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    Investor Heterogeneity, Auditor Choice, and Information...
    research summary posted May 31, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 11.0 Audit Quality and Quality Control 
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    Title:
    Investor Heterogeneity, Auditor Choice, and Information Signaling
    Practical Implications:

      This study is directly related to research on institutional factors that affect firms’ auditor choice and the overall audit quality in the market. It also stresses how investors’ knowledge in auditor quality could potentially affect firms’ auditor choice when investors are not allowed to choose auditors directly, which is currently an under-researched area. The paper also suggests that it is necessary to control for investor heterogeneity in archival studies on the market reactions to auditor choice and auditor switch; furthermore, this paper adds to the discussion on limitations of regulations.

    Citation:

    Wei, X., X. Xiao, and Y. Zhou. 2015. Investor Heterogeneity, Auditor Choice, and Information Signaling. Auditing: A Journal of Practice and Theory 34 (3): 113-138 

    Keywords:
    Investor heterogeneity, auditor choice, auditor quality, and information signaling
    Purpose of the Study:

    It is a long established fact that the audit market is differentiated.  This differentiation leads to two distinct effects on firms’ auditor choices.  For one, firms can hire high-quality auditors and use them to signal the credibility of their prospects to investors and distinguish themselves from low-value firms. On the other hand, firms can hire low-quality auditors if the firm engages in earnings management or adopts an aggressive accounting practice to reduce the risk of being detected or forced to switch to conservative accounting practices.  The decision on which type of auditor to hire is not taken lightly, and it is the belief of the authors that firms are considering both how investors will perceive their auditor choices and how investor perception will likely affect their share prices during the hiring process.  As a result, this paper provides a theoretical investigation of the consequences of investor heterogeneity on both firms’ auditor choices and the overall audit quality in the market. 

    Design/Method/ Approach:

    The authors developed a model of firms’ auditor choices based on the assumption that there are only two types of firms, high-value and low-value, and two types of auditors, high quality and low quality.  The Perfect Bayesian Equilibrium (PBE) was applied as the equilibrium concept to the model. 

    Findings:
    • The authors find that in any PBE a high-value firm is more likely to choose a high-quality auditor than a low-value firm.
    • The authors find that the market share of high-quality auditors increases with the proportion on sophisticated investors.
    • The authors find that as the penalty for firms that receive qualified audit opinions increases, the overall audit quality decreases.
    • The authors find that when there are sufficient investors who appreciate high-quality audits, managers who care about investor reactions will benefit from choosing high-quality auditors and the overall audit quality in the market will increase.
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes