The importance of information flow within auditors’ client portfolios to audit quality

Abstract

We extend prior research by exploring the importance of information flow within auditors’ client portfolios to audit quality. On the one hand, information flow fosters communication among clients concerning how to deal with an auditor, helping clients negotiate against proposed audit adjustments. On the other hand, information sharing helps spread indications that an auditor provides a low-quality audit to one client, making such signals known to their other clients. Accordingly, this motivates auditors to impose stricter external monitoring to protect their reputations and wealth. In analyzing which force dominates in shaping audit quality, we find that companies experience a higher likelihood of audit adjustments and a lower likelihood of accounting irregularities when their audit committee members are socially connected or interlocked with audit committee members of other clients audited by the same auditor. In contrast, we do not find any perceptible impact of informational connections stemming from top management on audit quality, consistent with executives not always demanding accounting transparency. Mechanism analysis reveals that auditors expend more effort on engagements when clients have more extensive information flow channels.