The Effect of Audit Market Characteristics on Auditors’ Reputational Damage Following Negative PCAOB Inspection Reports

ABSTRACT This study investigates auditors’ reputational damage following negative Public Company Accounting Oversight Board (PCAOB) inspection reports. Although prior studies reach different conclusions about the effects of PCAOB inspection reports on changes in auditors’ market share, we posit that a client's reaction may be moderated by its ability to find a replacement auditor in the local audit market. We find results consistent with this argument. Specifically, when audit market concentration is sufficiently low or when local potential replacement firms are better fits for the client, auditors with more negative inspection outcomes subsequently lose market share―having an impaired ability to both attract and retain audit clients. Furthermore, clients that dismiss their auditor tend to do so in favor of a new auditor with better inspection outcomes. Overall, our study provides evidence that PCAOB inspection reports can be valuable for signaling audit‐firm quality. However, the degree to which inspection findings affect auditor–client realignment depends on the local audit market's supply and demand dynamics.