The Responses of Non-Switching Audit Clients and Investors to Damaged Auditor Office Reputation

• In Event: Management Forecasts and Analyst Conference Calls

Abstract

We examine how client firms of reputationally-damaged auditor offices, as well as their investors, respond to perceived lower audit quality. We find that non-switching client firms that stay with their reputationally-damaged auditor office increase their number of management forecasts, while switching clients experience no changes in management forecast levels. Further, the response of non-switching clients is more pronounced when the client firm is exposed to a higher information demand environment (followed by more analysts, owned by a higher percentage of institutional investors, and is larger in size), is more closely aligned with the restating firm that caused the reputational damage (higher stock return correlation and located in the same geographical area), or is exposed to lower proprietary costs of disclosure. We also find that investors of non-switching clients react more (less) to management forecasts (audited reported financial information) after the audit office reputation damage. Finally, we document that increases in management forecasts bring market benefits for firms audited by reputationally-damaged auditor offices as they reduce the cost of equity for these firms. Our study extends the auditor reputation literature by documenting important ways in which client firms and investors respond to signals of decreased audit quality at the office level.

Authors

• Mei Cheng, University of Arizona

• Paul N Michas, University of Arizona-Tucson

• Meiling Zhao, University of Arizona