Auditor–Client Compatibility and Audit Firm Selection

• Published date: 01 June 2016
• Date: 01 June 2016
• Author: STEPHEN V. BROWN,W. ROBERT KNECHEL
• DOI: http://doi.org/10.1111/1475-679X.12105

DOI: 10.1111/1475-679X.12105

Journal of Accounting Research

Vol. 54 No. 3 June 2016

Printed in U.S.A.

Auditor–Client Compatibility and

Audit Firm Selection

STEPHEN V. BROWN

∗AND W. ROBERT KNECHEL

†

Received 12 March 2013; accepted 4 January 2016

ABSTRACT

We examine auditor switching conditional on the compatibility of clients and

their auditors using a unique text-based measure of similarity of financial

disclosures. We find clustering of clients within an audit firm based on this

measure. We find that clients with the lowest similarity scores are significantly

more likely (9.4%–10.6%) to switch auditors, and will change to an audit

firm to which they are more similar. Regarding the effect on audit quality,

we find that discretionary accruals are lower when similarity is higher. How-

ever, accounting restatements are more likely when text disclosures that are

unaudited—business description, and management discussion and analysis

(MD&A)—are more similar. We find no such similarity effect for the audited

footnotes. Finally, we find that firms that are more similar are less likely to

receive a going concern opinion (GCO), but the GCO reporting decision

is more accurate. It is unclear if this reflects higher or lower audit quality

since firms that are candidates for a GCO are intrinsically different from the

average firm in an auditor’s portfolio due to their financial distress. One

∗Unaffiliated; †University of Florida.

Accepted by Phil Berger. We are grateful for feedback from Stephen Asare, Ryan Cerf,

Praveen Pathak, and Jennifer Wu Tucker. We would also like to thank workshop participants

at the University of Texas–Austin, University of Toronto, Arizona State University, Florida In-

ternational University,Southern Methodist University,the U niversity of Florida,the University

of Illinois at Urbana–Champaign, the University of Kentucky,the University of South Carolina,

and the University of Virginia for their feedback on portions of this paper.

725

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

726 S.V.BROWN AND W.R.KNECHEL

implication of these results is that auditors might have greater involvement

in the quality of the text disclosures that are currently not audited.

JEL code: M42

Keywords: audit markets; auditor switching

1. Introduction

The process by which a client selects an auditor can be complex and can

be influenced by a number of factors. 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 (Johnson and Lys [1990], Chaney, Jeter, and Shaw

[1997], Knechel, Niemi, and Sundgren [2008]). Some of these attributes

are obviously more relevant than others for determining the overall quality

of the resulting audit. A limited amount of research has examined align-

ment between clients and certain types of auditors based on factors such as

the size of the audit firm (Shu [2000], Landsman, Nelson, and Rountree

[2009]) or degree of industry specialization (Knechel, Naiker, and Pacheco

[2007]). However, there is less research on the compatibility of specific au-

ditors and specific clients. What literature exists has focused on operational

and financing changes in a client (Johnson and Lys [1990]), the effects of a

client hiring a former audit partner (e.g., Lennox and Park [2007]), or the

effect of auditors and clients connected via the university education of man-

agement (Guan et al. [2016]) or the audit committee (He et al. [2014]).

Further, there is evidence that the supply of audits shifts over time, both

at the national level (DeFond and Lennox [2011]) and at the local level

(DeKeyser et al. [2015]). A recent paper by Gerakos and Syverson [2015]

analyzes the consumer surplus implicit in current auditor–client combina-

tions by estimating the implicit cost of lost surplus that would occur with

the introduction of mandatory audit firm rotation. The sizable loss of sur-

plus suggests that the current alignment of clients and auditors is beneficial

to clients, on average.1

In general, clients may have preferences about various aspects of the

audit process, its outcomes, and the nature of the relationship with their

auditor. While audit firm alumni, common educational experiences, and

1In related research, Francis, Pinnuck, and Watanabe [2014] report that clients of a single

audit firm in the same industry have earnings that are more comparable to each other than

to clients of other audit firms. Francis, Pinnuck, and Watanabe [2014] examine comparability

of accruals across pairwise sets of clients of a single auditor in the same industry. They do not

extend their analysis to include auditor switches, nor do they discuss the implications of the

observed comparability for overall audit quality. Wediscuss the study by Francis, Pinnuck, and

Watanabe [2014] in more detail later in this paper.However, if there is a gain in audit quality

by breaking client–auditor links that are based on social ties (He et al. [2014]), there could be

a net benefit to such rotation.

AUDITOR–CLIENT COMPATIBILITY AND AUDIT FIRM SELECTION 727

social ties may proxy for some of these characteristics, the alignment of au-

ditors and clients is likely to be much more complex. In this paper, we de-

fine auditor–client compatibility as the ability of the auditor to satisfy a client’s

preferences, given the auditor’s own preferences, abilities, and constraints.

If client preferences vary from company to company, and the ability of an

auditor to meet a client’s needs varies from firm to firm, the degree of fit

between any two entities will also vary.2A client’s preferences for a certain

audit firm can be represented conceptually as a vector of attributes that

are desirable to the client (e.g., location, cost, expertise, social links, etc.),

which can be mapped to a vector of attributes supplied by any given au-

ditor.3Compatibility would then reflect the degree of commonality across

the two vectors. Since many of these attributes are likely to be unobserv-

able (other than very obvious attributes such as specialization), the actual

degree to which a client and a specific auditor are compatible across the

entire spectrum of potential attributes is also unobservable.

One way that compatibility may manifest is in the numbers included in

the financial statements as examined in Francis, Pinnuck, and Watanabe

[2014]. However, the narrative disclosures of the financial statements are

also critical to evaluating a company’s performance, and are much harder

to analyze. Further, the auditor has different levels of responsibility—

audited versus reviewed—for different elements of the narrative disclo-

sures, potentially revealing either more (or less) influence of the auditor

on some disclosures. In this paper, we 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.

Based on this perspective, we develop a unique measure of auditor–client

compatibility for Big 4 firms based on the similarity of their financial disclo-

sures (rather than their financial results). We then use the similarity score to

evaluate a firm’s decision to switch auditors and the impact of increasing

compatibility (similarity) on audit quality.

The basic idea is that, on average, clients “cluster” in a specific audit

firm for a reason, even though we may be unable to observe the exact

2In this paper, we use the term “fit” interchangeably with “compatibility.”Johnson and Lys

[1990] argue that a lack of fit between an auditor and a client reflects a loss of efficiency in the

cost of conducting an audit. While that is certainly one possible explanation for an auditor–

client mismatch, our approach does not require the restricting assumption that a change in

auditor is due solely to cost considerations. More specifically, we assume that changes in ser-

vice, expertise, and quality considerations that are reflected in the accounting disclosures can

also be associated with an auditor–client misalignment.

3For purposes of this discussion, we do not specify whose desirable attributes drive the audi-

tor choice decision, that is, management, the audit committee, others, or some combination

of all three. A manager may want an auditor that is nondisruptive to the personnel of the

company or “cooperative” on accounting issues, while an audit committee may be focused on

reputation and ability to meet deadlines. The priorities assigned to these attributes depend

on the internal interactions of the stakeholders of the firm. See Fiolleau et al. [2013] for a

discussion of the process used, and the issues that arise, during an audit client tender and

subsequent change in auditors.