Audit Firm Reaction to SEC Enforcement Proceedings against a Client: Evidence of City-Level Audit Office Behavior

• In Event: Impact of Regulators

Abstract

When an SEC registrant is investigated and sanctioned by the SEC for inappropriate financial reporting, in addition to the company targeted by the enforcement action, the investigation also involves a city-level audit office either directly or indirectly because of the audit office’s association with the sanctioned client’s financial statements. In this study, we examine how these audit offices react on subsequent audit engagements after one of their clients is investigated by the SEC for improper financial reporting. Subsequent to the client’s public announcement of an SEC investigation, we find evidence suggesting that the audit offices improve audit quality by (i) restraining the level of clients’ discretionary accruals, (ii) decreasing the likelihood of clients restating their financial statements, and (iii) restricting their clients’ propensity to report small profits. Furthermore, we find evidence that these audit offices are unable to capture typical audit fee increases after one of the office’s clients is investigated by the SEC, suggesting that other clients financially penalize the auditor. Overall, the results suggest that SEC enforcement proceedings carry a deterrent effect to audit firms given that the city-level audit office improves future audit quality and may be required to forego typical fee increases with ongoing clients.

Authors

• Sharad Asthana, University of Texas-San Antonio

• K.K. Raman, University of Texas-San Antonio

• Michael C. Turner, University of Texas-San Antonio