ABSTRACT We examine the reputational impact of an audit office issuing adverse internal control opinions (adverse ICOs). While prior research has examined how clients that receive an adverse ICO respond, we focus on clients that did not receive an adverse ICO. We find that audit offices that issue more adverse ICOs experience lower growth and that this effect is stronger when the adverse ICO is associated with a more visible client or refers to an entity-level control weakness. Finally, we find that clients are less likely to select auditors that have a history of issuing adverse ICOs, and auditors are able to recoup some of their lost growth when they issue fewer adverse ICOs. Our results indicate that the market for audit services penalizes auditors for disclosing information critical of management, which undermines the value of direct-to-investor auditor communications and provides insight into potential longer-term implications of the expanded auditor's report.

Abstract We present the first large‐sample empirical evidence on U.S. auditors' responses to changes in entity‐level audit risk during 2006–2007, the period leading up to the financial crisis of 2008–2009. Treating fiscal year 2005 engagements as a pre‐crisis benchmark, we find that audit attention during fiscal year 2006 and 2007 bank audit engagements shifted in line with the shifting audit risks. One implication of these findings is that auditors were able to recognize and respond to financial statement impacts of the macroeconomic shocks that unfolded during the lead‐up to the crisis. Another implication is that auditors' failure to issue advance warnings of increasing auditee riskiness during the time leading up to the financial crisis more likely reflects limitations of extant accounting and auditing rules rather than a lack of auditor awareness or attention to those risks.

ABSTRACT We investigate how audit firms balance the tension between professional responsibility and client service by examining changes in partner assignments following adverse internal control opinions (ICOs). We find that partners are significantly more likely to be reassigned when they issued an adverse ICO to any of their clients in the previous year. Further, partners issuing adverse ICOs experience unfavorable changes in their client portfolios in the form of lower fees and less prestigious assignments. We find that consequences are more negative when adverse ICOs are issued to clients that are more important to the local office and that there are no consequences when partners issue continuing adverse opinions to clients they have “inherited” from an original adverse ICO partner. We also find that the consequences are stronger for partners of non‐Big 4 audit firms that are likely to be more sensitive to client service considerations. The negative portfolio effects we observe persist for at least three years, and our findings are robust to restrictions involving mandatory partner rotation and adverse ICOs that lead to client loss. Overall, our results are consistent with adverse ICO partners experiencing negative consequences as audit firms respond to client service incentives in the area of internal controls over financial reporting.