ARTI

CLEREVI
EW

AUDI
TFI
RM,
RETAI
NORROTATI
ON?(
CLI
ENTANDAUDI
TFI
RM
PERSPECTI
VES)

August2021
Ar
ti
cleRev
iew

ARTI
CLEREVI
EW

1.Backgr
oundAboutt
heAr
ti
cle

The ar
ti
cle,“
Audi
tFi
rm,Ret
ain orRot
ati
on? (
Cli
entand Audi
tFi
rm Per
spect
ives)
”,by
Ghol
amhossei
n Mahdav
iand AbbasAl
iDar
yaeiwaspubl
i
shed i
nthe j
our
nalofCogent
Economi
cs&Fi
nance,
Vol
ume5:
1313559,
int
hey
ear2017G.
C.

Thear
ti
clepr
ovi
desanewev
idencebydev
elopi
ngaf
ramewor
kforunder
standi
ngt
her
oleof
audi
tfi
rmr
otat
ioni
ncl
i
entexpect
edv
alue.

2.I
ntr
oduct
ion

I
nther
evi
ewedar
ti
cl
e,t
heaut
hor
ssuggest
edanexpl
anat
ionont
hepr
inci
plesofcl
i
entchoi
ce
by audi
torv
ia speci
fi
ed model
sfor
mal
i
zed t
hrough st
akehol
dert
heor
y.Accor
ding t
o
st
akehol
dert
heor
yowner
s’expect
edout
comei
sincr
easei
nthel
evelofr
epor
ti
ngqual
i
ty,al
l
el
sehel
dequal
.Theaut
hor
sinv
est
igat
edt
hemut
ualr
elat
ionshi
pbet
weenaudi
tfi
rm andcl
i
ent
i
namat
hemat
icalmodelandshowedt
hisr
elat
ionshi
phasdev
elopedbasedonbi
dandask
pr
ocess.

Basedoneconomi
ctheor
ies,t
heaut
hor
sal
sodi
scussedt
hatt
hepr
oduct
ionandsuppl
yofa
par
ti
cul
argoodorser
vice,orl
ackofi
tcanbeconsi
der
edasal
ogi
calconsequenceof
mechani
smst
hatexi
sti
nthemar
ketandt
hev
alueoft
hegoodorser
vicer
efl
ect
sthev
iewsof
consumer
s(Wal
l
ace,
1987)
.

Audi
tser
vicequal
i
typl
aysasi
gni
fi
cantr
olei
naudi
tfi
rmr
etent
iondeci
sions.Fr
om t
heowner
s’
v
iewpoi
nt,
impr
ovementofaudi
tfi
rm qual
i
tyshoul
dleadt
ohi
ghst
ockv
alueorexpect
edv
alue.
Audi
tser
vicequal
i
tyl
eadst
orepor
ti
ngqual
i
tyandf
inal
l
yri
singweal
thyowner
s.Posi
ti
veor
negat
ivesi
gnalf
rom audi
tfi
rmr
egar
dingt
heaudi
tfi
rm qual
i
tyandr
epor
ti
ngqual
i
tycoul
dlead
t
oret
ainorr
otat
ion.

I
nther
evi
ewedar
ti
cl
e,t
heaut
hor
spr
ovi
deaf
ramewor
kforunder
standi
ngt
her
oleofaudi
tfi
rm
r
otat
ioni
ncl
i
entexpect
edv
alue.Theyanal
yzedt
heef
fectt
hatr
epor
ti
ngqual
i
tyhasont
he
cont
ract
ualandmoni
tor
ingr
elat
ionshi
pbet
weent
heowner
sandt
heaudi
tfi
rm.Theyv
iewt
he
qual
i
tyofi
nfor
mat
iont
hef
ir
m di
scl
osesasachoi
cev
ari
abl
ethataf
fect
sthecont
ract
s
bet
weent
heowner
sandi
tsaudi
tfi
rm.Fur
ther
mor
e,t
heaut
hor
sexpl
orehow anaudi
tfi
rm
accept
sorr
eject
swor
kingpr
oposalf
rom cl
i
ent
.Indoi
ngso,
theyconcent
rat
eonaudi
tfeesas

1
Ar
ti
cleRev
iew

anef
fect
ivef
act
ori
nownerandaudi
tfi
rm cont
ract
.

3.TheModel

Theaut
hor
sdev
elopedamodelt
hatf
ocusont
her
elat
ionshi
pbet
weent
heaudi
tfi
rm andt
he
f
ir
m’sowner
s.I
nthi
smodel
,iti
sassumedt
hatt
heowner
sseekt
oassesst
heaudi
tqual
i
ty
basedont
hei
nfor
mat
ionav
ail
abl
etot
hem,andt
orepl
acei
tift
heassessmenti
stool
ow.On
t
heot
herhand,
theaudi
tfi
rm hascar
eerconcer
nThi
spr
ovi
dest
heaudi
tfi
rmi
ncent
ivest
odo
whati
tcant
oinf
luencet
hev
alueandi
nfor
mat
ionalpr
oper
ti
esoft
hei
nfor
mat
iont
owhi
cht
he
owner
shav
eaccess.Exogenousr
egul
ator
ychangest
hataf
fectdi
scl
osur
equal
i
tyt
husaf
fect
bot
hthei
nfor
mat
ionav
ail
abl
etot
heowner
s,andt
heaudi
tfi
rm’
sresponset
othei
nfor
mat
ion.

Themodel
hast
hef
oll
owi
ngt
imi
ngandf
eat
ures.

St
age1.Theowner
sofaf
ir
m est
abl
i
shal
evelofr
epor
ti
ngqual
i
ty,q(
it
schoi
cemaybe
const
rai
nedbyl
egalr
est
ri
cti
ons)
.Agi
venaudi
tqual
i
ty,α,i
sani
ndependentr
andom dr
awn
f
rom anor
maldi
str
ibut
ionwi
thmean0andknownv
ari
ance1/
τ(τi
sthepr
eci
sionoft
he
di
str
ibut
ion)
.

St
age2.Af
tert
heaudi
tfi
rm hasbeenempl
oyedf
orsomeper
iod,apubl
i
csi
gnal
,s,per
tai
ning
t
otheaudi
tqual
i
tyi
sreal
i
zed.Thesi
gnali
sdi
str
ibut
ednor
mal
l
ywi
thameanequalt
oαanda
v
ari
anceequalt
o1/
q.Let
ti
ngt
hepr
eci
sion,
q,oft
hedi
str
ibut
ionbet
hesameast
hequal
i
tyof
r
epor
ti
ng,
q.

St
age3.Theowner
sdeci
de,ont
hebasi
soft
hesi
gnal
,whet
hert
oret
ainorr
otat
iont
heaudi
t
f
ir
m.

St
age4.Speci
fyi
nggoodandbadcl
i
entsel
ect
ionwi
thr
egar
dtoaudi
tfi
rms’
per
spect
iveusi
ng
t
reemodel
.

3.
1.Audi
tFi
rm Pr
efer
encesandAudi
tQual
it
y

Theaudi
tfi
rm’
sli
fel
i
neut
il
it
yisgi
venby
:
12
U( F2)
F1)+U( (
1)

Fol
l
owi
ngpr
evi
ousst
udi
es,t
heaut
hor
sint
hei
ranal
ysi
sassumet
hatt
heaudi
tfi
rmi
sri
sk

eρ
1
wher 11i
sthecoef
fi
cientofabsol
uter
iskav
ersi
on.
2
Not
etheCARAut
il
it
yfunct
ionsat
isf
iest
heassumpt
ionsgi
venabov
efort
heut
il
it
yfunct
ion.

2
Ar
ti
cleRev
iew

av
erseandhast
heCARAut
il
it
yfunct
ion3.

Thecoef
fi
cientofabsol
uter
iskav
ersi
oni
sa;
45
U( 1 ρexp(-
F)=- ρF) (
2)

Thecaseofar
isk-
neut
ralaudi
tfi
rm canbeconsi
der
edt
obet
hel
i
mit
ingcaseasρ↓0.The
audi
tfi
rm hasar
eser
vat
ionut
il
it
y,UR,i
fexpect
edut
il
it
ies’audi
tfi
rmscannotbel hanUR;
esst
ot
her
wisei
twi
l
lnotacceptt
hecont
ractaudi
t.

Af
tert
hesi
gnal
,S,i
sobser
ved,t
hest
akehol
der
s(f
orexampl
e,owner
s)updat
ethei
rbel
i
efs
aboutt
heaudi
tqual
i
ty.Thepost
eri
ordi
str
ibut
ionofaudi
tqual
i
tyi
sal
sonor
mal
.

̇ qs
α =q +τ and τ' =τ+q (
3)

I
tisassumedt
hatt
hedi
str
ibut
ionoft
hesi
gnalSgi
vent
heaudi
tfi
rm’
str
uequal
i
ty,
αisnor
mal
̇
wi
thmean α andv
ari
ance1 q;hence,t
hedi
str
ibut
ionofsgi
vent
hepr
iorest
imat
eoft
he
audi
tqual
i
ty,
0isnor
mal
wit
hmean0andv
arance1 q +1 τ.Def
i ine
qs
H= (
4)
q +τ

t
obet
hepr
eci
si
onofSgi
vent
hepr
iorest
imat
eofaudi
tqual
i
ty,
0.

3.
2.TheRet
ain/
Rot
ati
onDeci
sion

Supposet
hatt
heout
comesr
eal
i
zedbyt
hef
ir
mift
heaudi
tfi
rm wasr
etai
nedatSt
age3i
s

̇ 6
F1
R =r +α +ε- (
5)

Assumet
hatt
heowner
sar
eri
skneut
ral
.Thedeci
siont
hatt
heymakeatSt
age3i
swhet
hert
o
r
etai
ntheaudi
tfi
rm,
inwhi
chcaset
hei
rout
comeswi
l
lbeRasgi
venbyexpr
essi
on(
5)ort
ofi
re
t
heaudi
tfi
rm,
inwhi
chcaset
hei
rout
comeswi
l
lbe

3
CARA(abbr
evi
ationforConstantAbsol
uteRi skAversion)uti
li
tyisaclassofuti
li
tyfunct
ionsthathasthefor
m,
f
orsomeposit
iveconstanta;
u(c)=- 1 a)
( e-ac.Underthisspeci
ficat
iontheel
ast
ici
tyofmar gi
nalut
il
it
yisequalt
o
-ac,
andthei
nstantaneousel
asti
cit
yofsubstitut
ionisequal t
o1 ac.
4
wher
eF1i
sit
sfeeasseti
nSt
age1andF2i
sit
sfeeasseti
nSt
age3.
5
Notethat
,forconveni
enceandwi t
houtl
ossofgeneral
i
ty,t
heauthorsi
gnoret
empor ar
ydi scount
ingandhav
e
r
uledoutdef
erredorcont
ingentpay
mentsfr
om t
heStage1personnelt
otheaudi
tfi
rm atStage3.
6 ̇
ē r i
wher saknownconst
antandεi
sanexant
eunknownamountdi
str
ibut
ednor
mal
l
ywi
thmean0andv
ari
ance¬σ2 .
AndRisdeci
sionr
etur
n.

3
Ar
ti
cleRev
iew

̇ 78
F1-
R =r +αN - RC78 (
6)

Audi
tfi
rmr
otat
ioni
ncr
easedt
heaudi
tcostt
ocl
i
ent
s.Thesecost
sar
eassumedt
orepr
esent
t
hecostofdi
srupt
ionpl
ust
hecompensat
ionnecessar
ytohi
ret
henewaudi
tfi
rmf
ort
hel
att
er
st
agesoft
heaudi
ti
ngpr
ocess.Becauset
heowner
sar
eri
skneut
ralandt
heuncondi
ti
onal
expect
ati
onofanaudi
tqual
i
tyi
szer
o,t
heowner
smaket
hei
rdeci
siont
oret
ainorf
ir
ethei
nit
ial
audi
tfi
rm basedonacompar
isonbet
weenwhatt
heyexpectt
orecei
vei
ftheyr
etai
nit
,

̇ ̇
F1
r +α - (
7)

Andwhatt
heyexpectt
orecei
vei
ftheyr
otat
eit
,

̇ ̇
r-α-RC (
8)

̇
Thef
ormeri
slesst
hant
hel
att
er̂ r <-
R.Usi
ngexpr
essi
on(
3),wecanr
est
atet
hisr
otat
ion
condi
ti
oni
nter
msoft
hesi
gnal
asf
oll
ows:
owner
srot
atet
hei
nit
ial
audi
tfi
rmi
fandonl
yif

q +τ)
( R
s< ≅S (
9)
q

I
nspi
teofmanyf
act
orst
hef
oll
owi
ngmodeli
spr
oposed:Expect
edVal
ue=F(
audi
tfi
rm
qual
i
ty,r
epor
ti
ngqual
i
ty)
.Gi
vent
hisopt
ionofchange,t
hecompany
’sexpect
edv
aluepr
iort
o
r
ecei
vi
ngasi
gnal
wit
hpr
eci
sionqi
s

4.Fi
ndi
ngsandDi
scussi
on

4.
1.Audi
tFee,
Audi
ti
ngQual
it
yandRet
ainorRot
ati
on

I
nor
dert
ounder
standhowaudi
tor
sabl
etobal
ancet
hei
rinher
entaudi
ti
ngr
esponsi
bil
i
tiesand

7
eαN i
wher sthequal
i
tyoft
henew(
repl
acement
)audi
tfi
rm.AndRCi
tsr
otat
ioncost
.
8
Iti
sassumedthatt
hefir
m cannotescapeit
sf eeobl
igat
iontotheinit
ialaudi
tfi
rm,hencethe -F1 t
erm,the
amount
,RCwhichi
sassumedtobenon-negat
ive,
refl
ect
sthecostsassoci
atedwithr
otat
ionthei
nit
ialauditf
ir
m.

4
Ar
ti
cleRev
iew

conductwi
tht
hei
mposedmar
ket
ingt
asks,i
tisi
mpor
tantt
oknowwhatt
asksar
eincl
udedi
n
t
heaudi
ti
ngpr
ofessi
onandwhatchar
act
eri
zest
hemar
ket
ingofpr
ofessi
onalser
vices.I
n
doi
ngsot
heaut
hor
ssupposeowner
sandaudi
tor
sandot
herst
akehol
der
scr
eat
ebal
ance.
Becausei
fnot
,basedonwhathasal
readydi
scussedt
hesi
gnal
,rot
ati
onpr
ocessesoccur
.
Thus,
theydi
scussedt
heaudi
ti
ngmar
ket
ingandi
tsi
mpactoncont
ract
s.

Tocr
eat
ebenef
it
sforcust
omer
s(orconsumer
s’)suppl
i
ersneedt
omai
ntai
nthei
rcompet
it
ive
adv
ant
age.Themostcompet
it
iveadv
ant
agesar
eonpr
iceandqual
i
tyoft
hepr
oduct(
or
ser
vice)
.Ther
ear
etwoway
sfort
hesel
l
er(
ser
vicepr
ovi
der
)tocr
eat
eval
uef
ort
hebuy
er.An
i
ncr
easei
npr
ofi
tsbyr
educi
ngcost
sfort
hebuy
er,t
hebuy
err
educescost
sthr
oughi
ncr
eased
buy
eri
nter
est
.Ment
almodel
sforunder
standi
ngt
heway
sinwhi
cht
her
esear
chwi
l
lbeusedi
n
f
act
,thesemodel
subj
ect
s’per
cept
ionsoft
hecauses,
andev
ent
sdepi
ctr
elev
antr
esul
ts.

4.
2.Cl
ientSel
ect
ionf
rom TheAudi
tor
’sPer
spect
ive

Thepr
obabi
l
ityt
hatt
heaudi
torcancompl
ywi
thaudi
ti
ngst
andar
ds,
aswel
lasr
ecei
vedesi
red
f
eesi
sP(
probabi
l
ityofgoodsel
ect
ion)andt
hepr
obabi
l
ityt
hatt
heaudi
torcannotcompl
ywi
th
audi
ti
ngst
andar
ds,aswel
lasdonotr
ecei
vedesi
redf
eesi
sQ(
probabi
l
ityofbadsel
ect
ion)
.
Ther
efor
e,i
nthi
sfr
amewor
kPandi
tscompl
ementQ=1−Pr
efert
otheCl
i
entSel
ect
ion(
CS)
.

Ther
efor
e,t
hepr
inci
pali
deaoft
hemodeli
stoder
ivet
hepr
obabi
l
ityPf
ort
heCS.I
neachCS
st
age(
branchpoi
ntoft
het
ree)
,theaudi
torcandi
scov
erdbr
anchpoi
nts(
int
het
ree)att
he
di
stanceofonest
age,d2br
anchpoi
ntsatt
hedi
stanceoft
wost
agesand,i
ngener
al,dk
br
anchpoi
ntsatt
hedi
stanceofkst
ages.Taki
ngaccountofi
nvest
igat
ivei
ntui
ti
onv
,the
audi
tori
sabl
etoi
nvest
igat
eCSi
n

br
anchpoi
nts.Eachbr
anchpoi
ntoft
het
reei
sident
icalwi
thr
espectt
othenumberofsub-
br
anches(
d)andpr
obabi
l
ityofgoodsel
ect
ion(
p).Thus,t
heaudi
tori
snotf
acedbyt
he
pr
obl
em ofopt
imi
zat
ionbei
ngi
ndi
ff
erentt
owhatpat
htochooseandcont
inue.

Whent
heaudi
torpr
oceedsandcont
inuest
heCS,
int
henextst
age(
branchpoi
nt)heorshei
s
abl
etoseedvnewbr
anchpoi
nts.Thus,af
term per
iods,mdvnewbr
anchpoi
ntswi
l
lappear
.
Si
ncet
heCShasr
esour
cest
oinv
est
igat
eforH st
agesahead,t
heaudi
torcanundert
his
const
rai
ntcont
inue(
aft
ert
hei
nit
ial
stage)f
oramaxi
mum ofH–vst
agest
osear
chf
oragood

5
Ar
ti
cleRev
iew

CS.

Thepr
obabi
l
ityt
hatabr
anchpoi
ntdoesnoti
ncl
udeagoodsel
ect
ioni
s1−p.Howev
er,t
he
pr
obabi
l
ityt
hatabr
anchpoi
nti
ncl
udesabadsel
ect
ionbutt
heaudi
torper
cei
vesi
tasagood
sel
ect
ion,
isp(
1−r
).

4.
3.Audi
ti
ngMar
ket
ingSel
ect
ionModel
s

Mar
ket
ersofAudi
tfi
rmsar
e chal
l
enged ev
erydaybyt
he uni
que char
act
eri
sti
csoft
he
pr
oduct
stheymar
ket
.Fol
l
owi
ngpr
evi
ousst
udi
es,t
heaut
hor
sfol
l
ow i
nev
eryper
iodt
he
economypr
oducesaf
inalgoodorser
vicecombi
ningl
aborandacont
inuum ofspeci
ali
zed
i
nter
medi
ategoodsorser
vicesaccor
dingt
othef
oll
owi
ngpr
oduct
ionf
unct
ion:

wher
eXi
,
tist
heamountofi
nter
medi
ategoodorser
viceii
nper
iodtwi
tht
echnol
ogyl
eveland
audi
torat
ti
tudeofXi
,
t.Ni
sthel
aborsuppl
y.Thef
inalser
viceZi
susedf
orconsumpt
ion,
asan
i
nputi
nto ent
repr
eneur
ialand audi
ti
ng mar
ket
ing,and an i
nputi
ntot
he pr
oduct
ion of
i
nter
medi
ateser
vices.Thepr
oduct
ionoft
hef
inalgood,whi
chi
sdef
inedast
henumer
ical
,
occur
sunderper
fect
lycompet
it
ivecondi
ti
ons.Thus,t
hepr
iceofeachi
nter
medi
ategoodand
ser
viceequal
sit
smar
ginal
product
:

Pr
ici
ngi
soneoft
hemosti
mpor
tantdeci
sionsi
nthemar
ket
ingoff
inanci
alser
vices.Audi
tor
’s
per
spect
ive,acl
i
entenv
ironmentcanhav
eani
mpactonaudi
tfeesbyaf
fect
ingt
her
equi
red
audi
tef
for
tandt
heaudi
tri
sk.Thepr
icecanbeconsi
der
edasaudi
tfeet
hatwasi
nvol
vedi
n
expr
essi
on(
1)asdesi
redf
eesf
oraudi
tort
hatef
fectgoodorbadsel
ect
ion.Audi
tfi
rmsmust
consi
dernotonl
ythebenef
it
sand ef
fi
cienci
esofknowl
edgegai
ned i
nthenon-
audi
ti
ng
consul
ti
ngmar
ketbutal
sot
hecost
s,i
nter
msofcompet
it
ion,
ofpr
ovi
dingbot
hser
vices.

5.Concl
usi
on

Theaut
hor
sassumed,i
ncont
rastt
otheexi
sti
ngl
i
ter
atur
e,t
hatr
etai
n-r
otat
ionaudi
tfi
rmv
s.
goodorbadsel
ect
ioncl
i
entr
elat
ionshi
pmustbeexami
nedt
oget
her
.Int
her
evi
ewedar
ti
cle,

6
Ar
ti
cleRev
iew

t
heaut
hor
sspeci
fi
edpr
ici
ngi
nthei
rmodeli
nfor
matofaudi
tfeeandpr
ovi
deanal
ysi
s.Resul
ts
showt
hatt
heowner
s’expect
edout
come(
V)i
sincr
easei
nint
hel
evelofr
epor
ti
ngqual
i
ty,al
l
el
sehel
dequal
.

Resul
tsal
soshow t
hatt
heowner
s’expect
edout
comei
sincr
easei
nthel
evelofr
epor
ti
ng
qual
i
ty,al
lel
sehel
dequal
.Al
socl
i
entsel
ect
ioni
sadecr
easi
ngf
unct
ionwi
thr
egar
dtot
he
f
act
orsaf
fect
ingi
t.Li
ket
henumberofsub-
branches,
probabi
l
ityofgoodsel
ect
ion,
probabi
l
ity
ofgoodper
cei
vedi
nabr
anchpoi
nt,
stagesaheadandt
aki
ngaccountofi
nvest
igat
ivei
ntui
ti
on.

The aut
hor
s pr
oposed t
hatr
etai
n-r
otat
ion audi
tfi
rm v
s.good orbad sel
ect
ion cl
i
ent
r
elat
ionshi
pdev
elopedbasedonbi
dandaskpr
ocess.Theaut
hor
s,dr
awi
ngont
hei
ranal
yti
cal
f
ramewor
k,pr
ovi
dedi
rect
ionsf
orf
urt
heroppor
tuni
ti
esf
orr
esear
chofcl
i
entandaudi
tfi
rm.