Disciplinary Sanctions and Audit Quality: Empirical Evidence from an External Oversight System

Abstract

This paper provides empirical evidence on the impact of disciplinary sanctions on audit quality, based on the external oversight system set up in Spain in the early nineties. Specifically, we examine the effects of the sanctions imposed by the Institute of Accounting and Auditing (ICAC), a government regulatory agency independent from the auditing industry. To proxy for audit quality, two client-specific earnings quality indicators are considered; i.e. the likelihood of loss reporting and abnormal accruals. According to our results, the Spanish external oversight system does not penalise isolated but structural audit malpractice, since sanctioned auditors exhibit lower average audit quality than non sanctioned auditors. In addition, the empirical evidence provided in this study suggests that audit quality dramatically increases after the start date of an external inspection ultimately leading to a sanction. Audit firms try either to influence the outcome of the ongoing disciplinary process, or to counteract the reputational costs inherent to the probable disclosure of a sanction.

JEL Classification: M42, M48