Timely Signals of Systematic Audit Quality from Market Participants: Evidence from Activist Short-Seller Campaigns

Abstract

Extant studies generally focus on signals of systematic audit quality from regulatory oversight of auditors, which can take up to several years to be revealed. Using a sample of firms targeted by activist short sellers (activists) for financial misreporting, I examine whether capital market participants provide credible and timely signals of systematic audit quality at the auditor office level. I find that activists provide timely signals of systematic audit failures at auditor offices of targeted firms (targeted offices) that exist across audits of concurrent non-targeted firms, and that these signals persist for three years on average. I also find that activist signals are more informative when the activists are more credible. Further, I document that non-targeted clients dismiss targeted offices following activist campaigns, but only when the activists are relatively credible, suggesting that clients recognize the variation in the quality of activist signals and respond accordingly. Finally, I find that audit failures revealed by activists are less persistent than those not revealed by activists, indicating that activists facilitate auditor offices’ remediation of systematic audit quality problems. Overall, my study highlights activist short-seller campaigns as a credible and timely channel through which systematic audit quality of auditor offices is signaled by market participants.