Audit Quality and Auditor Reputation: Evidence from Japan

We study events surrounding ChuoAoyama’s failed audit of Kanebo, a large Japanese cosmetics company whose management engaged in a massive accounting fraud. ChuoAoyama was PwC’s Japanese affiliate and one of Japan’s “Big Four” audit firms. In May 2006, the Japanese Financial Services Agency (FSA) suspended ChuoAoyama for two months as punishment for its role in the accounting fraud at Kanebo. This action was unprecedented, and followed a sequence of events that seriously damaged ChuoAoyama’s reputation for audit quality. We use these events to provide evidence on the importance of auditors’ reputation for audit quality in a setting where litigation plays essentially no role. Around one quarter of ChuoAoyama’s audit clients switched away from the firm as questions about its audit quality became more pronounced, consistent with the importance of auditors’ reputation for delivering quality. Larger firms and those with greater growth options were more likely to leave ChuoAoyama suggesting a greater value for audit quality in these firms.