Global Audit Firm Networks and Their Reputation Risk

Abstract

The globalization of audit markets not only provides an opportunity for the U.S. Big 4 auditors to establish international expertise through global networks, but it also exposes them to reputation risk arising from the acts of their local partners. We analyze the audit failure of ChuoAoyama, one of the Japanese Big 4 audit firms, and find that its credibility impairment reduced security prices of not only the clients of PricewaterhouseCoopers (PwC), their U.S. affiliate, but also the American clients of all other Big 4 auditors affiliated with the Japanese Big 4. Because the quality of the U.S. audit firms is perceived as superior to that of auditors in other countries, we also analyze the premiums arising from the affiliation with the U.S.-led global audit firm networks. We compare the effect of Andersen's audit failure with ChuoAoyama's in Japanese capital markets and find that the magnitude of negative market reactions is larger for Andersen's failure than for ChuoAoyama's. Together, these results suggest that global audit firm networks have created a network-wide reputation for their services that is susceptible not only to audit failures of the U.S. Big 4 but also to those of non-U.S. affiliates and that there is a quality premium for the U.S. Big 4 in Japanese markets. Our results provide a rational explanation for PwC's aggressive efforts to temper the negative impact of ChuoAoyama's failure on their reputation.

Coordination and Communication Challenges in Global Group Audits

“…Third, successful modularization requires that the component auditor understand and comply with the group auditor's instructions or plan. While some studies suggest that work practices and knowledge management apply across global networks (e.g., Carson 2009;Dowling 2009), others show that application of firm practices varies (e.g., Barrett et al 2005;Saito and Takeda 2014), and standardization may not improve audit outcomes (e.g., Boland, Brown, and Dickins 2017). These features suggest that successful modularization may be more difficult in auditing than in other business settings.…”

Share price response to the SEC administrative proceedings against Chinese auditors

“…Overall, their findings support the reputation argument because there is no auditor litigation in Japan. Saito and Takeda (2014) further examine whether the impairment of auditor reputation from the audit failure of ChuoAoyama had spilled over to the Big Four firms in the US. They find that the market negatively reacted to the events of ChuoAoyama not only for clients of PwC but also for clients of other US Big Four auditors who were affiliated with the Japanese Big Four auditors.…”

“…Dee et al (2011) indicate that investors negatively reacted to the PCAOB's sanctions on Deloitte. Skinner and Srinivasan (2012), Numata and Takeda (2010) and Saito and Takeda (2014) all provide evidence on the stock market's negative response to the events of ChuoAoyama. These studies suggest that information with adverse implications for audit quality results in negative impact on stock price.…”

Comments by the Auditing Standards Committee of the Auditing Section of the American Accounting Association on PCAOB Release No. 2015-004, Supplemental Request for Comment: Rules to Require Disclosure of Certain Audit Participants on a New PCAOB Form

“…A study by Saito and Takeda (2014) speaks to the issue of identifying other entities involved in the audit. Saito and Takeda (2014) analyzed a specific audit failure by the foreign-affiliate (ChuoAoyama) of a U.S. firm (PricewaterhouseCoopers). They find that the foreign-affiliate's failure damaged the reputation of PwC as well as other Big 4 firms with global networks as measured by stock price premiums.…”