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    Investors' Perceptions of Audit Quality: Effects of...
    research summary posted October 16, 2015 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
    Investors' Perceptions of Audit Quality: Effects of Regulatory Change.
    Practical Implications:

    The results from this study should also be of interest to regulators and legislators around the world who continue to debate the potential costs and benefits of auditor liability reform. Implications of these findings are threefold. First, contrary to regulators’ intent that AS5 would improve efficiency without sacrificing effectiveness of the audit of internal controls, investors appear to believe the new standard will achieve the improved efficiency by sacrificing audit quality. Second, investors appear to believe that economic incentives to reduce audit quality outweigh auditors’ reputation concerns following auditor liability reform. Third, individuals are likely to reduce their equity investments if shareholder recourse is further limited by additional liability reform.


    Smith, J. L. 2012. Investors' Perceptions of Audit Quality: Effects of Regulatory Change. Auditing: A Journal of Practice & Theory 31 (1): 17-38.

    auditor quality, audit liability, internal control, investor perceptions
    Purpose of the Study:

    Auditors provide a critical service to the world’s capital markets. Without high-quality audits, managers would face a higher agency cost, and investors would be less confident in corporate disclosures. Because actual audit quality is an unobservable state, investors’ perceptions of audit quality become their view of reality and likely affect their judgments and decisions.

    The author examines the effects of two heavily debated regulatory changes on individual investors' perceptions of audit quality. The first change he examines is from a bottom-up coverage-based standard (i.e., Auditing Standard No. 2) to a top-down risk-based standard (i.e., Auditing Standard No. 5) for conducting the audit of internal control pursuant to Section 404 of the Sarbanes-Oxley Act. The second change examined is the proposed passage of legal reform that reduces auditors’ liability exposure following an alleged audit failure. The author examines individual investors because they represent an important set of financial reporting users whose protection and advocacy is charged to oversight bodies like the Securities and Exchange Commission (SEC) and because international regulators have recently called for research to enhance the understanding of various stakeholders’—including investors’—perceptions of audit quality. He studies the effects of the two aforementioned regulatory issues because they both represent significant changes in the auditing environment that affect auditors’ incentives and loss function for an integrated audit engagement.

    Design/Method/ Approach:

    The author implements a 232 between-subjects repeated measures design. The participants in this study are 101 Executive and evening M.B.A. students from a large, public university. Participants have an average of 11.57 years of full-time work experience. Most of them have previously invested in mutual funds (85 percent), have purchased individual stocks within the past three years (57.4 percent), and plan to invest in individual stocks within the next two years (71.3 percent).The evidence was gathered prior to November 2010.


    The author finds that both regulatory changes cause significant reductions in investors’ perceptions of audit quality. In the case of the change in auditing standards, he finds evidence suggesting that the perceived reduction in audit quality is driven by a perceived focus on efficiency in the new standard. The results also suggest the perceived reduction in audit quality following the auditor liability reform is driven by a perceived reduction in the auditor’s cost of an audit failure. Interestingly, he finds that the perceived reduction in audit quality following both regulatory changes leads investors to expect a reduction in management’s investment in internal control. Finally, the author finds that investors significantly reduce their equity investments following the liability reform, but the effect of a change in auditing standards appears to be conditional on investors’ experience. Specifically, investors who purchased individual stocks within the past three years appeared more likely to increase their investment allocation following the change from AS2 to AS5 while individuals who had not purchased individual stocks were more likely to reduce their equity investment allocation.

    Audit Quality & Quality Control
    Proxies for Audit Quality