Auditor Responses to Audit Clients� Indirect-Effect Illegal Acts

Abstract

I investigate auditors’ responses to their clients’ illegal acts, which do not directly impact the financial statements (indirect-effect illegal acts). For an audit conducted under the PCAOB auditing standards, the auditor does not provide any assurance that indirect-effect illegal acts will be detected, and the related contingent liabilities will be accrued. This is because indirect-effect illegal acts usually relate to operational activities, and the auditor may not have the knowledge and ability to detect these violations. However, an auditor who is aware of a violation may consider its impact on the financial statements and reassess the client’s risk. I argue that regulatory fines and penalties provide auditors with an unambiguous signal of an indirect-effect illegal act and examine the auditors’ response to it. I find that clients that are fined for indirect-effect illegal acts are more likely to experience an auditor turnover. Moreover, fined clients that continue with their auditor pay a higher audit fee than non-fined clients. Lastly, audit offices that retain a larger portion of their fined clients subsequently experience a decrease in the number of audit clients and the total audit fees generated within the audit office. These findings indicate that auditors respond to public disclosure of their clients’ indirect-effect illegal acts despite their limited responsibility regarding these acts. More importantly, the audit market penalizes auditors who continue to audit their clients who are penalized for indirect-effect illegal acts.