Do Measures of Audit Quality Really Measure Audit Quality? Evidence From the Banking Industry

We examine whether measures of audit quality are able to measure the quality of audit in banks. We make use of a unique setting where the Reserve Bank of India (RBI) provided an accurate measure of asset quality in banks. We first attempt to establish that the RBI revealed asset quality is a better estimate than that disclosed by the banks. Using the difference between the RBI-revealed and the bank-reported figures as an external validation of audit,we are unable to find evidence that any of the generally accepted measures of audit quality do measure the quality of audit. We then examine whether the sensitivity of the bank’s asset quality to its borrowers’ health increases when the more accurate RBI-revealed figures are used and find that they do. Using the actual sensitivity of the bank’s true health to borrower health, we construct a novel measure of audit quality.