Government auditing standards place strong emphasis on strengthening internal controls and ensuring compliance with laws and regulations.1 A high quality audit can provide assurance to the municipal bond market that the local government's internal controls and legal compliance are adequate to minimize opportunities for waste and fraud and to assure the continued inflow of federal financial assistance. Simunic and Stein (1987) suggest that in the capital markets, auditor reputation is made credible by the potential loss of quasi-rents on fixed investments from the failure to deliver the implied audit quality and the subsequent revelation of such failure. Although auditor moral hazard has received some attention in the academic literature, it is perceived to be particularly acute in the government environment. In this environment, the chances of client financial failure and consequent ex post revelation of lower-than-implied audit quality are minimal. Thus, there is a need for alternative mechanisms for enhancing the credibility of the audit. Both the General Accounting Office (GAO 1987) and the American Institute of Certified Public Accountants (AICPA 1987) view appropriate audit procurement practices as a mechanism for ensuring that the contracted audit quality is in fact delivered. To the extent that management quality is multidimensional, appropriate audit procurement could be viewed as one dimension of the overall quality of administration, or perhaps as part of a larger managerial control dimension. Nonetheless, the GAO and the AICPA suggest that appropriate procurement practices can independently contribute to the selection of a competent auditor in a market in which it is difficult to directly assess whether an auditor possesses the specialized knowledge necessary to provide a high quality government audit. The bond market remains the primary source of (financial) market discipline at the municipal level. In this market, default risk is priced using yield-to-maturity which is a continuous variable. Thus, cities do not have to actually fail for bondholders to suffer capital losses. While information about audit quality may be conveyed by other means (e.g., by size of audit firm), the procurement practices recommended by the GAO (1987) offer the opportunity for additional discrimination in the municipal bond market. Prior research suggests that two discrete levels of implied audit quality (Big Eight/non-Big Eight) are available in the market for audit services.2 However, given the greater risk of auditor moral hazard in the government environment, the traditional Big Eight/non-Big Eight dichotomy is not considered sufficient for differentiating the quality of government audits. The highly specialized knowledge and skills required for government audits results in wide variation in auditor qualifications from firm to firm, and even from office to office within a Big Eight firm. Moreover, the risk of obtaining a low quality audit is relatively high because such audits traditionally have not been easily detected, and only recently have auditors faced significant business risk from providing low quality government audits. Both the GAO and the AICPA have stressed the role of appropriate procurement practices (client monitoring) in mitigating the widespread problem of substandard government audits by CPAs. The purpose of this paper is to evaluate the hypothesis that client monitoring is priced in the seasoned municipal bond market above and beyond other independent measures of local administration quality and the Big Eight/non-Big Eight dichotomy. Our empirical results are generally consistent with the hypothesis, even though the results for a subsample of cities with a Big Eight auditor are also consistent with the auditor competition hypothesis tested by O'Keefe and Westort (1992 and Copley and Doucet (1993).
