Who is the Best Fit? Ex-ante Beliefs about Auditor-Client Compatibility in the Audit Process

Abstract

This paper emphasizes the importance of ex-ante beliefs for auditor-client compatibility. High compatibility is characterized by the efficient transformation of audit effort into audit quality. Consequently, common intuition suggests that the highest compatibility guarantees the best outcome to the audit process. However, from an ex-ante perspective, the auditor-client compatibility is unknown to all market participants. In our model, we show that auditors with uncertain compatibility can outperform auditors whose type is known since a successful (unsuccessful) audit has a stronger positive (negative) impact on the market's beliefs if the auditor still has to prove her fit. Thus, given that litigation is rather moderate, auditors with uncertain compatibility have stronger effort incentives than certainly compatible types, which enables them to generate a higher audit surplus. The results highlight that litigation and market mechanisms provide a unique set of incentives for each auditor and cannot be viewed as perfect substitutes.

Keywords: auditor-client compatibility; information update; audit quality