Do Joint Audits Improve or Impair Audit Quality?

• Author: TONG LU,DAN A. SIMUNIC,MINLEI YE,MINGCHERNG DENG
• Date: 01 December 2014
• DOI: http://doi.org/10.1111/1475-679X.12060
• Published date: 01 December 2014

DOI: 10.1111/1475-679X.12060

Journal of Accounting Research

Vol. 52 No. 5 December 2014

Printed in U.S.A.

Do Joint Audits Improve or Impair

Audit Quality?

MINGCHERNG DENG,

∗TONG LU,

†DAN A. SIMUNIC,

‡

AND MINLEI YE

§

Received 30 December 2012; accepted 25 August 2014

ABSTRACT

Conventional wisdom holds that joint audits would improve audit quality by

enhancing audit evidence precision because “Twoheads are better than one.”

Our paper challenges this wisdom. We show that joint audits by one big firm

and one small firm may impair audit quality, because, in that situation, joint

audits induce a free-riding problem between audit firms and reduce audit

evidence precision. We further derive a set of empirically testable predictions

comparing audit evidence precision and audit fees under joint and single

audits. This paper, the first theoretical study of joint audits, contributes to a

better understanding of the economic consequences of joint audits on audit

quality.

JEL codes: M42; H48

Keywords: Joint audits; audit evidence precision; audit fees

∗Baruch College; †University of Houston; ‡University of British Columbia; §University of

Tor on to .

Accepted by Haresh Sapra. We would like to thank an anonymous reviewer, Gordon

Richardson, Mark Penno (Symposium discussant), and participants at the 20th University

of Illinois Symposium on Auditing Research, the European Accounting Association Annual

Congress 2013, and the Canadian Accounting Association Annual Conference 2013. We thank

an anonymous audit firm for providing the interview opportunity. Mingcherng Deng was sup-

ported by a PSC-CUNY Award and the Eugene M. Lang Junior Faculty Research Fellowships.

1029

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

1030 M.DENG,T.LU,D.A.SIMUNIC,AND M.YE

1. Introduction

Are two heads better than one? The answer to this question seems straight-

forward and it is the most commonly cited reason in support of joint

audits—where two audit firms simultaneously and yet separately audit a

company and sign a common audit report. Proponents of joint audits often

argue that two pieces of audit evidence produce higher total information

precision than just a single piece. For example, in auditing a company’s fair

value estimate of a certain asset, auditors are weakly better off with another

piece of audit evidence about the fair value estimate, because they always

have an option of ignoring the second piece of evidence if it is completely

uninformative.

Joint audits are not uncommon. For example, France has mandated by

law joint audits of public companies since 1966. South Africa has the same

mandate for the financial services sector. Various countries, such as India,

Germany, Switzerland, and the United Kingdom, have proposed voluntary

joint audits. In 2011, “joint audits are not made obligatory but are encour-

aged” by the European Commission (EC) and European Parliament.1

If two heads are indeed better than one, then joint audits probably would

be more prevalent in the world. But single audits are still the norm in

most countries, with the United States being a notable example. In 2005,

Denmark did a complete about-face change on joint audits—it abolished

the mandate for joint audits effective since 1930. Interestingly, only 19 of

182 Danish companies had more than one auditor in 2009 (Le Vourc’h and

Morand [2011]).

Apparently, proponents’ arguments do not form a complete picture of

the benefits and costs of joint audits. To reconcile the difference, we iden-

tify an economic force that may work against joint audits, that is, free-riding.

In joint audits, one of the audit firms may save audit resource cost by invest-

ing less in its own audit work and taking advantage of the other audit firm’s

hard work.

We consider three regimes that may vary in the magnitudes of potential

free-riding problems: single audits by one big firm (Regime B); joint au-

dits by two big firms (Regime BB); joint audits by one big firm and one

small firm (Regime BS). The goal of the paper is to compare audit evi-

dence precision and audit fees in these three regimes. While the first two

regimes serve as benchmarks, the third regime is particularly interesting

because it is the EC’s target regime; specifically the EC states that Regime

BS “could act as a catalyst for dynamising the audit market by allowing small

and medium-sized firms to participate more substantially in the segment of

large audits” (European Commission [2010], p. 17).

We make two assumptions to capture the differences between a big audit

firm and a small one. First, a big audit firm has an advantage in its auditing

1Available at http://europa.eu/rapid/press-release IP-11-1480 en.htm?locale=en

(accessed September 9, 2014).

DO JOINT AUDITS IMPROVE OR IMPAIR AUDIT QUALITY?1031

technology in the sense that it has a lower marginal cost of audit evidence

precision than a small firm (Simunic [1980], Dopuch and Simunic [1982],

Banker, Chang, and Cunningham [2003]). Second, a big audit firm bears

a larger proportion of misstatement costs (such as litigation risk and repu-

tation loss) than a small firm (DeAngelo [1981]).

Under our model assumptions, we find that Regime BB generates the

same audit evidence precision as Regime B. Also, audit fees are lower under

Regime BB than Regime B.2Comparing Regime BS with Regime B,wefind

that the total precision of audit evidence under joint audits is lower than

that under a single audit. In addition, the audit fees under joint audits are

lower than that under single audits if the technological difference between

the two audit firms is small and the big firm bears a large proportion of

misstatement cost.

Our research makes the following contributions. First, we extend the

theoretical literature on audit quality by identifying the strategic interac-

tions in an auditing game, that is, the joint auditors’ strategic free-riding

incentives between each other. In the context of single audits, previous re-

search analyzed different factors that may influence audit evidence preci-

sion (Dye [1993], Schwartz [1997], Pae and Yoo [2001], Beyer and Sridhar

[2006], Zhang [2007]). Our paper enriches the literature by identifying a

new strategic factor that may arise in the institutional setting of joint audits.

Second, to the best of our knowledge, there is no prior theoretical

study of joint audits (Ratzinger-Sakel et al. [2012]). The existing empir-

ical research provides mixed evidence on the impact of joint audits on

audit quality and audit fees (e.g., Gonthier-Besacier and Schatt [2007],

Piot [2007], Thinggaard and Kiertzner [2008], Francis, Richard, and

Vanstraelen [2009], Lesage, Ratzinger-Sakel, and Kettunen [2012]). Our

model reconciles these mixed findings and provides new empirical predic-

tions, which we elaborate on in section 6.

Finally, this study provides timely policy implications for regulators. To

encourage the growth of small-sized audit practices, the EC is considering

a mandate that large companies hire at least one audit firm outside the

Big 4 firms to conduct joint audits (European Commission [2010]). Our

analysis suggests such a mandate could damage audit quality. In light of

international convergence of audit practice and standards, our paper can

inform global regulators’ deliberations on the desirability of joint audits.

The paper proceeds as follows. Section 2 provides institutional back-

ground on joint audits. Section 3 presents the structure and ingredients

of the model under the three regimes, B,BB,andBS. Section 4 establishes

2Our analysis assumes there exists no fixed coordination cost in joint audits. Audit fees

can be higher under Regime BB than Regime Bif the fixed coordination costs between two

audit firms for working together swamp the economic savings generated under Regime BB.

We provide detailed discussion in Section 7.2 on the impact of fixed coordination cost on our

analysis and on why we do not observe the voluntary adoption of joint audits on a large scale

in practice.