Given the outsized role that reputation plays in the public perception of a professional service provider, it makes sense that auditors may be particularly selective when it comes to their client portfolios, actively screening out companies whose past or potential future behavior might harm the auditor’s reputation.
University of Notre Dame assistant professor of accountancy Zachary Kowaleski has outlined this strategy for reputation management in the recent paper “Auditors are Known by the Companies They Keep,” published in the Journal of Accounting and Economics. He worked with PCAOB’s Jonathan Cook, Michael Minnis of the University of Chicago, Andrew Sutherland of the Massachusetts Institute of Technology and Karla Zehms of the University of Wisconsin.
“The central hypothesis of our paper is that an auditor’s reputation is in part formed by its client portfolio – auditors are known by the companies they keep,” the paper opines, noting that an auditor’s reputation can take a hit when a client is caught behaving illegally or unethically. “Producers with a reputation for providing high-quality services to high-quality clients can, in turn, charge a premium.”
In studying how reputation concerns factor into auditor-client relationships, the researchers created measures for auditor misconduct disclosures and auditor reputation sensitivity and examined auditor’s client acceptance and continuation decisions. The team theorized that if new client misconduct has no litigation risk or has risk that auditors can mitigate simply by charging a premium, no relationship of misconduct would be found between the existing clients in an auditor’s portfolio and newly acquired clients. They also found that relationships between auditors with solid reputations and clients with a history of misconduct didn’t last long.
The team’s analysis of the reputation management aspect of audit-client relationships also revealed that clients matching with lower reputation auditors have a higher rate of new misconduct incidents in the next year. “We were surprised to find that an auditor’s reputation for accepting high misconduct clients predicts their new clients’ future misconduct,” Kowaleski says.
The bottom line, Kowaleski notes, is that auditors tend to be known by the company they keep – which is why firms need to be mindful about building their client portfolios.
“We show that an auditor’s clients have similar misbehavior profiles that are unrelated to audit work,” he says of the team’s research. “Furthermore, we observe evidence that auditors protect their reputations by avoiding clients who could harm their reputation.”