Specialist audit-quality differentiation in banks: The case of Hong Kong incorporated authorized institutions

This study examines specialist-quality differentiation in the market for audit services in banks. Specifically, this study examines whether demand for higher within-industry audit quality is explained by higher bank specific: (1) reporting discretion associated with regulatory capital objectives, (2) information uncertainty arising from market risk exposures, and (3) debt related contracting costs. It is hypothesized that: (1) specialist-quality demand, which is downward slopping in specialist fees, is an increasing function of financial reporting discretion, market risk, and debt related contracting cost, and (2) specialist fees are a positive function of specialist-quality demand, bank operation complexity, and auditor loss-sharing risk.;Two simultaneous-equation analyses are performed on pooled cross-sectional data (1995 to 1997) collected for all Hong Kong incorporated institutions authorized to engage in banking and deposit-taking business. An indirect-generalized least-squares procedure is used to examine the joint determination of the dichotomous specialist reputation (market leader identity) demand and audit fee function. A two-stage least-squares procedure is used to examine jointly the continuous specialist-quality demand and marginal fee function. The effects of five measures of bank reporting discretion are examined: (1) loan loss provisions, (2) miscellaneous gains and losses, (3) issuance of debt capital, (4) issuance of equity capital, and (5) their aggregate. Results on the whole support the hypotheses.