Auditor Reputation and Low-Quality Audits: Evidence from a Structural Model

Abstract

This study examines the reputational impact of low-quality audits. Based on an analytical model, we develop an intuition about how low-quality audits affect clients' preferences for an audit firm. Applying demand estimation methods, we provide novel evidence that clients, on average, have lower demand for Big 4 audit firms with a more frequent involvement in low-quality audits. Consistent with theory, we find that the reputational effects are more pronounced for Big 4 audit firms, for non-incumbent audit firms, and in highly competitive environments. Our structural approach allows us to conduct counterfactual analyses, offering initial evidence on audit market effects. Overall, we find that low quality audits have reputational consequences, but that their economic impact remains modest.

Keywords: audit market, auditor demand, restatements, auditor reputation

JEL Classification: M42