Changing audit risk characteristics in the public client market

Abstract

Financial audit services have changed in the US over the last half century, resulting in distinct cyclical patterns of relative audit risk. The purpose of this project is to describe changing patterns in the economic and institutional risk environment over time and investigate differences using empirical surrogates as measures of relative audit risk. Economic, competitive, and regulatory differences are analyzed over the period of study. Particularly important events included the Foreign Corrupt Practices Act of 1977 (likely reducing audit risk), the elimination of rules against advertising and direct solicitation in 1979 (increasing audit risk), the Private Securities Litigation Reform Act of 1995 (increasing risk), and the collapse of Arthur Andersen and Sarbanes–Oxley Act (2001–2002, reducing risk). Empirical models are used to evaluate financial risk (Altman’s Z-score), earnings manipulation risk (Sloan’s measure of accruals), and litigation risk (litigation index). Averages by year suggest cyclical patterns of relative audit risk that parallel regulatory, economic and institutional changes over the period.