Do SMP Auditors (Really) Deliver Poor Audit Quality to PIE Clients?

Abstract

This paper studies the relationship between client importance and audit quality for small and medium sized audit practices (SMP). We mobilize the German setting, where SMP client importance can be measured precisely and analyzed for public interest entity (PIE) clients. Our results show that common measures of economic dependence severely overestimate the actual dependence of SMPs. Relying on our precise measurement, we find a positive non-linear relationship between dependence and audit quality. Our results demonstrate that as long as client importance does not exceed critical thresholds, SMPs provide higher audit quality to more important PIE clients. In fact, we find that clients engage in less accrual-based earnings management (AEM) until reaching high client importance thresholds, at which point the relationship reverses. Furthermore, our results suggest that clients might trade off AEM with real earnings management (REM), supporting the notion that providing higher audit quality could also have detrimental effects. In additional analyses, we show how SMPs protect themselves against PIE client independence threats, thus further explaining why SMPs can deliver high-quality audits as dependence increases. Finally, we find that our results are robust and even stronger when relying on de-facto office and partner level analyses and using measures of extreme earnings management.

Daniel Schaupp

Assistant Professor of Strategy and Managerial Accounting

My research interests include performance evaluation, feedback, incentives and the impact of new digital technologies on management control.