Auditor Reputation and Financial Statements Credibility

• In Event: Breakfast and Research Forum
  In Roundtable Session: Table 6: Financial Statement Credibility and Misstatements

Abstract

This study examines the effect of auditor reputation on the perceived credibility of financial statements using a direct measure of the change in auditor reputation. I analyze the content of news articles identifying auditors. I construct a variable measuring the change in auditor reputation using the ratios of positive and negative words contained in these articles. This measure of change in auditor reputation is a better measure of the auditor reputation construct than the measures used in extant literature. I use this variable to test whether auditor reputation has an effect on the perceived credibility of financial reports by examining the its effect on earnings response coefficients (ERC) and the cost of equity capital.
I find that while ERC tests are weak, the ex ante equity risk premium tests show that an increase in auditor reputation, as measured using the reputation change score, is associated with a decrease in cost of capital. This decrease is statistically as well as economically significant. Further analysis shows that these results hold even after controlling for auditor designation as Big 4 firms. That is, I find that an increase in auditor reputation is associated with a decrease in cost of equity capital for client firms within the Big 4 auditors group.

Author

• Wael Aguir, Western Illinois University