The Impact of Monitoring by Short Sellers on Auditor's Risk Assessment: A Cross-Sectional Study

Abstract

We investigate two competing perspectives as to how institutional ownership, analyst following, and equity incentives moderates the effect of short interest on the behavior of auditors. It is unclear how information signal embedded in short interest affects the audit process for companies of different characteristics. In this paper, Wwe investigate two competing perspectives as to how external monitoring and managerial incentives affect the association between short interest and audit risk. The supply side perspective (i.e. labeled signaling) argues that if there is strong external monitoring and managerial incentives, short interests will not lead to greater amount of audit effort because auditor’s of auditors’ self-interest in minimizing costs, self-interest largely drives audit effort, while the demand side perspective argues that the same factors (i.e. institutional ownership, analyst following, and equity incentives) will lead to a greater demand for audit effort. Using audit fees as a proxy for audit risk, we find that an increase in short interest is associated with an increase in audit fees for companies that have weak external monitoring (i.e. low institutional ownership, low analyst following) and weak managerial incentives (i.e. compensation is less sensitive to stock price movements). In contrast, an increase in short interest is not associated with an increase in audit fees for companies that have a high institutional ownership, large analyst following, or managerial incentives that are more sensitive to stock price movements. Our results provide support for the signaling perspective, but not for the demand perspective.