Do sanctioned audit firms strive to restore their damaged reputation under imperfect institutional settings?

Abstract

In this paper, we investigate whether audit firms take measures to improve their audit quality subsequent to government sanctions in imperfect institutional settings. Using data from the emerging markets of China, we find that audit firms with damaged or shredded reputations have lower audit quality prior to the publicized accounting scandals and related disciplinary actions than non-sanctioned audit firms. The lower audit quality is particularly prevalent in less developed regions and smaller audit firms. Audit firms with shredded reputations significantly increased their audit quality after the disciplinary actions regardless of whether they are bigten or small audit firms. Such an improvement is more significant in state owned client firms, less developed regions, and firms sanctioned only once. These results suggest that institutional factors do play a significant role in encouraging audit firms to do high quality work. Finally, audit firms with shredded reputations experience more client turnover, although they do not earn audit fees lower than other firms. Among audit firms with shredded reputations, audit firms taking actions to improve are less likely to be dismissed by their clients and more likely to charge higher audit fees. These results have strategic implications for the regulators in emerging markets.