Short Sellers and the Contagion Effect of Audit Failures

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Abstract

We investigate whether the contagion of low-quality audit in an auditor office attracts short sellers. We identify an office with low quality audit by the presence of one or more clients who report a material downward restatement of earnings. We consider other, non-restating firms in the same audit office to be subject to low quality audit contagion, or to be “contaminated.” We find that in the month following the restatement abnormal short selling is significantly larger for contaminated firms, compared to firms audited by audit offices that do not have any clients reporting earnings restatements. Office size appears to mitigate contagion effect: contaminated firms in large audit offices experience lower abnormal short selling, and do not experience significantly negative returns. However, higher abnormal short interest in contaminated firms is associated with significantly negative returns, if the firms are audited by smaller audit offices, suggesting that short-sellers profit from trading shares of such contaminated firms.

Authors

• Truong X Duong, Iowa State University

• Olena Victoria Watanabe, Iowa State University