Corporate Governance

Why do clients stay with embroiled audit firms?

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A new study reveals how companies compensate for a tarnished auditor, and how effective the remedial strategies are

Featured faculty: Zhao Meiling
Written by Pan Jingyi

Reputation is the cornerstone for auditors to attract and retain clients. Investors rely on audited financial statements to assess a company’s financial health, and an audit is intended to provide assurance that the reported numbers are fairly stated. But what happens when an auditor suffers a reputation blow?

Despite hefty penalties and increasingly stringent regulatory standards, audit failures continue to occur. Even the prestigious Big Four are not immune to misconduct. EY in Germany, PwC and Deloitte in China, and KPMG in the UK have all been severely sanctioned for their high-profile audit failures in the past few years.

When a reputational crisis occurs, the public may begin to question the quality of all audits produced by the audit firm, and it may seem logical that clients would quickly switch to a different auditor to restore stakeholders’ trust. However, that is not always the case.

“The costs of switching are often evidently greater than the benefits. New auditors need time to understand the businesses, and there are always risks during the transition.”

Professor Zhao Meiling

A study by Zhao Meiling, an Assistant Professor at the School of Accountancy at the Chinese University of Hong Kong (CUHK) Business School, finds that around 90 percent of corporate clients remain with the embroiled audit office. The reason is largely practical.

“The costs of switching are often evidently greater than the benefits. New auditors need time to understand the businesses, and there are always risks during the transition,” she explains.

Professor Zhao’s study titled Auditor Office Reputation Damage and Their Audit Clients’ Voluntary Disclosures explores a straightforward question: If companies retain a “compromised” auditor, what actions do they take to rebuild stakeholders’ trust?

Voluntary disclosures to rebuild investors’ trust

Auditing
When a reputational crisis occurs, the public may begin to question the quality of all audits produced by the audit firm.

Working with Cheng Mei and Paul Michas of the University of Arizona, Professor Zhao analysed data from more than 31,000 US-listed companies to see how companies respond when their auditors are caught in the spotlight. The key pattern is clear: clients that stay with the embroiled audit office increase the number of management forecasts by 5 to 10 percent.

Management forecasts are voluntary, forward-looking disclosures that companies issue throughout the year. Some forecasts focus on expected earnings while others provide more granular information on sales, expenses, or specific product lines.

Since the auditor’s reputation damage may undermine investors’ trust, company management compensates by offering more direct and timely information. “Financial disclosure is an important means for managers to communicate private information to outsiders, thereby reducing the information asymmetry and providing greater clarity on firm  performance,” says Professor Zhao.

Meanwhile, companies that switch auditors do not exhibit a similar increase in voluntary forecasting. Such a difference suggests companies weigh the costs and benefits of two credibility-repair strategies: either incur the cost of switching auditors or retain the auditor and increase disclosure to offset the loss of credibility.

When do companies talk even more?

The study also identifies when the increase in voluntary forecasting is strongest. Companies become particularly more open when demand for information is high. Typically, investors and financial analysts are hungry for clarity shortly after scandals come to light.

auditing
Companies weigh the risks and consequences of sharing information when deciding how much to disclose.

Companies with heavier coverage by external financial analysts not only issue more disclosures but also tend to provide more detailed forecasts, including revenue and cost figures, rather than aggregate earnings forecasts. Managers adjust the type and quality of disclosures to align with the information most valued and trusted by the market.

However, not all companies respond by disclosing more. In highly competitive industries, such as technology and retail, greater disclosure may reveal proprietary information that rivals could exploit, causing more harm than good for firms.

Therefore, even though companies may be expected to increase voluntary disclosures when their auditor is mired in scandal to rebuild trust, if the risks and downsides of sharing that extra information are too high, they are less likely to issue management forecasts.

If the scandal is less severe, managers may feel that their existing audit reports already convey enough information, despite the problems with the auditors. “Issuing management forecasts is costly and can consume significant resources,” Professor Zhao says. “Overall, companies weigh the risks and consequences of sharing information when deciding how much to disclose.”

Real financial benefits for companies

For the final question of whether “talking more” actually works, the team examines the shareholder’s expected returns and realized stock returns. The evidence suggests that voluntary disclosure is not just busywork but instead delivers real benefits for companies.

A scandal-ridden auditor office could create a negative image for clients, leading to higher perceived risks and weaker stock performance, especially for companies that stay silent. Companies that increase management forecasts after a reputational shock can mitigate, and in some cases fully offset, those negative effects.

In other words, voluntary disclosure is not merely a public relations tool in this setting. The study suggests that it can reduce firms’ cost of equity and improve realized returns. As Professor Zhao says, “More voluntary disclosures during reputational shock save companies real money and help protect their stock price.”

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For investors, a rise in management forecasts can be a meaningful signal that the company is trying to reduce uncertainty and enhance transparency. For regulators, the results highlight that self-correction measures taken by the companies can help authorities build a clearer picture of where oversight is most needed and when more rules might add value.

Regulators could encourage greater transparency through voluntary disclosure, especially when audit quality concerns arise, and analyse circumstances in which such disclosures might do more harm. In such cases, there might be a greater need for targeted disclosure requirements to protect investors.

For company executives, given that changing auditors can be disruptive and expensive, increasing voluntary disclosures can be a lower-cost alternative to rebuilding credibility. “By stepping forward and communicating more, companies can use their own voice to rebuild trust,” Professor Zhao adds.