Auditor Conservatism and Reporting Quality: The Role of Auditor Portfolios

Abstract

We examine whether an auditor’s response to a specific client’s failure extends to other clients in their portfolio. Using a sample of commercial bank clients, we find that audit firms become more conservative across all client-banks in their portfolio when one of those banks fails (as deemed by the FDIC). Specifically, auditors require the surviving clients in their portfolio to accrue larger loan loss provisions, especially when the visibility of the surviving audit client is greater. However, we do not find that auditors experiencing a failure in their portfolio charge higher audit fees. Furthermore, we find evidence that the loan loss provisions were less timely, less accurate, and reversed in subsequent periods, suggesting that an auditor’s portfolio-wide response to a client failure may have been overly conservative. These results are consistent with auditors perceiving higher risk of litigation and reputational concerns when one client fails, and altering their audit behavior across the remaining clients.