Auditor Response to a Regulatory Shock Affecting Clients’ Trade Credit Risk

The audits of most clients involve consideration of trade credit risk. However, little is known about how suppliers’ trade credit risks affect their auditors’ decisions that determine audit pricing and audit quality. Data capturing trade credit risk generated by suppliers’ clients is quite limited in availability, and supplier-level changes in such risk are difficult to observe. This study investigates the effects of an exogenous shock to trade credit risk, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. BAPCPA increases creditor (supplier) protections when a customer initiates a Chapter 11 bankruptcy reorganization proceeding. Thus the Act’s effects largely are restricted to the subset of a supplier’s customers that are closest to bankruptcy. This enables us to employ the exogenous shock to identify the effects of changes in supplier-level credit risk on observable auditor decisions. Using a difference-in-difference design, we find that auditors levy lower audit fees, post-BAPCPA, on suppliers whose customers exhibit greater bankruptcy risk. Cross-sectional tests suggest that this result is stronger when suppliers’ own risks of several types are greater. Evidence suggesting that the decision to charge lower fees is associated with reduced auditor effort (proxied by shorter audit lags) is limited to the year after BAPCPA implementation, 2006. Thus fee reductions in most years are likely to have consisted, in part or in whole, of reductions in auditors’ fee risk premiums. The fee reductions are not associated with several measures of reduced audit quality. The fact that auditors passed rather opaque cost savings along to clients, mostly without reducing audit effort, suggests that the audit market behaved very competitively in this situation.