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SUMMARY: Using a large sample of audit client firms, this paper investigates whether and how the geographic proximity between auditor and client affects audit quality proxied by accrual-based earnings quality. We define an auditor as a local auditor (1) if the auditor's practicing office is located in the same metropolitan statistical area (MSA) as the client's headquarters, and (2) if the geographic distance between the two cities where the auditor's practicing office and the client's headquarters are located is within 100 kilometers, or they are in the same MSA. As predicted, our empirical results are consistent with local auditors providing higher-quality audit services than non-local auditors. In addition, as predicted, this quality difference is weakened for diversified clients with more operating or geographic segments. The results are robust to a variety of sensitivity checks. Overall, our evidence suggests that informational advantages associated with local audits enable auditors to better constrain management's biased earnings reporting, with greater advantages for less diversified clients.
Keywords: auditor locality; geographic proximity; audit quality; diversification.
JEL Classification: M42.
(ProQuest: ... denotes formulae omitted.)
INTRODUCTION
Since the Enron debacle and the subsequent collapse of Arthur Andersen, regulators, lawmakers, academic researchers, and the popular press have paid considerable attention to engagement-specific factors determining the auditor-client relationship and their impact on audit quality. The focus of this study is on a new engagement-specific factor that may play an important role in the development of the auditor-client relationship: geographic proximity between auditor and client, or auditor locality. Specifically, we examine whether the geographic distance between auditor and client plays a role in determining audit quality.
This study is motivated by a growing body of literature in accounting and finance that documents the importance of geographic proximity between economic agents (e.g., DeFond et al. 2011; Kedia and Rajgopal 2011; Malloy 2005). This strand of research suggests that geographic proximity lowers the information asymmetry between economic agents by facilitating information flows and monitoring. Building upon the implication from this recent literature, we expect that local auditors possess an informational advantage over non-local auditors because proximity to clients can facilitate the acquisition of more idiosyncratic client information, such as client-specific incentives, means, and opportunities for substandard reporting. We posit that this informational advantage attenuates managerial opportunism in...