Auditor Size and the Accuracy of Audit Reports : Reputation Theories Versus a 'Deep Pockets' Explanation

Existing empirical research and results presented in this paper indicate that large auditors are more accurate than small auditors. Two explanations for this are examined. DeAngelo (1981) has argued that large auditors have a greater incentive to maintain a reputation for accurate auditing. More recently Dye (1995) and Schwartz (1997) have shown that the depth of an auditor's pockets may be an important determinant of auditing accuracy. The aim of this paper is to discriminate between these two explanations. I show that although large auditors are more accurate than small auditors, they also tend to receive relatively more litigation and criticism; moreover, criticised auditors do not appear to suffer losses of clients or lower fees. These findings indicate that reputation is not an important factor in determining auditor accuracy. In contrast to reputation theories, it is shown that a deep pockets model can explain why both accuracy and litigation are positively correlated with auditor size. In addition, the deep pockets model extends previous research on auditor choice by examining how the depth of an auditor's pockets affects the auditor hiring decision (Titman and Trueman 1986; Datar et al. 1991)