External investigations and disciplinary sanctions against auditors: the impact on audit quality

Abstract

In this paper, we provide empirical evidence for the impact of disciplinary sanctions imposed on Spanish auditing firms and their engagement partners. The disciplinary sanctions resulted from external investigations, which revealed misapplications of auditing standards. In particular, we evaluate (a) the efficacy of the external supervisory board in identifying low-quality auditors and (b) the effectiveness of the disciplinary system in improving the quality of subsequent statutory audits performed by the sanctioned auditors. We employ two earnings management indicators as proxies for audit quality: loss avoidance through extraordinary items and abnormal accruals. And we compare these measures in the financial statements of client companies (auditees) audited by sanctioned and non-sanctioned auditors between 1995 and 2007. Our evidence is mixed. The results show that companies audited by Non-Big 4 sanctioned auditors in the pre-inspection period are less likely to avoid bottom-line losses. Additionally, we conclude that use of this earnings management tool decreases in the post-investigation period for all sanctioned auditors, whether Big 4 or Non-Big 4 firms. Contrary to our expectations, the enhancement performance on this measure of audit quality is observed only for smaller fines. The discretionary accrual approach to earnings management does not offer significant results, however. Therefore, the conclusions are not robust, and further investigation is needed. A feasible explanation for the elusive conclusion may be based on the strong incentives for private firms to avoid bottom-line losses for financing purposes and to manipulate earnings to minimize tax payments.