Distracted auditors, audit effort, and earnings quality

Abstract

ABSTRACT In this paper, we explore the implications of audit office distraction for audit effort and quality. We hypothesise that an audit office with financially distressed clients (i.e. a distracted auditor) faces greater time pressures and pays less attention to the audits of the remaining non-distressed clients in their portfolio. If an audit office is distracted, they will have less bargaining power over their audit fees; and non-distressed clients will have greater incentives to engage in earnings management given the reduced expected intensity of professional skepticism. We use the ratio of audit fees derived from financially distressed clients to total audit fees of the audit office to provide strong support for these hypotheses in a sample of US firms over the period 2000–2019. Specifically, we find that distracted auditors have longer delays in issuing audit reports and lower audit fees. When the level of distraction is high, non-distressed clients engage more in accrual and real earnings management and have relatively lower earnings response coefficients. Our results are robust to using entropy balancing, audit firm fixed effects, alternative measures of distraction, and a placebo test addressing mechanical bias and randomness effects. Further analysis indicates that audit firm tenure, and audit office size and industry specialisation reduce the negative effects of distraction on audit fees and audit delay. Overall, our results provide new insights on how auditor distraction affects clients’ earnings quality due to reduced effort.