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  • Jennifer M Mueller-Phillips
    Audit Market Concentration, Audit Fees, and Audit Quality:...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 11.0 Audit Quality and Quality Control 
    Title:
    Audit Market Concentration, Audit Fees, and Audit Quality: Evidence from China
    Practical Implications:

    This study is important given the continued concerns expressed by global regulators about the potential harm to audit quality caused by concentrated audit markets. The separation of offsetting direct and indirect effects of concentration on audit quality enhances the understanding of how concentration influences audit quality and could explain why the previous studies document mixed evidences. The study also provides evidence on how audit fees play an important role in the association between concentration and audit quality and that regulatory interventions changing one of the offsetting effects could produce potential unintended consequences. 

    Citation:

    Huang, T., Chang, H., and Chiou, J. 2016. Audit Market Concentration, Audit Fees, and Audit Quality: Evidence from China. Auditing: A Journal of Practice and Theory 35 (2): 121-145.

    Keywords:
    audit market concentration, audit fees, audit quality, and China
    Purpose of the Study:

    The potential effects of recent audit market concentration on audit fees and audit quality have been a point of concern for policy makers. The primary concern is that this concentration reduces clients’ choice of audit service suppliers, strengthens auditor’s market power, and encourages complacency among auditors, resulting in higher audit fees but lower audit quality. Despite the concern, the extant literature provides mixed evidence on the consequences of audit market concentration. The situation between developed countries where audit markets are dominated by the Big 4 audit firms, and the Chinese Ministry of Finance (MOF) is starkly different. As a result, the MOF has expressed concern about the competitive and immature Chinese audit market characterized by many small-seized audit firms, which increases auditors; incentives to compete for clients by providing fee discounts, resulting in low audit quality. The difference in attitudes toward concentration between the developed countries and China as well as the fact that China is a setting where competition is thriving, while most of the developed countries are more concerned about lack of competition is the primary motivation behind the authors examination of the Chinese audit market. The objective of the paper is to investigate the effect of concentration on audit quality in a setting with significant competition a relatively weak legal environment. 

    Design/Method/ Approach:

    The authors employ path analysis to further examine the indirect effects of concentration on audit quality through audit fees. The sample consists of 12,334 Chinese firm-year observations from 2001-2011. Audit market concentration is measured at the city level as the market shares of the local top 4 audit firms and two Herfindahl indexes of audit fees earned from listed clients of the local top 4 and all audit firms in a city-year grouping, respectively.

    Findings:
    • The authors’ findings support the claim that concentration influences audit fees; furthermore, the positive effects of concentration on audit fees is consistent with clients having a limited choice of audit service suppliers and audit firms having greater market power in concentrated audit markets. The increased market power reduces auditors’ fear of client loss and allows them to charge higher fees.
    • The authors’ findings suggest that audit market concentration has no significant overall effect on client earnings quality.
    • The authors’ findings support the notion that concentration results in poor audit quality through auditor overconfidence and complacency.
    • The authors find that concentration increases audit fees and such increases in turn improve earnings quality, suggesting that when the audit market becomes more concentrated, auditors with increased market power become less lenient with clients and charge higher fees to devote more resources and effort to audit tasks, leading to higher audit quality.
    • The authors’ findings suggest that auditors are less likely to issue modified audit opinions when the market becomes more concentrated.
    • The authors find that in concentrated audit markets auditors have greater market power and lower cost of tell the truth and can charge higher audit fees to devote more resources and efforts to the audits that they carry out.
    Category:
    Audit Quality & Quality Control, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions
  • Jennifer M Mueller-Phillips
    Audit Market Structure and Audit Pricing
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions 
    Title:
    Audit Market Structure and Audit Pricing
    Practical Implications:

    The results of this paper contribute to the understanding of the determinants of audit firms’ initial audit price discount decisions. The results suggest that concentration of audit firms within the local audit market has a stronger influence on non-Big 4 audit firms’ initial pricing decisions compared to Big 4 firms’ initial pricing decisions. In addition, the results are of interest to regulators and managers who are concerned about the effect of audit market concentration on audit pricing and audit quality.

    Citation:

    Eshleman, J. D. and B. P. Lawson. 2017. Audit Market Structure and Audit Pricing. Accounting Horizons 31 (1): 57 – 81. 

    Keywords:
    audit pricing, auditor switches, audit market concentration, and lowballing.
    Purpose of the Study:

    Increasingly, regulators, standard setters, and audit clients have expressed concern over the level of concentration in the U.S. audit market. The primary concern is that audit market concentration could result in higher fees for audit clients, which is supported by economic theory that suggests a positive association between concentration within an industry and industry prices. Despite this theory and the concerns that exist, the association between increased concentration within the U.S. audit market and audit fees remain unclear. Previous studies have examined this issue with mixed results. As a result of the mixed evidence that exists, the authors choose to re-examine the association between audit market concentration and audit fees. 

    Design/Method/ Approach:

    The authors use two settings to examine whether and how audit market concentration affects audit fees. First, they examine how concentration is related to audit fees in a sample of stable auditor-client relationships. Next, they examine how audit market concertation affects audit fees in a sample of firms that switch auditors. They conduct these examinations using a large sample of U.S. audit engagements covering the years 2000 – 2013.    

    Findings:
    • The authors find, in their test of non-changing audit clients, a significantly positive association between audit market concentration and audit fees.
      • The authors find that the positive association is driven by the inclusion of MSA-level indicator variables in the audit fee model that they chose. For example, when they control for MSA-level fixed effects in their models, they find the association between audit market concentration and audit fees changes from significantly negative to significantly positive.
    • The authors’ test of initial audit fee discounts indicates that increases in concentration significantly reduce the discounts.
    • The authors provide some evidence that the effect of local audit market concentration on audit fees is more pronounced for smaller clients.
    • The authors find that concentration is positively associated with audit quality, as proxied by abnormal accruals. 
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions
  • Jennifer M Mueller-Phillips
    Audit Pricing for Strategic Alliances: An Incomplete...
    research summary posted February 16, 2017 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity 
    Title:
    Audit Pricing for Strategic Alliances: An Incomplete Contract Perspective
    Practical Implications:

    This paper adds a new dimension to the research on strategic alliances by focusing on auditing rather than governance, performance, funding, or equity participation. It also identifies incomplete contracts as the driver of audit complexity, and extends the audit fee literature by documenting that the number of strategic alliances is a significant determinant of audit fees. Finally, the authors’ evidence that strategic alliances result in higher audit fees provides empirical support for the largely theoretical argument that incomplete contracts are complex. 

    Citation:

    Demirkan, S. and N. Zhou. 2016. Audit Pricing for Strategic Alliances: An Incomplete Contract Perspective. Contemporary Accounting Research 33 (4): 1625-1647.

    Purpose of the Study:

    A strategic alliance is a long-term contract between multiple firms where resources are pooled to accomplish preset objectives, creating dependence between otherwise legally independent firms. Prior research has focused on the emergence, management and survival of alliances; consequently, there is not substantial research on the relation between strategic alliances and auditing. This paper fills that void by investigating how auditors price their audit services for firms involved in strategic alliances. 

    Design/Method/ Approach:

    The authors conduct a study on the pricing of audit services for strategic alliances through compiling data and utilizing descriptive statistics.  

    Findings:
    • The authors find that the nonverifiability of information and potential agency behavior in alliances increase audit complexity, resulting in higher audit fees.
    • The authors find that auditors are less likely to issue going-concern modified opinions when there is an increase in strategic alliances; moreover, an increase in strategic alliances is associated with a reduction in bankruptcy risk as measured by Altman Z-Scores.
    • The authors find that an increase in strategic alliances is unrelated to the likelihood of financial misstatements.
    • The authors find that an increase in strategic alliances is unrelated to internal control weakness opinions. 
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Business Risk Assessment (e.g. industry - IPO - complexity)
  • Jennifer M Mueller-Phillips
    Auditor business process analysis and linkages among auditor...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement 
    Title:
    Auditor business process analysis and linkages among auditor risk judgments
    Practical Implications:

    The results of this study have implications for public accounting firms that have adopted business-risk audit methodologies and for regulators that have incorporated ideas and concepts from business-risk audit methodologies into promulgated standards

    • Public accounting firms adopting business-risk methodologies have broadened, deepened, and reemphasized the long-standing requirement in auditing standards to understand the client business so as to use this understanding as a source of information about possible material misstatements to the financial statements.
    • Firms and regulators should be encouraged by the support found in this study for the relationship and connections between, for instance, the significant business risks identified and the magnitude of the assessments of the risk of material misstatement at the entity level; the performance of business process analysis and the conservatism of entity- and process-level assessments of the risk of material misstatement; and the significant business risks identified and the risk of material misstatement at the process level.

    For more information on this study, please contact Natalia Kochetova-Kozloski.

    Citation:

    Kochetova-Kozloski, N., T. M. Kozloski, and W. F. Messier Jr. 2013. Auditor business process analysis and linkages among auditor risk judgments. Auditing: A Journal of Practice & Theory 32(3): 123-139.

    Keywords:
    business process analysis; risk assessment; risk of material misstatement; business risk identification
    Purpose of the Study:

    This research note examines two important and related issues:

    • Whether performance of a business process analysis assists auditors’ identification and assessment of significant business risks and the risk of material misstatement at a core process level.
    • Whether auditors link their entity-level risk assessments to their core business process risk assessments

    Based on review of the current literature, there has been relatively little research that has specifically examined how these two issues affect auditors’ risk-related judgments. Therefore, the current study examines the linkage between business risk identification, taking into account severity of each risk at the entity and process level, and the assessment of the risk of material misstatement at both the entity and process level in a more direct and externally generalizable fashion than was done previously—i.e., by focusing on efficacy of the process described by the auditing standards worldwide. 

    Design/Method/ Approach:

    The study employed a between-subject experimental design to test the hypotheses. The experiment was administered at training sessions of the Big 4 accounting firms held in the United States and Norway. The authors obtained usable responses from one hundred thirty-four (134) audit seniors after they completed a detailed case where performing or not performing a business process analysis was manipulated as a between-subject factor. The case used in this study was a hypothetical grocery retailer - National Foods, located in the Southeastern United States.

    Findings:

    The authors find:

    • A significant positive association between the identification of significant process-level business risks and the identification of significant business risks at the entity level for auditors who performed a business process analysis of the core business process.
    • Performing a business process analysis led to higher assessments of the risk of material misstatement at the core process level.
    • Auditors linked their assessments of misstatement risk at the process level with similar assessments made at the entity level, taking into account significant process-level risks.

    The authors stipulate that taken together, these results suggest that auditors link their entity-level identified business risks and assessments of the risk of material misstatement to risks and related assessments at the process level.

    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Client Risk Assessment
  • Jennifer M Mueller-Phillips
    Auditor Fees and Auditor Independence: Evidence from Going...
    research summary posted April 17, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 09.0 Auditor Judgment, 09.04 Going Concern Decisions 
    Title:
    Auditor Fees and Auditor Independence: Evidence from Going Concern Reporting Decisions
    Practical Implications:

    The finding of this study suggest that concerns over the relation between auditor fees and the possible impairment of auditor independence, as reflected in going concern modification decisions, are supported in the more recent years for highly distressed clients. The relationship between auditor fees and impairment of auditor independence with respect to auditor decision-making has long been a concern of many regulators in the accounting industry. This research may inform both audit firms and standard setters with respect to specific types of engagements and the judgments or behaviors most likely to be affected.

    For more information on this study, please contact Allen D. Blay.
     

    Citation:

    Blay, A. D., and M. A. Geiger. 2013. Auditor Fees and Auditor Independence: Evidence from Going Concern Reporting Decisions. Contemporary Accounting Research 30 (2).

    Keywords:
    auditor fees; auditor independence; going concern; regression analysis
    Purpose of the Study:

    The possible adverse effect of auditors providing services to clients who pay them directly has historically been a concern of the public accounting profession. Without independence there is no need for external auditors attesting to the purported accuracy and completeness of company financial statements. The association between fees received by audit firms directly from clients and the possible impairment of auditor independence, particularly with respect to going concern decisions, continues to be of considerable interest to regulators and others. This study assesses the potential impairment of auditor independence in the context of going concern reporting.

    Design/Method/ Approach:

    The authors derive their findings examining the association between both current and future audit service and nonaudit service fees received by U.S. auditors and the type of opinion rendered to a financially distressed client. To achieve their sample, the authors used the Audit Analytics database and first identified firms that received a going concern modified (GCM) audit opinion in the years 2004-2006. They also identified firms that had both negative income and cash flows from operations in the same year but did not receive a GCM opinion. Finally, the authors tested their hypotheses by using a research model to determine the probability of issuing a GCM audit opinion to a financially distressed client. 

    Findings:

    A negative correlation exists between future fees paid to auditors and auditor going concern opinion decisions.
    Higher levels of current nonaudit service fees paid to auditors reduces the frequency of going concern opinion modifications in the more recent 2004-2006 time period when using a more stringent control sample of financially distressed firms.
    Findings related to going concern decisions and nonaudit service fees in the United States are sensitive to both the time period examined and the selection of appropriate control samples of distressed non-GCM firms.
    A negative association exists between current nonaudit service fees and total subsequent fees paid to auditors.
     

    Category:
    Auditor Judgment, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Going Concern Decisions, Impact of Fees on Decisions by Auditors & Management
  • Jennifer M Mueller-Phillips
    Auditor Industry Specialization, Service Bundling, and...
    research summary posted September 17, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 04.0 Independence and Ethics, 04.03 Non-Audit Services, 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual 
    Title:
    Auditor Industry Specialization, Service Bundling, and Partner Effects in a Mining-Dominated City.
    Practical Implications:

    The authors contribute by providing some of the first evidence of service bundling in the economics of auditing literature. In doing so, they broaden the notion that strategic pricing occurs around audit switches. This study contributes to prior mixed findings of the existence of industry specialist premiums in the small-client segment, suggesting an additional reason why these mixed findings might occur. Where opportunities to package services are attractive, auditors may strategically price and discount audits with bundling premiums in mind. Where potential for such bundling opportunities is less attractive, it is possible the auditor may instead seek to generate premiums in the audit service.

    Citation:

    Ferguson, A., G. Pündrich, and A. Raftery. 2014. Auditor Industry Specialization, Service Bundling, and Partner Effects in a Mining-Dominated City. Auditing: A Journal of Practice & Theory 33 (3): 153-180.

    Keywords:
    audit fees, industry specialization, mining industry, non-audit services, second-tier firms, service bundling
    Purpose of the Study:

    This study examines auditor industry specialization effects in Perth, a remote mining town in Australia characterized by a large number of small, homogeneous firms. In this study, the authors consider whether an auditor industry specialist may strategically price a bundle of services in the small-client segment. They argue that the small company sector is a good environment to consider the existence of service bundling. The setting is the mining development stage entity (MDSE) market in Perth, the biggest industry and city in Australia by client numbers. This market is characterized by small (high-growth) firms where auditing is arguably of less importance to the client compared to tax advisory, the other primary service provided to them. Further, the firms are relatively homogeneous, an appealing feature of industry studies. Thus, the authors have arguably an attractive setting to observe service bundling by an industry specialist.

    First, the authors examine whether industry specialist auditors earn audit fee premiums in the Perth MDSE segment. To do this, an audit pricing model is developed and includes controls likely to impact on audit fees in a mining industry context. Second, the authors redefine the dependent variable to consider the pricing implications of the bundle of services provided by industry specialists.

    Design/Method/ Approach:

    The authors utilize an OLS regression model to test for audit fee premiums with respect to brand name and industry leadership. A sample of 1,799 firms listed on the ASX as of December 31, 2009 is obtained. Of the 1,799 listed entities nationally, 668 (37.13 percent) are domiciled in Perth, making it the largest city-level market by client numbers in Australia. At the city-level, the market share of non-Big 4 firms is 70.1 percent in Perth.

    Findings:

    The authors find no evidence of auditor industry leadership audit fee premiums accruing to either Big 4 (EY) or non-Big 4 (BDO) leaders. However, when the dependent variable is redefined to include non-audit services (NAS), the industry leader, BDO, obtains a total fee premium. This finding is of added interest given that the industry leader is a second-tier firm, implying that strategic audit pricing, such as service bundling, is not confined to Big 4 auditors. Nor is it confined to merely one location, since bundling premiums are observed at the national level. The authors argue MDSEs have little in the way of financial statement complexity, so they do not value specialist audits, but rather are willing to pay more for NAS. Last, in supplementary analysis, the authors find some evidence of partner-scale effects.

    Category:
    Audit Team Composition, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Industry Expertise – Firm and Individual, Non-audit Services
  • Jennifer M Mueller-Phillips
    Auditor Resignation and Firm Ownership Structure
    research summary posted October 29, 2013 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.06 Resignation Decisions, 13.0 Governance, 14.0 Corporate Matters, 14.09 CEO Tenure and Experience 
    Title:
    Auditor Resignation and Firm Ownership Structure
    Practical Implications:

    The audit profession operates in a highly legal environment, and because of this, audit firms must find ways to manage their risk exposure. One way to reduce the risk of litigation against the firm is to manage the client portfolio and resigning from high risk clients. According to the study, family owned firms are less of a litigation risk to the auditor than non-family owned firms, especially when the CEO of the family-owned firm is not a family member. However, if an auditor does resign from auditing a family-owned firm managed by a non-family CEO, the investing public reacts less negatively to this than if the firm were not family owned.


    For more information on this study, please contact Samer K. Khalil.
     

    Citation:

    Khalil, S., J. Cohen, and G. Trompeter. Auditor resignation and firm ownership structure. Accounting Horizons 24 (4): 703-727.

    Keywords:
    family firms; auditor resignations; corporate governance; market reactions
    Purpose of the Study:

    In order to manage risk exposure, audit firms can choose to resign from high risk clients. Auditor resignations can bring very negative outcomes to the discharged client because of the audit search and startup costs incurred and the investors’ interpretation in the information signaled by the auditor resignation. This study investigates whether the likelihood of auditor resignations and the subsequent stock market reaction in family firms differs significantly from that in non-family firms. Additionally, this study examines whether the identity of the CEO that manages the family firms has an effect on the aforementioned associations. The identity of the CEO refers to whether the CEO is a founder, a descendant, or a non-family CEO.

    Design/Method/ Approach:

    The evidence for this study was gathered using auditor resignations reported on the Audit Analytics database in the U.S over five calendar years, 2004-2008. Sample firms were matched with control firms that did not switch their auditors using four different attributes: firm size, firm industry, auditor type, and auditor tenure to serve as one benchmark.  A random sample of control firms that did not switch their auditors and had publicly available data on their corporate governance was used as a second benchmark.

    Findings:
    • The primary findings of this study were that: 1) auditors of family firms are less likely to resign than those of non-family firms and that 2) auditor resignations are less likely to occur in family firms managed by a founder or non-family CEO. These imply that auditors appear to attribute lower litigation risk to family firms because the family’s concern to preserve their reputation and contribute family wealth to future generations reduces the risk of misappropriation of assets and/or earnings management.
    • Another primary finding was that abnormal return following auditor resignations in family firms are significantly less negative than those in non-family firms. Furthermore, the findings suggest that the investing public places a lower weight on the bad news associated with auditor resignation in family firms managed by a non-family CEO as opposed to non-family firms. The public’s reaction to a resignation did not vary based on whether a family firm was managed by a founder or descendant CEO.
    • Secondary finding indicate that the following variables also have an impact on auditor resignation:
      • Firm audit reports modified for going concern reasons
      • Firms that report weaknesses in internal control over financial reporting
      • Firms that report a loss in the year preceding auditor resignation
      • The presence of an auditor-client mismatch
      • Firms with large variance in abnormal returns
      • Firms with higher likelihoods of bankruptcy and acquisition
      • Corporate governance mechanisms such as number of audit committee meetings, percentage of financial experts serving on the audit committee, and one or more institutional block holders.
         
    Category:
    Client Acceptance and Continuance, Corporate Matters, Governance
    Sub-category:
    CEO Tenure & Experience, Resignation Decisions
  • Jennifer M Mueller-Phillips
    Auditor Resignation and Risk Factors.
    research summary posted September 21, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment, 02.05 Business Risk Assessment - e.g., industry, IPO, complexity, 02.06 Resignation Decisions, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk 
    Title:
    Auditor Resignation and Risk Factors.
    Practical Implications:

    This study sheds light on why auditors choose to resign from auditing particular clients. The authors find that public information about audit risk, business risk, and litigation risk as well as private information about audit risk and business risk all play a role in the auditor’s resignation decision. This is useful for audit firms and regulators to consider. 

    Citation:

    Ghosh, A. and C.Y. Tang. 2015. Auditor Resignation and Risk Factors. Accounting Horizons 29 (3): 529-549.

    Keywords:
    auditor resignations, litigation risk, audit risk, business risk
    Purpose of the Study:

    While prior research has suggested litigation risk as the main reason for auditor resignations, the competing explanations of audit risk and business risk have not been tested concurrently to discover their incremental importance. Furthermore, prior research has not been able to isolate the auditor’s private information from public information about these risks. The authors attempt to close this gap in the literature by studying whether and how much the auditor’s private information about future audit risk, business risk, and litigation risk impacts the auditor’s resignation decision.

    Design/Method/ Approach:

    The authors use data from publicly-traded companies that switched auditors during the 1999-2010 time period. First, they compare auditor resignations to auditor dismissals based on pre-switch audit risk, business risk, and litigation risk. Then they test whether auditor resignations predict post-switch audit risk (e.g. internal control problems), business risk (e.g. delisting from stock exchange), and litigation risk (e.g. class-action lawsuits).

    Findings:
    • Compared to clients from which auditors have been dismissed, clients from which auditors resigned tend to have greater litigation risk, audit risk, and business risk before the change in auditors, but greater audit risk and business risk after the change.
    • The litigation risk, business risk, and audit risk existing before an auditor chooses to resign from an engagement all impact the auditor’s resignation decision, with litigation risk having the largest impact and audit risk the smallest.
    • Clients whose auditors have resigned are more likely to experience class-action lawsuits, internal control problems, and delisting from a stock exchange.
    • Auditor resignations reveal no private information about future litigation risk.
    • Auditor resignations reveal private information about future audit risk and future business risk, especially when one of the Big 4 audit firms resigned.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Business Risk Assessment (e.g. industry - IPO - complexity), Client Risk Assessment, Litigation Risk, Resignation Decisions
  • The Auditing Section
    Auditor Switches in the Pre- and Post-Enron Eras: Risk or...
    research summary posted May 7, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.06 Resignation Decisions, 03.0 Auditor Selection and Auditor Changes 
    Title:
    Auditor Switches in the Pre- and Post-Enron Eras: Risk or Realignment?
    Practical Implications:

    This study provides a more complete analysis (compared to the GAO 2006 study) of how Big 4 firms responded to the supply and demand shocks to the audit market by Andersen and SOX Section 404, which is useful for audit firms and regulators to consider.

    Citation:

    Landsman, W. R., K. K. Nelson, and B. R. Rountree. 2009. Auditor switches in the pre- and post-Enron eras: Risk or realignment?  The Accounting Review 84 (2):  531-558. 

    Keywords:
    Auditor switching, client risk, client misalignment, Sarbanes-Oxley Act, auditor appointment
    Purpose of the Study:

    The major accounting scandals of the early 2000s affected the market for audit services in two ways: the demise of Andersen resulted in an increase in the number of clients available to other accounting firms, and Section 404 of the Sarbanes Oxley Act (SOX) increased demand for audit services by accelerated filers.  These events resulted in temporary capacity constraints resulting in Big 4 firms rebalancing their public client portfolios.  Big 4 firms issued press releases during this time period indicating that they responded to these market forces by dismissing a number of clients that exposed their public client portfolios to unacceptable levels of risk.  The General Accounting Office issued a 2006 report further suggesting that the Big 4 firms have become more selective regarding risky clients.  This study investigates Big 4 auditor switch decisions during the pre-Enron (1993-2001) and post Enron (2002-2005) time periods to determine whether: 

    • Big 4 firms increased their sensitivity to client risk during the post-Enron period and dismissed clients that presented increased risk to their public client portfolios.  OR
    • Big 4 firms were faced with a capacity constraint due to Section 404 demand and elected to dismiss smaller clients that were misaligned with their overall portfolio strategy of serving larger clients.  The authors define auditor/client misalignment as occurring when a client is predicted to engage a non-Big 4 audit firm but actually engages a Big 4 audit firm.
    Design/Method/ Approach:

    The authors use data on publicly-traded companies and compare measures of client financial risk, audit risk, and auditor/client misalignment pre-Enron (1993-2001) to post-Enron (2002-2005) for three categories of Big 4 clients (as well as comparing resignations versus dismissals): (1) Big 4 clients that continue with their auditor, (2) new clients that switch laterally or upward to a Big 4 audit firm, and (3) Big 4 clients that switch to a national, regional or local audit firm.

    Findings:
    • The frequency of clients switching from Big 4 audit firms to the non-Big 4 audit firms more than doubled during the post-Enron time period relative to the pre-Enron period. 
    • Clients switching from Big 4 audit firms to non-Big 4 audit firms were more likely to be “misaligned” (as defined in the study) with a Big 4 audit firm during the post-Enron time period; however, demonstrated less risk during the post-Enron time period.  Lateral/upward switches during the post-Enron period demonstrated less client financial and audit risk and were less likely to be “misaligned” with a Big 4 audit firm.
    • Big 4-initiated resignations present greater risk compared to client-initiated dismissals, but there is no change in the sensitivities of resignations or dismissals to client risk or auditor/client “misalignment” during the post-Enron time period.           

    The authors claim their findings suggest that realignment decisions of Big 4 firms post-Enron were mostly due to auditor/client misalignment that resulted from the capacity constraints caused by the increase in supply of former Andersen clients and increased demand for audit services resulting from SOX Section 404, and not a change in the Big 4 firms’ sensitivity to client risk. 

    Category:
    Client Acceptance and Continuance, Auditor Selection and Auditor Changes
    Sub-category:
    Resignation Decisions
    Home:
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  • Jennifer M Mueller-Phillips
    Auditor Workload Compression and Busy Season Auditor...
    research summary posted October 20, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.06 Resignation Decisions, 10.0 Engagement Management, 10.01 Budgeting and Audit Time Management 
    Title:
    Auditor Workload Compression and Busy Season Auditor Switching
    Practical Implications:

    The distribution of fiscal year-end companies in an auditor’s client portfolio can place significant strains on the resources of a CPA firm. Auditors are cautioned about the damaging effects of workload compression on the auditor-client relationship. Policymakers should consider auditors’ workloads when enacting new rules and regulations.  

    Citation:

    López, D. M., and G. F. Peters. 2011. Auditor Workload Compression and Busy Season Auditor Switching. Accounting Horizons 25 (2):357-380

    Keywords:
    auditor switching, busy season, December year-end, workload compression
    Purpose of the Study:

    This study investigates the impact of the busy season and auditors’ workload compression on audit resources and the likelihood of auditor switching.

    Design/Method/ Approach:

    This study uses data from Compustat and Audit Analytics to get 10,238 observations comprised of 3,525 different companies across 163 different local auditor offices. 

    Findings:
    • December year-end companies have a lower likelihood of auditor switching than that of non-December year-end companies. This result is consistent with economic predictions of high switching transaction costs for busy season companies and their auditors.
    • The study also finds that the likelihood of switching increases with the level of auditor workload compression, providing evidence that workload compression has a damaging effect on the auditor-client relationship.
    • The likelihood of auditor changes is greater when there are more competing auditors within geographical proximity.
    Category:
    Client Acceptance and Continuance, Engagement Management
    Sub-category:
    Budgeting & Audit Time Management, Resignation Decisions

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