Don't Make Me Look Bad: How the Audit Market Penalizes Auditors for Doing Their Job

Abstract

We examine the reputational impact of an audit office issuing adverse internal control opinions (adverse ICOs). While prior research has examined how clients that receive an adverse ICO respond, we focus on clients that did not receive an adverse ICO. We find that audit offices that issue more adverse ICOs experience lower growth and that this effect is stronger when the adverse ICO is associated with a more visible client or refers to an entity-level control weakness. Finally, we find that clients are less likely to select auditors with a history of issuing adverse ICOs and that auditors are able to recoup some of their lost growth when they issue fewer adverse ICOs. Our results indicate that the market for audit services penalizes auditors for disclosing information critical of management, which undermines the value of direct-to-investor auditor communications and provides insight into potential longer-term implications of the expanded auditor's report.