Executive Summary
We examine the likelihood of a client switching auditors when that client does not fit well with other clients of the same auditor. The most dissimilar clients are around 10% more likely to switch auditors, and will tend to change to an auditor with which they are more compatible. Following an auditor change, there is a quick alignment in the footnotes of that client with existing clients of the new auditor, followed by slower changes in unaudited (but reviewed) sections of the 10-K. There is mixed evidence as to whether a better client-firm alignment improves audit quality. We informally conclude there may be unintended costs to (proposed) mandatory audit firm rotation and there may be benefits to expanding auditor reporting responsibilities to currently unaudited disclosures.
Innovations
Develops a new method for determining how similar or different a company is to other clients engaging the same auditor, solely using the narrative text in its annual 10-K filing. We are one of the first to document clustering of clients within firms, thus demonstrating that Big 4 audit firms are not necessarily interchangeable, as is the common assumption in the literature. Before now, there has been limited quantitative research into the fit between clients and their auditors.
Abstract
We examine auditor switching conditional on the compatibility of clients and their auditors using a unique text-based measure of similarity of financial disclosures. We find clustering of clients within an audit firm based on this measure. We find that clients with the lowest similarity scores are significantly more likely (9.4% to 10.6%) to switch auditors, and will change to an audit firm to which they are more similar. Regarding the effect on audit quality, we find that discretionary accruals are lower when similarity is higher. However, accounting restatements are more likely when text disclosures that are unaudited—business description and MD&A—are more similar. We find no such similarity effect for the audited footnotes. Finally, we find that firms that are more similar are less likely to receive a going concern opinion (GCO) but the GCO reporting decision is more accurate. It is unclear if this reflects higher or lower audit quality since firms that are candidates for a GCO are intrinsically different from the average firm in an auditor’s portfolio due to their financial distress. One implication of these results is that auditors might have greater involvement in the quality of the text disclosures that are currently not audited.
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Citation
Brown, S. V. and W. R. Knechel. 2016. Auditor-Client Compatibility and Audit Firm Selection. Journal of Accounting Research. 54 (3): 725-775.