Current Issues in Auditing American Accounting Association

Volume 4, Issue 1 DOI: 10.2308/ciia.2010.4.1.C12

2010
Pages C12–C19

COMMENTARY
Audit Quality Indicators: A Status Update on
Possible Public Disclosures and Insights
from Audit Practice
Jean C. Bedard, Karla M. Johnstone, and Edward F. Smith

SUMMARY: This paper addresses the current status of the recommendation by the Advi-
sory Committee on the Auditing Profession 共ACAP兲 that auditing firms provide periodic
reporting on audit quality indicators. We first consider several reasons why public reporting
of audit quality indicators in the U.S. is highly controversial. We then report some informa-
tion on how global network auditing firms are internally measuring audit quality in the
post-Sarbanes-Oxley environment.
Keywords: audit quality; audit practice; disclosure.

INTRODUCTION
On October 6, 2008, the Advisory Committee on the Auditing Profession 共ACAP兲, established
by U.S. Treasury Secretary Henry Paulson, released its final report 共ACAP 2008兲. As noted in the
introductory statement by co-chairs Arthur Levitt and Don Nicolaisen 共p. II-1兲, Paulson’s charge to
ACAP was to investigate the “sustainability of a strong and vibrant profession,” with the goal of
ensuring the “combination of transparency and trust that enables our financial markets to function
efficiently.” While the final report contains a broad variety of recommendations, several focus on
increasing transparency with regard to the governance and professional practices of audit firms.
The purpose of the transparency recommendations is to increase market participants’ ability to
observe audit quality, thus enabling differentiation among audit firms on the basis of publicly
available data, and providing incentives for firms to increase audit quality. Among the transpar-
ency related recommendations is Concentration and Competition Recommendation 3 共p. VIII-14兲,
which recommends that the Public Company Accounting Oversight Board 共PCAOB兲 “determine
the feasibility of developing key indicators of audit quality and effectiveness and requiring auditing
firms to publicly disclose these indicators.” If feasibility is determined, then the PCAOB is directed
to monitor the reported indicators as part of its oversight function. The purpose of this paper is to
summarize the current status of the debate on the public disclosure of audit quality indicators, and
to provide insights from audit practice on current efforts among the large, global network audit
firms to measure and improve audit quality among their professionals.

Jean C. Bedard is a Professor at Bentley University and a Professorial Visiting Fellow at the University of New South Wales,
Karla M. Johnstone is an Associate Professor at the University of Wisconsin–Madison, and Edward F. Smith is a Retired
Partner of KPMG LLP, and an Adjunct Professor at both Boston College and St. John’s University.

The authors thank Professor Dana Hermanson for thoughtful comments on an earlier draft of this paper.

Submitted: 23 November 2009

Accepted: 6 January 2010
Published: 26 March 2010
Bedard, Johnstone, and Smith C13

THE CURRENT STATUS OF THE DEBATE

ON AUDIT QUALITY INDICATORS
What is the rationale for public reporting of audit quality indicators by audit firms? The essence
of the argument for public reporting is that transparency reveals audit quality, thereby rewarding
firms with higher quality and providing incentives for improvements by firms with lower quality. The
same argument also supports public disclosure of PCAOB audit firm inspection reports, with
low-quality inspection reports generating negative publicity for the audit firms involved 共e.g., Wells
2005; Hermanson and Houston 2008兲. It is important to note that public reporting of audit quality
indicators is not a novel concept, and it has a track record of international acceptance and use
共Smith et al. 2009兲. For example, the Financial Reporting Council’s Audit Quality Framework
reflects audit quality inputs, processes, and outcomes including: the characteristics of and the
culture within an audit firm; the skills and personal qualities of engagement team members; the
effectiveness of the audit process; the reliability and usefulness of audit reports; and factors
outside the control of auditors that may affect audit quality 共see http://www.frc.org.uk/images/
uploaded/documents/Audit%20Quality%20Framework%20for%20web1.pdf兲. However, in the
U.S., reporting of such audit quality indicators has been resisted.1 Why the slow pace of change
on this issue?
The answer to this question lies in understanding the barriers to implementing such reporting,
which was extensively debated during the PCAOB’s Standing Advisory Group 共SAG兲
meeting held on October 22–23, 2008 共see http://www.pcaobus.org/News/Events/Pages/
10222008_SAGMeeting.aspx兲. This debate revealed three main difficulties in adopting audit qual-
ity reporting: 共1兲 defining audit quality; 共2兲 developing adequate indicators of audit quality; and 共3兲
addressing possible unintended consequences.

Difficulties in Defining Audit Quality

Listening to the webcast of the SAG meeting held on October 22–23, 2008 is instructive in
understanding the difficulties in defining audit quality. The debate during that meeting illustrates
that even seasoned professionals convening to discuss the notion of audit quality have difficulty
agreeing on a common definition. Table 1 illustrates the variation that exists in published
definitions of audit quality.
Taken together, the definitions reveal the importance of various aspects of audit quality:
adherence to professional standards, auditor effort, and auditor independence. However, each of
these definitions articulates the construct quite differently. Ultimately, the SAG meeting webcast
reveals disagreement about whether it is even necessary to derive a definition of audit quality
before moving forward with the selection of specific indicators. For some participants, a definition
is deemed necessary for adequate measurement. For others, a universally acceptable definition of
audit quality is less important than agreeing on indicators of the construct that would be useful for
market participants.

1
Deloitte LLP recently produced a report entitled “Advancing Quality Through Transparency” 共Deloitte 2010兲 containing informa-
tion on the firm’s governance processes, ethical principles, independence, and quality controls. In addition, the report describes
the legal structure of Deloitte LLP 共US兲, its US entities and the Deloitte Touche Tohmatsu network within which Deloitte LLP
operates. The Deloitte report contains information on a number of firm-level quality measures referred to later in this paper,
including the firm’s internal inspection procedures, partner evaluations, investments in training and litigation costs. However, it
does not contain engagement-level metrics such as staffing ratios or engagement hours.

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Bedard, Johnstone, and Smith C14

TABLE 1
Definitions of Audit Quality
Definition Source
A high-quality audit is one performed “in accordance with generally GAO 共2003兲
accepted auditing standards 共GAAS兲 to provide reasonable
assurance that the audited financial statements and related
disclosures are 共1兲 presented in accordance with generally
accepted accounting principles 共GAAP兲 and 共2兲 are not materially
misstated whether due to errors or fraud.”

Audit quality is “the market assessed joint probability that a given DeAngelo 共1981兲
auditor will both discover a breach in a client’s accounting
system, and report the breach.”

Higher audit quality is “greater assurance, which requires more Carcello et al. 共2002兲
audit work.”

Measuring Audit Quality

Despite the difficulties inherent in defining audit quality, there exist many indicators that are
potentially helpful in assessing it. Table 2 provides examples of audit quality indicators suggested
by regulators and researchers. We categorize audit quality indicators in terms of
engagement-level versus firm-level indicators, and in terms of indicators measuring inputs to audit
quality versus outputs of audit quality. The table illustrates the broad array of potential indicators
of audit quality.
One proposed solution to address the broad array of possible audit quality indicators is to not
focus on a single indicator, but rather to require reporting of a number of different indicators so that
the combination gives a multi-dimensional picture of audit quality. While such a strategy addresses
the problem resulting from looking at a complex construct from a limited perspective, it presents
other difficulties in terms of the cost-benefit balance. First, the more indicators that are reported,
the more costly the record-keeping will be for audit firms. Second, integrating the multiple
indicators, which may lead to different conclusions, potentially will be more costly to and difficult for
users.

Unintended Consequences
If the PCAOB ultimately does require public disclosures of audit quality indicators, one issue of
importance is whether there might be unintended consequences resulting from disclosure. For
instance, audit firms might manage their practices based upon the required indicators, analogous
to concerns about universities managing to program rankings, and companies to corporate
governance rankings. If so, firms may place undue focus on achieving high rankings rather than
expending resources in ways that incrementally improve audit quality. For example, imagine a
situation in which the number of audit firm training hours 共e.g., in total, per professional, by
professional level兲 is a required indicator. In this situation, audit firms will likely monitor other firms’
disclosures and will expend training hours similar to the industry “benchmark,” possibly without
particular regard for the specifics of training or the unique training requirements of a given firm.
A second concern is that certain indicators must be risk-adjusted to be meaningful. For

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American Accounting Association
Current Issues in Auditing

Bedard, Johnstone, and Smith

Measurable INPUTS
to Audit Quality
Engagement-Level Indicators
Audit hours
Training hours
Personnel assignment
Audit fees
Audit partner tenure
Tailoring of audit tests to
reflect client risk
Audit budgeting
Individual auditor industry
specialization
TABLE 2
Examples of Audit Quality Indicators
Example of Source Measurable OUTPUTS Example of Source
Using Indicator of Audit Quality Using Indicator
O’Keefe et al. 共1994兲 Accuracy of audit opinion Francis and Yu 共2009兲
Chen et al. 共2008a兲; Deloitte Accounting and Auditing SEC; Feroz et al. 共1991兲
共2010兲 Enforcement Releases detailing
Johnstone and Bedard 共2001兲; individual acts indicating low audit
Low 共2004兲 quality, including 10A Proceedings
Carcello et al. 共2002兲 Client discretionary accruals and Hoitash et al. 共2007兲;
Carey and Simnett 共2006兲; Chi other earnings quality measures Chen et al. 共2008b兲
et al. 共2009兲; Bedard and
Johnstone 共2010兲
Elder and Allen 共2003兲
Gist and Davidson 共1999兲;
Bedard et al. 共2008兲
Owhoso et al. 共2002兲;
Thibodeau 共2003兲

Firm-Level Indicators
Audit firm size
Audit firm industry
specialization
Audit firm tenure
Audit firm independence
Audit firm compensation
Volume 4, Issue 1, 2010
Francis 共1984兲
Craswell et al. 共1995兲
Carcello and Nagy 共2004兲
Simunic 共1984兲; Francis 共2006兲
Trompeter 共1994兲; Carcello et al.
Litigationa and related costs
Inspection activities and report
results
Peer review results
Internal inspection results
Palmrose 共1988兲; Khurana and
Raman 共2004兲; Deloitte 共2010兲
PCAOB; Hermanson et al.
共2007兲; Deloitte 共2010兲
AICPA; Casterella et al. 共2009兲

plans 共2000兲

a
While we classify litigation as a firm-level indicator, we acknowledge that litigation related to specific engagements may be linked to the quality of the conduct of
individual audit engagements.

C15
Bedard, Johnstone, and Smith C16

example, if the number of audit hours is a required indicator, it will be important for audit firms to
also reveal the relative riskiness of their individual clients and client portfolios. If audit hours are not
risk-adjusted, then the meaning of that number is obscured because audit effort is necessarily
associated with the audit firm’s private evaluation of the relative complexity and/or riskiness of a
given client. Revealing hours and not the level of auditor-assessed client risk potentially is
misleading, but auditors cannot and should not be required to publicly provide information
concerning their private assessments of client risk.2 Required disclosure of relative client risk could
result in audit firms resigning from or not accepting riskier clients, such as newly public companies
and those in financial distress, with a deleterious impact on investors in those companies.
The above issues represent significant barriers to public disclosure of audit firm quality metrics
in the U.S. As of this writing, no action has been taken by the PCAOB following the October 2008
SAG discussion of this issue.

ADDRESSING AUDIT QUALITY IN CURRENT PRACTICE

As immediate action by regulators on this issue does not appear likely, it is instructive to
consider how the global network firms currently assess and manage audit quality within their
practices.3 Changes in the professional auditing environment in the past decade have caused
audit firms to consider how to improve their practices in order to reduce the number of audit
failures; improve internal consistency with existing firm and professional policies and procedures
regarding GAAS and GAAP; and reduce and avoid negative results in the PCAOB inspection
process. Currently, the large global network audit firms consider audit quality primarily through
outcome indicators such as restatements, 10A actions by the SEC,4 and litigation. Additionally,
they focus strongly on results of PCAOB inspections of public client engagements. In addition to
these sources of information, the large firms also expend considerable resources on their training
budgets and internal inspection programs. They also consider the nature and frequency of na-
tional office consultations on difficult issues, including not only the nature of the issue but also the
frequency of consultations from particular locations 共i.e., region, area, or office兲, industry group-
ings, engagement teams, or specific partners.
All of the global network firms have expanded the quantity and quality of their internal inspec-
tions since the Sarbanes-Oxley Act was passed in 2002. These inspections number in the hun-
dreds of engagements annually, and exceed the number of PCAOB inspections within each firm
by a multiple of four or five. Most firms follow the practice of reviewing each partner periodically,
with more frequent inspections occurring if a risk-based analysis of the engagement, engagement
personnel, client, or industry warrant particular scrutiny, or if concerns or problems had been
raised or uncovered as a result of prior inspections. Factors that could warrant more frequent
inspections include specific issues related to the client’s industry 共e.g., allowance for loan losses,

2
However, most audit firms communicate with their clients and respective audit committees about identified risk factors relevant
to audit planning. Audit firms usually prefer to discuss specific risk factors rather than summary risk scores because a single
numerical score could become a point of debate and distraction rather than providing incrementally value-added information to
clients and audit committees. “Scoring” of public company risk may have value to investors, but in our opinion should be
generated by third parties, not the company’s independent auditor.
3
One of the authors of this paper is a former national office partner of a Big 4 firm, with responsibilities that included quality
control. We obtained information on current practices of other global network firms from senior firm personnel, with the provision
that we only discuss trends among the large firms as a group.
4
A “10A” action against an auditor represents the SEC’s notice of a specific kind of improper professional conduct; i.e., failing to
notify the SEC of a client’s inadequate action in the face of a potential illegal act. These actions are announced along with other
enforcement actions on the SEC’s website, but are not listed in a separate category.

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Bedard, Johnstone, and Smith C17

revenue recognition兲, the engagement 共e.g., poor or inadequate inspection results in a prior year,
a merger or acquisition兲, or the engagement team 共e.g., performance issues raised in a previous
inspection兲.
Issues and problems detected during the internal inspection process 共coupled with PCAOB
results兲 are used to enable firm leaders to perform issue identification and “root cause analysis”
that yield quality improvement action plans and/or remedial actions. For instance, some problems
uncovered in inspections might be more appropriately addressed at the firm-wide level 共e.g.,
training or revision of firm policy兲, while other problems might be considered engagement or
personnel-specific. In this latter case, remedial action would be aimed at the particular engage-
ment 共e.g., a more in-depth review process兲 or personnel 共e.g., a performance improvement plan,
change in assignment, compensation adjustment, or even termination兲.
In addition, some firms have increased their use of “targeted” reviews. Targeted reviews may
be performed after completion of the engagement or while an engagement is in progress. They
involve the specific selection of engagements in an industry or an engagement with certain iden-
tified high-risk characteristics and accounting issues. They are intended to provide assurance that
audit quality is acceptable in the identified high-risk areas, or that exhibit industry specific risks
共e.g., valuations, loan loss allowances, and revenue recognition for technology companies兲. A
targeted review that is performed while an engagement is in progress has the goal of ensuring
that the engagement team “gets it right” prior to completing an engagement and issuing the audit
opinion. Results of internal engagement inspections/reviews also are considered in annual per-
formance evaluations for auditors at all levels.
Selecting reviewers with appropriate experience and competence is very important to a quality
inspection program. Some firms have a core cadre of reviewers, while others conduct internal
inspections during the off-peak season by drafting partners with the desired skills and competen-
cies from the operating offices. Some firms require all partners to perform audit quality reviews at
some point in their career, and consider this activity in their development and annual performance
evaluation.
Completing remediation and monitoring actions regarding previously identified problems can
continue over several years, and such monitoring often is supervised by an internal quality com-
mittee or similar group. The global network firms make extensive use of automated tracking and
compilation tools for inspection results, thereby enabling them to perform trend analysis of recur-
ring or significant engagement performance issues over an extended period of time. As an ex-
ample, firm-wide trends over a two- or three-year period regarding planning or supervision could
indicate a need for expanded firm guidance, or a particular accounting issue could indicate a need
to clarify policies or expand training. The firms’ internal quality committees typically report to
senior partners charged with managing the firm’s individual practices 共audit, tax, or advisory兲 and
monitoring professional and technical issues. Monitoring quality often is under the purview of a
firm-level committee or even the firm’s board of directors. Internal quality committees have the
power to recommend to the firm’s operational management various penalties for partners that
have a record of poor audit quality that, as noted earlier, could include a performance improve-
ment plan, change in assignment, compensation adjustment, or even termination. Similar trend
analysis may be performed at the geographic level 共i.e., region, area, or office兲 with similar actions
taken, but at a higher and broader level within a firm.
Another way that global network audit firms address audit quality is through the use of elec-
tronic systems, media, or tools that are used 共1兲 for timelier monitoring; 共2兲 for ensuring adherence
to auditing standards and firm policies; or 共3兲 for conducting evaluations or providing data to
measure audit quality. Some reports of quality control systems appear in the auditing literature
共e.g., Winograd et al. 2000; Bell et al. 2002兲, illustrating significant and continuing investments in

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Bedard, Johnstone, and Smith C18

internally developed systems, media, and tools.5 These investments include the continued and
accelerated development and refinement of systems for capturing and maintaining workpaper
data, and for supporting client acceptance and continuance decisions. Of particular interest, some
firms make extensive use of third-party analysis and databases, including Audit Analytics 共http://
www.auditanalytics.com兲, Capital IQ 共http://www.capitaliq.com兲, FactSet 共http://www.factset.com兲,
SNL 共http://www.snl.com兲, Moody’s KMV 共http://www.moodyskmv.com兲, Audit Integrity 共http://
www.auditintegrity.com兲, Risk Metrics 共http://www.riskmetrics.com兲, Glass Lewis 共http://
www.glasslewis.com兲, Corporate Library 共http://www.thecorporatelibrary.com兲, and Global Metrics
International 共http://www.gmiratings.com兲.

SUMMARY
In the first section of this article, we discuss barriers to implementing public reports of audit
quality indicators that were suggested by ACAP, including selecting a definition that adequately
represents audit quality, developing indicators that are necessary and sufficient to address the
definition, and avoiding “managing to the measures,” which might have undesirable effects. At this
juncture, these barriers seem formidable. Until regulators address these difficult issues, audit
quality remains in the hands of the firms 共with the exception of PCAOB inspections兲. In the second
section, we present various ways in which the large, global network firms address audit quality,
including by investing in internal inspections and developing electronic systems to support audit
processes and decisions.

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