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