[The literature on the audit market has suggested that a valued attribute of audits is implicit insurance. The insurance stems from the investor's right to recover from auditors the losses sustained by relying on audited financial statements that contain misrepresentations. This "insurance hypothesis" has proven difficult to test empirically, despite the widespread evidence of litigation against auditors. In this paper we provide some empirical support, showing that investors assign a value to the right to recover investment losses from the auditor. We examine the effect on stock prices of Laventhol & Horwath (L&H) clients of two related events: first, the disclosure of their auditor's bankruptcy, and second, the appointment of a successor auditor. L&H's bankruptcy is a rare instance in which the insurance protection provided by the auditor was suddenly withdrawn and the ability of investors to recover losses from the auditor was significantly curtailed. We argue that the value assigned by investors to the right to recover potential losses from the auditor is a component of the stock price, and hypothesize that it varies with the likelihood that the right will be exercised. It is expected to increase with increasing magnitude of stock price declines and to be greater for recent initial public offerings (IPOs) than for seasoned securities. The results suggest that the disclosure of L&H's bankruptcy had an adverse effect on market prices of L&H clients. As hypothesized, the effect varied with previously incurred price declines, and was greater for IPOs. To more distinctly separate insurance and monitoring effects, we also examined the market reaction to clients' announcements of a replacement auditor. No significant reaction was observed, which is consistent with the insurance hypothesis. Overall, the results of the paper provide some empirical support for the theory that investors view the audit product as including insurance against potential investment losses.]

[An important differentiating attribute of the audit product is believed to be the credibility that the auditor is perceived to bring to an audit engagement. This study uses the context of the initial public offering (IPO) to investigate auditor credibility. It is contended that information asymmetry problems lead to a demand for credible auditors in companies going public. Entrepreneurs have incentives to signal their knowledge of favorable future earnings by selecting reputable auditors. Since there is limited information available on firms going public, employing credible auditors can convey monitoring cost advantages as well. Investment bankers also have a preference for credible auditors since they rely on audited financial statements in certifying the value of the firm and determining whether to underwrite the offering. In the present study, we consider auditor credibility in IPOs from the perspective of the client and the investment banker. If there is an increased demand for auditor credibility at the time of the IPO, there should be a significant number of credibility-increasing auditor changes prior to the offering. Furhter, if the investment banker benefits from having a more credible auditor sign off on statements prepared by the client, this should be reflected in the investment banker's fee structure. The empirical analysis is performed on companies that went public in 1985 and 1986. Relatively few auditor changes are observed prior to the offering. However, among those companies making auditor changes, there is a clear preference for more credible auditors. Logistic regression analysis shows that companies with prestigious investment bankers are more likely to change away from local auditors to more credible CPAs. The type of underwriting arrangement employed is also significant, consistent with an investment banker preference for credible auditors. A regression analysis is conducted, using the 1985 and 1986 IPOs, modeling investment banker compensation as a function of several factors, including type of auditor employed by the issuing firm. In the case of "firm commitment" offerings, the auditor type is found to be significant. Clients seem to be charged a smaller investment banking fee if they are associated with Big Eight auditors. There is no apparent auditor effect in the case of "best efforts" offerings. The evidence generally supports the hypothesis that investment bankers and their clients have a preference for credible auditors for the IPO.]

Reviews the book "Product Differentiation in Auditing: Auditor Choice in the Market for Unseasoned New Issues," by Dan A. Simunic and Michael T. Stein.

An important differentiating attribute of the audit product is believed to be the credibility that the auditor is perceived to bring to an audit engagement. This study uses the context of the initial public offering (IPO) to investigate auditor credibility. It is contended that information asymmetry problems lead to a demand for credible auditors in companies going public. Entrepreneurs have incentives to signal their knowledge of favorable future earnings by selecting reputable auditors. Since there is limited information available on firms going public, employing credible auditors can convey monitoring cost advantages as well. Investment bankers also have a preference for credible auditors since they rely on audited financial statements in certifying the value of the firm and determining whether to underwrite the offering. In the present study, we consider auditor credibility in IPOs from the perspective of the client and the investment banker. If there is an increased demand for auditor credibility at the time of the IPO, there should be a significant number of credibility-increasing auditor changes prior to the offering. Further, if the investment banker benefits from having a more credible auditor sign off on statements prepared by the client, this should be reflected in the investment banker's fee structure. The empirical analysis is performed on companies that went public in 1985 and 1986. Relatively few auditor changes are observed prior to the offering. However, among those companies making auditor changes, there is a clear preference for more credible auditors. Logistic regression analysis shows that companies with prestigious investment bankers are more likely to change away from local auditors to more credible CPAs. The type of underwriting arrangement employed is also significant, consistent with an investment banker preference for credible auditors. A regression analysis is conducted, using the 1985 and 1986 IPOs, modeling investment banker compensation as a function of several factors, including type of auditor employed by the issuing firm. In the case of "firm commitment" offerings, the auditor type is found to be significant. Clients seem to be charged a smaller investment banking fee if they are associated with Big Eight auditors. There is no apparent auditor effect in the case of "best efforts" offerings. The evidence generally supports the hypothesis that investment bankers and their clients have a preference for credible auditors for the IPO.

Reviews the book "A Time Series Analysis of the Effect of Internal Audit Activities on External Audit Fees," by Wanda A. Wallace.

The literature provides mixed evidence on whether investors find audit reports modified for going concern reasons to be useful. Using a substantially larger sample than previous studies, we observe negative excess returns when the going concern audit report (GCAR) is disclosed. We find that the reaction is more negative if the GCAR cites a problem with obtaining financing, suggesting that the GCAR provides new information to investors. Also, the reaction is more adverse if the GCAR triggers a technical violation of a debt covenant that restricts the firm from getting a GCAR. The evidence suggests that institutional investors drive the reaction to the GCAR, since there is no detectable reaction at low levels of institutional ownership. The market reaction gets more negative as the level of institutional ownership increases, and there is a decline in institutional ownership after the GCAR is issued. We attribute these results to sophisticated investors’ awareness of the firm’s financing needs and the covenants carried by the firm’s debt.

Audit clients often employ a former partner of their present auditor as an officer or a director. This “revolving door” practice presents a potential threat to auditor independence. Using the Jones (1991) model to calculate abnormal accruals for firms in 1998 and 1999, we find that firms employing former partners as officers or directors report larger signed and unsigned abnormal accruals than other firms, after controlling for other factors that plausibly affect abnormal accruals. To ensure that the results are not driven by performance characteristics of the former partner firms, we construct a performance-matched control sample and obtain consistent results. We also observe a disproportionately higher (lower) proportion of former partner firms than expected just meeting (missing) analysts' earnings forecasts.

Examines the effect Laventhol & Horwath's (L&H) disclosure of their auditor's bankruptcy and the appointment of a successor auditor on the company's stock prices. Insurance hypothesis; Investors' assignment of a value to the right to recover investment losses from the auditor; Adverse effect of bankruptcy disclosure on market prices of L&H clients.

Audit researchers have a long-standing interest in understanding whether issuing a going concern report to financially stressed clients protects auditors from litigation. An endogeneity issue arises, in that litigation risk affects the going concern decision and the going concern decision impacts auditor litigation risk. Using a simultaneous equations approach, we find a significant positive association between auditors' ex ante litigation risk and going concern reporting. By applying simultaneous equations, we also find a significant negative association between going concern reporting and auditor litigation, suggesting that auditors deter lawsuits by issuing going concern reports to their financially stressed clients. Our research further provides a more rigorous analysis of the relation between going concern reporting and lawsuit outcomes in the form of auditor litigation dismissals, small settlement amounts, and large settlement amounts. Our results indicate that when auditors are named in lawsuits, having issued a going concern report reduces the likelihood of large financial settlements. Data Availability: The data used in this study are publicly available through sources identified in the study.