Auditors’ reputational damage and audit clients’ cost of debt: Evidence from litigation against auditors

Abstract

This study examines how auditors’ reputational damage resulting from litigation affects banks’ assessment of audit clients’ creditworthiness. Focusing on a sample of syndicated loans, we find that banks require higher loan spreads when borrowers’ auditors are sued for alleged audit failures. Further analysis reveals that the results are more pronounced when participating banks perceive greater information asymmetry between themselves and either borrowers or lead banks. These reputational effects last for up to two years following litigation and are incremental to other proxies for the quality of audit outcomes. Collectively, our findings underscore the importance of auditor reputation even in the private debt market, where banks have access to private information about their borrowers. This study contributes to a comprehensive understanding of the costs and externalities of auditor litigation in capital markets.

Keywords: auditor litigation, auditor reputation, cost of debt, syndicated loans

JEL Classification: M41, M42