How Big-4 Firms Improve Audit Quality

Abstract

This paper studies whether and how Big-4 firms provide higher quality audits than non-Big-4 firms. Specifically, we first examine a Big-4 effect and then explore three sources of the Big-4 effect. To test the Big-4 effect, we use a unique dataset of individual audit partners for a large sample of private companies and employ a novel research design exploiting the fact that auditees may follow the auditor who switches affiliation from a non-Big-4 to a Big-4 firm. Thus, we compare audit quality and audit fees of the same partner-auditee pairs before and after the switch. The results show that the Big-4 effect exists in the private-firm segment. More importantly, we find evidence for three sources of the Big-4 effect. First, Big-4 firms are able to recruit non-Big-4 partners who deliver higher audit quality than other non-Big 4 partners in the pre-switch period. Second, enhanced learning has taken place after the switch. Third, the increased audit quality can also be attributed to stronger incentives/monitoring. These are new findings to the literature.

Keywords: Big-4 effect, auditing, audit quality, labor economics, learning, incentives, monitoring, auditor change, private firms, research design

JEL Classification: G30, G34, J01, J24, J62, M10, M41, M42