Audit demand and monitoring mechanisms: evidence from SEC comment letters and short sellers

Abstract

Purpose The paper aims to explore the impact of two types of monitoring mechanisms, namely, Securities and Exchange Commission (SEC) comment letters (CLs) and short sellers, on management’s demand for audit quality. Design/methodology/approach Using information on the short interest positions and a panel data of SEC CLs between 2005 and 2015, this study applies logit regression model to estimate the likelihood of hiring Big 4 and industry expert audit firm. This study also applies an ordinary least squares regression technique to estimate audit fees. Findings Consistent with disclosure and agency theories, results from empirical analyses provide that management demands higher quality audits measured by higher audit fees, and higher likelihood to hire Big 4 and industry expert audit firm. However, this study finds that the effect varies depending on the specific monitoring mechanisms. Additionally, when both monitoring mechanisms are in place, the SEC CLs drive the overall direction of the demand for audit quality when audit demand is captured by propensity to hire Big 4/industry expert audit firm. Research limitations/implications This study provides researchers with enhanced understanding of the factors having effect on the demand side for audit quality. Furthermore, it adds to the stream of literature on economic consequences of SEC CLs and short selling. Originality/value To the best of authors’ knowledge, this is the first comprehensive study to document the effect of two types of monitoring mechanisms, namely, SEC CLs and short selling, on the demand for audit quality.