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  • Jennifer M Mueller-Phillips
    Pricing of Risky Initial Audit Engagements.
    research summary posted September 14, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 02.04 Predecessor Auditor Factors 
    Title:
    Pricing of Risky Initial Audit Engagements.
    Practical Implications:

    This research contributes to the initial engagement literature by providing evidence that successor auditors charge higher fees to their clients that previously reported disagreements and other reportable events. The authors also contribute to the literature by examining fees over a six-year period surrounding the auditor change. More importantly, they find that only Big 4 auditors appear to charge higher fees following disclosures of disagreements and other reportable events. Finally, the authors add to the existing literature on audit fees for risky clients, especially the internal control weakness literature, by providing evidence that disagreements and other reportable events are priced incremental to internal control issues.

    Citation:

    Elliott, J. A., A. Ghosh, and E. Peltier. 2013. Pricing of Risky Initial Audit Engagements. Auditing: A Journal of Practice & Theory 32 (4): 25-43.

    Keywords:
    audit fees, auditor changes, Big 4 auditors, engagement risk
    Purpose of the Study:

    In this study, the authors reexamine the association between audit fees and risky initial engagements by developing an ex ante client-risk metric that is based on auditor change 8-K filings. They group adverse disclosures embedded in auditor change filings into four categories: clients with 

    1. Internal control weaknesses,
    2. Going concern issues or those filing for bankruptcy,
    3. Disagreements with the predecessor auditor, and
    4. Other reportable events.

    Because prior studies examine internal control weaknesses and going concern opinions, the authors focus on auditor-client disagreements and other reportable events, including restatements, management integrity issues, scope limitations, illegal acts, and reaudits. A fundamental distinction between this study and prior studies on risk and fees is that the authors measure client risk based on public information available to auditors before they accept an engagement.

    The authors investigate the association between an ex ante measure of risk (using information in auditor change 8-K filings) and audit fees for initial engagements. The authors also examine whether the size of the successor/predecessor auditor affects fees. Finally, they examine inter-temporal fee changes, i.e., how fees change subsequent to a switch and how fees change prior to the switch, for both risky and other clients.

    Design/Method/ Approach:

    The auditor change and fee data are obtained from Audit Analytics. Data for the financial variables are from Compustat Annual files.  The final sample consists of 2,396 auditor switches over the years 2001 to 2011. The categorization based on auditor change 8-K filings indicates that 317 auditor switches have a disagreement or other reportable event disclosed in the filings, while the remaining 2,079 observations do not report any such issue.

    Findings:
    • The authors find that firms disclosing reportable events or auditor-client disagreements pay a fee premium of about 23 percent compared to less risky initial engagements.
    • They find that only clients switching to Big 4 auditors pay higher fees when disclosing disagreements or other reportable events in the 8-K.
    • The results indicate that Big 4 auditors charge a fee premium for risky clients, but not non-Big 4 auditors.
    • Over the three years prior to the auditor switch, audit fees for risky Big 4 clients increase by about 36 percent. Following the auditor switch, the fee premium persists for at least three years.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment, Predecessor Auditor Factors
  • The Auditing Section
    The Association between Audit-Firm Tenure and Audit Fees...
    research summary posted April 16, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.04 Predecessor Auditor Factors 
    Title:
    The Association between Audit-Firm Tenure and Audit Fees Paid to Successor Auditors: Evidence from Arthur Andersen
    Practical Implications:

    The results from this study are important for regulators when considering mandatory audit firm rotation. The evidence suggests that auditors are concerned about the length of their new client’s relationship with their former auditor and perceive this as a risk factor in pricing their engagements. 

    However, the authors caution that the evidence does not necessarily support mandatory rotation. As Andersen was a high-profile case, it is possible that the fee premium observed in this study is unique to Andersen clients. Moreover, in examining mandatory rotation, the authors suggest that switching costs should also be considered in conjunction with the fee premium.

    Citation:

    Kealey, B. T., H. Y. Lee, and M. T. Stein. 2007. The Association between Audit-Firm Tenure and Audit Fees Paid to Successor Auditors: Evidence from Arthur Andersen.  Auditing: A Journal of Practice and Theory 26 (2): 95-116.

    Keywords:
    Auditor tenure, Arthur Andersen, audit fees, audit risk, auditor selection and auditor change, client acceptance and continuance.
    Purpose of the Study:

    There has been a long-standing debate on the effect of auditor tenure on audit quality and whether mandatory auditor rotation should be imposed on audit firms. Opponents of mandatory rotation, including the accounting industry, have argued that longer auditor tenure leads to more institutional knowledge being possessed by the auditor about their clients. This in turn helps increase audit effectiveness and audit quality. Proponents of mandatory rotation contend that it will lead to increases in actual and perceived independence and audit quality. 

    Recently, the Sarbanes-Oxley Act of 2002 set the mandatory tenure limits on engagement and review partners. While Congress was also interested in limiting audit firm tenure, they have not imposed such a requirement, but instead have issued a request for additional research on the impact of auditor tenure on independence. This study addresses Congress’ concern on the effect of tenure on auditor independence by examining whether successor auditors view their clients’ tenure with the predecessor auditor as a risk factor and whether they price this perceived lack of independence.

    Design/Method/ Approach:

    The authors use data on publicly-traded companies which were audited by Arthur Andersen in 2001, but who switched to another auditor in 2002. They examine the association between client tenure with Andersen and audit fees charged by the successor auditor.

    Findings:

    The authors document that newly hired auditors charge higher audit fees when the length of the client’s tenure with Arthur Andersen was higher. This suggests that new auditors perceive increased tenure with a predecessor auditor as riskier.

    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit fee decisions, Predecessor Auditor Factors
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  • The Auditing Section
    Forced Audit Firm Change, Continued Partner-Client...
    research summary posted April 23, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.04 Predecessor Auditor Factors, 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers 
    Title:
    Forced Audit Firm Change, Continued Partner-Client Relationship, and Financial Reporting Quality
    Practical Implications:

    The results of this study are important for regulators to consider when scrutinizing auditor changes and former audit partners. The evidence indicates that former audit partners may adopt a strategic approach to auditing follower clients by being more conservative in their audits in the first post-switch year when the level of scrutiny is high, but allowing more aggressive earnings management after the first post-switch year.

    Citation:

    Chen, C. J. P., X. Su, and X. Wu. 2009. Forced Audit Firm Change, Continued Partner-Client Relationship, and Financial Reporting Quality.  Auditing: A Journal of Practice and Theory 28 (2): 227-246. 

    Keywords:
    Forced audit firm change, former audit partner, financial reporting quality, auditor selection and auditor change, audit partner/audit firm switching.
    Purpose of the Study:

    The authors use a setting of forced auditor changes (e.g. the forced demise of Andersen resulting in partners and staff going to work for other firms) to examine whether clients follow their former audit partner, and the implications for earnings management.  Forced auditor changes following an audit failure scandal raise the level of perceived and/or actual regulatory risk to both former audit partners and the new audit firms that take on such partners. However, regulatory scrutiny of the new audit firm in subsequent years may not be as strong as in the first year following the partner switch to the new audit firm. This study investigates the financial reporting quality of Chinese listed firms following forced partner/audit firm changes. The main objectives of the study are to  determine whether: 

    • Former audit partners tend to be more conservative in the first post-switch year.
    • Former audit partners become less conservative after the first post-switch year.
    Design/Method/ Approach:

    The authors use data on publicly-traded companies in the Chinese stock market which faced forced partner/audit firm changes in 2001 to examine the financial reporting quality associated with audits performed by these audit partners with their new audit firm in the post-switch years.

    Findings:
    • The authors document that firms with greater earnings management activities are more likely to follow their former audit partners to a new audit firm.  
    • Follower clients with aggressive earnings management behavior who are audited by former partners do not report abnormally high earnings management in the first post-switch year. 
    • While new audit firms are more likely to assign brand new audit partners to follower clients in the first post-switch year, a large number of former audit partners return to their clients in subsequent years. 
    • The authors find that the financial reporting of aggressive follower clients audited by former partners becomes significantly more aggressive in the second and third post-switch years.
    Category:
    Client Acceptance and Continuance, Auditor Selection and Auditor Changes
    Sub-category:
    Impact of SEC Actions, Predecessor Auditor Factors, Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc
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  • The Auditing Section
    Competition for Andersen's Clients (article and...
    research summary posted May 7, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.04 Predecessor Auditor Factors 
    Title:
    Competition for Andersen's Clients (article and discussion)
    Practical Implications:

    Audit firms may find this study interesting because it contributes to an understanding of the competitive nature of the U.S. audit market among the remaining Big Four firms.  Additionally, this study appears to have implications for audit firms operating in a market where a major accounting firm either leaves the market or dissolves.  Specifically, the results imply that a potential growth strategy for firms remaining in such markets may be to purchase the practices of such firms, where possible.  Further, this study appears to have implications for portfolio management related to small clients and large clients, since the audit fees for these firms behaved differently following the demise of Andersen. 

    Additionally, the results suggest that the decreasing number of Big Four audit firms may be detrimental to competitive forces in the audit market, which is of importance to audit market regulators in the U.S. and globally. Given that the dissolution of an audit firm is a very rare event, this study provides unique empirical evidence on the consequences of such a dissolution. 

    In their discussion of the study, Ramnath and Weber (2008) raise concerns related to what a purchase of an Andersen office really means and how this definition may differ across markets.  They also note that a more appropriate level to examine these issues would be the partner level (e.g. clients may have chosen to remain with their Andersen partner at their new firm).  

    Citation:

    Kohlbeck, M., B. W. Mayhew, P. Murphy, and M. S. Wilkins. 2008. Competition for Andersen's Clients. Contemporary Accounting Research 25 (4): 1099-1136.

    Ramnath, S. and J.P. Weber. Discussion of “Competition for Andersen’s Clients”. Contemporary Accounting Research 25 (4): 1137-1146.

    Keywords:
    auditor selection, auditor changes, Arthur Andersen, audit market competition
    Purpose of the Study:

    The authors study the competition for Andersen’s clients, with the following objectives:  

    • To investigate the competition for audit clients among the remaining Big 4 audit firms and the various approaches taken by the firms (e.g. purchasing entire offices versus targeting specific clients).
    • To investigate the association between the level of competition and audit fee changes, and whether client size affects this competition.
    • To provide evidence related to the GAO's concern that large clients have relatively few auditor choices after Andersen's demise.
    Design/Method/ Approach:

    The sample is comprised of 4,754 audit clients including 674 former Andersen clients from 65 Andersen offices, 39 of which were purchased by other Big 4 firms. Four types of Andersen client switches are considered: early switchers, clients who were part of a practice group purchased by another audit firm and stayed with that new firm, clients that switched auditors after the audit practice was purchased, and clients that were part of an Andersen practice office that was not purchased. The office purchase data was collected by examining press releases and articles to identify Andersen office purchases by other audit firms. This data was validated, when possible, by comparing it to the Public Accounting Report analysis of Andersen office purchases.  The authors use this data to examine audit fee changes and make inferences about the implications of reduced competition in the market for audit services.

    Findings:
    • An Andersen office purchase by another audit firm reduced competition among the Big Four within a local market, resulting in increased market power by the remaining audit firms.
    • Larger clients that face limited options when seeking a new auditor did not receive fee discounts, whereas smaller clients with more audit firm options to choose from did receive fee discounts, indicating that competition for the smaller clients affected audit pricing.
    • Clients that continued with an office purchased by another audit firm did not receive fees discounts, while clients who sought a new auditor rather than remain with the purchasing firm paid higher fees. Finally, in markets where the Andersen office was not purchased, clients received fee discounts from their new auditor.
    • Firms that chose to purchase an Andersen practice office were more likely to have a presence in the local market before the purchase, were similar in size to the Andersen office, and had already acquired a significant number of early Andersen switching clients. Offices that were purchased earlier retained a higher percentage of clients compared to offices that were purchased in later periods.
    • Purchasing offices increased the number of clients gained relatively equally across all client size levels.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit fee decisions, Predecessor Auditor Factors
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