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    Restatements: Do They Affect Auditor Reputation for Quality.
    research summary posted February 17, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 11.0 Audit Quality and Quality Control, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
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    Title:
    Restatements: Do They Affect Auditor Reputation for Quality.
    Practical Implications:

    This study offers insights into how restatements by one client may impact an auditor’s other clients. The authors find evidence suggesting that when an auditor’s clients restate their financial statements, the auditor’s reputation for audit quality suffers. Non-restating clients experience a small negative market reaction around the restatement date and a higher likelihood of dismissing that auditor. These findings may inform audit firms and their clients about the potential negative consequences of restatements by other clients.

    Citation:

    Irani, A.J., S.L. Tate, and L. Xu. 2015. Restatements: Do They Affect Auditor Reputation for Quality. Accounting Horizons 29 (4): 829-851.

    Keywords:
    financial restatements, audit quality, auditor reputation, auditor dismissal
    Purpose of the Study:

    Signals of low audit quality should harm an audit firm’s reputation for quality in order to make the reputation more accurately reflect the firm’s true audit quality. While prior research has found negative responses from clients and the stock market following strong signals of low audit quality (e.g., SEC disciplinary actions), it is unknown how these stakeholders will react to weaker signals of low audit quality (e.g., restatements). However, the research on industry contagion effects suggests that restatements by one firm in an industry lead to decreased expectations for other firms in the industry, so it would not be surprising if restatements by one firm lead to decreased expectations for other firms that share its auditor. The authors attempt to tie up these loose ends by investigating whether restatements by one firm lead to (1) auditor dismissals by and (2) negative market adjusted returns for other firms that share its auditor(s), especially when restatements are more severe.

    Design/Method/ Approach:

    The authors use data from publicly-traded companies during the 2004-2012 time period. First, they test whether non-restating companies are more likely to dismiss auditors whose other clients filed restatements in the prior year. Second, they test whether non-restating companies experience negative market adjusted returns after one of their auditor’s other clients files a restatement. For both tests, they investigate whether the predicted reputation effect is stronger for more severe restatements.

    Findings:
    • About 4.5% of non-restating companies dismissed their auditor.
    • Non-restating companies more likely to dismiss their auditor had auditors with a higher percent of clients filing restatements and more misstated items in the restatements. The non-restating companies more likely to dismiss their auditor had weaker internal controls, a net loss, higher leverage, and a smaller size.
    • Auditor resignations are not related to the number of clients filing restatements.
    • On average, restating companies (non-restating companies sharing a restating company’s auditor) had a -1.78% (-0.04%) market adjusted return over the 2 day restatement window.
    • Over the 2 day restatement window, the decrease in market value of a non-restating company was higher when there was a stronger decrease in market value for the shared auditor’s restating client, the restatement adversely affected the restating client’s net income, the restatement had more restated items, a larger window existed between the misstatement period and the restatement announcement, the auditor was an industry expert, the auditor was one of the Big 4, the non-restating company had higher cash flow from operations, the non-restating company had lower total accruals, and the non-restating company was bigger.
    Category:
    Accountants' Reporting, Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements