Abstract
This paper examines how investors and companies in China benefit or penalize other audit firms (and their clients) when one Big 4 audit firm fails to detect a fraud. Using a detailed archival study of a fraud by a manufacturing firm (Kelon), we propose that an audit failure by one Big 4 firm hurts not only itself and shareholders of its clients, but also competing Big 4 firms and their clients. Unlike results in developed countries, clients of both the failing auditor (Deloitte) and other foreign (Big 4) auditors experience more negative stock market reactions than local non-Big 4 auditors’ clients at the disclosure event pertaining to Kelon. Negative effects are more pronounced for companies in Kelon’s industry. Shareholder losses are moderated by government ownership. Furthermore, companies are less likely to switch to other Big 4 auditors after disclosure of the fraud case. Our results are robust to additional analyses, including controls for self-selection of Big 4 auditors.
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