Does the Market Value Auditors' Industry Specializations? Evidence from the Contagion Effects of Restatements

Abstract

SYNOPSIS This study investigates whether auditors' industry specializations are valued by the capital market. By using a quasi-experimental research design, we control for the confounding effects of auditor choices, which are often found in prior studies. Specifically, we examine whether an auditor's non-restating audit clients suffer collateral damage from restatements of the same auditor's other clients. If an auditor's industry specialization is valued by the market, the contagion effect should be greater for clients of industry specialist auditors. We find that the non-restating clients of city-level industry specialists whose other clients issue restatements experience −0.8 percent abnormal returns around restatement announcements. For national industry specialists, we find negative market reaction to the auditors' non-restating clients only when the restatements convey severe negative signals. Overall, the evidence is consistent with the notion that auditors' reputations as national- and city-level specialists are priced at a premium in the capital markets.

The Value of Restatement to Fraud Prediction

“…The empirical results provide support for Hypothesis 1, which posits that restatements are earlier warnings for future fraud revelation. We also perform a logistical regression to test the contagion effect of industry restatements on fraud (Ji, Kumar, Pei, & Xue, 2019). The results are consistent with our main findings, which suggest that industry restatements increase the firms' future fraud revelation (untabulated).…”

The impact of financial restatements on financial markets: a systematic review of the literature

“…Further, they conclude that this intra-industry contagion effect is more extreme for peer firms that exhibit similar levels of accounting quality and when they share the same external auditor. Similarly, Ji et al (2019) report that peer firms' market value loss increases when they hire an industry specialist auditor that has clients that restated their financial accounts. This paper complements the findings of Liu et al (2012), who investigate the contagion effect that the Enron episode had on the credit rating of firms in the same industry.…”