Weak Incentives for Audit Quality: Evidence from Broker-Dealers

Abstract

Much of the literature develops theory using audits of publicly owned companies with agency costs that create demand for audit quality. In contrast, I study auditor size and industry specialization in the broker-dealer (BD) industry, where entities have weak incentives to demand and supply high audit quality. Using proprietary data, I test whether larger firms and industry specialists provide better audit quality, as proxied by audit adjustments. Consistent with theory, I find that larger firms provide higher audit quality. In contrast, industry specialists perform worse than non-specialists; industry specialist partners in small firms drive this result. These findings suggest that clients with weak demand for auditing hire low quality auditors, who in turn gain market share in the industry. Overall, my findings illustrate the importance of considering clients’ demand for auditing when evaluating audit quality and industry specialization.