Economic demand for auditing services in the “registered” investment management industry

Abstract

We hypothesize that the demand for auditing in the registered investment management industry arises from the auditor's ability to act as a solvent indemnifier when outside parties incur losses because of financial misrepresentations. Consistent with this insurance demand, we find that, relative to financial companies, registered investment companies are more likely to retain Big 4 auditors. Restricting the sample to the registered investment management industry, we construct three direct tests of the insurance demand hypothesis. We find that (a) the market share of a Big 4 firm is positively associated with the firm's wealth, (b) changes in audit fees are positively associated with changes in the audit firms’ wealth, and (c) net fund flows increase when clients switch from non-Big 4 to Big 4 auditors. Our results highlight an unusually high demand for Big 4 auditors in the registered investment industry, which we attribute to the insurance demand for auditing services.