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  • 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
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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
  • The Auditing Section
    Client Retention and Engagement-Level Pricing
    research summary posted April 13, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.06 Resignation Decisions, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 04.02 Impact of Fees on Decisions by Auditors & Management 
    Title:
    Client Retention and Engagement-Level Pricing
    Practical Implications:

    The results of this study are useful for regulators to consider the motives for auditor changes and to understand audit client portfolio management. The findings underscore the importance of engagement pricing as a determinant of audit firm’s client retention decisions.  Specifically, the evidence suggests that engagement pricing pressure occurs on more than an isolated basis and the audit firm’s inability to recover unexpectedly high labor usage is associated with the severing of the auditor-client relationship.

    Citation:

    Hackenbrack, K. E. and C. E. Hogan. 2005. Client Retention and Engagement-Level Pricing.  Auditing: A Journal of Practice and Theory 24 (1): 7-20. 

    Keywords:
    Engagement realization rates, client retention, engagement-level pricing, engagement management, client acceptance and continuance.
    Purpose of the Study:

    Prior research suggests that auditors do not accept new audit clients that are expected to yield audit fees insufficient to cover expected costs. This implies that auditors may not expect to frequently have engagements which generate insufficient rates of return in their portfolios. This study focuses on this matter by examining the relationship between engagement-level pricing and auditor retention decisions. The objectives of the study are to examine: 

    • whether audit firms find themselves in the position of earning an insufficient audit fee on more than an isolated occurrence 
    • how important engagement-level pricing is, relative to other factors, in audit firms’ client retention decisions 
    • Another important factor affecting client retention examined in the study is client delays which unexpectedly cause auditors to use more engagement hours than budgeted.  

    The engagement-level pricing measure used in the study is the difference between “realized” realization rates (the ratio of the audit fee billed to the standard audit fee) and “expected” realization rates for each segment of the firm’s client portfolio. This measure is also referred to as an unexpected component of realization rates.

    Design/Method/ Approach:

    The authors employ a sample of fiscal 1991 public and private audit engagements of a Big 6 audit firm. The data used are from proprietary sources, including a survey, audit working papers, and a 1996 client list of the audit firm, as well as public sources. The authors use these data to examine the relationship between the unexpected component of realization rates and the audit firm’s client retention over the five-year window (fiscal 1991 - 1996).

    Findings:
    • The authors document that the likelihood of client retention over a five-year window decreases as the difference between realized realization rate and the expected realization rate decreases. 
    • The authors find that the probability of retaining a client decreases with a combination of the impact of client-induced delays on engagement hours and the auditor’s inability to recover unexpectedly high labor usage. The probability of client retention, however, does not depend on the realization rates alone or client-induced delays alone.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Audit fee decisions, Resignation Decisions, Impact of Fees on Decisions by Auditors & Managmeent, Audit Fees & Fee Negotiations
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  • Jennifer M Mueller-Phillips
    Debt Covenant Violations, Firm Financial Distress, and...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 02.01 Audit Fee Decisions, 02.06 Resignation Decisions, 12.01 Going Concern Decisions 
    Title:
    Debt Covenant Violations, Firm Financial Distress, and Auditor Actions
    Practical Implications:

    The findings from this study impact firms with debt covenant requirements. Violations from debt covenants occur frequently and are often due to tight restrictions rather than signs of financial distress. These types of violations often lead to renegotations or waivers instead of immediate repayment. However, this study shows that auditors will still have negative reactions regardless of whether or not the violation is due to financial difficulty. It is important for firms to not only consider the financial and lending consequences of a violation, but the auditing consequences as well.

    Citation:

    Bhaskar, Lori Shefchik, G. V. Krishnan, and W. Yu.2017. “Debt Covenant Violations, Firm Financial Distress, and Auditor Actions”. Contemporary Accounting Research 34.1 (2017): 186.

    Purpose of the Study:

    This study investigates auditor actions resulting from debt covenant violations for firms. The violations increase business risk and subsequently cause the auditor to respond negatively. The audit actions examined in this paper are:

    • Adjustments in the audit plan causing higher audit fees.
    • The issuance of a going concern opinion.
    • The resignation of the auditor.

    The authors also consider the financial health of the firms before the violation was given. It is hypothesized that auditors are more likely to have a negative reaction to firms that are already financially distressed.

    Design/Method/ Approach:

    The sample includes 4,267 violations occurring from 2000 to 2008. All of the firms were U.S. nonfinancial public companies. The authors gathered the information from databases such as Compustat and Audit Analytics. The analysis was performed by estimating models of the auditor actions based on different client characteristics.

    Findings:

    The authors find the following:

    • Firms with debt covenant violations have significantly higher audit fees.
    • Firms have an increased likelihood of receiving a going-concern opinion after a violation. This is increased even more for firms that are not financially distressed. The authors attribute this to the fact that auditors tend to act more strongly because the information was inconsistent with prior beliefs.
    • Debt covenant violations lead to an increased likelihood of auditor resignation.
    • There is a positive association between the Big 4 auditors and all three auditor actions listed above.
    Category:
    Accountants' Reporting, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Going Concern Decisions, Resignation Decisions
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  • Jennifer M Mueller-Phillips
    Evidence on the Association between Financial Restatements...
    research summary posted October 31, 2013 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.06 Resignation Decisions, 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 12.0 Accountants’ Reports and Reporting, 12.03 Restatements 
    Title:
    Evidence on the Association between Financial Restatements and Auditor Resignations
    Practical Implications:

    Restatements are an important determinant of auditor resignation. Severe restatements affect new auditor choice. Auditor resignations are another significant cost imposed on restatement companies since companies tend to hire a lower-quality auditor.

    For more information on this study, please contact Ying Huang.
     

    Citation:

    Huang, Y. and S. Scholz. 2012. Evidence on the Association between Financial Restatements and Auditor Resignations. Accounting Horizons 26 (3): 439-464.

    Keywords:
    restatement; auditor resignation; new auditor type
    Purpose of the Study:

    Regulators, standard setters, and investors have expressed concern over the increasing frequency of financial statement restatements. This study examines the effect of restatements on auditors’ client continuance decisions by investigating the association between financial restatements and auditor resignations.

    Design/Method/ Approach:

    The authors use a sample of financial restatements from 2003 – 2007. They examine client dismissals of auditors and auditor resignations during the quarter before a restatement announcement and the four quarters afterwards. The authors compare auditor resignation firms with dismissal firms and with firms that have no change in auditor.

    Findings:

    19 percent of restating companies experience an auditor resignation in the five-quarter window surrounding the restatement announcement, significantly more than the 1 percent of non-restating companies that experience a resignation in a given sample year.
    Restatements are more positively associated with auditor resignations compared with dismissal firms or no-switch firms. Specifically, restatement increases the odds of an auditor resignation more than 28-fold when the control group is no-switch companies, and nearly nine-fold relative to dismissal companies, after controlling for other determinants of auditor resignations.
    Resignations are associated with more severe restatements when compared with no-switch firms. However, restatement severity does not distinguish between resignations and dismissals.
    Clients with relatively serious restatements tend to hire new auditors from a smaller tier.
     

    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes, Client Acceptance and Continuance
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Resignation Decisions, Restatements
  • Jennifer M Mueller-Phillips
    Real Activities Manipulation and Auditors’ C...
    research summary posted October 22, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.06 Resignation Decisions, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management 
    Title:
    Real Activities Manipulation and Auditors’ Client-Retention Decisions
    Practical Implications:

    The results of this study are important for auditors, investors, clients’ audit committees, and regulators. Disclosure about auditor resignations may reveal useful information about clients’ financial reporting practices. Since auditor resignations potentially signal risk arising from clients’ opportunistic financial reporting behavior, investors can make more informed decisions when they understand the linkage between RAM and auditor resignations. The findings of this study also have an important implication for clients’ audit committees, because these committees can help to avoid potential negative consequences associated with RAM and auditor resignations by overseeing management reporting practices. Further, the results of this study are important for regulators because they are concerned about auditor changes that are triggered by management opportunism.

     

    For more information on this study, please contact Yongtae Kim.

    Citation:

    Kim, Y., and M. Park. 2014. Real Activities manipulation and auditors’ client-retention decisions. The Accounting Review 89 (1): 367-401.

    Keywords:
    Real activities manipulation; auditors’ client retention decision; auditor resignation
    Purpose of the Study:

    Although earnings management through accounting choices is receiving considerably more attention in the literature, survey results show that executives are more willing to take real actions than accounting actions to meet earnings benchmarks. Despite the pervasiveness of real activities manipulation (RAM) and considerable attention to auditor switches, especially in the post-SOX era, there is little evidence for the implication of RAM for auditors’ client-retention decisions.

    Auditors are concerned about client’s abnormal operating practices for the following reasons. First, RAM has a negative impact on cash flows and future performance. Deterioration of the client’s performance and financial health limits an auditor’s future business opportunities with the client. Second, clients’ poor financial performance often leads to auditors being held liable for clients’ stakeholder losses, even if the auditors are not directly responsible. Thirds, RAM can result in inventory build-up and increase in receivables, both of which increase audit risk. Finally, aggressive RAM reflects the management’s opportunism in financial reporting and the discovery of opportunistic operating decisions that dissipate firm value casts doubt on the integrity of management and its financial statements.

    Facing resource constraints, auditors may drop clients with limited future opportunities and greater risk. Since auditors cannot effectively control the clients’ RAM, they attempt to adjust their client portfolios by resigning from risky engagements. The authors examine whether auditors are more likely to resign when clients engage in RAM aggressively.

    Design/Method/ Approach:

    The research evidence is collected from a sample of auditor changes between 2000 and 2010. Following prior literature, the authors estimate and examine three types of activities manipulation: (1) sales manipulation, (2) overproduction, and (3) reduction of discretionary expenses. To mitigate the concern that clients’ financial performance may explain the relation between RAM and auditor resignation, the authors construct performance-adjusted RAM measures, explicitly control for the client’s financial performance by including several proxies of the client’s financial performance in the regressions, and employ a performance-matched control sample.

    Findings:
    • Clients’ opportunistic operating decisions, proxied by abnormal cash flows and abnormal discretionary expenses, are positively associated with the likelihood of auditor resignations.
    • Abnormal production costs are not significantly associated with the likelihood of auditor resignations.
    • The results are robust to three sets of control samples: client-initiated auditor changes, all continuing audit clients, and performance-matched continuing audit clients.
    • Clients whose auditors resign tend to engage in RAM more aggressively to meet or beat earnings benchmarks prior to auditor changes. Auditors are especially sensitive to clients’ RAM to just meet or beat earnings benchmarks in their client-retention decisions, with the exception of RAM through overproduction.
    • Clients whose auditors resign from engagements tend to employ non-Big 4 auditors as successor auditors and that these clients engage in RAM more actively than other clients whose incoming auditors are Big 4.
    • The association between RAM and the likelihood of auditor resignation is especially prevalent for small clients and during the post-Sarbanes-Oxley Act of 2002 period.
    • Clients’ abnormal cash flows and abnormal discretionary expenses are significantly associated with litigations against auditors.
    Category:
    Client Acceptance and Continuance, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Resignation Decisions
  • Jennifer M Mueller-Phillips
    Recent Auditor Downgrade Activity and Changes in Client’s D...
    research summary posted October 3, 2013 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.06 Resignation Decisions, 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 11.0 Audit Quality and Quality Control 
    Title:
    Recent Auditor Downgrade Activity and Changes in Client’s Discretionary Accruals
    Practical Implications:

    This study displays the many outcomes and reasons for those outcomes that could occur when a company decides to switch auditors or when auditor decide to leave a client. Although this study did not find consistent evidence to support the idea that auditor downgrade leads to greater discretionary accruals and possible audit deterioration only highlights the complexities of the client-auditor relationship. Both client companies and audit firms could benefit from the findings of this study by considering the wide range of effects of auditor switching on financial reporting before deciding to switch.

    For more information on this study, please contact Brian T. Carver.
     

    Citation:

    Carver, B.T., C.W. Hollingsworth, and J.D. Stanley. 2011. Recent auditor downgrade activity and changes in clients’ discretionary accruals. Auditing: A Journal of Practice and Theory 30 (3): 33-58.

    Keywords:
    audit quality; auditor switches; discretionary accruals; financial reporting quality
    Purpose of the Study:

    The discovery of Enron’s accounting irregularities in 2001 brought many changes to the external audit environment. One of these such changes was an increased level of auditor switching activity driven by large auditors’ concern over capacity limitations after the demise of Arthur Andersen as well as the increased level of work that was necessary to meet the standards of the Sarbanes-Oxley Act of 2002. This study addresses the association between clients switching to a smaller auditor and subsequent changes in financial reporting by examining changes in accruals following recent auditor-client changes in clients that switch to a lower class of auditor as well as clients that make a lateral, or within the same class, auditor switch. Many speculate that auditor downgrades could lead to the deterioration of the quality of a client’s financial reporting; others reason that clients want a smaller auditor to gain more individualized service and reduced audit fees while maintaining adequate quality. However, the authors aim to provide an objective investigation based on empirical evidence of relationship between auditor downgrade activity and subsequent changes in clients’ financial reporting quality.  

    Design/Method/ Approach:

    This study was conducted by gathering information from Audit Analytics of firms identified as having switched auditors during the period from 2003 to 2005. The authors then examined changes in discretionary accruals over the two years following the switch using the lateral switch firms as a control group to help distinguish the effects of auditor downgrade activity from the general auditor switching activity.

    Findings:
    • Firms switching to a smaller auditor report a significant increase in signed discretionary accruals over the two years following the switch.
    • An analysis of companies that make lateral auditor switches does not reveal any change in financial reporting following the switch.
    • A comparison between the two samples fails to provide consistent evidence of any differences in discretionary accruals.
    • An examination of a small sample of firms that moved up in auditor class provided limited evidence that auditor upgrading companies experience a decrease in discretionary accruals in the time after the switch different from the accrual changes that occur when a firm downgrades in auditor class.
    • The results do not provide consistent support for concerns over the effects of large auditors purposefully pushing less desirable clients to smaller auditors and firms voluntarily making a downward switch in auditor class.
    • The findings suggest that recent auditor downgrade activity is associated with adverse changes in financial reporting; however, the results do not provide consistent evidence that downgrade clients report differently than other clients that switched auditors during the sample period.
       
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes, Client Acceptance and Continuance
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Resignation Decisions

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