Painted With the Same Brush? Audit Consequences of Allied Firms’ Financial Misconduct

UC-Carl H. Lindner College of Business 

I examine the audit consequences associated with financial misconduct by a firm within a strategic alliance. Core earnings restatements, which involve corrections to a firm's primary operational activities, such as revenues, cost of goods sold, and selling, general, and administrative expenses, are particularly relevant to its alliance partners. I find evidence that audit fees increase for allied partners following a core earnings restatement. This increase does not appear to be driven by more audit effort but from an increased risk premium, to compensate for the higher perceived audit risk, and is concentrated on contractual alliances rather than joint ventures. Additional analyses indicate that this effect is not limited to core earnings restatements but extends to fraudulent restatements. Cross-sectional tests reveal that the spillover effect deriving from core earnings restatements is concentrated among firms with lower accruals quality, while the spillover effect deriving from fraudulent restatements is concentrated among firms with better accruals quality. Overall, this study indicates that financial misconduct in one firm has detrimental consequences to allied partners' perceived audit risk, which translates into higher audit fees.