Exogenous Loss of Analyst Coverage and Choice of Audit Quality

Abstract

We show that a firm’s likelihood of appointing auditors with industry expertise or with a larger office increases after the firm is affected by an exogenous reduction in analyst coverage, relative to its matched control firms. This effect is stronger for affected firms with greater reductions in analyst monitoring, for smaller or younger firms, for firms with lower institutional or CEO ownership, and when the lost analysts are more effective monitors. We further show that affected firms that switch to high-quality auditors receive more positive market reaction, experience smaller decrease in stock liquidity and smaller increase in cost of equity capital relative to other affected firms, suggesting that audit quality has real payoffs. These results collectively provide causal evidence supporting the agency incentive driven demand for high-quality external auditing.