The auditor reputation cycle: A synthesis of the literature

• Date: 01 July 2020
• Author: Jason Bergner,Partha Mohapatra,Blair B. Marquardt
• Published date: 01 July 2020
• DOI: http://doi.org/10.1111/ijau.12193

ORIGINAL ARTICLE

The auditor reputation cycle: A synthesis of the literature

Jason Bergner

1

| Blair B. Marquardt

2

| Partha Mohapatra

3

1

Western Kentucky University, United States

2

University of NorthTexas, United States

3

California State University, Sacramento,

United States

Correspondence

Blair B. Marquardt, University of North Texas,

G. Brint Ryan College of Business, 1155 Union

Circle #305219, Denton, TX 76203–5017.

Email: blair.marquardt@unt.edu

The auditor reputation hypothesis states that auditors conduct high-quality audits to

build a positive reputation in the marketplace so that they can retain clients and earn

fee premiums. We consolidate the dispersed literature on this hypothesis and intro-

duce a framework that presents auditor reputation as a cycle. The overall conclusions

support the predictions of our framework regarding reputation as an incentive for

audit quality. However, challenges remain in isolating and quantifying the impact. We

observe moderating factors on both the supply and demand sides. We also find that

existing research has emphasized certain aspects of our framework while addressing

others more sparsely. Relatively little is known about how audit firms earn their repu-

tation or how they rebuild it after an audit failure. Mixed evidence in some areas,

along with research gaps in the framework, provides opportunities for future

research on auditor reputation. Our framework can guide these endeavors.

KEYWORDS

audit quality, auditor reputation, reputation cycle, reputation hypothesis, reputation loss

JEL CLASSIFICATION

M42

“Auditing is a business about reputation.”– James

Doty, Former Chairman of the Public Company

Accounting Oversight Board (PCAOB, 2015b)

1|INTRODUCTION

The auditor reputation hypothesis proposes that an auditor faces an

incentive to build a reputation of providing high-quality audits

(Watts & Zimmerman, 1983). Since the audit process is largely

unobservable, an auditor's reputation serves as a primary signal of

quality. Auditors who maintain their reputations may improve their

market share and capacity to charge fee premiums. Although this

hypothesis is intuitively appealing, it was questioned at the turn of the

millennium when auditors were implicated in multiple high-profile

accounting frauds and the U.S. Sarbanes-Oxley Act of 2002 (SOX)

was passed. These events led to a spurt in research about the various

incentives for auditors to provide higher audit quality, including

reputation. We revisit this hypothesis with the goal of consolidating

the evidence produced since these scandals.

We first present a framework of auditor reputation as a continu-

ous cycle with four stages: 1) the auditor signals its audit quality, 2)

the market assesses that quality and revises the reputation of the

auditor, 3) the updated reputation of the auditor impacts its ability to

attract clients and charge fee premiums, and 4) in the case of a dam-

aging event, the auditor may implement recovery strategies to rebuild

its reputation. This framework serves to guide future research by

summarizing theory, comparing empirical evidence to its predictions,

and highlighting gaps in the extant literature. Our review covers the

archival audit literature published in leading accounting journals for

the period 1997 to 2018. Since we focus on reputation as a driver of

audit quality, we also emphasize articles that intend to differentiate

reputational forces from those related to legal risk.

1

Our review suggests that reputation threats continue to influence

auditors' behavior on average, due to the substantial costs associated

with reputation loss. For example, research finds that Big N firms lose

significant audit clients and revenues following an audit failure and

Received: 30 July 2019 Revised: 25 April 2020 Accepted: 27 April 2020

DOI: 10.1111/ijau.12193

292 © 2020 John Wiley & Sons Ltd Int J Audit. 2020;24:292–319.wileyonlinelibrary.com/journal/ijau

subsequent loss of reputation (e.g., Skinner & Srinivasan, 2012). Fur-

thermore, we document a pattern of supply and demand moderating

factors. For example, reputation effects are stronger when clients face

greater media scrutiny (Barton, 2005), have risk characteristics similar

to those of a tarnished client (Krishnamurthy, Zhou, & Zhou, 2006),

and have access to alternate auditors (Blouin, Grein, &

Rountree, 2007). This evidence implies that the incentive for reputa-

tion is sensitive to other environmental factors. Thus, it does not sug-

gest that reputation by itself can be the sole incentive for auditors to

maintain audit quality.

We also observe notable gaps in the extant research within the

reputation cycle. The preponderance of archival literature exists at

the second and third stages in the cycle (outcomes of reputation on

the auditor and its clients), whereas relatively little research exists in

the first and fourth stages (inputs to reputation and brand recovery).

It also remains unclear how close reputation incentives bring us to an

acceptable rate of audit failures, in isolation or as compared to other

concurrent drivers of quality like litigation.

This literature review contributes to both the academic and pro-

fessional realms. Reputation is fundamental to academics' understand-

ing of audit quality, but the only attempt to review the related

literature occurred over 20 years ago (Moizer, 1997).

2

Since then, sev-

eral major accounting scandals triggered dramatic changes in the

auditing landscape. Such changes include regulation mandated by

SOX, the establishment of independent audit regulators such as the

Public Company Accounting Oversight Board (PCAOB), and globally

heightened attention to auditor independence. Thus, a review of the

literature is warranted to address reputation in light of these events

and to consolidate the substantial expansion of this literature stream.

As a market-drivenconstruct, reputation influences auditors across

legal and regulatory regimes (Khurana & Raman,2004). This wide rele-

vance highlights the importance of reputation research. Thus, our

review provides a distinct contribution relative to other literature

reviews in the auditfield. For instance, while DeFondand Zhang (2014)

providea comprehensiveoverview of archival auditresearch, they focus

on U.S.-onlystudies. They acknowledgethe limitation this scopingdeci-

sion presents for their brief examination of reputation, due to the liti-

gious environment in the United States. Moreover, they call for

research that would establish a stronger link between reputation risk

and audit quality. Thisreview addresses that call by summarizing many

non-U.S. studies and presenting a framework that conveys the cyclical

relationshipbetween reputationand audit quality.

Further, our framework of auditor reputation and the

corresponding literature review can inform audit firms and regulatory

bodies. The evidence suggests that audit firms should strive to main-

tain high audit quality and avoid adverse inspection reports from regu-

latory bodies in order to safeguard their reputations. Our review

suggests that the cost of an audit failure and subsequent damage to

reputation can be massive. Empirical studies find that reputation dam-

age can lead to loss of clients, as well as negatively affect the acquisi-

tion of new clients (e.g., Skinner & Srinivasan, 2012). Similarly,

regulators should not forgo making their sanctions and inspection

reports public, as these impact an auditor's reputation. For example,

releasing Part II of the PCAOB inspection report to the public and dis-

closing partner names appear to improve the market's ability to char-

acterize an auditor's reputation (e.g., Johnson, Reichelt, &

Soileau, 2018). Finally, our review provides timely evidence to regula-

tors weighing the costs and benefits of regulation under the concur-

rent incentive of reputation (SEC, 2020). While the evidence supports

the reputation hypothesis overall, we note several exceptions and

moderators, suggesting that reputational incentives should be accom-

panied with appropriate complementary mechanisms.

We continue this review with a background on the reputation

hypothesis, followed by the presentation of our framework. We then

provide details on the scope of our literature review and discuss the

relevant literature as it pertains to each stage of our framework. We

conclude with our suggestions for future research.

2|BACKGROUND

Organizational theorists generally define reputation as the consumer's

perception of a firm's standing compared to its competitors (Rhee &

Haunschild, 2006; Sine, Shane, & Di Gregorio, 2003). Economists con-

jecture that, even in the absence of regulation, reputation provides an

incentive for parties to faithfully fulfill their contractual obligations

(Hayek, 1948; Klein & Leffler, 1981). Consumers typically rely on past

performance and reputation to make their purchase decisions

(Wilson, 1985), and hence, firms have an incentive to safeguard their

reputation to avoid losing customers (Klein & Leffler, 1981). Further,

reputation can be considered an organizational asset, resulting in

lower costs and higher selling prices and profits (Roberts &

Dowling, 2002; Shapiro, 1983). However, there is an “expectancy vio-

lation effect”when reputation is tarnished (Rhee & Haunschild, 2006).

Since buyers' expectations are higher for reputable firms, those firms

experience more severe repercussions from the disclosure of a prod-

uct or service defect.

An examination of reputation theory in the audit profession is

worthwhile, given its uniqueness and economic significance.

3

An audit

is valuable because it reduces information risk for financial statement

users. Outside investors face information asymmetry and price down

a security, and managers attempt to minimize this discount by pur-

chasing outside assurance of the financial reports from an indepen-

dent auditor (Jensen & Meckling, 1976; Watts & Zimmerman, 1983).

Generally, the auditor's sole output is an opinion on the financial

statements, as the inputs are cost-prohibitive for outsiders to observe

(Simunic & Stein, 1987). Thus, relative to many other professions,

quality is highly unobservable, amplifying the importance of reputa-

tion. Audit firms earn substantial quasi-rents from the reputation

effects built from high-quality audits, including the addition and reten-

tion of clients and increased audit fees (DeAngelo, 1981; Firth, 1990).

Since the auditor bears a reputational cost in the face of an audit fail-

ure, theory suggests that auditors voluntarily submit to an appropriate

level of audit quality (Ball, 2009).

The tenability of the reputation hypothesis came into question

after multiple international accounting scandals at the turn of the

BERGNER ET AL.293