Does Reputation Discipline Big 4 Audit Firms?

Audit quality is thought to occur primarily due to litigation pressure. We report results from a study conducted in a low litigation environment (China) where a Big 4 audit firm (Deloitte) failed to detect a fraud involving a public company (Kelon). We find that Deloitte’s clients have negative abnormal returns of 4.4% at events pertaining to Kelon, and there is a spillover to clients of other Big 4 audit firms (negative abnormal returns of 1.2%) though these negative market reactions are moderated by strong corporate governance. Deloitte loses clients to local audit firms, and all Big 4 firms lose market share in the IPO market. Our results support a reputation rationale for audit quality, and also show contagion among Big 4 audit firms, and vulnerability of Big 4 firms to loss of clients to non Big 4 firms.