Examining the Audit Offices' Client Portfolios Pre- and Post-Client Fraud

Abstract

In the post-SOX environment, I examine the client portfolios of audit offices’ pre- and post-client financial reporting fraud. I find that the overall audit quality declines in the offices preceding the occurrence of client fraud - they experience a larger number and higher percentage of financial statements that are restated in the future for accounting issues (but not for fraud). The differences between fraud and control offices emerge three years before the fraud. The majority of the fraud clients have been with the incumbent auditor for at least four years, which suggests the differences are less likely the result of fraud clients’ opportunistic shopping behavior but rather deterioration over time. Meanwhile, the audit fees show a simultaneous increase amplified in the more concentrated audit markets, indicating that the fraud offices could have been charging a risk premium. I also find that after the Accounting and Auditing Enforcement Releases (AAER) are disclosed to the public by the U.S. Securities and Exchange Commission (the SEC), the inflow clients to the audit office are not different from the continuing clients in terms of their riskiness, whereas the outflow clients are riskier than the continuing clients. At the same time, the inflow clients pay much lower fees compared to the continuing clients, and to themselves the year before they switch. These findings shed light on the restructuring process of the audit offices’ client portfolios post-fraud.