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    Auditor-Client Compatibility and Audit Firm Selection
    research summary posted February 27, 2017 by Jennifer M Mueller-Phillips, tagged 11.0 Audit Quality and Quality Control, 15.0 International Matters, 15.04 Audit Firm Rotation 
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    Title:
    Auditor-Client Compatibility and Audit Firm Selection
    Practical Implications:

     The authors’ results may be of interest to policy makers for two important reasons. First, regulatory discussions on mandatory audit firm rotation could have implications for the cost and quality of auditing if a client is forced to switch from a compatible auditor to one that is less compatible. Second, proposals to expand the auditor’s reporting responsibilities might mitigate the loss of audit quality when similarity arises in unaudited disclosures.

    Citation:

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

    Purpose of the Study:

     A great number of factors affect the complicated process of a client selecting an auditor. The factors that might affect the degree of compatibility between an auditor and a client include pricing, expertise, location, interpersonal associations and the extent of agency problems in the client. Research in the past has looked into some of these attributes and how they are relevant in determining the overall quality of the resulting audit. A limited amount of research has examined alignment between clients and certain types of auditors based on factors such as the size of the audit firm or degree of industry specialization. However, there is less research on the compatibility of specific auditors and specific clients. The authors define auditor-client compatibility as the ability of the auditor to satisfy a client’s preferences, given the auditor’s own preferences, abilities and constraints. With this in mind, the authors examine the narrative disclosures included in the text-based parts of the financial statements that provide information about a company, its operations and its accounting choices. Next, they develop a unique measure of auditor-client compatibility for Big 4 firms based on the similarity of their financial disclosures rather than their financial results.

    Design/Method/ Approach:

     The authors focus on three narrative disclosures separately and together: the company’s business description, the accounting footnotes, and management discussion and analysis. They also compare the similarity of an individual client to all of the current clients within an industry of a specific auditor to generate a proxy for how well that company fits into each auditor’s client base.

    Findings:
    • The authors find that clients clustered within an industry at the audit firm level tend to have higher similarity scores when compared to clients of other auditors in the same industry and time period; this suggests that the authors’ proxy is capturing information about the compatibility between an individual client and an individual audit firm.
    • The authors find that the poorer the fit with an existing auditor, the greater the probability the client will choose to switch to a new auditor.
    • The authors find that the successor auditor is generally the non-incumbent firm that has the best relative fit.
    • The authors find that discretionary accruals are lower when auditor-client compatibility is better, suggesting higher audit quality; however, they find a higher incidence of accounting restatements when the similarity of the unaudited MD&A and client business description is high but not when the similarity of the audited footnotes is high.
    • The authors find that financially distressed firms that are more similar are less likely to receive a going concern opinion, but similarity is also associated with increased accuracy in going concern opinion reporting. 
    Category:
    Audit Quality & Quality Control, International Matters
    Sub-category:
    Audit Firm Rotation