David versus Goliath : Audit Service Differentiation and Audit Quality in UK Private Firms

We examine whether Big 4 auditors and non-Big 4 auditors maintain similar or different levels of financial reporting quality for private firms. DeAngelo (1981) suggests that litigation and reputation considerations incentivize Big 4 auditors to deliver higher audit quality than non-Big 4 auditors. However, because client demand may be driven more by tax planning objectives than by financial reporting quality (FRQ) objectives and because Big 4 audit firms' profitability structure is less optimized for private firm auditees than is non-Big 4 audit firms' profitability structure, Big 4 auditors may have weaker incentives than non-Big 4 auditors to improve FRQ in private firms. We provide evidence that Big 4 auditees have lower FRQ and avoid more taxes than non-Big 4 auditees in UK private firms. We further find that the difference in FRQ between Big 4 and non-Big 4 auditees is mitigated for private firm clients with dispersed ownership structures and dissipates in public firms where clients are more likely to demand FRQ. Our results suggest that Big 4 auditors prioritize tax planning over FRQ in the private firm market when client demand for assuring representational faithfulness of financial statements is low