We examine whether audit quality varies across different sizes of CPA firms under high or low auditor-specific litigation risk exposure. We measure audit quality by the issuance of modified audit opinions and the audit fees charged to clients, and we use the organizational form of CPA firms as the proxy for auditors’ litigation risk exposure, where a partnership (limited liability) CPA firm represents a high (low) litigation risk exposure. Built on Choi, Kim, Liu, and Simunic’s (2008) theoretical framework, we hypothesize that the litigation risk exposure of CPA firm moderates the association between auditor size and audit quality. Our results show that when the auditor’s liability is capped (i.e., registered as a limited liability form of CPA firm), larger size CPA firms are associated with higher audit quality when compared to smaller size CPA firms. However, this positive association between auditor size and audit quality disappears for audit firms that are subject to high litigation risk exposures (i.e., registered as a partnership form of CPA firm). Our research provides new insights on the impact of auditor-specific litigation risks on the relation between audit quality and auditor size. In particular, we show that only when auditor-specific litigation risk is limited, do large CPA firms appear to perform higher quality audits than small CPA firms.

INTRODUCTION

Prior research demonstrates that the risk associated with legal organizational form plays an important role in affecting audit quality in terms of auditors’ reporting behavior and audit pricing (e.g., Chan & Pae, 1998; Choi et al., 2008; Firth, Mo, & Wong, 2012; Muzatko, Johnstone, Mayhew, & Rittenberg, 2004; Simunic & Stein, 1996). These studies generally conclude that increasing an auditor’s litigation risk exposure provides incentives for improving audit quality and reporting conservatism. Auditor size is another factor that may have a positive correlation with audit quality and audit pricing, and these associations have received support from previous theoretical and empirical research. While both streams of research show that audit quality is significantly affected by litigation risk and auditor size, there is a general lack of evidence about the interactive effect among litigation risk, auditor size, and audit quality. Many studies find that audit quality increases with auditor size (e.g., Chen, Chen, & Su, 2001; Davidson & Neu, 1993; DeAngelo, 1981; DeFond, 1992; DeFond, Wong, & Li, 2000; Francis, 1984; Francis & Simon, 1987; Francis & Wilson, 1988; Johnson & Lys, 1990). However, some more recent studies arrive at an opposite conclusion and show that the audit quality of a small auditor is the same as or even higher than that of a large auditor (Boone, Khurana, & Raman, 2010; Geiger, Raghunandan, & Riccardi, 2014; Lawrence, Minutti-Meza, & Zhang, 2011; Lisowsky, Robinson, & Schmidt, 2011). One reason put forward to explain this finding is that small CPA firms are less well diversified, and thus, they cannot spread their risk exposure over many clients. Furthermore, small CPA firms find it more difficult to obtain insurance coverage. To counter this increased risk exposure, small CPA firms perform higher quality audits. We believe that these different findings on the association between auditor size and audit quality are caused, in part, by the different levels of litigation risk that the auditors face.