Auditor Responses to Regulatory Risk: Evidence from SEC Investigations

Abstract

We investigate whether auditors respond to ongoing SEC investigations, the majority of which do not reveal severe audit failures or lead to regulatory enforcement actions. We find that auditors are more likely to resign from clients under investigation, increase audit fees and audit effort, and issue more conservative opinions, suggesting that auditors proactively manage increased regulatory risk. We observe auditors’ responses in the first year immediately following the initiation of an investigation. We also find that small auditors take more aggressive measures to manage risk by resigning from investigated clients and increasing audit fees. In contrast, large auditors are more likely to respond to regulatory risk by increasing audit effort and issuing more conservative opinions. Additionally, our results are more pronounced for companies with low ex-ante audit quality. Overall, our findings suggest that auditors incorporate regulatory risk in their risk management strategies even before the risk materializes.

Keywords: Regulatory Risk, SEC Investigation, Audit Quality, Audit Market

JEL Classification: D80; M40; M42