Auditor-client distance: determinants and implications for audit quality

Abstract

The finance geography literature has provided evidence on the informational advantage possessed by local investors, analysts, investment banks, mutual fund managers, and market makers. The plausible explanations for the information advantage of local stakeholders are lower cost of information and better access to information. Geographical advantages may apply in the audit market as well. In this study, I investigate factors that determine a firm's choice of a local or non-local auditor. I also extend prior studies of the consequence of auditor-client distance on audit quality by using going concern report accuracy and the likelihood of financial restatements. Based on the assumption that firms prefer high audit quality at an affordable audit fee, I hypothesize that there are three main reasons that may explain why clients choose non-local auditors. First, the availability of local auditors may be limited. Second, local auditors may be unwilling to accept risky clients or may charge an unacceptably high risk premium. Third, non-local auditors may charge lower audit fees compared to local auditors with the same level of audit quality. 17 percent (11,016 firm years) of my sample of firms from 2000-2012 engage non-local auditors. My results suggest that the availability of local Big 4 auditors and auditors with industry specialization lowers the likelihood of firms hiring non-local auditors. Loss firms, firms receiving going concern audit reports, firms with lower profitability, and firms with internal control problems are more likely to engage non-local auditors. Collectively, the evidence suggests that firms with high audit risk are more likely to hire non-local auditors. Lastly, I observe that non-local auditors' fees are higher than local auditors' fees. This suggests that firms fail to lower audit fees by hiring non- local auditors. One possible explanation is that non-local auditors charge higher fees to compensate for risks arising from information asymmetry between a non-local auditor and the client. There is some evidence indicating that local auditors have higher audit quality. Financial statements audited by local auditors are less likely to be restated. While local auditors are less likely to issue a going concern opinion, their going concern reports better predict firms' bankruptcy within a 2-year timespan.