Smaller audit firms that get dinged in their regulatory inspections generally lose their public audit clients or just drop out of public company auditing entirely, according to recent academic research.

Brian Daugherty, assistant professor at the University of Wisconsin, said the smallest audit firms, typically auditing only one public audit client, are the firms hardest hit by a negative inspection report from the Public Company Accounting Oversight Board. They typically lose their clients to other small audit firms that have so far not been the subject of a published negative inspection finding, he said.

Daughtery said earlier academic research has already established that PCAOB inspection reports are deemed a strong indicator of audit quality for firms that are inspected only every three years. Those are firms that audit fewer than 100 public company clients annually.

“We demonstrate that firms that receive deficient reports are more likely to lose their publicly traded clients, either by resigning or being dismissed,” Daugherty said. “The initial results say the smallest firms are losing clients at a higher rate than the larger triennially inspected firms.”

The data suggest when public companies decided to work with another audit firm, they chose one that received a clean inspection report—one with no audit deficiencies reported—or a firm for which no inspection report had yet been published. “Only 12 percent went from an audit firm with a deficient report to another firm that also had a deficient PCAOB inspection report,” said Daugherty. A handful of companies chose to work with a larger firm instead of a smaller firm, he said.

Big 4 and “second tier” firms—those with more than 100 public audit clients inspected annually—aren’t as hard hit by a negative inspection report, said Daugherty. “For a large, multinational publicly traded company, they’re effectively limited to picking one of the Big 4 or a large firm,” he said. “The large firms have the resources, so the big firms are continuing to maintain their client base.”