THE EFFECT OF ETHICAL LAPSES ON THE REPUTATION OF INDEPENDENT AUDITORS

Abstract

Independent auditors strive to maintain a reputation for providing high quality audit services. This positive reputation brings many benefits to the auditor. One aspect of maintaining a positive reputation is the avoidance of ethical difficulties. The primary value of an audit report is the credibility it lends to the financial statements, yet this credibility is undermined if the ethics of the auditor are questionable. In this study, we explore how ethical lapses affect the reputation of auditors.

The ethical lapses involved in this study have two components each hypothesized to be important in determining how the lapse affects reputation: the punishment effect and the service effect. Because ethics are crucial to the credibility of audit reports, the accounting profession has a strong commitment to see that its members adhere to ethical standards. State Boards of Accountancy are authorized to discipline members that violate ethical standards and have discretion in the levels of punishment meted for an ethical violation. The more serious punishments should correspond to the more serious violations. We call this the punishment effect. Because the purchasers of audit services are often trying to assess

the quality of future audit services, a newly revealed ethical lapse should provide some ability to infer about audit quality. This ability to infer about future audit quality should vary depending on the type of professional service being performed when the ethical lapse occurred. We call this the service effect.

Our results show that any announcement of an ethical lapse is associated with a diminished reputation (p < 0.0001). In addition, both the punishment effect (p = 0.0005) and the service effect (p = 0.0001) are significantly associated with a diminished reputation. These results suggest a strong link between the ethics of the auditor and the auditor’s reputation.