2012 - W. Robert Knechel

Audit Quality: Insights from the Academic Literature
W. Robert Knechel
Frederick E. Fisher Eminent Scholar in Accounting
Fisher School of Accounting
University of Florida
Gainesville, FL 32611
Phone: 352-273-0215
Email: [email protected]
Gopal V. Krishnan
Professor
Department of Accounting & Taxation
Kogod School of Business
American University
Washington, DC 20016
Phone: 202-885-6460
Email: [email protected]
Mikhail Pevzner
Assistant Professor
George Mason University
School of Management
4400 University Drive, MS 5F4
Fairfax, VA 22030
Phone: (703) 993-1755
E-mail: [email protected]
Lori Shefchik
PhD Candidate
College of Management
Georgia Tech
800 West Peachtree Street NW
Atlanta, GA 30308
Phone: 404-385-1388
Uma Velury
Professor
University of Delaware
Department of Accounting and Management Information Systems
Newark, Delaware 19716
Phone: (302) 831-1764
October 31, 2012
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AUDIT QUALITY: INSIGHTS FROM THE ACADEMIC LITERATURE
Summary
This study presents a review of academic research on audit quality. We begin with a review of
existing definitions of audit quality and describe general frameworks for establishing audit
quality. Next, we summarize research on indicators of audit quality, such as inputs, process, and
outcomes. Finally, we offer some suggestions for future research. The study should be useful to
academics interested in audit quality as well as to the Public Company Accounting Oversight
Board (PCAOB) and other regulators.
Keywords: Audit quality; audit quality indicators; auditor judgment; PCAOB synthesis
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AUDIT QUALITY: INSIGHTS FROM THE ACADEMIC LITERATURE
INTRODUCTION
Audit quality is much debated but little understood. Despite more than two decades of
research, there remains little consensus about how to define, let alone measure, audit quality. The
objective of this study is to review and synthesize the academic literature on audit quality and
propose ideas for future research. To start, it is important to note that the perception of audit
quality can depend very much on whose eyes one looks through. Users, auditors, regulators and
society—all stakeholders in the financial reporting process—may have very different views as to
what constitutes audit quality, which will influence the type of indicators one might use to assess
audit quality. The user of financial reports may believe that high audit quality means the absence
of material misstatements. The auditor conducting the audit may define high audit quality as
satisfactorily completing all tasks required by the firm’s audit methodology. The audit firm may
evaluate a high audit quality as one for which the work can be defended against challenge in an
inspection or court of law. Regulators may view a high quality audit as one that is in compliance
with professional standards. Finally, society may consider a high quality audit to be one that
avoids economic problems for a company or the market. In the end, different views suggest
different metrics.
Much like the Hindu parable of the four blind men identifying an elephant from narrow
but diverse viewpoints, all these perspectives are correct … to an extent. But all views are also
incomplete.1 Audit quality reflects a similar challenge, with a significant exception: the observers
can see just fine but the focus of attention is hard to define. While it would be ideal to define
1
The most famous version of this parable in English is captured in the 19th century poem "The Blind Men and the
Elephant" by John Godfrey Saxe (1816–1887). One man believed he was touching a tree (leg), another a wall
(chest), a third a snake (trunk), and a fourth a spear (tusk). The story appears in different forms in many cultures
from the Mideast through Asia with variations in the number of blind men involved.
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audit quality for what it “is,” the reality is that researchers, regulators and professionals can often
do no more than describe what high audit quality “is not,” i.e., in terms of errors or deficiencies
that reduce audit quality.2
To reconcile different viewpoints, and to begin to understand what the absence of high
quality may look like, we first adopt a theoretical frame through which we can view the notion of
audit quality. This framework will help to identify the fundamental characteristics against which
the quality of an audit can be discussed. For the purpose of this paper, we shall start with a
general observation: An audit is a professional service delivered by experts in response to
economic and regulatory demand. Expanding on this rather obvious statement, we can identify a
number of characteristics that could influence audit quality (refer to Knechel 2010):
 An audit is an economically motivated response to risk, i.e., incentives matter.
 The output of an audit is a report but the outcome is uncertain and

unobservable. While audit quality might be generally believed to be high or
low, it is not possible to “know” the residual risk of an engagement (achieved
assurance level), i.e., uncertainty matters.3
 Each engagement is different. The idiosyncratic nature of an audit arises due

to variations in client characteristics, audit teams, timing of work, and
assessed risk and procedures used, i.e., uniqueness matters.
 The audit is a systematic activity, i.e., process matters.
 The execution of the audit process depends on appropriately leveraging the

knowledge and skills of experts, i.e., professional judgment matters.
As we will show below, audit quality depends on how these fundamental characteristics manifest
in any given engagement. For example, if the outcome of an audit is considered to be
2
In this sense, the difficulties encountered in trying to define audit quality are similar to those related to defining
auditor independence. While there is a general “understanding” of what independence means, many definitions
adopt a negative perspective by focusing on a lack of independence, rather than a positive focus which would
emphasize what independence is. The problem arises because it is much easier to observe when independence is
lacking and very difficult to observe when independence is present, i.e., an absence of impairments to independence
is not the same as actually being independent.
3
The audit risk model embeds the assumption that the outcome of the audit is not zero risk (or perfect assurance).

unobservable, it is difficult to define audit quality in terms of an achieved outcome.4 In contrast,
the audit process is observable but the idiosyncrasies of the client means that professional
judgment is used to decide how the systematic process should be applied. A broader issue is
whether the systematic process is even appropriate. We will explore these issues in more detail
as we discuss the extant literature on audit quality later in the paper.
The paper makes several contributions to existing research. First, we develop a
framework for synthesizing and understanding research related to audit quality. The framework
includes linkages across the primary attributes of the audit (incentives, uniqueness, process,
uncertainty and judgment) and among the different aspects of the audit—inputs, process,
outcomes and context. Thus, we use a “balanced scorecard” approach to understanding audit
quality. Second, we extend the work of Francis (2011) in several important ways by presenting a
comprehensive review of the academic literature on audit quality.5 While Francis (2011) takes a
supply-side perspective and focuses on archival-based audit research, we include a broader
perspective by also including behavioral, experimental, and survey method research.6 Third, in
the spirit of advancing our knowledge about audit quality, we offer many suggestions for future
research for both the primary attributes of the audit as well as the different aspects of the audit.
Therefore, this study should be useful to academic researchers, practitioners, regulators,
investors, and others who are interested in understanding audit quality.
4
Not all audit literature is in agreement on this point. Traditionally, much of the economic theory of auditing has
treated an audit as an experience good, something for which quality can be observed after purchase (e.g., the quality
of a restaurant meal). More recent theoretical work has raised the possibility that the audit is a credence good,
something for which quality can only be observed at a prohibitive cost (e.g., the quality of a car repair). See
Causholli and Knechel (2012a) for a more complete explanation of the distinction between experience and credence
goods.
5
The Francis (2011) paper was not intended to provide acomprehensive review of the literature but rather provided
examples of different approach to research on audit quality. Rather, Francis’ objective was to illustrate different
approaches to conducting research on audit quality.
6
We also include international research on audit quality, whereas, the Francis (2011) paper limits his attention to
papers published in North American journals.

The remainder of this paper is organized as follows: In the next section we will review
the existing definitions of audit quality and, where possible, reconcile the many different
perspectives that exist on audit quality. In the third section, we discuss general frameworks for
establishing audit quality. The fourth section examines potential measures of audit quality
including measures of audit inputs, process, outcomes and the context of the audit. In the fifth
section, we offer some suggestions for future research and conclude with a summary section.
EXISTING DEFINITIONS OF AUDIT QUALITY
The problem of audit quality being in the “eye of the beholder” is reflected in the broad
range of diverse, and sometimes divergent, definitions that have been offered by numerous
authorities and individuals over the past 20 years.7 We review some of the definitions below to
highlight the current diversity.
From early on, audit quality has been defined as an outcome conditional on the presence
of certain attributes of auditors. The widely used definition by DeAngelo (1981, 186) defines
audit quality as “the market assessed joint probability that a given auditor will both discover a
breach in a client’s accounting system, and report the breach.” This definition is often interpreted
to break down audit quality into two components: (1) the likelihood that an auditor discovers
existing misstatements and (2) appropriately acts on the discovery. The first component links to
an auditor’s competence and level of effort while the latter relates to an auditor’s objectivity,
professional skepticism and independence. These two components also suggest that different
7
As a result, several regulators and standard setters seem to have reached the conclusion that arriving at consensus
on a definition of audit quality may be impossible. For instance, the Financial Reporting Council (FRC 2006, 16)
state “there is no single agreed definition of audit quality that can be used as a ‘standard’ against which actual
performance can be assessed.” In the Consultation Report of International Organization of Securities Commissions
(IOSCO 2009, 3), a similar sentiment is expressed in that audit quality is difficult to define and is specific to the
stakeholder and consensus difficult to achieve.

aspects of the audit can influence overall audit quality. The discovery of a misstatement requires
that appropriate resources be effectively utilized in the audit process (i.e., inputs and process)
while reporting a misstatement requires an auditor to take appropriate action given the current
context at the end of the audit (i.e., output and context). The following problems arise from this
definition, however: (1) it has not been reconciled with the audit risk model which is used to
guide the audit and reflects the auditor’s perceptions and (2) the perception of market
participants can be erroneous. Despite this limitation, the DeAngelo (1981) definition of audit
quality identifies two important components of audit quality.
There are a number of definitions of audit quality in the literature that reference the
responsibilities of the auditor in terms of the audit process or the goal of the audit. For instance,
the Government Accountability Office (GAO 2003, 13) defines audit quality as one
performed “in accordance with Generally Accepted Auditing Standards (GAAS) to provide
reasonable assurance that the audited financial statements and related disclosures are (1)
presented in accordance with Generally Accepted Accounting Principles (GAAP) and (2) are not
materially misstated whether due to errors or fraud.” Material deviations from the standards are
presumed to reflect poor audit quality. This view is consistent with the practitioner literature as
well (e.g., Tie 1999; Krishnan and Schauer 2001). Other practitioners focus on error detection
and the financial statement outcome, suggesting that a high-quality auditor will detect errors in
reported earnings and enhance the reliability of the financial statements (e.g., Chan and Wong
2002; Gul et al. 2002; Behn et al. 2008; Chang et al. 2009). Further, others indicate that audit
quality is directly linked to the amount of audit work (Carcello et al. 2002). Even with these
varying views, a common link is the idea that audit quality exists on a continuum where more is
assumed to be better than less.

Finally, some researchers focus on defining “poor audit quality” by identifying adverse
outcomes from an audit (e.g., Peecher and Piercey 2008). Defining audit quality in terms of
failure is appealing because it is easy to operationalize the definition. However, while Casterella
et al. (2009, 716) state, “…we believe poor audit quality is observable with hindsight if an
engagement results in litigation or a claim of malpractice against the audit firm,” there are
relatively few cases of detectable audit failures (see Francis 2011). In summary, there is currently
no unified definition of audit quality. As a result, developing a framework may be the best
alternative to gauge overall audit quality.
GENERAL FRAMEWORKS FOR ESTABLISHING AUDIT QUALITY
The first formal attempt to develop an audit quality framework was undertaken by the
U.K.’s Financial Reporting Council (FRC) in 2006. 8 After extensive consultation, the FRC
(2008) identified five drivers of audit quality: (1) the culture within an audit firm; (2) the skills
and personal qualities of audit partners and staff; (3) the effectiveness of the audit process; (4)
the reliability and usefulness of audit reporting; and (5) factors outside the control of auditors
affecting audit quality (see Figure 1). For each driver, the FRC identified several potential
indicators of audit quality. For example, some of the indicators of the culture of an audit firm
include: creating an environment where achieving high quality is valued, nurtured, and rewarded;
ensuring partners and staff have sufficient time and resources to deal with difficult issues; and
ensuring robust systems for client acceptance and continuation. Other examples pertain to the
8
Subsequent examples of audit quality frameworks were developed by the Australian Treasury (Commonwealth of
Australia 2010) and the International Auditing and Assurance Standards Board (IAASB 2011). The former proposed
a framework for managing audit quality sustainability. The IAASB (2011) discussed audit quality from the
perspective of an investor as well as a member of the audit committee and noted that audit quality is influenced by
input factors (auditor attributes), outputs (auditor’s report) and contextual factors (laws and regulations).

effectiveness of the audit process in a firm: the design of audit methodology and tools, the
availability of technical support, and the enforcement of ethical and independence standards.
[Insert Figure 1 About here]
Recently, Francis (2011) proposed a framework (see Table 1) for understanding and
researching audit quality. He notes that audit quality is a complex concept and there are
gradations of audit quality across a continuum. Based on a structural view of the audit
environment as reflected through different paradigms of archival research, Francis (2011) argues
that audit quality is influenced by six levels of analysis that range from a granular view of the
audit process to a very broad view of the outcomes of the audit, including (1) audit inputs, (2)
audit processes, (3) accounting firms, (4) audit industry and audit markets, (5) institutions, and
(6) economic consequences of audit outcomes. The different levels of analysis illustrate how
audit quality reflects the cascading of conditions at different levels of the overall system.
[Insert Table 1 About here]
The various frameworks for audit quality highlight that the evaluation of audit quality is a
multi-dimensional challenge from both a theoretical and practical perspective. If one crosses
Francis’ levels of audit quality with the theoretical attributes of an audit mentioned earlier, the
complexity of the problem becomes apparent. For each level in the Francis framework, the issues
of incentives, outcomes, uniqueness, process and judgment manifest in different ways. For
example, at each level, different participants—auditor, team, firm, regulator—may have different
and potentially conflicting incentives. Further, the nature of the process at each level varies,
while the outcome of each level inherently feeds into the next higher level of analysis, i.e.,
individual auditor decisions aggregate into a process, processes aggregate into an engagement,
engagements aggregate into a firm, etc. Depending upon the level at which an observer sits the

nature of necessary judgment will vary. Given this obvious complexity combined with the
difficulty of defining audit quality from various viewpoints, we believe a “balanced scorecard”
for auditing might provide a way in which to simultaneously address different stakeholder
viewpoints. A scorecard allows stakeholders to focus on the indicators of audit quality that are
most relevant rather than imposing a fixed structure for a “generalist” stakeholder.
INDICATORS OF AUDIT QUALITY
We organize our discussion of quality indicators around a “balanced scorecard” with four
categories: inputs, process, outcomes and context. This allows us to link the general attributes of
audit quality—incentives, uncertainty, uniqueness, process and judgment—more directly to the
existing research on audit quality. 9 First, the inputs to an audit are primarily reflected in the
individual characteristics of the audit team such as professional skepticism, knowledge and
expertise. Second, audit quality is influenced by the characteristics inherent to the audit process,
e.g., risk assessment, analytical procedures, and workpaper review, etc. The uniqueness of each
engagement is apparent in these process indicators due to variations across clients in business
plans, transactions, management incentives, risks and controls. Third, we consider relevant
outcomes which may be reflected in various observable characteristics, e.g., restatements,
financial reporting quality, accuracy of audit reports, and results of regulatory reviews. Finally,
we examine indicators associated with the context of the audit, including the existence of
abnormal audit fees, audit tenure, audit partner compensation, and audit fee premiums, all of
which may influence auditor incentives. Overall, the indicators included in a scorecard include
9
Though there are important differences between our audit quality framework and Francis (2011), we note that
“inputs”, “process”, and “outcomes” in Figure 2 are similar, respectively, to “audit inputs”, “audit process”, and
“economic consequences of audit outcomes” in Table 1. While Francis (2011) describes how audit research can be
conducted at each of the three levels, our objective is to describe the causal relations among inputs, process, and
outcomes. Other elements in Francis (2011), i.e., “accounting firms”, “audit industry and audit markets” and
“institutions” are subsumed in our framework under “context”.

both financial (e.g., restatements) and non-financial measures (e.g., auditor expertise). Further,
links across the phases of the audit suggest that improvements in one area can result in
improvements in other areas, e.g., more training and recruitment of talented employees would
enhance audit processes which in turn would have a favorable impact on audit outcomes.10
[Insert Figure 2 About here]
Inputs
A presumption of the audit risk model which drives audit planning and evidence
gathering is that the riskiness (i.e., uncertainty) of each client is unique (i.e., idiosyncratic). The
riskiness of a client is dependent on the complexity of transactions and accounting systems in
place and can be influenced by management’s incentives to produce reliable financial statements.
As a result, the resources needed to obtain “reasonable assurance” vary across engagements. An
audit is a knowledge-based professional service producing an uncertain and unobservable
outcome. Consequently, the resources needed for an audit depend on the personnel available for
an engagement, the abilities and expertise of the audit team, and the audit technology and
methodology being used. Thus, it is important to realize that inputs of audit quality cannot be
defined in strictly quantitative terms as would be the case in a process that produces a large
volume of nearly identical tangible products. The idiosyncratic nature of the audit process means
that an auditor’s effort level needs to be tailored to each client within the structure of the basic
audit methodology as applied by the audit team using their best judgment. The ability to make
sound judgments directly influences the quality of the audit so the better the personnel, the better
the outcome of the audit is likely to be. However, to understand the quality of judgment it is
10
For a similar overview of audit quality framework see Arrunada (2000). The focus of Arrunada, however, is
narrower focusing on how audit quality attributes interact with regulation.

important also to understand the nature of incentives and cognition in the audit process and how
they relate to the inherent uncertainty and idiosyncrasies of the engagement.
Incentives and Motivation
Experimental research has documented that auditor judgments can be impacted by
incentives which, in turn, can negatively or positively influence the quality of the audit process.
Specifically, the quality of auditor judgments has been found to be adversely impacted by the
perceived risk of client loss (e.g., Farmer et al. 1987; Blay 2005); fee pressure (e.g., Houston
1999; Gramling 1999), client retention incentives (e.g., Lord 1992; Trompeter 1994; Chang and
Hwang 2003), economic benefits contingent on specific actions (e.g., Schatzberg and Sevcik
1994; Beeler and Hunton 2002), and other client-related and engagement pressures (e.g.,
Hackenbrack and Nelson 1996; Haynes et al. 1998; Jenkins and Haynes 2003; Kadous et al.
2003; Blay 2005). However, there are several countervailing incentives in place, such as
concerns for regulatory enforcement, potential litigation costs, and potential reputation losses,
promoting high audit quality (e.g., Nelson 2009). In general, it is believed that incentives lead to
preferences for a desired outcome which unintentionally influence one’s decisions, in a self-
serving manner (e.g., Kunda 1990; Russo et al. 2000).
Professional Skepticism
Existing research has documented a positive relation between professional skepticism and
audit quality (Chen et al. 2009). Specifically, auditors who exercise higher levels of professional
skepticism are more likely to confront a client or perform additional procedures when high risk
irregularities arise (Shaub and Lawrence 1996), are more likely to detect fraud (Bernardi 1994),
exhibit high quality assessments of evidence (Hurtt et al. 2008), and are less trusting of a client,
and more likely to invest in high levels of audit effort (Bowlin et al. 2012). Several dispositional
10

and situational factors directly influence an auditor’s professional skepticism (Nelson 2009). For
example, auditor actions consistent with higher levels of professional skepticism are positively
associated with the following dispositional traits: ethical development and moral reasoning (e.g.,
Bernardi 1994; Shaub and Lawrence 1996; Sweeny and Roberts 1997; Brown-Liburd et al.
2009), professional identification (Aranya et al. 1981; Bamber and Iyer 2007), conservatism
(Brown-Liburd et al. 2009), and trait skepticism (Hurtt et al. 2008).11 Interestingly, Shaub (1996)
finds that an auditor’s experience with a client (i.e., tenure and history of client accuracy) and
other situational factors (e.g., risk of misstatement and the quality of communication) are
stronger determinants of an auditors’ level of professional skepticism than are dispositional
factors including individual traits.
Knowledge and Expertise
Auditor knowledge and expertise has a direct bearing on the quality of the audit. Domain-
specific knowledge (e.g., knowledge accumulated through client, task, and industry experience)
is associated with higher quality auditor judgment (e.g., Bonner 1990) and is necessary for
developing auditing expertise (e.g., Frederick and Libby 1986; Bedard 1989; Bonner and Lewis
1990). For example, auditors with more domain-specific knowledge make decisions that are
more consistent with professional standards and have a higher consensus level (e.g., Bedard
1989). Likewise, the level of auditor’s client-specific knowledge has been found to be positively
related to auditor performance over time (e.g., Beck and Wu 2006). Finally, an auditor’s industry
expertise has been found to be positively related to the quality of audits. Auditors with industry
specialization have been found to outperform non-specialists in error detection (Owhoso et al.
11
Trait skepticism is defined as a multi-dimensional construct which includes the following characteristics: a
questioning mind, a suspension of judgment, a search for knowledge, interpersonal understanding, self-esteem, and
autonomy (Hurtt 2010).
11

2002), in performing analytical procedures (Wright and Wright 1997; Green 2008), in assessing
components of audit risks (Taylor 2000; Low 2004; Hammersley 2006; Maroney and Simnett
2009), and in disclosing internal control deficiencies (Rose-Green et al. 2011; Stephens 2011).
Similarly, empirical evidence documents that industry experience is positively associated with
compliance with Generally Accepted Auditing Standards (O’Keefe et al. 1994) and that clients
with higher levels of industry experience have lower abnormal accruals (Reichelt and Wang
2010).
Within-Firm Pressures
The quality of an auditor’s judgment is also influenced by pressures emanating from the
firm itself. These pressures can arise from immediate supervisors on the audit team or the overall
evaluation process used by the firm. For example, audit managers held accountable to a partner
who aggressively tries to grow the firm’s business are more likely to support bidding on a client
who engages in aggressive accounting practices (Cohen and Trompeter 1998). Likewise, audit
managers who perceive audit partners to value efficiency as compared to effectiveness may rely
on questionable work by an internal auditor to a greater extent (Gramling 1999) and engage in
less skeptical behaviors during audit testing (Brown et al. 1999). Finally, research also finds
auditors’ perceived goals of the audit (Sweeney and McGarry 2011) and perceptions of how the
audit firm values them (Herrbach 2001) influences auditors’ judgments.
Empirical research has also documented that time budget and time deadline pressures
adversely impact the quality of audits (see DeZoort and Lord 1997 for review). Time budget
pressures have been found to result in tradeoffs of audit effectiveness for audit efficiency
(McDaniel 1990) and to increase the likelihood of engaging in “reduced audit quality acts” such
as under-reporting of time (e.g., Lightner et al. 1982; Kelley and Margheim 1990; Ponemon
12

1992) and prematurely signing off on audit workpapers (e.g., Alderman and Detrick 1982;
Kelley and Margheim 1990; Reckers et al. 1997).
Summary of Inputs
The quality of an audit is greatly influenced by the level of inputs into the audit process.
In general, improvements in inputs should lead to improvements in other indicators of audit
quality (i.e., outcomes). Due to the riskiness of audits and the idiosyncratic nature of audit
engagements, the inputs required to effectively carry out an audit engagement may vary
substantially across audit engagements. Accordingly, there is no prescriptive level of inputs
designed to yield a desired level of auditor assurance; rather, the level of inputs is qualitative and
based on auditor’s professional judgment. In general, literature suggests that increases in the
quality of inputs, such as applied levels of professional skepticism as well as auditor knowledge
and expertise, increase the quality of auditor judgments. However, client-related incentives, such
as client retention and within-firm economic pressures can threaten the quality of auditor
judgments and thus audit quality.
Process
An audit consists of a number of phases. In a very general sense this includes risk
assessment, internal control evaluation, testing, and review. The quality of the audit depends on
the quality of auditor judgments during all stages of the audit; therefore, we first discuss audit
quality issues related to professional judgment and then explore specific aspects of the audit
process in more detail. When applicable, for each aspect of the audit process, we highlight some
of the common factors that may threaten audit quality.
Judgment in the Audit Process
13

Research in auditing has shown that auditors are subject to many of the same heuristics
and biases that cause systematic errors in judgment that are observed in general decision making
settings. Most notably, auditors have been found to be susceptible to two common heuristics:
anchoring and adjustment and representativeness (Tversky and Kahneman 1974; see Smith and
Kida 1991 for a review). For example, auditors tend to focus on an initial condition (e.g.,
unaudited book values) but then insufficiently adjust from that value to arrive at a judgment (e.g.,
account balance expectation) (Kinney and Uecker 1982; Biggs and Wild 1985). The use of
heuristics is not always damaging, however. Simple judgment heuristics can be efficient and
sometimes effective, i.e., when the use of more complex judgment strategies may provide little
improvement in auditor decisions (Thorngate 1980; Kleinmuntz 1985; Paquette and Kida 1988).
Auditors are found to be least susceptible to biases when they have an appropriate level of
expertise and familiarity with the task (Smith and Kida 1991). Accordingly, the importance of
matching the appropriate level of auditor experience and expertise is critical.
Systematic biases in auditor judgment also can occur as a result of knowledge of certain
information (e.g., the “curse of knowledge,” hindsight, and outcome biases). For example,
knowledge of client-recorded book values may bias auditors’ expectations of analytical review
procedures (Kinney and Uecker 1982; Biggs and Wild 1985; Heintz and White 1989; McDaniel
and Kinney 1995); subsequent outcome knowledge may bias auditor evaluations of client
conditions (Buchman 1985; Reimers and Butler 1992; Kennedy 1995; Emby et al. 2002), and
knowledge of management’s internal control assessments may bias auditors’ internal control
evaluations (Earley et al. 2008; Kaplan et al. 2008). Other cognitive biases that may harm audit
quality include recency (Asare 1992), framing (Emby 1994; Emby and Finley 1997), dilution
(Hackenbrack 1992; Glover 1997; Hoffman and Patton 1997), and escalation of commitment
14

(Church 1991; Jeffrey 1992). While the biases can negatively impact the quality of auditor
judgments, in many cases researchers have also identified factors that mitigate the biases
including experience (Jeffrey 1992; Kennedy 1993; Messier and Tubbs 1994; Trotman and
Wright 1996), restructuring a task (Earley et al. 2008), accountablability (Kennedy 1993;
Cushing and Ahlawat 1996), and varying the timing of audit evidence (Favere-Marchesi 2006).
Audit Production
A number of studies have examined the nature of the audit production process and the
factors that influence it. Most notably, the degree of client complexity and risk significantly
influence audit production in terms of (a) the planned extent or hours of testing (O’Keefe et al.
1994; Caramanis and Lennox 2011; Calderon et al. 2012), (b) the nature of planned testing
(Hackenbrack and Knechel 1997), and (c) the personnel assigned to the audit (Johnstone and
Bedard 2001). For example, the acceptance of higher risk clients is facilitated by employing the
use of audit staff with greater expertise (Johnstone and Bedard 2001) and auditor specialists
(Johnstone and Bedard 2003). In addition to client risk, audit production is also influenced by
earnings manipulation, corporate governance (Johnstone and Bedard 2004), disclosure policies
(Krishnan and Sengupta 2011), auditor business risk (Bell et al. 2008; Houston et al. 1999), and
the audit firm’s political risk (Redmayne et al. 2010). Research further shows that induced
reductions in auditor effort, not necessarily supported by underlying client characteristics,
adversely affect audit quality. For example, time pressures during busy season are associated
with lower earnings quality (Lambert et al. 2011; Lopez and Peters 2012).
The overall conclusion of these papers is that auditors adjust their production plan in
response to increased risk factors (e.g., increase effort or utilize more experienced/expert audit
staff). Yet, the total amount of labor hours and labor mix may not be a sufficient indicator of
15

audit quality by itself. What may be more important is the interaction of various circumstances
within a client such as tight deadlines, the structure of the audit team, and the presence or
absence of other services.12 In fact, it is possible for auditors to work a lot of hours and still not
produce a desirable level of audit quality.13
Assessing Risk
As discussed, auditor risk assessments are important because they determine the nature,
extent and timing of planned procedures.14 In this section, we note a few factors have been found
to impair the quality of auditor risk assessments. First, the approach auditors use to assess risks
can result in different assessments (Jiambalvo and Waller 1984; Zimbelman 1997; O’Donnell
and Schultz 2003; Wilks and Zimbelman 2004). For example, experimental studies find that
fraud risk assessments tend to be understated when auditors use holistic approaches as compared
to an approach that separately assesses the risks of fraud for different components (Zimbelman
1997; Wilks and Zimbelman 2004). Second, experimental studies suggest that auditors have a
difficult time properly modifying the planned audit procedures in responses to risk assessments
(Zimbelman 1997; Glover et al. 2000; Glover et al. 2003; Hammersley et al. 2011). Third,
performing a strategic risk assessment of the client’s business model as a first step for assessing
12
This goes to a more specific point that audit hours per se are not necessarily indicative of bad or good audit
quality; more important is the notion of how these hours are spent. For example, to reduce busy season work, some
accounting firms do a large portion of audit work prior to the actual year end (i.e., interim work). Then, during the
actual busy season, their focus is on whether there have been any significant changes in a client financial position
since the interim work was completed. By itself, such an approach does not imply bad or good audit quality. What
matters is whether it is appropriate for that particular client to achieve a desired level of audit quality.
13
Because a client does not observe actual quality of the auditor’s work product (i.e., audits are credence goods),
auditors could under-audit and earn rents from the excessive fees they charge, given the level of their work product
(Causholli et al. 2012). Moreover, Francis and Michas (2012) show that financial restatements tend to concentrate in
particular audit offices, suggesting that audit quality is not necessarily just a function of effort level.
14
Interested readers can also refer to Allen et al. (2006), a synthesis of the literature that provides insights on issues
and proposed changes to the auditor risk assessment process.
16

risk (i.e., as required by audit methodology) has been linked to unintended consequences on
subsequent auditor risk assessments (O’Donnell and Schultz 2003).15
Analytical procedures
Analytical procedures are an integral component of the audit process and greatly benefit
risk assessments made by the auditor. In this section, we describe several factors that threaten the
quality of auditor judgments when performing analytical procedures. First, a host of studies
examine “interference effects” whereby thinking about or inheriting certain information (e.g., an
incorrect non-error explanation) inhibits auditors’ abilities to consider alternatives (e.g., an actual
error) (e.g., see Koonce 1993 and Messier et al. 2012 for reviews). More specifically, an
auditor’s ability to generate hypotheses for significant differences can be negatively influenced
by information provided by management (Peecher 1996; Bierstaker et al. 1999); explanations
provided by other auditors (Church and Schneider 1993; Yip-Ow and Tan 2000); and other
relevant information that causes interference effects (Anderson et al. 1992; Heiman-Hoffman et
al. 1995; Bierstaker et al. 1999). When developing an expectation, an auditor’s knowledge of the
client’s book value can reduce the accuracy of auditor expectations (Kinney and Uecker 1982;
Biggs and Wild 1985; McDaniel and Kinney 1995). Further, when evaluating explanations,
auditors sometimes fail to sufficiently attend to source credibility (Anderson et al. 1994;
Bernardi 1994; Hirst 1994). Finally, during the evaluation process, auditors fail to dig deeper
when information is consistent with their expectations rather inconsistent (Earley 2002) and tend
to rely more on analytical procedures that result in favorable outcomes, i.e., an expectation that is
not significantly different from the unaudited numbers (Glover et al. 2005).
15
Specifically, O’Donnell and Schultz (2003) find that auditors who developed favorable strategic risk assessments
were less likely to subsequently adjust account-level risk assessments for inconsistent fluctuations as compared to
auditors who did not perform initial strategic risk assessments.
17

Obtaining and Evaluating Audit Evidence
The audit process for an engagement is dictated by the firm’s audit methodology which
can vary from firm to firm. An audit methodology is specifically designed to help an audit team
cope with the uncertainty in an audit in a systematic manner. More specifically, audit support
systems enable the audit process and enforce the audit firm’s methodology. However, aspects of
standard audit programs and decision support systems can restrict an auditor’s decision process,
potentially reducing the quality of auditor judgments (Dowling and Leech 2007). For example,
decision aids and standardized checklists could potentially reduce auditor performance by
causing auditors to over-rely on the recommendations of the aids when professional judgment is
required (Pincus 1989; Ashton 1990; Arnold and Sutton 1998; Asare and Wright 2004).16 Due to
the iterative nature of an audit (and across audits), auditors may fail to adequately consider the
idiosyncrasies of a specific engagement. For example, auditor judgments often exhibit contrast
effects whereby the performance of one task unduly influences performance on another task
(O’Reilly et al. 2004; Bhattacharjee et al. 2007).
Inherent uncertainty in the audit process and the application of accounting principles
compounds the judgment challenges an auditor faces. Unknown future events and subjectivity in
standards serve to heighten an auditor’s uncertainty about the appropriate accounting treatment
of a transaction. For example, subjective probability phrases lead to lower levels of consensus
among auditors (Amer et al. 1994) and systematic errors in judgments (Amer et al. 1995).
Further, prior experimental research finds that incentives can influence the quality of auditor
judgments when auditors face uncertainty resulting from (1) imprecise accounting standards
(Nelson and Kinney 1997; Nelson et al. 2002; Nelson et al. 2003); (2) mixed accounting
16
See Nelson and Tan (2005) and Dowling and Leech (2007) for reviews on the limitations of decision aids.
18

precedents (Salterio 1996; Salterio and Koonce 1997); and (3) subjectivity in accounting
standards (Hackenbrack and Nelson 1996; Braun 2001; Hronsky and Houghton 2001).
Further, auditors also face uncertainty about the materiality of misstatements. Materiality
assessments require complex, subjective judgments and estimates, opening the door to errors and
biases. For example, auditors tend to underestimate the effect of known errors when projecting to
the population (Burgstahler and Jiambalvo 1986; Dusenbury et al. 1994; Burgstahler et al. 2000).
Materiality assessments are also influenced by incentives as auditors are more likely to waive a
quantitatively immaterial misstatement that would result in the client missing an earnings target
as compared to one that doesn’t (Libby and Kinney 2000; Ng 2007; Ng and Tan 2007).
Auditor-Client Negotiations
As part of the audit process, auditors negotiate with their client to produce the resulting
financial statements (Antle and Nalebuff 1991). Auditor-client negotiations are influenced by
several contextual features including external conditions and constraints (e.g., GAAP, GAAS),
interpersonal factors (e.g., auditor-client relationship, incentives), auditor characteristics (e.g.,
accounting expertise, negotiation experience), client characteristics (e.g., inherent risk), and other
environmental factors (e.g., litigation risk, regulatory environment) (Gibbins et al. 2001; see
Brown and Wright 2008 for a more complete review). For example, negotiation experience has
been shown to improve the auditor’s negotiation performance, leading to more successful
outcomes and reduced influence of the client’s preferred position (Johnstone et al. 2002; Brown
and Johnstone 2009). Likewise, higher levels of audit rank—partners compared to managers—
tend to take a tougher stance against aggressive client-positions during negotiations (Trotman et
al. 2009). On the other hand, experimental and survey evidence suggest that clients have a more
favorable negotiation position when the audit firm has a shorter tenure (Iyer and Rama 2004), a
19

client’s board is perceived as less conservative (Beattie et al. 2004), and contentious issues arise
late in the financial reporting process (Beattie et al. 2004). Finally, the outcome reached can be
significantly influence by an auditor’s and client’s negotiation strategies (Gibbins et al. 2001,
2005, 2010; Ng and Tan 2003; Bame-Aldred and Kida 2007; Sanchez et al. 2007; Hatfield et al.
2008), negotiation timing (Tan and Trotman 2010), and the amount of negotiation concessions
(Ng and Tan 2003; Trotman et al. 2005; Bame-Aldred and Kida 2007; Sanchez et al. 2007;
Hatfield et al. 2008).
Review and Quality Control
Much research demonstrates the positive effects of a good quality control and review
processes on audit quality.17 However, a few studies identify some aspects of the review and
quality control process that can lead to unintentional, negative effects on the quality of auditor
judgments. First, auditor judgments are often biased when auditors are made aware of the
reviewer’s preferences prior to performing auditing tasks, i.e., biased in favor of the reviewers’
preferences (Peecher 1996; Turner 2001; Wilks 2002; Shankar and Tan 2006). Second, Messier
et al. (2008) show partners tend to be over-confident in predicting the abilities of their
subordinates which can adversely affect staffing decisions. Others show that reviewer judgments
of a preparer’s work can be biased by the preparer’s performance reputation (Tan and Jamal
2001) and by the congruency with their own initial opinions (Tan and Shankar 2010). However,
higher levels of audit review, including concurring partner reviews, help to reduce these biases
(Ayers and Kaplan 2003; Woods and Jacobs 2010). Finally, the medium by which a review is
conducted (electronic versus face-to-face) (Brazel et al. 2004; Agoglia et al. 2010) and the
17
See Epps and Messier (2007) and Schneider and Messier (2007) for reviews related to engagement quality
reviews, i.e., concurring partner reviews. See Bedard et al. (2008) for a review of firm-level risk monitoring and
control, e.g., client acceptance/continuance procedures, independence, consultation units, etc.
20

timeliness of reviews (Lambert and Agoglia 2011) are found to influence the quality of audit
work.
Summary of Process
An audit is a systematic process that varies across audit engagements due to
idiosyncrasies of the client (e.g., variations in business plans, management incentives, risks, etc.).
Therefore, the quality of the audit process is dependent on the quality of auditor judgments
during each phase of the audit process, e.g., when assessing risks, performing analytical
procedures, obtaining and evaluating audit evidence. Because of large amounts of uncertainty
both during the audit process and in audit outcomes, auditors’ judgments are susceptible to
individual cognitive biases. In our review, we focus on common factors and biases that have
been found to threaten audit quality when making professional judgments during the different
audit processes. We also recognize that the audit process has steps in place designed to mitigate
the effects of individual errors in judgments such as review and quality control processes.
Outcomes
The literature has traditionally viewed the presence of higher audit quality in terms of
lacking certain negative outcomes (such as restatements or litigation) or having certain positive
outcomes (such as issuing going concern opinions when merited). We discuss these outcome
measures in turn.18
Adverse Outcomes
18
One potential limitation of this approach is that it focuses on extreme events (e.g. restatements) which could be
rare, and may not be representative of a more holistic state of audit quality. In addition, some outcome measures
suffer from potentially strong measurement error (e.g. discretionary accruals), and audit quality measures in question
may have internal validity limitations (such as use of market share as a proxy for audit quality which may actually
capture a firm’s attitudes towards growth that results in the firm accepting riskier clients).
21

A common indicator used to proxy for negative audit quality is the presence of an
accounting restatement. Although sample size for the analysis of restatements is generally small
(Francis 2004), prior research shows that higher levels of audit quality are associated with a
lower likelihood of accounting restatements. For example the presence of restatements is
negatively associated with various proxies for audit quality including auditor industry expertise
(Romanus et al. 2008; Chin and Chi 2009), auditor tenure (Stanley and DeZoort 2007), and
aggregate audit team experience (Li and Chen 2011). Moreover, the occurrence of restatements
is negatively associated with the ratifications of auditor selection by shareholders (Liu et al.
2009), and small auditors are more likely to be dismissed by their clients following the discovery
of egregious restatements (Hennes et al. 2012).19
Another potential adverse outcome suggesting negative audit quality is litigation against
an auditor. Empirical work during the 1990’s examined auditor litigation extensively (see
Palmrose 1998). Prior literature identifies several key findings in this area. First, auditors can
only be sued when there is very strong evidence of financial statement fraud, i.e., auditors were
negligent in their audits and did not follow GAAS (Fuerman 2006). Second, auditors are named
in a small number of class-action lawsuits initiated under securities law. Finally, a majority of
lawsuits against auditors are settled out of court and settlement amounts are often confidential. In
general auditors contribute a small percentage to the overall settlements (Palmrose 1997).
Fuerman (2012) shows that tendency to sue auditors and the amount of settlement awards has
decreased in the period after the passage of the Sarbanes Oxley Act. Given these findings,
auditor litigation as a measure of audit quality is somewhat limited.
Financial Reporting Quality
19
Literature distinguishes between irregularities and errors when it comes to restatements. Irregularities tend to be
more egregious restatements which are much more likely to be intentional, i.e., fraudulent.
22

Another common way to examine audit quality is to consider the overall quality of
financial reporting or earnings quality (Behn et al. 2008). Given that no comprehensive or
generally accepted measure of earnings quality exists, researchers have examined various
dimensions of earnings quality such as neutrality (proxied by discretionary accruals measuring
deviation of accruals from a certain norm), feedback value or earnings “credibility” (the
association between earnings and market returns), and earnings conservatism. A limitation of this
line of research is that one cannot easily separate audit quality from the quality of financial
reporting standards (Knechel 2009). We discuss the two most common proxies examined in the
literature: discretionary accruals and accounting conservatism.
In general, research has shown a negative relation between the level of discretionary
accruals in total, or income-increasing accruals alone, and proxies for audit quality including Big
N auditors (Francis et al. 1999; Kim et al. 2003), auditor specialization (Krishnan 2003b; Balsam
et al. 2003), auditor tenure (Myers et al. 2003) and audit office size (Francis and Yu 2009).
Further, Francis and Michas (2012) find higher levels of clients’ discretionary accruals for
auditors whose offices have had a higher incidence of past restatements, suggesting that history
of past audit failure is associated with a higher likelihood of future earnings management. It is,
however, unclear whether discretionary accruals are an appropriate earnings quality proxy since
they are already heavily scrutinized by auditors (Schelleman and Knechel 2010).
While it is widely debated as to whether accounting conservatism is a desired proxy for
the quality of accounting information, research suggests that higher levels of accounting
20
conservatism are associated with proxies for audit quality. For example, accounting
conservatisms is negatively associated with auditor litigation (DeFond et al. 2012), and
20
See Watts (2003a, 2003b) for a summary of the empirical evidence on conservatism.
23

positively associated with auditor industry specialization, auditor size (Basu et al. 2000), and
longer audit tenure (Jenkins and Velury 2008). Moreover, as a unique example, clients of the
Houston office of Arthur Andersen (responsible for the failed Enron audit) exhibited lower levels
of conditional conservatism than a control group (Krishnan 2006) and Andersen clients that
switched auditors following Andersen’s downfall showed increases in conservatism (Krishnan
2007).
Audit Reports
The accuracy of audit reports is often viewed as a signal for audit quality. However,
auditor reporting judgments such as issuing going concern opinions have proven to be difficult,
resulting in relatively high levels of Type II and Type I errors (Mutchler 1985, 1986; Chen and
Church 1992; Carcello and Palmrose 1994; Reynolds and Francis 2000; Geiger and Rama 2006;
Church et al. 2008). Carson et al. (2012) synthesize the literature on going-concern reporting.
They report that, on average, 40 to 50 percent of bankrupt companies in the U.S. do not receive a
prior going concern opinion (i.e., a Type II error) and that 80 to 90 percent of companies
receiving a going concern opinion do not enter bankruptcy in the subsequent year (i.e., a Type I
error). They also report that going concern reporting errors have changed over time with changes
in auditor litigation resulting from the Private Securities Litigation Reform Act (PSLRA) and
Sarbanes-Oxley Act (SOX). Finally, much research has also examined users’ reactions to going
concern reports (e.g., stock market reactions) suggesting that users perceive going concern
reports as informative to signaling higher audit quality.
Others argue that the effectiveness of the auditor’s report as an indicator of audit quality
is limited due to the restricted content of the report, i.e., it is essentially a pass/fail report. In their
synthesis of the literature, Church et al. (2008) conclude the auditor’s report has symbolic value,
24

but it provides little communicative value (e.g., the inputs of the auditor’s reporting decision are
not disclosed). Mock et al. (2012) note that there are limitations related to the current auditor’s
report because of the “information gap” between auditors and users. Such information includes
undisclosed audit information such as materiality, independence, significant audit risks, and the
audit partner’s name.
In addition, the accuracy of auditors’ SOX 404 reports also can signal audit quality.
While relatively little research has been performed to date, Rice and Weber (2012) provide some
empirical evidence on the effectiveness of SOX 404 reports. For a sample of financial statement
restatements (i.e., firms had a material weakness at the time of the misstatement), they find a
large number of material weaknesses are unreported in a timely manner (i.e., only 32.4 percent
of firms receive an adverse SOX 404 report) and that the proportion has declined over time. The
findings suggest that auditor’s SOX 404 reports may not be very effective for signaling the
quality of internal control over financial reporting or the auditor’s ability to compensate for weak
internal control, which is a hallmark of the audit risk model.
Regulatory Reviews of Audit Firms
Perhaps the most direct outcomes of audit quality are the results of regulatory reviews of
audit firms. For the U.S., this includes self-regulation through peer reviews for all audits prior to
SOX, as well as auditors of private clients after SOX, and independent inspection by the PCAOB
for auditors of public companies after SOX. 21 The two systems have yielded significantly
21
The PCAOB tries to inspect non-U.S. firms that play a role in the U.S. market but has encountered issues with
conducting foreign inspections. The PCAOB has established cooperative agreements with several non-U.S.
jurisdictions that allow the PCAOB to rely on inspection work performed by a home-country regulator (PCAOB
2010). However, the PCAOB is still prevented from inspecting the U.S.-related audit work of PCAOB-registered
firms in certain European countries, China, and Hong Kong. Carcello et al. (2011) find that the market reacted
negatively when the PCAOB announced it would not be able to inspect auditors in certain foreign countries
suggesting that the market perceives PCAOB inspections as valuable.
25

different results over time. For peer review, an overwhelming number of reports are unqualified
(i.e., “clean” reports) (Wallace 1991). While this is suggestive of relatively high audit quality, it
also may result from an ineffective peer review process (Fogarty 1996; Anantharaman 2007;
DeFond 2010). 22 Nonetheless, there is some empirical evidence documenting a positive
association between peer review results and audit quality (Grant et al. 1996; Casterella et al.
2009). Likewise, firms with good peer review reports attract and retain clients (Hilary and
Lennox 2005) and are considered by audit committee members when recommending an auditor
(Woodlock and Claypool 2001).
PCAOB inspections are independent and can impose higher sanctions for poor quality
(Gunny and Zhang 2011; DeFond 2010).23 However, many argue that the PCAOB inspection
results are not valuable for signaling audit quality because the reports do not include an overall
evaluative assessment and the quality control deficiencies are often not disclosed (DeFond 2010;
Lennox and Pittman 2010).24 Descriptive analysis of the inspection results for large accounting
firms (those with more than 100 public clients) through 2009 indicates firms received
approximately 14 auditing deficiencies per year, on average, and that every large firm received
quality control criticisms each year. However, none of the criticisms warranted public disclosure
because firms made reasonable progress in addressing the criticisms following the report. 25
22
Under the AICPA peer review system, audit firms choose their reviewers. Fogarty (1996) and DeFond (2010)
argue that because peer reviewers are not independent, the effectiveness of reviews are compromised. Similarly,
Anantharaman (2007) provides evidence that accounting firms choosing friendly reviewers fare better in peer
reviews than other firms.
23
We note that the PCAOB inspections and reporting processes are similar to those of audit regulators in other
countries such as the FRC in the U.K., the CPAB in Canada, and the ASIC in Australia, although there are
differences across countries in the manner in which the inspection process is conducted and results are disclosed.
24
For example, Lennox and Pittman (2010) find no association between the PCAOB inspection results and
subsequent changes in clients’ audit firm choices. The findings are contrary to those for peer review reports (Hilary
and Lennox 2005).
25
Auditing deficiencies are publicly disclosed in the inspection reports without identifying the client affected.
Criticisms of quality control remain confidential provided the firm addresses the quality control defects to the
PCAOB Board’s satisfaction within 12 months of the report date (PCAOB 2006).
26

Church and Shefchik (2012) note that the number of auditing deficiencies identified, as well as
the severity of auditing deficiencies, have significantly decreased over time. While the decrease
in auditing deficiencies is consistent with improvements in audit quality, it may simply reflect
that firms are better at “managing” the inspection process. For smaller accounting firms (those
with fewer than 100 public clients), Hermanson et al. (2007) document a relatively lower average
number of auditing deficiencies per inspection (1.6 per report) but a much larger incidence of
unremediated (disclosed) quality control criticisms (70 percent). Further, Bishop et al. (2012)
provide descriptive analyses on the results of inspections for international firms noting that
approximately one half of the inspection reports identify audit deficiencies and two-thirds
identify quality control defects.
Researchers are just beginning to examine the effectiveness of the PCAOB inspection
process in spite of the empirical challenges.26 Research studies suggest that PCAOB inspections
may improve audit quality, especially for small audit firms. Small audit firms with low quality
are increasingly likely to exit the market since the inception of the PCAOB (DeFond and Lennox
2011), are more likely to be dismissed following disclosure of PCAOB inspection deficiencies
(Abbott et al. 2008; Dougherty et al. 2011), are more likely to issue going concern opinions after
being inspected (Gramling et al. 2011), and are more likely to increase audit effort following
inspection deficiencies (Knechel et al. 2012). Further, there is a positive association between
inspection results and clients’ earnings quality (Gunny and Zhang 2011), as well as abnormal
market reactions following inspections that reveal audit deficiencies (Offermanns and Peek
2011) or when there are unremediated quality control deficiencies (Dee et al. 2011).
26
First, the inspection reports do not identify the issuers inspected. Second, the PCAOB uses a risk-based approach
to selecting issuer engagements for review so the sample of issuers is not representative of the population. Third,
empirical results from analyzing inspection reports and changes in the overall audit market are confounded with
many other changes in the audit market during the same time period.
27

Summary of Outcomes
The outcome of an audit is uncertain and unobservable. As such, researchers turn to
indirect, but measureable, proxies for audit outcomes. Further, they tend to identify what high
audit quality “is not” (e.g., errors and deficiencies) rather than what it “is”. The common
measures of audit outcomes to proxy for low audit quality include the presence of financial
statement restatements, auditor-related litigation, poor financial reporting quality (e.g., presence
of abnormal accruals), inaccurate audit reports, and audit deficiencies identified during
regulatory reviews. In addition, the presence of going concern reports for financially distressed
firms is used as a positive audit quality outcome measure. We note that these measures are
indirect and each has their own unique limitations as proxies for audit quality. However, due to
the lack of ability to observe audit outcomes, using indirect measures may be the next-best
solution.
Context27
Audit Partner Compensation
Currently, there is little evidence documenting a direct link between partner incentives
and audit quality. A number of studies, mostly in Australia, have found that there is a positive
association between the size of a client—which proxies for revenue opportunity and fees—and
audit quality. Trompeter (1994) found that firms with a large profit sharing pool had higher audit
quality than firms where profits were shared locally. Using actual tax return data of Swedish
audit partners, Knechel et al. (2011) find a negative association between client significance to a
27
In addition to the five factors discussed below, we acknowledge that there are other contextual factors that can
impact the audit process and therefore, audit outcomes. For example, laws and regulations governing financial
reporting, auditing standards, and investor protection, audit firm governance, and audit firm methodology and
technology could impact the audit process.
28

partner’s personal income and wealth and audit quality, proxied by likelihood of issuing a going
concern opinion. Thus, some evidence exists suggesting that partner compensation affects audit
outcomes.
Abnormal Audit Fees
Researchers have documented that abnormal audit fees, i.e., audit fees much higher than
the norm, can be indicative of financial reporting problems within a firm (Hribar et al. 2010).
Further, higher abnormal audit fees are associated with declines in future firm performance
(Picconi and Reynolds 2010; Stanley 2011) and a higher cost of capital (Hope et al. 2009).
Similarly, Hackenbrack et al. (2011) argue that increases in negotiated audit fees are associated
with an increased likelihood of a negative price shock to a firm’s stock price.28 On the other
hand, both the PCAOB and SEC have expressed concerns over audit fees that are too low which
could indicate than an auditor is conducting insufficient work. 29 Recent empirical evidence
supports this notion and documents a decline in accounting quality subsequent to fee reduction
during the global financial crisis (Ettredge et al. 2011; Krishnan and Zhang 2012). The use of
abnormal fees as a warning sign for poor audit quality may be problematic for a number of
reasons: (1) the audit fee model has not been validated for predictive use, (2) the fee residual is
interpreted as being meaningful when it may simply be noise unless the standard error of the
prediction is considered, and (3) it creates a “can’t win” situation where any deviation from a
predicted fee—high or low—is interpreted as “bad.”
Non-audit Fees
28
That is, auditors price their private information ex-ante and excess auditor effort or risk premium signals the
presence of potential problems. The latter findings should not be interpreted as showing either lack of or presence of
high audit quality. Rather, the audit fees’ level itself signals negative future bad news to investors.
29
For example, PCAOB Board Member Jay Hanson raised this concern at AICPA conference on PCAOB and SEC
developments in the end of 2011. See also http://jimhamiltonblog.blogspot.com/2011/12/pcaob-member-discusses-
fair-value.html.
29

One of the major SOX reforms was the prohibition of the provision of most non-audit
services to audit clients. The claim is that non-audit services create an economic bond between
auditors and clients which impairs independence and threatens audit quality. However, the
documented evidence on the potential negative effects of economic bonding arising from
auditor-provided non-audit services is mixed. In their synthesis of the literature on the impact of
non-audit fees, Bedard et al. (2008) conclude there is a lack of evidence to support the claim that
auditor independence is compromised by provision of non-audit services.30 Yet, recent studies
continue to add to the mixed results. For instance, recent studies show that abnormal non-audit
fees are positively associated with abnormal loan loss provisions of small banks (Kanagaretnam
et al. 2011) and with more negative outcomes of auditor class action litigation (Schmidt 2012).
The latter suggests that these services are negatively viewed by some stakeholders.
On the other side of the debate, some argue that non-audit services are beneficial and
improve audit quality. Most notably, non-audit services are thought to have a “knowledge
spillover” effect whereby providing non-audit services allows the auditor to develop better
expertise about a client and the utilization of that expertise improves the quality of the audit (e.g.,
Simunic 1984; Lai and Krishnan 2009; Knechel and Sharma 2011; Krishnan and Yu 2011;
Svanström and Sundgren 2012). For example, studies indicate that auditor-provided tax services
(ATS) are associated with higher financial reporting quality and audit quality (Robinson 2008;
Gleason and Mills 2011; Krishnan and Visvanathan 2011).
Audit Fee Premium - Big N Auditors and Industry Specialists
Researchers have investigated whether certain types of auditors are able to command a
fee premium that would be consistent with higher quality. Big N auditors have been shown to
30
Earlier studies of NAS also include Frankel et al. (2002), DeFond et al. (2002), Ashbaugh-Skaife et al. (2003),
Larcker and Richardson (2004), Lennox (1999), Gul et al. (2006), and Kinney et al. (2004).
30

earn a fee premium in many countries while simultaneously being associated with superior
earnings quality (Francis et al. 1999; Kim et al. 2003; Francis and Wang 2008; Francis and Yu
2009; Rusmin 2010). Similar results have been found with respect to fee premiums for auditors
who are industry specialists (Craswell et al. 1995; Seethamaran et al. 2002; Balsam et al. 2003;
Ferguson et al. 2003; Krishnan 2003b; Francis et al. 2005; Ferguson et al. 2006; Basioudis and
Francis 2007; Carson and Fargher 2007; Choi et al. 2008; and Carson 2009). However, the audit
fee premium may also reflect the higher option value of a Big N firm in the event of litigation.31
Connected to this stream of research is the emerging evidence that audit partner specialization
also has a positive effect on audit quality (Nagy 2012).
Auditor Tenure
The length of the auditor-client relationship can potentially impact the quality of audits.
The well-established debate on the issue revolves around two competing arguments: (1) short
tenure means an auditor has less knowledge of a client versus (2) long tenure may mean that an
auditor’s objectivity is potentially impaired. Research in this area has documented both a positive
(Chen et al. 2008; Chi et al. 2009) and negative (Carey and Simnett 2006) relation between
auditor partner tenure and financial reporting quality. Evidence pertaining to audit firm tenure
and earnings quality has been mixed as well. It has been documented that auditor tenure is
associated with lower levels of discretionary accruals (Myers et al. 2003; Johnson et al. 2002)
and accrual persistence (Johnson et al. 2002). Davis et al. (2009) is one of the few studies to find
that auditor tenure is associated with higher earnings management in both short and long tenure
situations but this is only observable prior to the passage of SOX. Further, in short-tenure
31
One way to disentangle legal liability effect from quality effect in audit fee premium literature is to do a cross-
country study where liability regimes differ. That is, in some jurisdictions lawsuits against auditors are quite rare,
and hence any premium that may exist in those countries would be attributable to higher quality. Choi et al. (2008)
and Seethamaran et al. (2002) are two examples of such studies.
31

situations where earnings quality is reduced the presence of an industry specialist moderates the
negative effect (Gul et al. 2009). On the other hand, Boone et al. (2008) find that client’s risk
premium (cost of equity in excess of risk free rate) increases as auditor tenure increases,
implying that markets view auditor tenure as a risk factor.32 A recent meta-analysis of studies in
auditing literature identifies auditor tenure, as well as auditor size and specialization, as factors
positively affecting accounting quality (Lin and Hwang 2010).
Market Perceptions of Audit Quality
Evidence shows that the market rewards companies that employ better auditors and
auditor reputation matters (e.g., Moizer 1997; Skinner and Srinivasan 2012). Clients of Big N or
industry specialist auditors enjoy lower costs of debt financing (Mansi et al., 2004; Pittman and
Fortin 2004; Fortin and Pittman 2007; Karjalainen 2011; Causholli and Knechel 2012b), lower
costs of equity capital (Khurana and Raman 2004; Azizkhani et al. 2010), higher earnings
response coefficients (Balsam et al. 2003; Ghosh and Moon 2005), and lower levels of IPO
under-pricing (Chang et al. 2008). These results are supported by De Franco et al. (2011) who
show that employing a Big 4 auditor is associated with higher proceeds from sales of controlling
interests in the U.S private firms. Similarly, Fan and Wong (2005) show that East Asian audit
clients with a Big N auditor receive smaller share price discounts when the clients have agency
problems. However, not all country level studies find a positive Big 4 effect on accounting
quality or associated Big 4 premium (Langendijk 1997; Bauwhede and Willekens 2004). Further,
archival evidence shows that the market reacts to discretionary accruals (Subramanyam 1996)
and views discretionary accruals more credibly when financial statements are audited by Big N
auditors (Krishnan 2003a).
32
This result is consistent with the popular view among some commentators that long audit tenure is bad. For
example, Schilit (2009) cites longer auditor tenure as a possible financial “red flag.”
32

Summary of Context
Many contextual features have been found to influence audit quality. We focus on a few
factors that are prevalent in the literature (e.g., audit partner compensation, non-audit fees,
auditor tenure, etc.). As shown in figure 2, contextual features are thought to directly influence
audit inputs (e.g., incentives and pressures) and/or the audit process (e.g., judgments and
evidence evaluation) which indirectly influence audit outcomes (e.g., accuracy of audit reports
and financial reporting quality). However, because changes to audit inputs and the audit process
are generally unobservable, the literature tends to test for associations between contextual
features and audit outcomes. We note that there are mixed findings related to the effects on audit
quality of many of these contextual features. Further, there are limitations inherent in the
research methods used to test context because causal inferences are not easily obtainable.
Nonetheless, contextual factors are important to consider because they have significant
interactive effects with audit inputs and audit process that ultimately influence the quality of an
audit.
FUTURE RESEARCH
In spite of the tremendous amount of research already conducted related to audit quality,
there is still much room for future research. Such research could address the primary attributes of
the audit—incentives, uniqueness, process, uncertainty and judgment—within the different
aspects of the audit—inputs, process, outcomes and context. Because the list of research
questions is potentially huge, the examples provided below are designed to spur additional
interest in some new areas of audit research.
Research Related to Conducting an Engagement: Inputs and Process
33

The quality of the inputs to an audit and the audit process itself are difficult to observe
externally. Nevertheless, some parties, notably clients, regulators and the auditors themselves
can observe what goes on within an engagement. As a result, archival research related to inputs
and processes requires access to proprietary data in the possession of insiders, while
experimental, survey, and qualitative research requires access to insiders within the audit process
(audit team, management, and inspectors). Further, the links between attributes of input, such as
professional skepticism and expertise, and the quality of outcomes are difficult to measure. The
ambiguous nature of these links may provide a fruitful area for the application of qualitative
research techniques. Some research questions that might be addressed related to audit inputs and
process include:
 Incentives: How do internal mentoring, training, evaluation, compensation and

promotion incentives and policies influence individual auditor decisions and the
planning and execution of the audit process? How can negative incentives be
realigned or mitigated? Are client scanning procedures used to manage a firm’s risk
appropriate and effective?
 Process: What are the appropriate metrics for assessing the quality of audit inputs and
processes? How do changes in the environment (e.g., increased use of fair value
accounting, introduction of principles based standards) influence changes in the audit
process? How does technology and standardization impact the quality of the audit
process? Are different skill sets needed within an audit team to improve audit quality
(i.e., specialists, higher levels of experience)? How does the audit of internal control
over financial reporting influence auditor judgment and the audit process? Does the
inspection process influence the audit process for better or worse?
 Uniqueness and uncertainty: How does increased uncertainty or ambiguity about

client conditions influence individual auditor decisions? Do auditors adequately
adjust audit inputs and processes to unique attributes of a client? How does input and
process quality link to outcome quality?
 Judgment: How is professional skepticism developed? How does a judgment

framework influence actual auditor judgments? Is a judgment framework
appropriate? How does technical expertise and skepticism interact?
Research Related to the Completed Audit: Outcomes
34

There are many characteristics of an audit that can be externally observed after it is
completed and the financial statements are released even though the level of assurance (residual
audit risk) is generally not observable. Audit reports, financial statements and stakeholder and
market reactions can generally be observed upon release of the financial statements. Other
outcomes of an audit are not externally observable but are also the result of the audit process,
e.g., workpapers and documentation, management letters, reports to the Board, personnel
evaluations, to name just a few. A great deal of research has focused on the externally observable
manifestations of the audit but very little research has looked at the other products of the audit.
Since many of these are internal to a firm, researchers need access to proprietary data or access
to firm personnel for surveys and interviews. Some research questions that might be addressed
related to audit outcomes include:
 Incentives: How do incentives and wrap-up procedures influence auditor decisions

related to the negotiation of audit differences or the form of the audit report? How
does firm culture influence auditor reporting decisions? What are the consequences to
audit partners of poor decision making? How does the anticipation of inspection
influence the finalization of documentation and audit reporting decisions? Does
individual partner signing influence the quality of audit reporting decisions?
 Process: What are the appropriate metrics for assessing the quality of audit outcomes?
How do drivers of the quality of an audit process link to the externally manifested
indicators of the quality of audit outcomes? Does internal and second partner review
improve the quality of audit outcomes? How do perceptions of the evaluation process
for personnel influence audit quality?
 Uniqueness and uncertainty: Does the audit report adequately reflect the uniqueness
of the client and the uncertainty in the environment? Should financial statements be
graded or otherwise made more distinctive? Should audit reports be expanded?
Should an audit report be used as a source of primary information about a client?33
33
Historically, the audit report is used to comment on the fairness of information provided by a client. Recent
proposals have suggested that auditors should reveal some of the first-hand knowledge the have about a client which
is not covered by financial reporting standards, e.g., business risks, quality of management. Such a requirement
would make the auditor a producer of information as well as an assurer of information.
35

 Judgment: Does inspection influence auditor judgments and decisions? Does a focus
on compliance influence auditor judgment and decisions? Does consultation lead to
better auditor decisions? Should auditors have alternative communication channels to
reveal problems to regulators or government agencies?
Research Related to the Audit Firm: Context
The context of the audit in terms of regulation, audit standards and firm practices has
received an extensive amount of attention from researchers because the presumed cause of
auditor behavior (i.e., regulation) is easily observable even if the effect is not. Two of the most
frequently studied areas of auditing are of interest here: non-audit services and auditor tenure. It
is relatively safe to say that, in both cases, the research is mixed and will continue. Another topic
that has received extensive attention is the area of audit fees, which are actually a function of
many aspects of the audit: the inputs to the audit (factors of production), the audit process,
competitiveness of the audit market.34 While much of the research in these areas has utilized
public data, future research may benefit from increased use of surveys and qualitative techniques
that focus on stakeholders of the audit such as Boards, investors and interested third parties.
Some research questions that might be addressed related to the context of the audit include:
 Incentives: What is the appropriate role of the external audit in a system of

governance and control? Does the nature of a firm’s capital structure influence audit
quality (public offerings, debt, and analyst following)? What does audit quality mean
to different stakeholders (shareholders, employees, creditors, suppliers, customers, or
government entities), and what information about the audit and auditor would they
like to have available? Should auditors expand the nature of assurance services that
they market and provide to clients? What is the nature and cost of the audit tender
process? Should audit firm rotation be mandatory?
 Process: What are the appropriate metrics for assessing the quality of firm and
regulatory structures? Why do restatements occur and how are they discovered? Is the
audit process influenced when a common auditor serves multiple clients with
34
See Causholli et al. (2010) for overview of audit markets and audit fees.
36

operational or strategic links (e.g., clients in a supply chain)?35 How are joint audits
conducted and are they better than single audits? How do audit standards influence
the quality of the audit? Do differences in international and US standards result in
differential audit quality (e.g., group audits)? How does audit quality vary over time
and business cycles?36
 Uniqueness and uncertainty: Do standards result in over-standardization of the audit

process? Does inspection result in over-standardization of the audit process? Do
inspectors underweight the uniqueness of individual clients in their evaluations? How
do auditors apply rules-based standards to the audit of individual but unique clients?
 Judgment: Is the education, licensing and training of auditors appropriate for the
complexity and context of current audits? How does firm advancement and retention
policies influence audit quality? Does standardization and an emphasis on workpaper
documentation create over-confidence in auditor judgment?
SUMMARY AND CONCLUSION
Auditing is an integral part of the capital markets and audit quality has received much
attention in the wake of several high-profile accounting scandals. This paper presents a synthesis
of a large body of research on audit quality. We contribute to the literature by providing a
framework for synthesizing and understanding research related to the primary attributes of an
audit (incentives, uniqueness, process, uncertainty and judgment), as well across the different
aspects of the audit (inputs, process, outcomes, and context). This multi-faceted view lends itself
to viewing audit quality through a “balanced scorecard”. We augment prior literature related to
audit quality frameworks (e.g., Francis 2011) by providing a comprehensive review of the related
literature and by adopting a much broader perspective by including archival, behavioral,
experimental, and survey method research, as well as including international research.
35
For example, Johnstone et al. (2012) show that employing a common auditor is facilitated by closer supply chain
relationships, and, as a consequence, audit quality of members of such supply chains improves.
36
Jenkins et al. (2006) document a decline in earnings quality of client firms of industry specialist auditors in the
late 1990’s. Their study suggests that even high quality auditors were unable to prevent the wide spread decline in
earning quality of the late 1990’s. See also Leone et al. (2012).
37

Currently, there is little consensus about how to define audit quality, and the various
frameworks and disclosures that exist are incomplete. The range of definitions is quite broad
because they focus on different attributes of the audit, such as outcomes, process, and judgments.
As a result, stakeholders cannot observe audit quality in its entirety, just the attributes that
manifest through the various phases of the audit itself. While regulators demand that audits be
conducted in accordance with GAAS, investors and audit committee members may simply
demand that audits uncover frauds. Therefore, to consider what matters the most for improving
audit quality, it is important to keep in mind the attributes of the audit itself: incentives,
uncertainty, uniqueness, process, and judgment.
Research has shown that incentives related to auditor tenure, non-audit services, internal
firm pressures, and partner compensation can influence auditor decisions in a positive or
negative manner. Studies of audit outcomes have shown that uncertainty can manifest in
potentially negative ways, i.e., levels of accruals, restatements and nature of audit reports.
Further, the degree of uniqueness has been shown to manifest as variations in risks, controls,
audit procedures and evidence. The audit process attempts to compensate for the uncertainty and
uniqueness an auditor faces but has also been shown to influence audit quality in unforeseen
ways. Finally, audit quality is ultimately dependent on the judgment of a team of auditors. A
great deal of research has pointed to some of the potential causes of auditor errors, as well as
providing insight into compensating factors and techniques for mitigating such errors.
Nevertheless, virtually every so-called “audit failure” can be traced to an error in judgment—
whether unintentional or not—made by the audit team during the course of an engagement.
So what conditions lend themselves to achieving a high quality audit? In summary, one
might conclude that a “good” audit is one where there is execution of a well-designed audit
38

process by properly motivated and trained auditors who understand the inherent uncertainty of
the audit and appropriately adjust to the unique conditions of the client. In short, all five
attributes must be considered when considering whether an audit is high or low quality. It is
important to bear in mind that audit quality is a perceived, rather than directly observed, trait
since we can only learn about cases when audit quality is compromised (e.g., through the
revelation of fraud). To facilitate stakeholder perceptions about audit quality, we believe that a
useful strategy is to develop a “balanced scorecard” that that captures the key attributes of
auditing. The elements of a scorecard could be populated with appropriately directed research,
some of which is already available. For example, prior research documents that some of the
factors affecting the perception of audit quality include knowledge of a client, industry
experience, audit committee oversight, compliance with auditing standards, audit firm ethics,
economic independence of the auditor, rotation of audit partners, and audit inspection (Beattie et
al. 2012). To take the research on audit quality to the next level, researchers need access to new
and better data on drivers of audit quality whether it comes from the firms, clients, regulators or
other sources. With such information in hand, the scholarly quest for a better understanding of
audit quality can continue.
39

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63

Figure 1
UK’s Financial Reporting Council: Audit Quality Framework (FRC 2008, 1)
Skills and
Audit firm Personal
Culture Qualities of
Partners &
Staff
Audit Quality
Factors
Effectiveness of Reliability &
Outside the
Audit Process Usefulness of
Control of
Audit Reporting
Auditors
Note: The figure above includes key drivers of audit quality as defined the U.K.’s Financial
Reporting Council. Interested readers can refer to FRC (2008) for a listing of audit quality
indicators specific to each driver.
64

Figure 2
Indicators of Audit Quality
Inputs Process Outcomes

 Incentives and motivation  Judgment in the audit process  Adverse outcomes
 Professional skepticism  Audit production o Restatements
 Knowledge and expertise  Assessing risk o Litigation
 Within-firm pressures  Analytical procedures  Financial reporting quality
 Obtaining and evaluating o Discretionary accruals
evidence o Accounting conservatism
 Auditor-client negotiations  Audit reports
 Review and quality control  Regulatory reviews of audit
firms
Context
 Audit partner compensation
 Abnormal audit fees
 Non-audit fees
 Audit fee premium - Big N auditors and industry specialists
 Auditor tenure
 Market perceptions of audit quality
65

`
Table 1
Units of Analysis in Audit Research (Francis 2011, 126)
Audit Inputs
 Audit tests
 Engagement team personnel
Audit Process
 Implementation of audit tests by engagement team personnel
Accounting Firms
 Engagement teams work in accounting firms
 Accounting firms hire, train, and compensate auditors, and develop audit
guidance (testing procedures)
 Audit reports are issued in name of accounting firms
Audit industry and Audit Markets
 Accounting firms constitute an industry
 Industry structure affects markets and economic behavior
Institutions
 Institutions affect auditing and incentives for quality
Economic Consequences of Audit Outcomes
 Audit outcomes affect clients and users of audited accounting
information
66

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Audit Quality: Insights from the Academic Literature

October 31, 2012

Electronic copy available at: https://ssrn.com/abstract=2040754

that reduce audit quality.2

general observation: An audit is a professional service delivered by experts in response to

 An audit is an economically motivated response to risk, i.e., incentives matter.

 The output of an audit is a report but the outcome is uncertain and

 Each engagement is different. The idiosyncratic nature of an audit arises due

 The audit is a systematic activity, i.e., process matters.

 The execution of the audit process depends on appropriately leveraging the

in any given engagement. For example, if the outcome of an audit is considered to be

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as we discuss the extant literature on audit quality later in the paper.

The paper makes several contributions to existing research. First, we develop a

supply-side perspective and focuses on archival-based audit research, we include a broader

Therefore, this study should be useful to academic researchers, practitioners, regulators,

investors, and others who are interested in understanding audit quality.

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EXISTING DEFINITIONS OF AUDIT QUALITY

highlight the current diversity.

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quality identifies two important components of audit quality.

assumed to be better than less.

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alternative to gauge overall audit quality.

GENERAL FRAMEWORKS FOR ESTABLISHING AUDIT QUALITY

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[Insert Figure 1 About here]

[Insert Table 1 About here]

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INDICATORS OF AUDIT QUALITY

audit quality—incentives, uncertainty, uniqueness, process and judgment—more directly to the

outcomes which may be reflected in various observable characteristics, e.g., restatements,

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[Insert Figure 2 About here]

riskiness of a client is dependent on the complexity of transactions and accounting systems in

audit is a knowledge-based professional service producing an uncertain and unobservable

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they relate to the inherent uncertainty and idiosyncrasies of the engagement.

Incentives and Motivation

Experimental research has documented that auditor judgments can be impacted by

serving manner (e.g., Kunda 1990; Russo et al. 2000).

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stronger determinants of an auditors’ level of professional skepticism than are dispositional

factors including individual traits.

Knowledge and Expertise

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audit firm values them (Herrbach 2001) influences auditors’ judgments.

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Kelley and Margheim 1990; Reckers et al. 1997).

In general, improvements in inputs should lead to improvements in other indicators of audit

substantially across audit engagements. Accordingly, there is no prescriptive level of inputs

judgments and thus audit quality.

of the common factors that may threaten audit quality.

Judgment in the Audit Process

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matching the appropriate level of auditor experience and expertise is critical.

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reductions in auditor effort, not necessarily supported by underlying client characteristics,