Working Paper: Auditor Size, Partner-Specialization, and Private Company Audit Adjustments: Insights from the Broker-Dealer Industry

Paper Author:  Zachary T. Kowaleski

Abstract: This study examines whether auditor size and partner-specialization predict audit adjustments when privately-owned broker-dealers (BDs) change audit firms. Private company auditors have relatively low incentives to compete on quality because managers may select the auditor without involving an audit committee, and these audits present relatively lower reputation and litigation risks compared to public companies. Though I predict that larger firms will provide higher audit quality in this environment, it is unclear whether partner-specialists' will use their BD domain-knowledge to provide higher audit quality where the market does not demand it. Analyses reveal that BDs that change to a larger (smaller) auditor are more (less) likely to record material audit adjustments. BDs that change to a specialist partner, however, are less likely to record material audit adjustments; partners from BD audit firms with no issuer clients drive this effect. Using a subsample with available fee and hour data shows that the auditor size improvements to audit quality correspond with increases to fees and hours, but also incremental to hours. Conversely, partner-specialists employ fewer audit hours than nonspecialists. Collectively, these results show that smaller firms, especially the partner-specialists within those firms, are willing to tolerate a higher risk of material misstatement than larger firms will accept when the demand for audit quality is low.

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