Short Interest as a Signal of Audit Risk

Evidence from the accounting and finance literatures suggests that short sellers are sophisticated users of financial information who target firms with suspect financial reporting. This literature provides evidence that short sellers take positions in firms before their accounting problems are publicly revealed through SEC enforcement actions, restatements, or lawsuits. Thus, we investigate whether short interest (total shares sold short scaled by total shares outstanding) provides a signal of the degree of audit risk. We find a positive association between audit fees and short interest after controlling for other determinants of audit fees that have been identified by prior work. We also find that the association strengthened after events in the early 2000s which increased auditors' responsibilities to deter fraud and made the implications of fraud particularly salient to external auditors. Our study provides a number of important contributions to the literature. We extend the findings of prior audit fee studies by providing evidence that short interest is an indicator of audit risk and reflects information that is not captured by traditional risk measures. We also provide evidence that the trading behavior of short sellers is associated with audit pricing decisions, which suggests that short interest provides information about risk that other parties may find useful. Finally, our results indicate that auditors' attention to risk factors increased after 2002, which implies that efforts by regulators and standard setters to improve auditors' client risk assessments have been successful.