Post Audit Evidence and Stealth Withdrawals

This paper studies the impact on audit effort, audit opinions, and audit informativeness of shifting from a regime in which audit report withdrawals are not public (previous practice) to one in which auditor withdrawals are disclosed by auditors to investors (PCAOB Release No. 2008-004). Our model captures two informational frictions: (i) the monitoring effort is privately-known to the auditor, (ii) potential accounting irregularities are privately-known to the firm. If fines for audit failures do not adjust to the new regulatory environment, the new legislation will eliminate high effort audits altogether. Even if fines are increased to adjust to the new environment, the legislation will be detrimental to compliant firms if the informational asymmetry between auditors and clients is severe. Auditors (non-compliant firms), on the other hand, typically gain (lose) from the legislation if fines adapt to the new regulatory environment. Overall, the results suggest that the new legislation worsens the agency problem between the firm and its auditor (i), but helps resolve the adverse selection problem between the firm and its outside investors (ii). Finally, we examine whether qualifications should be given if the auditor is uncertain about the firms' type, or only if the auditor detects an accounting irregularity. We show that, whenever the fine is set optimally, the auditor will always issue an unqualified opinion when uncertain but qualifications may occur if the fine is too high.