Criticisms of auditors and the association between earnings and returns of client firms

Empirical research suggests that auditors subject to enforcement action by the SEC experience impairment of their reputation that causes losses in market share, lower audit fees from new clients, and a decline in market value of client firms. Recent research also suggests that audit quality differentiation based on audit firm size and brand name is associated with higher earnings response coefficients (ERC) of client firms. It is hypothesized that a sanction issued against an audit firm degrades assessed audit quality and reduces the perceived credibility of client earnings numbers. This in turn is expected to reduce ERCs. The sanction effect is examined by comparing stock returns associated with earnings information of client firms immediately before and after the sanction against the auditor.