Currently, bank loans account for more than half of the total debt financing in the United States. The results from this study indicate that there is an increase in loan costs for companies within the following year of an auditor change. This is a factor companies should consider when applying for loans after a switch.
Francis, Bill B., D. M. Hunter, D. M. Robinson, Michael N. Robinson, and X. Yuan. 2017. “Auditor Changes and the Cost of Bank Debt”. The Accounting Review. 92.3 (2017): 155.
Companies change auditors for various reasons, however due to the costs associated with switching, it is often an indication of potential problems between the auditor and company. This study examines the effects that an auditor change has on bank loan contracting. Specifically, whether companies that switch auditors incur increased costs and more stringent nonprice terms on loans. The authors address two potential reasons of why an auditor change would lead to information risk, and subsequently higher costs on loans. The first is if creditors perceive that the auditor change is opportunistic, such as management trying to find a more compliant auditor. The second information risk is related to the new auditor’s lack of client-specific knowledge. Both of these risks would cause for audit quality to decrease and, therefore loan costs would increase. The authors also consider the type of switch and its effect on loan costs. The three types examined are from (Non)Big 4 to (Non)Big 4, Big 4 to Non-Big 4, and Non-Big 4 to Big 4.
The sample includes 312 pairs of auditor change companies and non-audit change companies from 1998-2014. The audit change information was gathered using Audit Analytics and the bank loan data was from DealScan. Additionally, the authors excluded all audit switches due to the collapse of Arthur Andersen in 2002. The authors utilize a difference-in-differences (DID) research design comparing loan spreads between auditor change companies (before and after switch) and non-audit change companies.
Overall, the authors find that when companies initiate a loan within a year of changing auditors there is a 22% increase in loan costs.
Specifically, the authors find the following:
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The results from this study demonstrate that product differentiation in the form of market leadership and industry specialization may not provide a firm the power to mitigate the adverse consequences of a PCAOB censure.
Boone, J. P., I. K. Khurana, and K. K. Raman. 2017. Spatial Competition in Local Audit Markets and the Fallout on Deloitte from the 2007 PCAOB Censure. Auditing, A Journal of Practice and Theory 36 (21): 1-19.
The 2007 PCAOB censure on Deloitte regarding a pharmaceutical client in California caused the firm to suffer both audit fee and client losses. The objective of the paper is to determine whether auditor market power in a local area overrides the audit quality issues resulting from a censure. Specifically, authors investigate the effects of the censure on Deloitte’s ability to retain existing clients (or, switching risk) and potential loss of audit fees. The initial assumption is that auditor-client alignment and auditor-closest-competitor distance can help create differentiation among the Big 4 and this would lead to lower audit fee and client losses for a particular metropolitan area. Researchers looked at specific market specialization and geographic areas to analyze the effects on Deloitte.
The research evidence was collected from 2008-2010, the period after the censure. There were 65 local audit markets used within the sample. Each of these markets had a minimum of 6 to a maximum of 1,662 clients observed. Deloitte-client alignment for the individual local audit markets was based on Deloitte’s expertise in the client’s industry, measured according to whether Deloitte is the national leader in the industry (top fee earner), an industry specialist (significant fee earner), or a local audit market leader (top fee earner locally). Deloitte-closest-competitor distance measures Deloitte’s implied differentiation and reputation. It was calculated by comparing the distance between the firm’s fee market share and its closest competitor both at the national level and in the local market.
The overall finding is that audit quality issues override auditor market power and that differentiation does not provide Big 4 firms market power against adverse regulatory action.
The authors specifically find that:
The results of this study are important for audit firms to consider given interest from regulators on the role of shareholder ratification on auditor selection. The evidence indicates that while shareholders, through auditor ratification voting, are not responsible for the acceptance or dismissal of a firm’s auditor, subsequent auditor dismissals do appear to be influenced by increased shareholder resistance. A one percent increase in shareholder votes against auditor ratification is associated with a four percent increase in the likelihood of auditor dismissal within the following year.
Abhijit Barua, K. Raghunandan, and Dasaratha V. Rama (2017) Shareholder Votes on Auditor Ratification and Subsequent Auditor Dismissals. Accounting Horizons: March 2017, Vol. 31, No. 1, pp. 129-139.
The role of shareholders in the process of auditor selection is of great interest to regulators, investors, activists, and audit firms. Corporate governance activists as well as the U.S Treasury’s Advisory Committee on the Auditing Profession have recommended the adoption of an annual ratification of a firm’s independent auditors, since the primary responsibility of auditors is to the shareholders of their clients. This study looks at whether shareholder voting on auditor ratification is associated with the likelihood of subsequent auditor dismissal. As many of these votes are non-binding and on average an auditor ratification vote receives over 98% approval, the role of shareholder ratification in the auditor selection process remains an empirical question.
The authors use company-year observations from public U.S. companies with shareholder voting on auditor ratification from 2011 to 2014. Auditor dismissal within one year of a shareholder ratification vote occurred in 3.3% of the sample.
The authors find that:
The results of this study are important for audit firms to consider given interest from regulators on the role of shareholder ratification on auditor selection. The evidence indicates that proxy advisor recommendations significantly influence the number of dissenting auditor ratification votes. Unfavorable recommendations are more likely when there are concerns regarding auditor independence rather than audit quality.
Lauren M. Cunningham (2017) Auditor Ratification: Can't Get No (Dis)Satisfaction. Accounting Horizons: March 2017, Vol. 31, No. 1, pp. 159-175.
This study looks at the role of proxy advisor recommendations in shareholder voting on auditor ratification. Given the importance of shareholder involvement and the influence of proxy advisors to influence other voting outcomes, the author investigates the characteristics of the company and audit firm that lead to an unfavorable recommendation on auditor ratification.
The author uses company-year observations for the Russell 3000 firms with shareholder voting on auditor ratification occurring during shareholder meetings from January 1, 2009 to June 30, 2012. More than ninety percent of firms in their sample voluntarily include auditor ratification on the ballot.
The author finds that:
Private debt lenders are more likely to include a covenant that prohibits the borrower from receiving an audit report with going-concern modifications (GCAR) when the borrower has poor creditworthiness and the loan term is long. The auditor choice is more likely to be specified in the loan agreement when a GCAR covenant is included. The borrower with a GCAR covenant experiences both increased audit fees and higher probability of getting a GCAR when financial distress occurs. The results imply the GCAR covenant may complement traditional financial covenants in protecting the lenders but comes with a cost borne by the borrowers. It also shows the lenders’ use of audit reports can influence the auditors’ behavior.
Menon, K., and D. D. Williams. 2016. Audit Report Restrictions in Debt Covenants. Contemporary Accounting Research 33 (2): 682–717.
Prior studies on debt contracting mainly focus on financial covenants. This paper extends prior research by investigating why lenders put an audit-related covenant – GCAR covenant – into the loan agreement and the effect of this covenant on auditors. The authors argue a GCAR serves as an effective warning for potential defaults even if common financial covenants are not violated. They expect borrowing firms with low credit quality to have a GCAR covenant. They also expect long-term loans to have a GCAR covenant because the lenders face higher probability that the firm’s financial condition deteriorates before the loan matures. To prevent opinion shopping and for insurance purpose, lenders who impose a GCAR covenant are expected to restrict the borrower’s freedom on auditor selection. From the auditor’s stand point, the authors believe the GCAR covenant increases litigation risk to the auditor and/or require additional audit effort. As a result, audit fees are expected to increase and the borrowers are more likely to receive a GCAR.
The initial sample comes from new private debt placement made by public companies between 2003 and 2009. The final sample consists of 7,749 loan contracts (firm-years) from 3,304 unique companies. The authors obtain debt information from DealScan, financial information from COMPUSTAT and audit-related data from Audit Analytics. The authors first test what factors determine the inclusion of a GCAR covenant and then examine the effect of this covenant on audit-related issues.
This study is directly related to research on institutional factors that affect firms’ auditor choice and the overall audit quality in the market. It also stresses how investors’ knowledge in auditor quality could potentially affect firms’ auditor choice when investors are not allowed to choose auditors directly, which is currently an under-researched area. The paper also suggests that it is necessary to control for investor heterogeneity in archival studies on the market reactions to auditor choice and auditor switch; furthermore, this paper adds to the discussion on limitations of regulations.
Wei, X., X. Xiao, and Y. Zhou. 2015. Investor Heterogeneity, Auditor Choice, and Information Signaling. Auditing: A Journal of Practice and Theory 34 (3): 113-138
It is a long established fact that the audit market is differentiated. This differentiation leads to two distinct effects on firms’ auditor choices. For one, firms can hire high-quality auditors and use them to signal the credibility of their prospects to investors and distinguish themselves from low-value firms. On the other hand, firms can hire low-quality auditors if the firm engages in earnings management or adopts an aggressive accounting practice to reduce the risk of being detected or forced to switch to conservative accounting practices. The decision on which type of auditor to hire is not taken lightly, and it is the belief of the authors that firms are considering both how investors will perceive their auditor choices and how investor perception will likely affect their share prices during the hiring process. As a result, this paper provides a theoretical investigation of the consequences of investor heterogeneity on both firms’ auditor choices and the overall audit quality in the market.
The authors developed a model of firms’ auditor choices based on the assumption that there are only two types of firms, high-value and low-value, and two types of auditors, high quality and low quality. The Perfect Bayesian Equilibrium (PBE) was applied as the equilibrium concept to the model.
The results of this study are important for regulators concerned about the lack of competition in the audit market for large publicly-traded companies. These data indicate that audit firm associations can increase competition in this sector of the market by providing small firms with the necessary resources to adequately audit large, global, and complex audit clients. These findings should also be of interest to small audit firms interested in better serving larger audit clients. Lastly, these results should be of interest to corporate governance bodies and investors interested in the relationship between audit firm type and audit quality.
Bills, K. L., L. M. Cunningham, and L. A. Byers. 2016. Small Audit Firm Membership in Associations, Networks, and Alliances: Implications for Audit Quality and Audit Fees. The Accounting Review 91 (3): 767-792.
Small audit firms are often restricted in their ability to audit large public companies because these companies often have global operations and complex business and financial reporting environments which demand a level of resources difficult for smaller firms to provide. Many of these small firms seek membership in accounting firm associations in an effort to overcome these barriers. Accounting firm associations are autonomous organizations in which all firm members are independent in legal name and structure, but membership affords participating firms access to resources provided by the association itself as well as fellow association members.
Because accounting firm associations can pre-screen affiliate members and provide access to resources that would otherwise be more difficult or costly for small audit firms to obtain, audit quality for the clients of these affiliate members is likely to be higher than the clients of unaffiliated small audit firms. Addressing this issue is important because over half of all publicly traded companies are audited by small audit firms and little accounting research to date examines differences in audit quality across the clients of small audit firms. Below are three objectives the authors address in their study:
The authors use hand-collected audit firm association membership data from 2010-2013, along with financial statement data for publicly traded firms, to examine whether audit quality and audit fees for publicly traded clients differs between small audit firms affiliated with an audit firm association and small firms with no such affiliation. Audit quality was measured using PCAOB inspection findings, financial statement misstatement rates, and differences in levels of client discretionary accruals.
The results of this study are important to audit policymakers, academics, and practitioners. Though Non-Big 4 firms audit fewer publicly traded companies, the results indicate that they are still able to develop a reputation on their full book of business that enables them to become market leaders. In addition, policymakers’ efforts to increase Non-Big 4 market share may not work nationwide. The authors show that certain local characteristics impact the likelihood of Non-Big 4 local leadership, which suggests that targeted efforts may be more beneficial than nationwide efforts. Finally, the results imply that though the presence of a Non-Big 4 local market leader creates downward fee pressure on audit firms, Big 4 and Non-Big 4 firms are not substitutes as Big 4 firms still earn a fee premium in these markets.
Keune, M.B., B.W. Mayhew, and J.J. Schmidt. 2016. Non-Big 4 local market leadership and its effect on competition. The Accounting Review. 91(3): 907-931.
Non-Big 4 public accounting firms in many major metropolitan areas are as large as or larger than the Big 4 firms present in the market. However, prior academic research has assumed that little competition exists between Big 4 and Non-Big 4 public accounting firms. As a result of this supposed lack of competition, policymakers in the U.S. and Europe have suggested that they step in to grow Non-Big 4 firms. Regulatory intervention may be unwarranted though given a Government Accountability Office study from 2008 that shows that though large publicly traded companies are limited in their choice of auditor, they still obtain competitive fees. This paper investigates whether and how these seemingly contradictory findings can be accurate. Specifically, the authors:
The authors also introduce a new measure of market leadership based on overall office size.
The authors collected the accounting firm rankings from local business publications for the top 50 largest U.S. Metropolitan Statistical Areas. The accounting firm rankings are based on the number of employees, professional staff, or CPAs in the local office. Audit fees, local market characteristics, and other variables were obtained from the Audit Analytics database and Compustat. The information collected on these firms was for years 2005-2010.
The study results are important to regulators, practitioners, and academics. The findings show that internal controls opinion shopping appears to occur among firms that have clean internal control opinions prior to a restatement. In addition, clients have the incentive to manipulate the audit process, via internal control opinion shopping, due to the increased focus and oversight on internal controls reporting. Finally, auditor dismissals that occur late in the fiscal period are more likely to be associated with internal control opinion shopping.
Newton, N. J., J. S. Persellin, D. Wang, and M. S. Wilkins. 2016. Internal Control Opinion Shopping and Audit Market Competition. The Accounting Review 91 (2): 603–623.
This study evaluates three research questions related to opinion shopping using the internal controls environment. There have been historical concerns with the presence of audit opinion shopping. However, most studies use going concern opinions in assessing audit clients’ retention and dismissal behavior. This study expands the opinion shopping environment to internal control reporting. Going concern opinions typically have a low base rate of occurrence and have leading indicators (poor growth, bankruptcy indicators, etc.). Internal control opinions do not have similar indicators that give rise to a warning of an adverse internal control opinion. From this background, the authors investigate: 1) whether internal control opinion shopping exist; 2) how audit market competition influences internal control opinion shopping; and 3) does the timing of an auditor dismissal indicate opinion shopping motivations.
This study also provides an avenue to evaluate opinion shopping in the period after the passage of the Sarbanes-Oxley Act. In addition, it highlights the unintended consequences of increased audit market competition. Finally, it lends support to recent regulatory concern over the decrease in material weakness assessments that may not be the caused by improved internal control environments.
The authors employ an archival research methodology in this study. Audit opinion and audit client data is from Compustat, Audit Analytics, and the Center for Research in Security Prices (CRSP). The sample period starts in 2005, the year after the implementation of SOX Section 404, and ends in 2011.
This study offers insights into how restatements by one client may impact an auditor’s other clients. The authors find evidence suggesting that when an auditor’s clients restate their financial statements, the auditor’s reputation for audit quality suffers. Non-restating clients experience a small negative market reaction around the restatement date and a higher likelihood of dismissing that auditor. These findings may inform audit firms and their clients about the potential negative consequences of restatements by other clients.
Irani, A.J., S.L. Tate, and L. Xu. 2015. Restatements: Do They Affect Auditor Reputation for Quality. Accounting Horizons 29 (4): 829-851.
Signals of low audit quality should harm an audit firm’s reputation for quality in order to make the reputation more accurately reflect the firm’s true audit quality. While prior research has found negative responses from clients and the stock market following strong signals of low audit quality (e.g., SEC disciplinary actions), it is unknown how these stakeholders will react to weaker signals of low audit quality (e.g., restatements). However, the research on industry contagion effects suggests that restatements by one firm in an industry lead to decreased expectations for other firms in the industry, so it would not be surprising if restatements by one firm lead to decreased expectations for other firms that share its auditor. The authors attempt to tie up these loose ends by investigating whether restatements by one firm lead to (1) auditor dismissals by and (2) negative market adjusted returns for other firms that share its auditor(s), especially when restatements are more severe.
The authors use data from publicly-traded companies during the 2004-2012 time period. First, they test whether non-restating companies are more likely to dismiss auditors whose other clients filed restatements in the prior year. Second, they test whether non-restating companies experience negative market adjusted returns after one of their auditor’s other clients files a restatement. For both tests, they investigate whether the predicted reputation effect is stronger for more severe restatements.