Distracted institutional investors and audit risk

Using a newly developed institutional investor distraction measure, we examine whether auditors increase their risk assessment when clients’ institutional investors temporarily reduce their monitoring activities. We find that audit fees and audit report lags increase during periods when institutional investors temporarily focus their attention on other parts of their portfolio. This effect is stronger when dedicated institutional investors are distracted. We further show that the identified relationship is weaker in the post-Sarbanes-Oxley Act period. Finally, we find that the impact of investor distraction on audit fees and lags is more pronounced for firms with weaker board oversight and higher discretionary accruals. Collectively, our results suggest that institutional shareholders’ monitoring activities benefit auditors by reducing audit risk. This paper also shows that the negative effect of investors’ limited attention on corporate monitoring can be somewhat mitigated by auditors.