Auditor-Client Compatibility and Audit Firm Selection


Executive Summary: When clients don't fit as well with their auditors, they're more likely to switch to one with a better fit. Using textual disclosure similarity to assess auditor-client fit, after an auditor change there is a quick alignment in the footnotes of that client with existing clients of the new auditor, followed by slower changes in unaudited sections of the 10-K.

Abstract: We examine auditor switching conditional on the compatibility of clients and their auditors using a unique text-based measure of similarity of financial disclosures. We find clustering of clients within an audit firm based on this measure. We find that clients with the lowest similarity scores are significantly more likely (9.4% to 10.6%) to switch auditors, and will change to an audit firm to which they are more similar. Regarding the effect on audit quality, we find that discretionary accruals are lower when similarity is higher. However, accounting restatements are more likely when text disclosures that are unaudited-business description and MD&A-are more similar. We find no such similarity effect for the audited footnotes. Finally, we find that firms that are more similar are less likely to receive a going concern opinion (GCO) but the GCO reporting decision is more accurate. It is unclear if this reflects higher or lower audit quality since firms that are candidates for a GCO are intrinsically different from the average firm in an auditor's portfolio due to their financial distress. One implication of these results is that auditors might have greater involvement in the quality of the text disclosures that are currently not audited.

Citation: Brown, S. V. and W. R. Knechel. 2016. Auditor-Client Compatibility and Audit Firm Selection. Journal of Accounting Research. 54 (3): 725-775.

DOI: 10.1111/1475-679X.12105