Academic journal article Economic Inquiry

Reputation Effects in the Market of Certifiers: Evidence from the Audit Industry

Academic journal article Economic Inquiry

Reputation Effects in the Market of Certifiers: Evidence from the Audit Industry

Article excerpt

I. INTRODUCTION

Asymmetric information between seller and buyer can impede mutually beneficial transactions. One of the solutions to this problem is to recruit an independent third party--a certifier--who verifies unobserved product characteristics for the buyer. The certifier's independence is at the heart of the tripartite arrangement. This independence, however, can be compromised when sellers pay for the certification. For instance, in the market of auditors and credit rating agencies (CRA) it is not the investor (i.e., the buyer of the security) who pays for the certifier's services, but the company which is to be impartially rated or audited. In this business model, companies can naturally manipulate their ratings/audits. Furthermore, investors only have a limited power to weed out dishonest certifiers simply because companies, instead of investors, choose auditors and CRA. Ultimately, these problems can pervert the certifier's mission to serve the investing community (Dranove and Jin 2010).

Not surprisingly, this conflict of interest has often been cited as a cause for accounting scandals and, more recently, for inflated credit ratings (e.g., BIS-CFGS 2008; The Economist 2004, 2006). Auditors and CRA alike refute the criticism of their business model, arguing that the threat of losing their reputation is a sufficient disciplinary device (e.g., The Economist 2005). (1) However, this claim has not yet been empirically substantiated.

A successful mechanism of reputation has three components in the presence of conflicts of interest. Consider the audit market. (2) First, investors have to punish companies which chose low quality auditors. There is evidence that capital markets severely penalize companies whose audit reports are of dubious quality (e.g., Chaney, Philipich, and Kirk 2002; GAO 2003a; Krishnamurthy, Zhou, and Zhou 2006; Pacini and Hillison 2003). Second, this negative capital market reaction should feed into companies' auditor choice, i.e., companies should choose high quality auditors. Third, auditors then should have the incentive to provide high quality audits. The second stage of this mechanism has not been empirically validated yet. In particular, it has not been analyzed whether the adverse capital market reaction to low audit quality feeds into companies' auditor choice and if it does, how. A positive effect of adverse quality signals on audit demand means that firms prefer to engage lenient auditors in order to receive favorable reports, suggesting that conflicts of interest overwhelm reputation concerns and clearly fail the disciplinary mechanism. A negative effect, on the other hand, indicates that while investors do not pay for audit services, they can exert discipline on auditors indirectly by forcing public companies to choose high quality auditors--a success of reputation.

In this paper, I exploit the natural experiment of Arthur Andersen's collapse and test the effects of audit quality signals on companies' auditor choice in discrete choice models. The quality signals in this study are auditors' industry-specific financial restatement histories, i.e., the proportion of clients in an industry which restated financial statements in the past. I find that auditors' restatement histories are a crucial driving force in the subsequent auditor choice of deserting Andersen clients. There are compelling reasons why auditors' financial restatement histories should forcibly feed into a company's auditor choice. Restatements are material corrections of published financial statements which cannot be relied upon anymore and have to be reissued. Since the very role of the independent auditor is to ensure that financial statements are fairly presented in all material respects, it appears natural to think that the auditor has not done his job properly if a financial statement has to be restated later. Indeed, there is ample evidence that capital markets receive restatements badly. …

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