Do auditors consider client’s group affiliation? Contagion effect of financial misreporting within business groups

Abstract

This study investigates the intra-group contagion effect of financial misreporting within Korean business groups by focusing on the response of auditors in terms of audit effort and audit fees. I find that the revelation of financial misreporting within a business group increases the likelihood of subsequent misreporting events for other affiliated firms in the same group. I also find that auditors increase audit fees and audit hours following a misreporting event that occurred within their client’s affiliated group. Further analyses reveal that there is a systematic difference between audit fees and audit hours in the persistence of the contagion. Empirical results indicate that the effect on audit hours is immediate but ends after a year, but it takes more than one year to realize the full effect on audit fees. Lastly, I show that the contagion effects are stronger when the misreporting firm comprises a larger portion of its affiliated group or when a focal firm is more closely connected with the misreporting firm. Collectively, these findings suggest that there exists an intra-group contagion effect of financial misreporting, and auditors rationally respond to misreporting events that occurred within their client’s affiliated group.