THE EFFECTS OF SIGNIFICANT CHANGES IN AUDITOR CLIENTELE AND AUDITOR-CLIENT MISMATCHES ON AUDIT QUALITY

Abstract

This study contributes to the current debate on mandatory audit firm rotation by investigating how possible consequences of mandating audit firm rotation may affect audit quality. I find that audit offices with large increases in their clientele (strained capacity) or decreases in their clientele (excess capacity) have significantly lower audit quality as measured by the absolute value of discretionary accruals. I find evidence of a smaller effect for larger audit firms with strained capacity supporting a reputational or flexibility hypothesis. Additionally, audit offices with strained capacity are more likely to issue going-concern opinions to companies that do not subsequently go bankrupt (Type I errors). I further investigate the effect of strained and excess capacity on an audit firm\'s client acceptance decisions and find that mismatches, where a large audit firm accepts a client expected to be served by a small audit firm, are less likely to occur when a large audit firm has strained capacity. Finally, I investigate the effect of auditor-client mismatches on audit quality. I find that audit quality is positively affected when a large audit firm performs the audit for a company expected to be served by a smaller audit firm and is negatively affected when a small audit firm performs the audit for a company expected to be served by a larger audit firm.