The Contagion Effect of Low-Quality Audits

Abstract

We investigate if the existence of low-quality audits in an auditor office indicates the presence of a ''contagion effect'' on the quality of other (concurrent) audits conducted by the office. A low-quality audit is defined as the presence of one or more clients with overstated earnings that were subsequently corrected by a downward restatement. We document that the quality of audited earnings (abnormal accruals) is lower for clients in these office-years (when the misreporting occurred) compared to a control sample of officeyears with no restatements. This effect lasts for up to five subsequent years, indicating that audit firms do not immediately rectify the problems that caused contagion. We also find that an office-year with client misreporting is likely to have subsequent (new) client restatements over the next five fiscal years. Overall, the evidence suggests that certain auditor offices have systematic audit-quality problems and that these problems persist over time.

Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions

“…Finally, we extend our empirical models reported in Tables by adding office‐level dummies to the various models. The purpose of this analysis is to confirm that our findings are incremental to the office‐level findings in Francis and Michas (). Our primary results do not change.…”

“…Francis and Michas () employ a similar approach with office‐level data from the United States and report evidence that local offices with an audit failure in a year are more likely to be associated with other audit failures.…”

Audit Office Reputation Shocks from Gains and Losses of Major Industry Clients

“…The evidence in Table is consistent with a capacity constraint effect. To further identify if the change in the quality of audited earnings is driven by audit office capacity, we partition audit offices each year into the largest quartile of office size versus all other offices based on the office's total yearly audit fees, consistent with recent studies (Francis and Michas ; Francis et al. ).…”

“… Audit contracting takes place between a client and an audit partner in a local engagement office of the accounting firm that administers the audit and issues the audit report on the audit office's letterhead (Wallman ). Prior studies document audit office characteristics are associated with audit quality; for example, auditors report more conservatively when a client is large relative to overall engagement office size (Reynolds and Francis ; Li ); a fee premium exists for engagement offices with city‐specific industry expertise (Ferguson, Francis, and Stokes ); larger engagement offices are more likely to issue going‐concern audit reports and have fewer client restatements, which are suggestive of higher quality audits (Francis and Yu ; Choi, Kim, Kim, and Zang ; Francis and Michas ; Francis, Michas, and Yu ); and audited earnings quality is higher for offices with city‐level industry expertise (Reichelt and Wang ). …”

Business Strategy and Intra-Industry Information Transfers

“…Relatedly, Kedia, Koh, and Rajgopal (2015) find that firms are more likely to begin managing earnings when there is an accounting restatement announcement by an industry peer firm. There is also research showing that audit offices have information transfers or 'contagion', such that a misstatement at one firm is associated with misstatements at other firms who have the same auditor (Francis and Michas 2013;Swanquist and Whited 2015).…”