THE VOLUNTARY CHOICE OF AN AUDIT OF ANY LEVEL OF

QUALITY


David Hay*

David Davis**


February 2002


Abstract

We examine auditor choice in a modern voluntary audit setting, where entities are free to
choose an audit of any level of quality. We test the association of incentives for auditing
with mechanisms that indicate audit quality to users, namely auditor reputation, auditor
size, auditor professional institute membership and auditor education. Logistic regression
tests of each successive choice of a higher quality auditor show that greater entity size is
associated with the choice of a higher level of audit quality. In addition, higher debt is
associated with the choice of a professionally qualified auditor; higher salaries are
associated with the choice of an auditor, with the choice of a qualified auditor and with
the choice of a large audit firm. Receipts of higher voluntary contributions by donations
and grants are negatively associated with the choice of a Big 5 firm. These results
suggest that demand for a higher quality audit is related to incentives for contracting,
signaling and management control but not with demand for insurance.

Keywords: voluntary auditing; audit quality.

JEL Classification: M41, L31

* Department of Accounting and Finance, University of Auckland, Private Bag
92019, Auckland, New Zealand.
Telephone 64 9 373 7599 extension 4878
Fax 64 9 373 7406
Email d.hay@auckland.ac.nz

** The Open Polytechnic of New Zealand.

Acknowledgements
We appreciated helpful comments on earlier versions of this paper by Julie Cotter, Dan
Dhaliwal, Katarzyna Kosmala-MacLullich, Jane Needham and participants at the 2001
Summer Research Workshop at the University of Technology, Sydney, at the 3
rd
Asia
Pacific Interdisciplinary Research in Accounting Conference and at seminars at the
University of Auckland and the Open Polytechnic of New Zealand.

THE VOLUNTARY CHOICE OF AN AUDIT OF ANY LEVEL OF
QUALITY





Abstract

We examine auditor choice in a modern voluntary audit setting, where entities are free to
choose an audit of any level of quality. We test the association of incentives for auditing
with mechanisms that indicate audit quality to users, namely auditor reputation, auditor
size, auditor professional institute membership and auditor education. Logistic regression
tests of each successive choice of a higher quality auditor show that greater entity size is
associated in every case with the choice of a higher level of audit quality. In addition,
higher debt is associated with the choice of a professionally qualified auditor; higher
salaries are associated with the choice of an auditor, with the choice of a qualified auditor
and with the choice of a large audit firm. Receipt of higher voluntary contributions by
donations and grants are negatively associated with the choice of a Big 5 firm. These
results suggest that demand for a higher quality audit is related to incentives for
contracting, signaling and management control but not with demand for insurance.



Keywords: voluntary auditing; audit quality.

1
THE VOLUNTARY CHOICE OF AN AUDIT OF ANY LEVEL OF
QUALITY

1. Introduction
The purpose of this paper is to examine the reasons why entities choose to have an
audit, and why they choose a higher quality audit. Most voluntary auditing and auditor
quality research is restricted to a very limited set of possible states of nature. It is
conducted in settings in which auditing is regulated in that (1) it is compulsory for certain
business entities and (2) auditors must have certain qualifications and be subject to the
quality control of their professional institute. In those circumstances, many studies are
able to examine audit quality only to the extent of examining the choice between Big 5
audit firms and the rest. In this study, we examine a setting in which the entities can
make the voluntary choice of an audit of any level of quality. In an unregulated market
for audit services, entities find many levels of quality are of value. They therefore choose
an audit based on the appropriate level of reputation, size, professional institute
membership, and educational qualifications, and some choose an audit with none of these
quality assurance mechanisms. The paper contributes to the literature by examining the
issue of voluntary auditing, regarding which there are few studies; and by considering
several levels of auditor quality.
This study examines the demand for auditing and the choice of auditor quality by
considering contemporary voluntary auditing practice. The data are obtained from
incorporated societies, a common form of organization in New Zealand. This setting has
the advantages for research that, first, auditing is voluntary, and second, financial
statements must be made available as a public record. The entities are similar to more
2
widely researched corporate forms of organization. This setting provides an opportunity
to examine the issues of voluntary auditing and voluntary choice of higher audit quality,
which are otherwise difficult for researchers to examine, but which are nevertheless of
importance in many other countries and settings.
The next section reviews the existing explanations for voluntary auditing and
auditor quality. We then describe the possible levels of auditor quality. This is followed
by an explanation of incorporated societies, development of hypotheses, and presentation
of the data and results. The final section of the paper discusses the results.
2. Reasons for the voluntary choice of an auditor and for the choice
of level of auditor quality
Several complementary explanations for the choice of an audit or the choice of a
particular level of audit quality have been suggested:
- Monitoring by principals and bonding by agents, for example between owners and
managers, or other forms of contracting between parties, an example being between
borrowers and lenders;
- Signaling insiders knowledge of superior performance through selection of an auditor
with a higher reputation, thereby demonstrating reduced measurement error for the
superior performance shown in the financial reports;
- Insurance, whereby trustees, investors or creditors wish to demonstrate prudence and
insure against losses;
- Organizational control for internal management.
Monitoring, bonding and other contracting
Previous studies provide evidence that auditing (or similar assurance services) is
associated with high agency costs, indicated by greater size, higher debt leverage or
lower managerial ownership (Chow, 1982; Ettredge, Simon, Smith and Stone, 1994).
Blackwell, Noland and Winters (1998) report evidence that small companies in the US
3
pay lower interest rates if they appoint an auditor. Carey, Simnett and Tanewski (2001)
find demand for external auditing in family companies is positively correlated with the
proportion of non-family management, non-family directors and debt.
Signaling
Audits can be used as a means of signaling through audit firm selection. Choosing
a larger audit firm, especially a member of the Big 5, indicates a higher quality audit and
can be a means of signaling insiders knowledge of superior performance. Datar, Feltham
and Hughes (1991) present a model showing that the choice of a higher-quality auditor
and the resulting audited report are a means by which an entrepreneur can inform
investors about the entrepreneur s private information. Beatty (1989) provides some
support for a negative relationship between auditor reputation and IPO underpricing.
Willenborg (1999) studies the demand for auditing by IPOs, and finds support for
signaling (as well as insurance). He shows that there is no Big 5 premium for start-up
companies, where the quality of the audit of past historic financial statements does not
matter, even though there is a Big 5 premium for established companies. This result
suggests that a Big 5 audit is more valuable when there are financial statements to be
analyzed. Wallace (1987) suggests that the information effect could carry over to the non
profit sector, and asks, 'do non-profit entities that issue audited financial statements
receive greater contributions?'
Insurance
Dye (1993) demonstrates that audit fees depend on the option value of the claim
financial statement users have on the auditors' wealth in the event the audit is determined
to have been substandard (as well as the informational value of the audit). This is the
insurance or deep pockets explanation for an audit. Chow, Kramer and Wallace (1988)
4
suggest that providers of external financing and custodians of others funds may demand
audits as a way of increasing the chance of recovering certain types of losses or as
evidence of due care in discharging responsibilities. The bankruptcy of US audit firm
Laventhol and Horwath resulted in the insurance protection offered by the audit being
withdrawn. Consistent with the insurance hypothesis, disclosure of the bankruptcy had
an adverse effect on the share prices of their client companies (Menon and Williams,
1994; Baber, Kumar and Verghese, 1995). Willenborg (1999) studies the demand for
auditing by IPOs, and finds support for the insurance explanation for auditing (as well as
signaling). He shows that Big 5 firm premiums are related to the proceeds of the IPO,
suggesting that auditors charge for the insurance coverage they provide.
Organizational control
In a small organization, the owner or manager controls operations by direct
supervision and personal observation. As it grows larger, delegation becomes necessary,
and reduced observability gives rise to risk of moral hazard and opportunism. Abdel-
Khalik (1993) proposes that owners seek voluntary audits as a compensatory control
system for organizational loss of control in hierarchical organizations. The greater the
number of employees, the more administrative layers the organization has and the more
difficult it is to observe the actions of subordinates. The size of the company (total
assets) is also relevant, as it indicates the maximum amount of wealth at risk. Abdel-
Khalik (1993) finds significant relationships between audit fees and number of layers of
hierarchy, size and debt.
Summary
There are several overlapping explanations for the choices of voluntary auditing
and auditor quality, but there is still relatively little evidence available about any of them.
5
The various explanations all appear to contribute some explanatory power, with different
explanations being supported in different settings. To further develop empirical tests of
the issues of voluntary auditing and auditor quality, we test multiple explanations for both
the choice to have an audit and the choice of auditor quality, controlling for the other
explanations while examining each variable.
3. Auditor quality
Auditing is regulated in virtually all settings in which research has been carried
out. In most commercial settings, not only is auditing required, but it can only be carried
out by a person or firm with appropriate education and professional membership. In
those settings, higher audit quality is generally identified with a firm of larger size or a
firm with a higher reputation. In the setting used for this study, auditing is closer to a
state of nature without the imposition of regulations to prevent anyone at all from being
engaged as an auditor. Thus we can examine audits of all levels of quality.
Audit quality is defined as the probability that the auditor will both detect and
report a breach in the contract to provide fair accounting information (DeAngelo, 1981;
Watts and Zimmerman, 1986). However, audit quality is difficult to observe, and users
must evaluate audit quality using surrogate measures (DeAngelo, 1981). Measures that
help to indicate audit quality include the auditors reputation, membership of professional
societies and large-scale audit firms (Watts and Zimmerman, 1986). The reputation of an
audit firm, particularly a member of the Big 5, is used in many studies as an indicator of
quality (e.g., Francis and Wilson, 1988). In some studies, the existence of second tier
firms with a national reputation is also recognized (e.g., DeFond, 1992). The size of an
audit firm can also represent a proxy for quality, as auditors with a greater number of
6
clients have more to lose by failing to report a discovered breach in a particular clients
records (DeAngelo, 1981). However, Francis and Wilson (1988) find evidence to support
the brand name model but not the size model. Our sample of incorporated societies
includes entities that do not choose to have an audit as well as those that choose auditors
which are able to exhibit various quality mechanisms represented by auditor
qualifications, control by the professional institute, size and reputation.
Choice of any auditor
Our setting includes audits done by unqualified people who are not members of
any professional body, are not subject to any professional regulation and do not have a
large audit practice or a widespread reputation as professional auditors. These
individuals, even if they do not comply with generally accepted auditing standards, add
credibility to the financial statements by putting their reputation at stake. These audits
are also not without cost, even if the cost consists merely of the incorporated societys
committee requesting a donation of time as a favor from a reputable person. However,
this is the lowest level of audit quality, with few if any mechanisms for demonstrating the
competence or independence of the auditor.
Choice of a qualified auditor
At the next higher level of audit quality are individuals with an accounting
qualification. These people, having education in accounting and auditing, are more
competent and more likely to comply with auditing standards. However, they are usually
not audit specialists and they often carry out very few audit engagements. These auditors
are of higher quality by virtue of their education, but do not have other means of
demonstrating quality.
7
Choice of an audit firm
Higher audit quality can be shown by operating as a chartered accountant in
public practice. Chartered accountants in public practice can operate as sole
practitioners, partnerships or (under certain circumstances) as limited liability companies.
We refer to all of these business forms as the choice of an audit firm. To practice as a
chartered accountant in public practice, the auditor must be a member of the Institute of
Chartered Accountants of New Zealand, and this is a mechanism by which information is
provided to financial report users about audit quality. Firms are subject to regular review
by the Institute of Chartered Accountants of New Zealand, and have professional
indemnity insurance. The level of quality of these audits is higher than the previous two,
but an audit firm (auditor in public practice subject to quality control by a professional
institute) is the standard of professional auditing normally considered to be the minimum.
Choice of a larger auditing firm
Larger audit firms are expected to have a higher level of quality. These firms
include the New Zealand members of international practices of second-tier firms such
as BDO and Grant Thornton as well as the international Big 5. These firms carry out a
substantially larger number of audits. Auditors with a greater number of clients have
more to lose by failing to report a discovered breach in a particular clients records, and
this collateral aspect increases the audit quality supplied by larger audit firms (DeAngelo,
1981).
Choice of a Big 5 firm
Big 5 audit firms are not only very large but also have well-established
international reputations as auditors. There is considerable evidence that Big 5 firms (Big
6 or Big 8 in earlier periods) are perceived to provide a higher quality audit. There are
many studies showing they are able to charge fee premiums (e.g., Francis and Simon
8
1987; Johnson et al., 1995). Further evidence is provided by Colbert and Murray (1998),
who find from AICPA peer reviews that auditor size is positively associated with audit
quality. Palmrose (1988) also reports that audits by Big 8 firms are less likely to result in
litigation. Krishnan and Schauer (2000) find that, for not-for-profit organizations in the
US, there is a positive assoc iation between auditor size and audit quality measured by
GAAP compliance. Teoh and Wong (1993) find that companies audited by Big 8 firms
have higher earnings response coefficients, implying that investors find their
announcements more convincing. DeFond (1992) finds that the Big 5 name-brand is a
good substitute for a more complex measure of several quality measures including size,
expertise and independence.
The six choices (from no audit to Big 5) represent increasing levels of quality.
Previous studies examining auditor quality have not been able to examine a wide range of
auditor quality levels, including small firms and qualified and unqualified individuals.
We examine the associations between auditor quality choice and the reasons previously
suggested for choice of an auditor and for choice of a higher quality auditor by reference
to data from 380 incorporated societies in New Zealand.
4. Background: incorporated societies
Previous research on the demand for auditors has not examined incorporated
societies. However, these entities are a common form of organization that has
accountability issues similar to other forms of incorporated entity. They are of interest
for research because they are subject to voluntary audit in a modern setting and they
voluntarily choose from a wide range of auditor quality choices. Incorporated societies
are now discussed in more detail.
9
Incorporated societies in New Zealand exist under the Incorporated Societies Act
1908. They are separate legal entities from their members, with perpetual succession and
limited liability. Incorporated societies include industry associations, trade unions and
voluntary groups formed for sports or cultural purposes. Although by law they are not
permitted to exist for the purpose of making gains to distribute to members, they can
engage in trading activities towards other ends, and some are substantial enterprises such
as the New Zealand Rugby Union, the Consumers Institute of New Zealand, or the New
Zealand Automobile Association. There are tax advantages to choosing this form of
entity, provided it is not intended to distribute profits to members. It is not compulsory
for the financial statements of an incorporated society to be audited and, although the
Registrar of Incorporated Societies recommends that it is 'desirable' to engage an auditor
(Companies Office, 1999), many incorporated societies choose not to. However,
incorporated societies are required to deliver annual financial statements to the Registrar
of Incorporated Societies, and these statements are then available on a public file.
Incorporated societies have many similarities to the usual corporate form. There
is separation between ownership and control, as members (owners) cannot all take part in
management of the entity except in the smallest bodies. Members are equivalent to the
shareholders of a company and have an equity interest in their society surviving and
prospering, even if they are unable to receive dividends from it. Employees of an
incorporated society have their own self-interest, and members will wish to provide
controls over this. In smaller organizations with few or no employees, some activities
will be carried out by volunteers, but the other members will still need controls over
them. And in most organizations there will be an inner group of members forming the
10
equivalent of a board of directors, who have an interest in demonstrating good
stewardship to the other members and in attracting new members. Lenders and other
suppliers are interested in the ability of the (limited-liability) society to repay loans.
Financial distress can and does occur, and is costly to members, management and other
employees as well as to the lenders. Donors and providers of grants are also
stakeholders, and can have a greater interest in a society than a customer does in a
company, as they may have an interest in the activities being carried on, or may have
provided funds for a long term purpose. Donors and providers and grants, as well as
lenders, have an insurance interest as they may rely on the financial reports as evidence
of proper use of their funds and depend on being able to sue the auditor if they incur
losses. In larger entities, there will be a hierarchy of employees, and top managers need
to have control over lower level employees. Thus the explanations for auditor choice,
and for choice of a higher quality auditor, that exist in previous literature all apply to
incorporated societies.
Incorporated societies may appoint anyone as auditor, whether or not the auditor
has any qualifications. There is a statutory exemption in legislation specifically
permitting an unqualified person to call themselves auditor in these circumstances.
1

Thus the members must not only choose whether or not to have an audit carried out; if
they choose an audit, they must then choose between an engaging an audit firm or
prevailing upon a qualified accountant who may be willing to do the audit; or even
appointing a completely unqualified person if this is appropriate to the entitys needs.
11
5. Hypotheses
We hypothesize that each succeeding higher level of auditor quality will be
associated with variables for size, salaries, debt and donations and grants.
Size
The benefit of an audit is relatively greater as an incorporated society becomes
larger, as increased size means the ratio of the cost in proportion to the relative benefits is
lower, and the potential for wealth transfer and amount of wealth at risk is higher. As
incorporated societies increase in size from being very small, it is more likely that
members will demand an audit as a means of monitoring or that the controlling group of
members or management will find it desirable to provide one to facilitate monitoring and
bonding. An unqualified auditor who is a respected member of the society may be able
to conduct an audit that is adequate for the monitoring or bonding function, particularly
in smaller societies. As the society becomes larger, a higher quality audit will be needed
for monitoring or bonding and will also be of relatively greater benefit in proportion to its
costs under any of the other explanations. It is hypothesized that:
H
1
Increased size is associated with choice of a higher quality audit.


Salaries
Monitoring and bonding will become more valuable when there is a self-
interested agent, such as an employee to manage the societys affairs. It is expected that
as the extent of salaries paid increases, there will be greater demand for an audit and for a
higher-quality audit. Management control can also provide an explanation for auditing as
the organization grows larger and has a larger number of administrative layers and more
employees. Higher salary expense by the incorporated society proxies for more staff, and
12
therefore more levels of management indicating greater possibility of loss of control. The
benefits provided by the auditors contribution to the management control function
require expert professional advice to management, and therefore this function is likely to
require knowledgeable and experienced auditors, from larger firms. We hypothesize that
increased salaries will be associated with demand for audits and for higher quality audits
as a means of monitoring and bonding or management control:
H
2
Increased salaries are associated with choice of a higher quality audit.



Debt
Contracting parties such as lenders may lead to a need for an auditor. Debt
contracting requires the existence of an independent auditor, outside the membership of
the entity. Lenders are unlikely to consider an audit by an unqualified member of the
society to be adequate, so that a qualified auditor is likely to be necessary where there is
debt. Nevertheless, for consistency with the other issues investigated, we examine the
hypothesis that audit choice and all of the levels of audit quality are associated with debt:
H
3
Increased debt is associated with choice of a higher quality audit.


Funds from members or donations and grants
Incorporated societies receive their revenue either from members, as subscriptions
or payments for activities, or from non-members, as donations and grants. There are
theoretical reasons for an association between either of these sources and auditor choice.
Firstly, consider funds from members. The signaling function of auditor choice in
societies is analogous to that in IPOs it is a means for management, and existing
members, to signal to prospective members that insiders are aware of superior past
performance. Signaling the insiders knowledge of superior performance, by selection of
13
an auditor with a higher reputation appeals to potential members (and existing members
renewing their membership). Signaling will therefore be of benefit to entities which
obtain their revenue from members, through subscriptions and other charges.
Alternatively, donations and grants could affect auditor choice. Entities might
engage auditors to signal good performance to potential donors and grantors as financial
report users (Wallace, 1987) or as a means of insurance for lenders or donors and
grantors (Chow et al., 1986). Unqualified auditors and qualified individuals usually do
not have professional indemnity insurance and are unlikely to have the deep pockets
which are believed to motivate the choice of auditors as insurers. Larger audit firms are
likely to have greater professional indemnity insurance and more substantial assets, and
therefore are more likely to provide this insurance role. In addition, firms will have
professional indemnity insurance, and deeper pockets, than individuals. It is
hypothesized that:
H
4
Increased revenue from donations and grants (which equates to reduced revenue
from members) is associated with choice of a higher quality audit.

Size is measured by total assets (ASSETS). Debt is measured by the percentage
of debt to total assets (DEBTPER), salaries by the percentage of salaries and wages to
total revenue (SALARYPER) and donations and grants by the percentage of these items
to total revenue (DGPER).
The tests conducted examine whether there are relationships between the
explanatory variables and the choice of an audit, measured by dependent variables
indicating whether there is an audit or not; whether the auditor is qualified or unqualified;
whether an audit firm or an individual is engaged; whether the audit firm is large (either
14
one of the Big 5 or a second tier audit firm) or small; and whether a large firm is one of
the Big 5 firms or a second tier firm.
The same independent variables are used for testing of each of the five dependent
variables, for consistency and clarity, although the importance of each independent
variable can be expected to differ across the various models. For example, DEBTPER is
likely to influence the choice of a qualified auditor more than the simple choice of any
auditor, including an unqualified individual. Logistic regression is used to test the
hypotheses, while controlling for the other variables. The following logistic regression
models are tested:
Audit (0, 1) = 0 + 1 Size + 2 DEBTPER + 3 SALARYPER + 4 DGPER +
e
Qualified auditor (0, 1) = 0 + 1 Size + 2 DEBTPER + 3 SALARYPER +
4DGPER + e
Audit firm (0, 1) = 0 + 1 Size + 2 DEBTPER + 3 SALARYPER + 4
DGPER + e
Large firm (0, 1) = 0 + 1 Size + 2 DEBTPER + 3 SALARYPER + 4
DGPER + e
Big 5 (0, 1) = 0 + 1 Size + 2 DEBTPER + 3 SALARYPER + 4 DGPER + e

6. Data and results
A random sample of the names and registration numbers of 600 incorporated
societies, 300 each in Auckland and Wellington, was purchased from the Registrar of
Incorporated Societies. The office of the Registrar in each city was visited, and the
financial statements held on the files for each society was inspected. Of the 600 items
sampled, there were 380 usable sets of financial statements available (Table 1). The most
15
common reason for an incorporated society being unusable was that it had not filed any
recent financial statements (later than 1996).
Descriptive statistics are shown in Table 2. The observations are progressively
broken down, among the six alternative levels, and Mann-Whitney tests carried out on
the distinction between each adjacent pair of groups. Firstly, we consider the distinction
between entities with no audit and those with an audit. Of the 380 observations, 80 chose
no audit. This no audit group are on average the smallest on both of the criteria of assets
and revenue, and have lower debt, salaries and donations and grants. All of these
differences except donations and grants are significant at p = 0.000; donations and grants
are not significant. Those choosing an audit are then broken down according to whether
the auditor is qualified or not. Again, those choosing an unqualified auditor are lower on
average on every measure, and again these differences are significant at p = 0.000, except
for donations and grants. Those with qualified auditors are further broken down
according to whether a firm is used, again with results showing those making the higher
quality choice of an audit firm have higher assets, revenue, salaries, debt and donations
and grants. These results are significant at p < 0.05, again except for donations and
grants. The next breakdown is by whether the audit firm is large (including Big 5 and
second tier) or small. The entities that choose larger audit firms are on average larger,
have higher debt and higher salaries, and these differences are significant at p = 0.01 or
less. DGPER is larger for the entities audited by small firms, and this difference is
weakly significant at p = 0.08. We then examine differences between incorporated
societies audited by Big 5 and second tier firms. The breakdown finds that, on average,
entities choose a Big 5 audit as each of the variables for size, debt, and salaries increase,
16
but these differences are usually not significant (except for assets, where p = 0.094).
Donations and grants are an exception incorporated societies choosing a Big 5 audit
have lower donations and grants and lower DGPER, and this difference is significant at p
= 0.018.
The results of these univariate tests are consistent with the predictions in the
hypotheses, except where donations and grants are concerned. Hypothesis 4 predicts a
relationship between DGPER and audit choice/auditor quality choice, although we note
that there is also theoretical support for a negative relationship, based on higher quality
audits being associated with a greater contribution by members (and hence a lower
contribution from donations and grants). The results show no relationship for three of the
choices, and support for a negative association with donations and grants (positive
association with members contributions), in the cases of larger firms and Big 5 firms.
Ordinary Least Squares regression tests of the relationships between audit fees
and the explanatory variables are carried out for each level of auditor quality, in order to
confirm whether the audit quality implied by education, professional control, size and
reputation is supported by fee premiums. Not all of the entities disclose audit fees, but a
substantial proportion do (144 out of 300 audited entities). These results are reported in
Table 3. They show that in each case, there is a significant fee premium for each more
highly qualified group of auditors. This provides evidence that the audits by qualified
auditors are perceived as higher quality than those by unqualified auditors; further, audits
by firms are of higher quality than audits by individuals; audits by large firms are of
higher quality than small firms; and audits by the Big 5 are of higher quality than second
17
tier firms. Thus the measures we use for audit quality are supported by evidence from fee
premiums.
Logistic regression results of the tests of auditor choice at each level are reported
in Table 4. Assets are significantly related to all of the auditor choices, consistent with
Hypothesis 1, except for the choice between Big 5 and second tier. Hypothesis 2 is
supported by the significant positive relationship between SALARYPER and the choice
to have an audit, and by the significant positive relationships of SALARYPER and the
choices of a qualified auditor and a large firm. Hypothesis 3 is not supported by the
relationship between increased debt and voluntary auditor choice, but Hypothesis 3 is
supported by the significant positive relationship between DEBTPER and the choice of a
qualified auditor. This suggests that, as discussed above, an audit for debt contracting
purposes must be of higher quality than the minimum. Hypothesis 4 is not supported, as
there is no relationship between DGPER and the choice of an auditor, a qualified auditor,
an audit firm or a large firm, and there is a negative and significant relationship between
DEBTPER and the choice of a Big 5 firm. These results support signaling for members,
not signaling or insurance for providers of donations and grants, as an explanation for
auditing.
The overall models are significant at p < 0.05 in each case. The percentage of
accurate predictions varies from 78.7% for the choice of auditor or no auditor, to 67.6%
for the choice between an individual and a firm. Although the models are all significant,
the pseudo R
2
measures are not high, suggesting that although the variables tested are
important determinants of auditor choice, there appear from this to be other factors as
well. Although the explanatory variables are correlated to some extent, diagnostic tests
18
using condition numbers and variance inflation factors (conducted using OLS) do not
indicate the existence of multi-collinearity problems. Alternative specifications of the
model using revenue instead of assets as a size measure, using a log transformation of
assets, and using debt as a categorical variable produce similar results with similar levels
of significance.
7. Discussion
Previous studies of voluntary auditing and audit quality have been constrained by
their settings to examine only the tip of the iceberg of auditor choice. We are able to
extend examination of the research questions in those studies to a setting where it is
possible to examine a choice of many levels of auditor quality. The setting (incorporated
societies) is a commonplace one and the forces driving the demand for auditing are
similar to those affecting companies. Given the choice, most entities do choose an audit.
Those that do not choose to have an audit are small, and have low if any salaries and
wages and low if any debt.
Among entities that are audited, the choices of level of auditor quality are
consistent with expectations. Most of the remaining entities choose a qualified person or
firm, those choosing an unqualified individual being comparatively small with low debt
and low salaries. The next choice, for those entities that have a qualified auditor, is
between an individual and a firm. Size is positively associated with the choice of a firm.
Size and salaries also appear to influence the choice between those selecting a larger
(second tier or Big 5) firm and the rest. Finally there is a choice between a second tier or
Big 5 firm. This selection is not associated with size (unlike the others) and is negatively
associated with donations and grants.
19
The results support the prediction that audits are relatively more likely to be
selected as entity size increases. In addition, higher quality auditors are more likely to be
selected as entity size increases, except at the level of selecting a Big 5 auditor. Higher
salaries are also associated with audits, with the selection of a qualified auditor and with
the selection of a larger audit firm. Debt is not associated with the selection of an auditor
when the other variables are controlled for, although it is associated with the choice of a
qualified auditor. Revenue from members is associated only with the selection of a Big 5
auditor, not with any of the other levels. Donations and grants are not associated with
any of the choices of auditor or audit quality (except negatively with the choice of a Big 5
auditor). Although Wallace (1987) asks whether an audit is associated with greater
contributions, there is no evidence of that in this study.
The results support monitoring and bonding as an explanation for auditing, and
they also support contracting where debt is involved. They support signaling as an
explanation of auditing. The results also support auditing as a means of compensating for
organizational loss of control. The results do not support the insurance or deep pockets
explanation of auditing
2
.
The results regarding the Big 5 firms are not consistent with the findings of
previous studies. Big 5 firms do not appear to be preferred by the largest entities and
those with the highest debt. Entities with larger donations are more likely to be audited
by second tier audit firms. Anecdotal evidence from Big 5 firm partners suggests that
Big 5 firms prefer not to become involved with incorporated society audits (and partners
are encouraged to support their community organizations with donations of money, not
donations of audit services). Thus the Big 5 are more likely to be involved with
20
incorporated societies of a commercial nature, not community organizations supported by
donations and grants, and this is consistent with the results showing a negative
relationship between DGPER and Big 5 auditors. This negative relationship suggests that
Big 5 audits are chosen where it is necessary to signal high quality financial reporting to
members (as a low level of DGPER corresponds to higher revenue from other sources,
mainly members).
The study is concerned with auditor choice when there is no regulation of
auditing, and voluntary choice of auditor quality. This issue is difficult to research, as
researchers are frequently limited to settings in which auditing is regulated. The results
suggest that, in a setting where auditing is not compulsory, most entities choose to be
audited. They frequently choose an audit of higher than the minimum quality, and pay a
premium for it. Auditing is not a commodity, but takes a wide variety of forms - entities
that choose to have an audit can find benefits in engaging unqualified auditors, or
qualified individuals as well as firms, second tier firms and Big 5 firms. The choice of an
audit, and from the five levels of auditor quality, can be explained by incentives for
contracting, signaling and management control, but not by the insurance explanation.
Further research could extend examination of these issues to other settings where
there is a voluntary choice of an audit of any level of quality, to confirm the application
of the theoretical models to other settings apart from New Zealand incorporated societies.
In addition, studies of auditor switching in settings like this could provide further
evidence about auditor choice.
21
References
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Beatty, R. 1989. Auditor Reputation and the Pricing of Initial Public Offerings.
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Carey, P., Simnett, R. and Tanewski, G. 2001, Voluntary Demand or Internal and
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Influences, The Accounting Review, 57, 272-291.
Chow, C.W., Kramer, L. and Wallace, W.A. 1988. The Environment of Auditing, in
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valuing new issues. Journal of Accounting and Economics, 14: 3-49.
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DeFond, M. 1992. The Association Between Changes in Client Firm Agency Costs and
Auditor Switching. Auditing: A Journal of Practice and Theory, (Spring): 16-31.
Dye, R. 1993. Auditor Standards, Legal Liability and Auditor Wealth. Journal of
Political Economy. 101 (5) 887-914.
Ettredge, M., D. Simon, D. Smith and M. Stone, 1994, Why Do Companies Purchase
Timely Quarterly Reviews? Journal of Accounting and Economics , 19, 131-155.
Francis, J. R. and Simon, D. T. 1987. A Test of Audit Pricing in the Small-Client
Segment of the US Audit Market. The Accounting Review, (January): 145-157.
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Relating to Agency Costs and Auditor Differentiation. The Accounting Review,
(October): 663-682.
22
Johnson, E. N., Walker, K. B. and Westergaard, E. 1995. Supplier Concentration and
Pricing of Audit Services in New Zealand. Auditing: A Journal of Practice &
Theory, (Fall): 74-89.
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Accounting Review. 69 (2): 327-342.
Palmrose, Z. An analysis of auditor litigation and audit service quality. Accounting
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Teoh, S. and T. Wong 1993. Perceived auditor quality and the earnings response
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238.
23

Table 1: Usable observations

Societies sampled 600
Less:
Duplications in sample supplied


14
Wound up or struck off 4
Latest financial statements older than 1996 62
No financial statements on file* 121
Incomplete financial statements 3
Financial statements subject to a review or compilation 16
Useable entities 380

* Of these, 25 were incorporated in 1999 or 2000






- 24 -
Table 2: Panel A. Descriptive statistics by auditor quality (n = 380)
Variable
a
Unaudited
(n=80)
Audited
(n=300)
Total
Audited
Unqualified
auditors)
Qualified auditors
(n=228)
(n=72 Total
qualified
Individuals
(n=87)
Firms
(n=141)
Auditors Total
firms
Small firms
(n=103)
Big 5 or second tier
(n=38)
Total Big 5 or
second tier
Second tier
(n=20)
Big 5
(n=18)
Assets
Median
Mean
Std. Dev.

7,537
32,416
102,49 6

34,603
304,527
1,062,403

14,462
68,348
163,678

45,840
379,109
1,206,251

25,438
133,821
630,576

102,650
530,458
1,433,364

77,572
228,339
411,437

292,174
1,349,359
2,522,781

268,647
706,052
1,517,499

640,955
2,064,144
3,201,628
Revenue
Median
Mean
Std. Dev.

7,737
22,478
53,477

30,222
363,076
2,878,602

10,747
33,216
64,974

50,639
467,242
3,296,648

23,613
64,593
96,076

73,219
715,685
4,177,669

52,294
158,692
304,927

406,666
2,225,428
7,910,573

313,586
740,557
1,318,969

506,572
3,875,285
11,347,993
DEBTPER
Median
Mean
Std. Dev.

0.00
0.06
0.16

0.00
0.11
0.22

0.00
0.04
0.18

0.01
0.13
0.22

0.00
0.11
0.21

0.04
0.14
0.23

0.01
0.13
0.24

0.11
0.18
0.20

0.07
0.15
0.19

0.14
0.21
0.22
SALARYPER
Median
Mean
Std. Dev.

0.00
0.03
0.13

0.00
0.14
0.24

0.00
0.06
0.16

0.00
0.17
0.33

0.00
0.15
0.27

0.03
0.17
0.24

0.00
0.15
0.23

0.17
0.25
0.24

0.22
0.26
0.24

0.14
0.24
0.24
DGPER
Median
Mean
Std. Dev.

0.00
0.20
0.33

0.04
0.21
0.34

0.02
0.16
0.27

0.05
0.23
0.33

0.07
0.25
0.34

0.03
0.22
0.32

0.06
0.23
0.34

0.00
0.18
0.29

0.06
0.29
0.36

0.00
0.07
0.11
Panel B. Mann-Whitney U statistics for the difference in mean rank (1-tailed significance in brackets)
Variable
a

Audited/unaudited Qualified/unqualified Firms/individuals Big 5 or second tier/small firms Big 5/second tier
Assets 6365
(0.000)
5206
(0.000)
3864.5
(0.000)
1110
(0.000)
135
(0.094)
Revenue 6239
(0.000)
4428
(0.000)
4036
(0.000)
994
(0.000)
155
(0.239)
DEBTPER 8876
(0.000)
5373.5
(0.000)
4993
(0.007)
1470
(0.010)
146
(0.166)
SALARYPER 8015
(0.000)
5720.5
(0.000)
5297
(0.036)
1292
(0.001)
173
(0.419)
DGPER 10324
(0.751)
7887
(0.325)
5839
(0.287)
1645
(0.080)
108
(0.018)
a
Assets = total assets in $; Revenue = total revenue in $; DEBTPER = total debt divided by total assets; SALRYPER = total salaries and wages divided by total revenue; DGPER = total donations and grants
divided by total revenue.
- 25 -
Table 3: OLS regressions of the relations between audit fee and size (total
assets), debt, salaries/wages, donations/grants and auditor quality

LNAudit fee = 0 +1LNASSETS +2DEBTPER +3SALARYPER +4DGPER
+5Auditor +e
Auditor variable Unqualified
or qualified
auditor
Individual
or firm
Small firm
or large
firm
Second tier
firm or Big
5 firm
Independent
variables
a




LNASSETS
Significance
b



.485
.000
.442
.000
.397
.000
.413
.000
DEBTPER
Significance
b



1.084
.001
1.046
.001
.929
.005
1.011
.094
SALARYPER
Significance
b



.775
.011
.880
.003
.736
.022
.302
.329
DGPER
Significance
b



-.267
.138
-.255
.135
-.0944
.360
.597
.148
Constant
Significance
c



.0389
.468
.545
.132
1.985
.001
1.850
.078
Auditor quality variables
Qualified auditor
Significance
b

.845
.000

Firm
Significance
b

1.046
.000

Large firm
Significance
b

.486
.007

Big 5 firm
Significance
b

.775
.017
Sample size
d
144 124 98 32
Adjusted R
2
.611 .639 .564 .455
F
Significance
45.876
.000
44.569
.000
26.137
.000
6.186
.001
a
LNASSETS = log of total assets
DEBTPER = total debt divided by total assets
SALARYPER = total salaries and wages divided by total revenue
DGPER = total donations and grants divided by total revenue

b
One-tailed.
c
Two-tailed.
- 26 -
Table 4: Logistic regressions of the relations between auditor quality and
size (total assets), debt, salaries/wages and donations/grants
Auditor choice(0, 1) = 0 +1Assets +2DEBTPER +3SALARYPER +4DGPER +e
Dependent
Variables-
Choice of
an auditor
Choice of a
qualified
auditor
Choice of a
firm
Choice of a
large firm
Choice of a
Big 5 firm
Independent
variables
a




Assets
Significance
b


.000005
.00
.000002
.02

.0000009
.02
.000001
.00
.0000002
.17

DEBTPER
Significance
b


.590
.22
1.901
.03
.510
.22
.177
.43
2.246
.16
SALARYPER
Significance
b


2.826
.01
1.769
.02
.186
.38
1.946
.01
.004
.49
DGPER
Significance
b


-.215
.31
.429
.20
-.201
.33
-.521
.23
-4.086
.03
Constant
Significance
c


.732
.00
.488
.01
.219
.28
-1.768
.00
-.145
.84
Sample size

380 299 227 140 38
Model Chi-
Square
Significance

43.335
.00

31.347
.00

12.194
.02

25.655
.00

9.761
.04
Percentage of
correct
predictions

Pseudo R
2
measures
McFadden
Cox & Snell
Nagelkerke


78.7%



.108
.167


75.92%



.094
.100
.149


61.67%



.039
.052
.071


76.43%



.159
.167
.243


71.05%



.189
.227
.302
a
Assets = total assets
Revenue = total revenue
DEBTPER = total debt divided by total assets
SALARYPER = total salaries and wages divided by total revenue
DGPER = total donations and grants divided by total revenue

b
One-tailed.
c
Two-tailed.
d
Reduced sample sizes for these tests are because not all entities disclosed audit fees.
- 27 -

Endnotes

1
Institute of Chartered Accountants of New Zealand Act 1993, section 15. The Act otherwise requires that
anyone describing themselves as accountant or auditor must be suitably qualified by holding a certificate,
degree, diploma, registration, or similar qualification that is relevant to the practice of accounting or
auditing.
2
Lack of support for this explanation may be related t o the setting examined, as it is less common for the
auditors of an incorporated society to be subject to legal action (although this is not unknown - in a widely
reported example, the auditors of the New Zealand Sports Foundation were threatened with legal action
after a management fraud).