Audit Partner Disciplinary Actions and Financial Restatements

Abstract

This study investigates the signalling role and rectification effectiveness of an audit partner disciplinary system. The signalling role refers to whether sanctions reflect the poor audit quality of disciplined audit partners, and rectification effectiveness addresses whether disciplinary actions enhance subsequent audit quality. The sample consists of Taiwanese listed companies, in the period 2000 to 2006, where the identities of audit partners who sign audit reports and who are sanctioned are accessible. Empirical results indicate that in the pre-sanction period, the probability of financial restatements by clients of disciplined audit partners is significantly higher than that of non-disciplined audit partners. The more severe or frequent the sanctions, the higher the likelihood of financial restatements in the pre-sanction period. These findings imply that audit partner disciplinary actions can serve as a signal of lower audit quality provided by those partners. The rectification effectiveness of disciplinary actions is examined from two perspectives: (1) the effects on subsequent improvements of audit quality of disciplined audit partners; and (2) audit quality enhancement of successor non-disciplined audit partners who accept clients from disciplined audit partners. Empirical results show a lower probability of restating financial statements audited by disciplined audit partners after sanctions. We also find a lower likelihood of restating financial statements audited by successor non-disciplined audit partners in the post-sanction period. Both findings support our conclusion that audit partner sanctions improve audit quality. Overall, audit partner disciplinary actions can signal lower quality audit partners and are effective in enhancing audit quality.