Does the Big-4 Effect Exist When Reputation and Litigation Risks are Low? Evidence from Audit-Partner Auditee Pair Switches

Abstract

This paper studies whether Big-4 firms provide higher quality audits relative to non-Big-4 firms when the characteristics of audit partners and auditees are held constant. When an audit partner switches her affiliation with an audit firm to a different firm, some auditees follow the partner (hereafter, the partner-auditee pair). Employing a unique dataset of individual auditors for a large sample of private companies in a setting with documented low litigation and reputation risk, we analyze audit quality of the partner-auditee pairs that switch affiliations between Big-4 and non-Big-4 firms. We proxy for audit quality using measures of earnings management, deviations from clean audit reports, and accuracy of going-concern reporting. Our evidence is consistent with a Big-4 effect. We find less earnings management, higher going-concern accuracy, and higher audit fees after a switch from a non-Big-4 firm to a Big-4 firm. For switches from Big-4 firms to non-Big-4 firms, we find lower going-concern reporting accuracy and lower audit fees after the switch. We further show that the increase in going-concern accuracy and the decrease in earnings management coincide with a lower likelihood of issuing modified audit reports; we attribute this effect to the Big-4 firms’ ability to more accurately identify and evaluate financially-troubled auditees and their greater competency and independence to provide higher quality financial reporting by the auditees, resulting in less use of modified reports.