Liquidity Constraints and Auditor Responses to Repo Transactions

Repurchase agreements (repos) are often used by banks to manipulate their reported quarter‐end risk levels. Prior research has documented adverse capital market consequences associated with active window dressing of repo liabilities. In this study, we investigate whether a client bank's repos also affect its auditor's risk assessment. We find that auditor responses to repos are contingent on the bank's liquidity constraints rather than on the extent of repo transactions. Specifically, downward quarter‐end deviations in repo liabilities are not perceived by auditors as risky for banks with greater liquidity. For banks with high liquidity constraints, however, we document a strong positive association between repo deviations and audit fees. Our findings suggest that auditors utilize the contextual cue of liquidity constraints to help resolve ambiguity surrounding repo transactions and accordingly charge higher fees for clients with higher liquidity risk. This main finding persists when a change in auditor or the issuance of a going‐concern opinion is used instead of audit fee as a measure of auditor response