Auditors are Known by the Companies They Keep

Abstract

We study the role of reputation in auditor-client matching. Using 1.2 million employment records from US broker-dealers, we find that broker-dealer clients of the same auditor have similar financial adviser misconduct profiles. Our estimates indicate that variation in client misconduct behavior is nearly half as important as variation in client size in explaining matches. Auditors adjust their portfolios when presented with new information about client behavior, and those with the most significant reputation concerns are least likely to deal with high misconduct clients. Finally, we find that an auditor’s reputation for accepting high misconduct clients predicts their new clients’ future misconduct. Together, our results present new evidence on how reputation affects audit relationships, and the consequences of auditors’ reputation concerns for client behavior. Our results also indicate an unintended consequence of audit mandates: non-discerning auditors emerge to serve clients with low endogenous demand for auditing.