Clint Firms’ Rejection by Auditors: The Effect of Client Firms’ Financial Position and Auditors’ and Client Firms’ Reputation

Intense competition among audit firms will likely encourage auditors to find new clients. An audit firm tries to reach a good reputation in the society. Higher reputation audit firms provide better audit quality service to their clients to protect their reputation in society. They do not tend to audit a firm known for management abuses or providing misleading financial reports. Besides, an incorrect acceptance decision by the audit firm can lead to legal claims and impose excessive costs on the auditor, as well as the loss of reputation of the auditor and public trust in the profession and financial reporting of companies. Paying attention to the good reputation of auditors and the client firms and clients’ financial position is likely to be an effective factor in the auditors' acceptance or rejection decision. Therefore, the purpose of this research is to investigate the effect of client firms’ financial position, auditors’ and client firms’ reputation on the rejection decision of client firms by auditors.  The sample of this research contains 109 participants, including Iranian audit partners, managers and senior audit supervisors. In order to test the hypotheses, a quasi-experimental method is used. This study has a 2x2x2 mixed design. Two independent variables, including “reputation” and “financial position” of the client firm, are between-subjects variables, and the third independent variable is “auditors’ reputation”, a within-subjects variable. All the participants in the experiment were divided into four groups. Subjects in these groups receive different levels for the financial position of the client firm and auditors’ and client firms’ reputations (profitable and unprofitable, reputable and disreputable) and provide us with their acceptance or rejection decision. In each scenario, the audit firm is asked to suppose that it would be considered for the role of a large auditor with a high reputation or a small auditor with a low reputation. Each participant assesses his tendency to accept the client's firm. Hypotheses are examined using multivariate analysis of variance (ANOVA).  The results show that auditors’ and client firms’ reputations and the client firms’ financial position significantly affect the auditor's acceptance decision. In addition, changes in the reputation of client firms do not affect the willingness of auditors with higher reputations to accept that client. As the client firms' financial position improves, more reputable auditors' willingness to accept clients’ offers increases.  To manage the reputation risk, large audit firms should prevent accepting client firms with a high risk. Besides, more reputable auditors usually have large client firms, making them considerable income. Therefore, they might more easily reject client firms who are not qualified for them. Also, audit firms with a higher reputation are usually under the supervision of the government, shareholders and the public, making them more cautious in accepting new clients and avoiding clients who damage their reputation. In addition, the client firm's reputation is considered a factor affecting the auditor's acceptance decision. Auditors would not accept notorious clients as they know this would lead to reputational damage and threaten their independence.Due to the effect of the client’s financial position and profitability on the auditor's decision, we conclude that auditors perceive that a firm in financial distress or goes bankrupt may not be able to pay the auditors' fees and provide them with the necessary facilities, and for this reason, they refuse to accept it. Therefore, one of the factors considered in the acceptance decision would be the audit fee, which can be realized from the last annual financial statements. If the client does not have the ability to pay the fee, the audit firm should reject that client.This study makes the following contributions. First, despite doing research at the international level about the factors affecting the rejection decision of client firms, to the best of our knowledge, this is the first study that examines the factors separately and interactively in an experimental design. Second, This research provides interesting evidence about the impacts of the client firms’ and auditor’s reputation, which may not be easily measured in archival research. Therefore, the findings of this study contribute to auditors’ Judgment and decision-making (JDM) quality literature. In order to reduce the risk of legal claims, it is recommended that audit firms pay attention to the point that the financial information and the reputation of the client firm are closely related, and they should consider factors such as the company's disclosure quality, financial position and performance, cash flows, and corporate governance characteristics.