Client Stock Market Reaction to PCAOB Sanctions Against a Big 4 Auditor*

Abstract

We examine client stock market reaction to news of PCAOB sanctions imposed upon Deloitte and Touche, LLP - the first against a Big 4 auditor. The PCAOB Order against Deloitte contains three potentially value relevant pieces of information. First, it shows that Deloitte did not conduct a quality audit of Ligand’s 2003 financial statements (the “Ligand audit failure”). Second, it highlights serious problems in Deloitte’s quality control policies and procedures that go beyond the Ligand audit failure. Finally, the PCAOB Order reiterates the remedial actions Deloitte took to improve its quality control policies, which may alleviate investors’ concerns and signal improvements in the quality of the firm’s future audits. Using Schipper and Thompson (1983) methodology, we find that Deloitte (non-Deloitte) clients had a significantly negative (an insignificant) market reaction to news of the PCAOB sanctions. The results suggest that the negative effects of the sanctions outweigh the possible remedial effects of Deloitte’s corrective actions taken after the sanctions. In cross-sectional analysis using the Sefcik and Thompson (1986) portfolio weighting approach, we find a more negative reaction for Deloitte clients that are financially distressed. Our findings are consistent with both the reputation and insurance hypotheses, as in Baber et al. (1995). Since the severity of Deloitte’s quality control problems was made public for the first time by the PCAOB sanctions, we conclude that the negative market effects we observe are most likely the result of disclosure of the quality control weaknesses at Deloitte.