others. In advancing this contingency perspective we focus primarily on expected differences in auditor production costs. However, audit structure may affect competitiveness in other ways, such as through its influence on the working relationships between auditor and client. In this paper, we report the results of a study which examined the association between a client’s environment and the audit structure employed by the client’s auditor. First, we examined auditors’ client portfolios over the period 1976 to 1986. Differences in audit structure were only just beginning to emerge in the early part of this period, but had become more pronounced by 1986. Thus, we hypothesized a positive association between audit structure and the client environment for 1986, but not for 1976. Next, we examined the displacement of auditors over the same period. It was expected that the
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selection of the successor auditor would follow a trend towards the matching of the client with the auditor whose structure corresponds with the client’s environment. Finally, we examined a sample of fee-driven auditor changes, to see if the expected relationship between auditor choice and client environment holds for this sample. In the next section we review relevant literature and discuss the research questions explored in this study. The third section describes the research methods employed and the results obtained. Implications of the study are presented in the final section.
Audit Structure and Competitiveness Audit Structure Cushing and Loebbecke (1986, p. 32) define a structured audit methodology as “a systematic approach to auditing characterized by a prescribed, logical sequence of procedures, decisions, and documentation steps, and by a comprehensive and integrated set of audit policies and tools to assist the auditor in completing the audit. ’ ’ ’ More broadly, Bamber and Snowball (1988, p. 492) defined a structured audit as “the extent to which auditors’ task related behaviors are subject to formalized prescriptions and restraints.” In their view (p. 492), the structured audit approach provides a “blueprint” for the performance of an audit that specifies the steps to be followed in carrying out audit t&S.* The field auditor’s discretion to ignore template specifications is restricted. On the other hand, an unstructured audit approach may be characterized by the relative absence of a template and the need for the audit team to exercise greater discretion during the conduct of the audit (Bamber and Snowball 1988, p. 492). Cushing and Loebbecke (1986, p. 35) ranked 12 national CPA firms according to the degree of structure they employed in an audit. In order to arrive at this ranking, they examined audit firms’ materials and assessed the nature and level of guidance provided by each firm. Firms classified as most structured laid greater stress on initial audit planning, used preprinted standardized materials more extensively, and relied more on quantitative audit techniques and decision aids. Several other recent studies have examined questions relating audit structure to auditor behavior. Morris and Nichols (1988, pp. 251-253) found an association between audit judgment consensus and the audit structure. Bamber
‘As Cusbittg and Loebbecke (1986, p. 32) note in their study, their concept of structure in the audit approach is similar to concepts proposed in an earlier study by Dirsmitb and McAllister (1982). Dirsmitb and McAllister (1982, p. 215) used the terms “organic” and “mechanistic,” rather than “unstructured” and “structored.” 2We prefer the term “template,” first suggested to us by a reviewer of this paper, to “blueprint” in describing the structured method, and use this term in the remainder of tie paper.
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and Snowball (1988) did not find a similar association (p. 499). However, they did find that members of unstructured firms tended to view their tasks as less analyzable and less routine (p. 497). Kinney (1986, p. 84) found that the voting pattern of the Auditing Standards Board appeared to be influenced by the structure of the firms with which the Board members were associated. Williams and Dirsmith (1988, pp. 501-503) found that clients employing unstructured audit firms took longer to release their earnings when earnings fell below expectations. Finally, Bamber et al. (1989, p. 293) found that audit seniors’ perceptions of their role stress differed systematically across firms with different degrees of audit structure.
Audit Structure and Client-Auditor
Fit
One of the espoused benefits of using a structured audit approach is the control of audit costs (Cushing and Loebbecke 1986, p. 42). Grobstein and Craig (1984, p. 16) and Mullarkey (1984, p. 82), among others, have also contended that structured approaches contribute to efficiencies in audits. Sullivan (1984, p. 64), on the other hand, suggested ways in which structured audits are inefficient, such as their disregard for qualitative evidence. Cushing and Loebbecke (1986, p. 43) also indicated that while it may help to control costs in “typical” audit environments, a structured approach designed to anticipate features of the typical audit environment may be more difficult to apply to the “atypical” environment. Newton and Ashton (1989, p. 24) posited a positive relationship between structure and efficiency. This led them to expect that structured auditors would tend to displace unstructured auditors over time (p. 34). They examined (p. 34) auditor changes in the Canadian market, expecting to observe a general change away from unstructured auditors to more structured ones. Their evidence showed that unstructured auditors actually increased their share of the firms in the sample, rather than losing share (p. 34). Our analysis of the cost efficiencies of audit structure builds upon the contingent perspective suggested by Cushing and Loebbecke (1986, p. 43). We argue that the selection of an audit approach affects the auditor’s production cost function, making it possible for the auditor to supply a lower cost audit for certain types of consumers while increasing the relative cost to the auditor of providing services to other types of consumers. One important determinant of the effect of audit structure on costs is the task environment of the individual auditor. If the auditor is operating in a stable task environment, then few deviations from programmed procedures may be Audit staff members would be able to accomplish their tasks necessary. expeditiously by following firm-supplied program aids. In the event of an unexpected contingency, staff members would resort to what Bamber and Snowball (1988, p. 493) term “coordination and control” mechanisms. These are mechanisms used to overcome inflexibility and achieve a fit between
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structured audit approaches and uncertain tasks. An example of such a mechanism is consultation with managers or supervisors. In a stable task environment, uncertainties may be few, and may require only minimal use of coordination and control mechanisms. While a structured approach would allow the systematic selection of audit procedures to meet specific objectives, the unstructured methodology may result in more unnecessary procedures being performed. The relative absence of firm-supplied decision aids requires the unstructured firm auditor to rely on individual discretion in making decisions that would be routinized in a structured approach. Inefficient choices may be made in such decisions as sample size selection. In a stable task environment, then, an unstructured audit may be more time consuming and inefficient. However, as the task environment becomes less certain, the relative cost advantages should shift. Bamber and Snowball (1988, p. 501) found that auditors from structured firms tended to rely more extensively on coordination and control mechanisms than unstructured firm auditors, in response to increasing task uncertainty. In making less use of these costly mechanisms, auditors from unstructured firms may be able to accomplish their tasks more efficiently. Additionally, if structured firm auditors are limited in their discretion to depart from procedures prescribed in the audit manual, they may perform unnecessary procedures only because of a need to comply with the standardized instructions. In a dynamic task environment, a structured audit may be more time consuming and inefficient than an unstructured audit. The stability of the auditor’s task environment is likely to be related to the stability of the client’s environment. The organizational theory literature has consistently posited a relationship between an organization’s structure and the stability of its environment, suggesting that “mechanistic” structures “fit” stable environments, while “organic” structures fit dynamic environments (e.g., Bums and Stalker 1961; Mintzberg 1979). According to Mintzberg (1983, p. 137), for example, in a stable environment the organization can easily protect its operating core and standardize its activities, establishing rules and formalizing procedures. Dynamic environments pose uncertainties that require more flexible and less formal coordination and control mechanisms, as well as more responsive decision-making systems.3 Audit clients operating in a stable environment are likely to have standardized systems, routinized procedures, and relatively formal and elaborate organizational structures. This leads to a stable task environment for the auditor. The use of a template in these circumstances should reduce the amount of judgment and time required to conduct the audit. The relative stability of the environment also makes it more likely that a template used in one year can be
3Contingency researchers have exploredthe relationship between the environment and internal accounting and information systems. For a summary of this research, see Macintosh (1985).
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modified easily for use in subsequent years, as well as allow for the use of similar templates in firms from the same industry. Unstructured audits are likely to be more costly for clients in such environments because of their reliance on the discretionary judgments of audit staff. On the other hand, an unstructured audit approach may have production cost efficiencies for consumers operating in a dynamic environment. A firm that faces a rapidly changing environment is generally unable to standardize procedures or establish a formal organizational structure to the same extent as a firm in a stable environment. The auditor’s task environment will be more uncertain. This makes the use of a template more difficult. Because the environment is changing quickly and unexpectedly, a template will be able to provide only limited guidance to the auditor without significant and costly changes being made to it during the audit. Audits for firms in dynamic environments are likely to involve substantially more unexpected contingencies that call for discretionary judgments. The lower cost suppliers are likely to be those who routinely employ judgment intensive methods and are experienced in responding to unstructured situations. Thus, we would expect unstructured auditors to be better placed to deliver cost-efficient services to consumers in a dynamic environment. Relative production cost advantages should be reflected in audit product pricing over the long term. The increasing competition in the audit market has resulted in the competitive pricing of services (Berton 1985, p. 33). Prior research has provided evidence of the importance of price in auditor selection and retention decisions (Bedingfield and Loeb 1974, p. 68; Eichenseher and Shields 1983, p. 30; Simon and Francis 1988, p. 263). A recent survey reported that 37% of the firms that changed auditors in 1987 claimed to be replacing their existing Big Eight auditor because of excessive fees (PAR 1988, p. 3). We expect that the differentiation of audit firms along the lines of audit structure has led to unstructured firms having a competitive edge in certain market segments and structured firms the edge in others, through relative cost advantages. However, cost differentials may not be the only, nor indeed the principal effect of audit structure on the competitiveness of the auditor. The presence of a fit between the auditor’s structure and the client’s environment may convey other kinds of benefits. For example, it is plausible that auditor structure may affect the working relationships between auditor and client. A good working relationship was found to be a critical factor in auditor retention decisions in a survey conducted by Eichenseher and Shields (1983, pp. 29-30). A structured audit may be more congruent with the organizational culture of a client in a stable environment. That is, both the auditor and the client may prefer structured approaches to organizational control issues. Clients in stable environments may believe that the structured audit would be a more effective approach for their firm. On the other hand, an unstructured audit approach may be congruent with the organizational culture of dynamic clients, who tend to use less structured and more informal control systems.
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Audit structure differentiation is likely to have begun to make its impact on the relative market positions of the major suppliers only in recent years. Differences in audit structure only began to emerge in the mid-1970s (Cushing and Loebbecke 1986, p. 1). It has taken a number of years for each firm to formulate an approach that is consistent with its strategy and capabilities, and to develop the necessary technology and expertise to implement the approach. Now that developments in audit structure are more than a decade old, their effect on auditor selection decisions should be discernible. Our analysis was restricted to Big Eight auditors.4 The differences between Big Eight and non-Big Eight auditors in terms of such product characteristics as credibility and product line scope are likely to have been substantial enough to confound our findings. Restricting the sample in this manner has the consequence of limiting the insights obtained from the study to the Big Eight sector of the audit market. However, Big Eight firms are so dominant in the audits of publicly traded companies as to make the understanding of this market sector important in its own right. The primary emphasis of the empirical part of this study was the analysis of the relationship between audit structure and client environmental stability over the period 1976 to 1986. This analysis was conducted on two different sets of firms: the first a set representing all firms, and the second a set of firms making auditor changes over the period. We expected that the client portfolios of the audit firms would change in a manner consistent with the firms’ audit structure. On a cross-sectional basis, the stability of the client’s environment should be positively correlated with the audit structure employed by its auditor. Firms changing auditors should show a marginal preference for the matching type of auditor. A secondary analysis was conducted to see whether there is any support for attributing clients’ auditor preferences to cost advantages conveyed by structure. In this analysis, we tested the hypothesized audit-structure environmental-stability relationship on a sample of companies whose motivation for changing auditors was to reduce audit fees. In the next section, we describe the research methods employed and the results obtained.
Method and Results The analyses performed in this study required the use of surrogate measures for audit structure and client environmental stability. The measure used to represent the degree of audit structure (AS) adopted by each Big Eight firm is the one developed by Kinney (1986). While Kinney (1986) does not report the rating for each firm, these ratings are disclosed in Morris and Nichols (1988, p. 241). Kinney reports (p. 83) that his rankings are consistent with those
4T~o mergers between Big Eight firms have taken place in the period since the study was conducted, reducingto six the numberof independentfirms in this class of auditors.
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Table 1. Audit Firm Structure (AS) Ratings“ Firm
AS Rating
Deloitte Ha&ins & Sells Peat Mat-wick Mitchell Touche Ross Arthur Andersen Arthur Young Ernst & Wbinney Coopers & Lybrand F’rice Waterhouse
15 15 13 11 10 10 5 5
Classification Structured Structured StNCtURd
Intermediate Intermediate Intermediate Unstructured Unstructured
“These ratings were developed by Kinney (1986) and subsequently reported in Morris and Nichols (1988, p. 241). The classification of firms into structured/intermediate/unsuuctured types is also taken from Kinney (1986, p. 84).
developed by Cushing and Loebbecke (1986). The AS ratings are presented in Table 1. Kinney classified the eight firms into three groups: structured, intermediate, and unstructured. This classification is also presented in Table 1. A measure for environmental stability (ES) was developed for each client by computing the coefficient of variation for the first difference in sales in the industry in which the firm operates. This metric was first proposed by Bourgeois (1985, pp. 555-556). Other objective measures of environmental stability/volatility have been proposed by organizational theorists (e.g., Tosi et al. 1973). Bourgeois argued that a measure based on first differences of sales is free of influences from major trends and is a true indicator of discontinuities.’ The metric suggested by Bourgeois (1985, p. 556) is presented in equation 1.
ES, = xj
(1)
where: ES, = the environmental stability measure for industry j, Xti = the first difference in sales for industry j for year i, Xj = the mean Xti for industry j, t is an index for year, with a maximum value of 5, and j is an index for the industry. Following Bourgeois’ method, ES,s were computed for each industry using six consecutive years of sales, ending in the year of interest (which yielded five first differences). The three-digit SIC code was used as the basis for grouping
sEnvironmental stability has often been operationalized by organizational theorists using perceptual measures taken from organizational members (Duncan 1972; Downey and Slocum 1975; Pennings 1975). Because of the large number of firms in this study and need for measures of stability for a prior period, it was not feasible to use a perceptual measure. We chose to rely on an objective measure.
Effect of Audit Structure on Audit Market
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firms into industries. Using Bourgeois’ measure results in clients in the same industry being assigned the same value for environmental stability. The environmental stability measure for each client i is denoted ES, in this paper. Bourgeois’ use of industry sales in computing environmental stability is based on the assumption that the uncertainty faced by a firm is largely related to the rate of change in the industry. It equally could be contended that firm-specific environmental uncertainty is more likely to be related to the volatility of the firm’s own sales, which should reflect both industry-related and firm-specific factors. We tested the sensitivity of our results to this assumption by using two different ES, metrics, one computed at the industry level and the other specific to the firm. The results obtained for the two sets of analyses were very similar. However, sample sizes for the analyses using the firm-specific metric were significantly smaller than for analyses using the industry-level metric. Results obtained for the analyses using the firm-specific metric are reported in footnotes.
Incumbent Auditor Analysis The incumbent auditor analyses employed a cross-sectional data set representing all publicly traded firms. The set was drawn from the expanded COMPUSTAT II database.6 In order to be included in the set, the firm had to have a Big Eight auditor. Additionally, we restricted our analysis to industries that had a minimum of 20 firms listed on COMPUSTAT II. The set included samples for 1976 and 1986. The 1976 sample consisted of 3939 firms, while the 1986 sample contained 5 119 firms. Data to compute ES,s were obtained from COMPUSTAT II. Information on the client’s incumbent auditor also was obtained mainly from COMPUSTAT II, supplemented where necessary by reference to Who Audits America (1976- 1986).’ First, we examined the client portfolio of each Big Eight auditor, to see if there is a correlation between the audit structure adopted by the auditor and the environmental stability faced by its clients. The stability of the portfolio of clients held by each Big Eight firm was measured as the average client stability, weighted by the size (and thereby presumably the importance) of the client. The formula used to compute average client stability is presented in equation 2. ACS” = C(ESi”(Si” / CSin))
(2)
%OMPUSTAT II contains financial and auditor data for approximately 10,000 publicly traded coypanies that are registered with the Securities and Exchange Commission (SEC). In computing ACS (see p. 10) for each audit firm, clients who received a disclaimer of opinion from their auditors were excluded (31 in 1976, 19 in 1986) on tbe grounds that the auditor did not provide a complete audit of the financial statements.
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Table 2. Audit Structure (AS) Rating and Average Client Stability (ACS) Firm Deloitte Haskins & Sells Peat Marwick Mitchell Touche Ross Arthur Andersen Arthur Young Ernst & Whinney Coopers & Lybrand Price Waterhouse
AS Rating
1976 ACS
(n)
1986 ACS
(n)
15 15 13 11 10 10 5 5
1.22 1.20 1.23 1.29 1.32 1.19 1.36 1.16
(390) (583) (366) (738) (362) (517) (481) (502)
1.58 1.53 1.45 1.61 1.54 1.70 1.70 1.78
(495) (786) (512) (923) (488) (702) (644) (569)
where: ACS, = average client stability measure for auditor n, ES,, = environmental stability for client i (equal to ES,, where client i belongs to industry j) of auditor n, Si, = log of sales for client i of auditor n, and i, j, and n are indices for client, industry, and audit firm, respectively. If there is a tendency for client firms to be attracted to cost-efficient auditors, and if audit structure affects supplier production costs as described in the previous section, then the client portfolio of the CPA firms should show different characteristics. Independent auditors with higher AS ratings (indicating more structured approaches) can be expected to have lower ACS values (indicating more stable environments) than those with lower AS ratings. We computed ACS for each Big Eight auditor for 1976 (the first year of the period we examined) and for 1986 (the last year). Table 2 shows ACS for each of these years, along with the auditor structure (AS) rating. Limiting the number of observations to the eight CPA firms considered in the study weakens any statistical test for association. However, a test for rank correlation shows no evidence of association between AS and ACS in 1976 (Spearman’s correlation coefficient = -0.27, p = 0.51), but a significant association in 1986 (Spearman’s correlation coefficient = -0.78, p = 0.02).8
sThe metric used here to represent an auditor’s client portfolio gives greater weight to larger clients. Alternative metrics could have been used. For example, an unweighted portfolio metric could have been employed; i.e., ACS, = XES,,/k, (where k, = the number of clients belonging to auditor n). We correlated these unweighted AC.3 measures for the Big Eight auditors with audit structure. The results were similar to those for the weighted portfolio metric. There was no significant association between average client stability and audit structure in 1976 (Spearman’s correlation = - 0.17, p = 0.69). ACS and AS were statistically correlated in 1986 (Spearman’s correlation = - 0.68, p = 0.06). A series of pairwise comparisons (using Tukey’s test) showed statistically significant differences between mean ES, values in three cases in 1986 (Price Waterhouse-Deloitte Haskins & Sells, Price Waterhouse-Peat Marwick Mitchell, and Price Waterhouse-Touche Ross) and two cases in 1976 (Coopers & Lybrand-Price Waterhouse and Coopers & Lybrand-Arthur Young). The 1986 differences are consistent with our expectation, but the 1976 difference between Coopers & Lybrand and Price Waterhouse, two unstructured firms, is difficult to interpret.
Effect of Audit Structure on Audit Market
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The change in the relationship between audit structure and average client stability of the Big Eight firms from 1976 to 1986 is consistent with our expectation. According to Cushing and Loebbecke (1986, p. 1) and others, major changes in the auditing methodologies of the large accounting firms were introduced in the period following the mid-1970s. There was only limited differentiation in firms’ audit structure in the mid-1970s. Our analysis shows little relationship between audit structure and average client stability at that time. However, audit structure and the environmental stability of clients appear to be related in 1986, by which time significant differences in audit structure are known to have existed. If client stability is associated with auditor selection, we would expect to find a positive cross-sectional correlation between the client’s environmental stability measure (ES,) and the audit structure measure of its CPA firm (AS). We computed the correlation coefficient for these two variables, for each of the years 1976 and 1986. There was no correlation at all between AS and ES, for the 1976 sample (Pearson’s correlation coefficient = -0.01, p = 0.65). A small, but statistically significant, negative correlation was observable for the 1986 sample (Pearson’s correlation coefficient = -0.08, p = 0.04).9 The absence of a correlation in 1976 is not surprising. The recency of the development of audit structure differentiation leads to the expectation that there should indeed be no association between AS and ES, in 1976. This would be consistent with the results of the analysis in the previous section. The existence of a statistically significant correlation in 1986 may be an indication that audit structure is beginning to emerge as an important factor in audit market dynamics. However, the observed correlation is very small.”
Auditor Change Analysis Prior researchers have documented a number of reasons for firms to change auditors. ‘I This paper suggests that the fit between audit structure and environmental stability is another factor influencing a firm’s selection of an auditor. A
‘In order to control for the effect of client size in this analysis, two regressions were run, one each for 1976 and 1986, using AS as the dependent variable and ES, and the log of the client firm’s sales as independent variables. The regression results were consistent with the reported correlations. While statisticaUy significant models were obtained, the R-squared values were very low (less than 1%). The coefficient for the independent variable ES, was negative in each case, but significant (p c 0.01) only in 1986. The cocfficiene for the size was negative and significant in both models. “The incumbent auditor analysis was repeated using a firm-specific environmental stability metric. ESi was recomputed by substituting firm sales data for industry data in equation (1). Average client stability (ACS) was then computed for each auditor. Again, ACS was significantly correlated with AS only in 1986 (1986: S pearman’s correlation = -0.81, p = 0.01; 1976: Spearman’s correlation = 0.1, p = 0.82). A cross-sectional correlation between firm-specific ESj measures and AS was also conducted. As with the industry level analysis, a small but significant negative correlation was detected for 1986 (1986: Pearson’s correlation = -0.04, p = 0.04; 1976: Pearson’s correlation = -0.01, p = 0.77). “Chow et al. (1988) and Knapp and Elikai (1988) identify many of the important contributions to the auditor changes literature.
ma
S.
E. Kaplan
et al.
sample of firms making auditor changes should show, in aggregate, a tendency to select an auditor who employs an approach that matches the firm’s environment. Clients in relatively stable environments should show a tendency to displace unstructured auditors with more structured ones, while clients in relatively unstable environments should tend to prefer unstructured auditors. The sample of firms used in this analysis consisted of 950 clients who changed from one Big Eight auditor to another over the period 1977 to 1986. Again, data on auditor changes were obtained from COMPUSTAT II, supplemented where necessary by data from Who Audits America. Two related tests were performed. The first test examined the characteristics of the Big Eight firms’ new client pool. Clients making auditor changes were partitioned into two sets: 1976- 1981 changes and 1982-1986 changes. Client environmental stability measures (ES,) were used to compute a measure of new client stability for each auditor, NCS, for each of the two periods examined. NCS, for each auditor n, was defined as the mean of the ES, values for the new clients acquired by auditor n. NCS values for the first period were computed using 1981 ES, values, while NCS values for the second period were computed using 1986 ES, values. More structured auditors were expected, on average, to be more attractive to clients in relatively stable environments, while unstructured auditors were expected to attract clients in more volatile environments. This would then result in NCS decreasing as the auditor structure increased. However, this relationship was only expected to exist in the more recent period, in view of the recent differentiation of firms’ audit structure. Table 3 shows the NCS for each Big Eight auditor, along with the auditor’s structure (AS) rating, for each of the two periods examined. The analysis showed that clients switching auditors appear to have a preference for an auditor that matches the client’s environment. As expected, this preference is evident only in the later period examined. The correlation between NCS and AS was not significant in 1977 to 1981 (Spearman’s
Table 3.
Audit Structure (AS) Rating and New Client Stability (NCS)
FirIll Deloitte Haskins 8c Sells Peat Marwick Mitchell Touche Ross Arthur Andersen Arthur Young Ernst & Whinney Coopers & Lybrand Price Waterhouse
AS Rating 15 15 13 11 10 10 5 5
1977- 1981 NCS (n)
1982- 1986 NCS (n)
1977- 1986 NCS 00
1.60 1.62 1.19 1.70 1.93 1.75 1.58 1.90
1.47 1.13 1.38 1.79 1.65 1.49 2.07 1.64
1.50 1.28 1.29 1.75 1.75 1.59 1.86 1.76
(24) (44) (47) (86) (31) (54) (59) (44)
(59) (99) (54) (86) (60) (89) (76) (47)
(83) (143) (101) (163) (91) (143) (135) (91)
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Effect of Audit Structure on Audit Market
Table 4.
Direction of Auditor Changes
A. Auditor
Changes During
1977-1981 Successor
Predecessor
Auditor
Unstructured Intermediate Stmctwxl Total B.
Unstructured
Auditor
Intermediate
Total
StlUCtUred
18 45 40
47 47 68
28 50 37
93 142 145
103
162
115
380
AuditorChangesDuring 1982-1986 Successor
predecessor
auditor
Unstructured Intermediate Structured Total
Unstructured
Intermediate
Auditor Structured
Total
18 62 43
69 80 86
64 88 60
151 230 189
123
235
212
570
correlation coefficient = -0.39, p = 0.34). It was significant in the 1982 to 1986 period (Spearman’s correlation coefficient = -0.77, p = 0.04). However, while the ordering of NCS and AS were negatively correlated in this period, a series of pairwise comparisons, using Tukey’s test, showed a statistically significant difference between mean ESi values for only one pair of CPA firms (Peat Marwick Mitchell and Coopers & Lybrand). When auditor changes for the two periods were combined, NCS and AS were negatively correlated (Spearman’s correlation coefficient = -0.89, p = O.Ol).‘* A second test was conducted to see whether the direction of the auditor change made by client firms was consistent with the hypothesized auditor-structure environment-stability relationship. For this test, we grouped auditors into the three classes identified by Kinney (1986, p. 84), that is, structured, intermediate, and unstructured (see Table 1). Table 4 shows the number of firms changing from and to each of these three classes. If the arguments made in this paper are valid, firms changing to a more structured auditor than their incumbent auditor should be in more stable environments, on average, then those seeking a less structured auditor. In order to test this, the sample of firms changing auditors for each of the two periods, 1977-1981 and 1982-1986, were classified into two groups: those changing to an auditor with a more structured approach (MS), and those
‘*An alternative way of assessing this association between the client tim’ environmental stability and the successor auditors’ struchlre is simply to correlate AS and ES,. For the firms which changed auditors in the 1977 to 1981 period the correlation between AS and ES, was not significant (Pearson’s correlation = -0.05, p = 0.33). However, a significant correlation was obtained for the sample of firms changing auditors in the 1982 to 1986 period (Pearson’s correlation = - 0.11,
p=
0.01).
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choosing a less structured auditor than the incumbent (LS). Firms making changes within the same audit structure class were omitted.i3 In the 1977-1981 period, the MS group contained 125 firms, while the LS group had 153 firms. The MS group had 221 firms in the 1982 to 1986 period, while the LS group consisted of 191 firms. Mean ES, values were significantly different between these groups for the 1982 to 1986 period (MS group mean ES, = 1.38, LS group mean = 1.90, t value = 2.53, p = O.Ol), with clients selecting more structured auditors tending to belong in more stable environments. The difference in stability between the groups for the 1977 to 1981 period was not significant (MS group mean ES, = 1.45, LS group mean ES, = 1.75, t value = 1.11, p = 0.27).14
Analysis of Fee-Motivated Auditor Changes While the prior analyses provide some evidence that auditor-client pairings are influenced by the match between the auditor’s structure and the client’s environment, they do not shed light on the reasons for this relationship. Earlier in this paper, we had offered as one potential explanation the argument that each type of audit approach conveys cost advantages for certain types of clients. The reflection of these cost advantages in prices could result in auditors and clients being matched in the manner observed. A direct test of this hypothesis requires audit cost information, which, unfortunately, is not publicly available. However, the Public Accounting Report annually identifies firms that cited audit fees as a reason for changing auditors. If cost advantages flow from audit structure differentiation, this should be reflected in a sample of firms that have been motivated by price to change auditors. A sample of 153 firms that changed from one Big Eight auditor to another over the period 1984 to 1986, citing reduced fees as a motivation, was obtained from the Public Accounting Report. Table 5 shows the direction of the changes, using the unstructured-intermediate-structured trichotomy to classify both the old and new auditors.
‘sFirms making changes within an audit structure class were omitted because the focus of this analysis is the client’s attraction for a new auditor with a different structure. that more closely matches the client’s environment. Changes between firms of equivalent structure simply cannot be explained within the framework proposed in this paper. Indeed, the ES, values for the firms in this category did not show any detectable pattern. 14The analyses for the sample of firms changing auditors were repeated using the firm-specific metric of client stability rather than the industry-level metric. Insufficient data for ES, calculations for a number of these firms resulted in the sample size being reduced to 306 firms. However, the results were consistent with those repotted for the industry-level metric. NCS (new client stability) was computed for each auditor as the mean of its new clients’ ES,s, where ESi was based on the client firm’s sales volatility. These NCS measures were correlated with AS at statistically significant levels in the 1982 to 1986 period but not in the 1977 to 1981 period (1982 to 1986: Spearman ‘S correlation = -0.84, p = 0.01; 1977-1981: Spearman’s correlation = 0.40, p = 0.33). t tests showed that mean ES, values of the MS group were less than mean ESi values of the LS group only for the 1982 to 1986 period (1982-1986: MS group mean = 1.94, LS group mean = 2.65, t value = 2.16, p = 0.03; 1977-1981: MS group mean = 2.17, LS group mean = 2.40, t value = 0.64, p = 0.52).
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Effect of Audit Structure on Audit Market
Table 5. Direction of Price-Motivated
Auditor Changes (1984- 1986) Successor Auditor
Predecessor Auditor
Unstructured
Intermediate
StNCtUd
Total
Unstructured Interndiate Structured
4 18 9
13 12 35
17 35 10
34 65 54
Total
31
60
62
153
ES, measures were computed for these firms for 1986. Three firms had missing data. Omitting these firms resulted in a sample of 150 firms at this stage. Clients’ ES, measures were associated with the successor auditors’ AS ratings at a statistically significant level (Pearson’s correlation coefficient = -0.20, p = 0.01). However, this correlation by itself does not reveal whether the direction of the auditor change was consistent with the audit structure, environmental-stability hypothesis. In order to assess this, the sample was divided into firms changing to a more structured auditor (MS) and firms moving to a less structured auditor (LS). There were 65 firms in the MS group and 62 in the LS group. Firms making changes within an audit structure class were omitted. Mean ES, values for the MS and LS groups were then compared. As expected, firms selecting more structured auditors tended to belong in more stable environments (MS group mean ES, = 1.53, LS group mean = 2.53, t value = 2.08, p = 0.04).15 While this result provides some support for the argument that certain audit approaches have cost advantages for clients in certain types of environments, it is by no means unambiguous. Disconfirming results from this test would have been a clear rejection of the cost advantages argument, but confirmatory results obtained could be explained by factors other than audit costs. It is plausible that some omitted variable could explain why clients in more volatile environments are attracted to unstructured auditors and clients in relatively stable environments are attracted to structured auditors in both the entire population of auditor switching firms and the sample of fee-motivated switchers.
Conclusion This study has been motivated by the tendency for many major CPA firms to develop more structure in their audit approaches. Previous researchers have documented these changes and demonstrated their importance in audit practice
“Using a firm-specific Es, metric rather than an industry-level metric provided similar results. The additional data rqtdrements resulted in the sample of fee-motivated changes shrinking to 52. The mean ES, for the LS group (3.50) was higher than the mean for the MS group (2.17). The difference was significant (t-value = 2.03, p = 0.05).
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(see, for example, Cushing and Loebbecke 1986; Grobstein and Craig 1984). There has also been recognition that the cost structure of audit services is likely to be affected by these changes. Some authors have suggested that structured audits inevitably result in lower audit costs. We maintain that a structured audit approach conveys benefits in some situations, but an unstructured approach may have advantages in others. Specifically, the relative advantage of a structured approach may be contingent upon the stability of the client’s environment. For example, a relatively unstructured audit is likely to be cost efficient for clients in unstable environments, while a structured approach is likely to be more efficient for clients in stable environments. While there has been some increase in the audit structure in the industry as a whole in recent years, the major CPA firms have increasingly differentiated themselves in terms of the extent of structure employed. Any ensuing differences in attractiveness to clients should translate into changes in the market positions of these firms. We examined the client portfolios held by different Big Eight auditors and changes in these portfolios to see if there is any evidence of an audit structure effect. A number of tests were performed with consistent results. The evidence supported the principal thesis of this paper. Irma-Big Eight market shares in different client market segments have changed in recent years in a manner consistent with the audit structure the firm has adopted. There has been a tendency for the more structured firms in the Big Eight to increase their share of clients in stable environments, while more unstructured firms have increased their share of client firms in unstable environments. Client firms changing their auditor have shown a preference for a successor auditor whose approach is more consistent with the client’s environment. It is not our intention, in this paper, to empirically explain why audit firms prefer one type of audit approach over another. A number of potential explanations exist. However, one potential explanation that is implicitly rejected by our results is that audit structure differentiation emerged as a consequence of the dominant presence in structured auditors’ portfolios of clients in more stable environments. There is no evidence that the audit structure rating of the firms is associated with their client bases, as they existed in the mid-1970s. The reasons for the observed audit-structure environmental-stability relationship are also somewhat speculative at this stage. While we believe tbat this relationship is driven primarily by the cost advantages conveyed by different types of audit structure in different types of client environments, none of the analyses directly tested tbe role of audit costs. We did examine a sample of firms that cited lower fees as a motivation for changing their auditor. Firms choosing an auditor belonging to a different structure class tended to make a choice consistent with their environment. However, alternative explanations other than relative cost advantages could explain the observed results. For
Effect of Audit Structure on Audit Market
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example, the structured (unstructured) auditors in our sample may have chosen to specialize in industries that would be classified in this study as having stable (volatile) environments for reasons other than cost advantages. Since audit firms have sought to differentiate their product by differentiating themselves along lines of audit structure, it should not be surprising that audit structure has an effect on the relative market positions of these firms. The structure employed by a firm is an integral part of the way it conducts its business. The attention paid to this issue by the audit community is indicative of its importance. Our study has been exploratory in nature, and only examined broad trends in the audit market. The evidence we have provided, while consistently supporting a relationship between audit structure and client stability, should be viewed as being preliminary rather than conclusive. The results of this study point to a need for additional research in this area. An important direction for further research would be to explore in detail the linkages between audit methods, audit costs, and auditors’ market positions. We acknowledge the helpful comments and suggestions of Jane Mutchler and Kenneth B. Schwartz. This research was supportediu part by The Committee of 100, College of Business at Arizona State University, the Institute for Accounting Research and Education at Boston University, and the Peat Marwick Foundation.
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