Do Clients Avoid “Contaminated” Offices? The Economic Consequences of Low-Quality Audits

ABSTRACT This study investigates whether the market for audit clients penalizes auditors following association with low-quality audits. Specifically, we examine whether audit offices experience a loss in local market share following client restatements. We document that the frequency of restatement announcements within an office-year (“contamination”) is inversely related to subsequent year-over-year change in local market share. Further analysis indicates that restatements impair the office's ability to both attract and retain audit clients. We find that this effect is strongest in high competition markets and diminished in low competition markets. We also examine auditor retention decisions at the client level and find that the likelihood of auditor dismissal increases with contamination, even for non-restating clients. We also find that, on average, clients dismissing their auditor select less contaminated audit offices. Taken together, our results suggest that market forces penalize auditors for association with audit failures, thereby providing an incentive to maintain high-quality audits and protect reputational capital.