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  • Jennifer M Mueller-Phillips
    A Reexamination of Audit Fees for Initial Audit Engagements...
    research summary posted December 3, 2014 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 04.0 Independence and Ethics 
    Title:
    A Reexamination of Audit Fees for Initial Audit Engagements in the Post-SOX Period
    Practical Implications:

    The results of the study strongly suggest that initial-year audit discounts are quite common and substantial in the post-SOX period. Although the existence of lowballing seems to be a threat to independence, at least in appearance, the existing research on lowballing provides mixed results on its impact on audit quality. The findings will likely be of interest to the PCAOB as it searches for ways to bolster auditor independence and other regulators because many, including the GAO, believe that without non-audit service fees, auditors are less likely to offer ‘‘loss-leader’’ fees for audits.

    For more information on this study, please contact Rosemond Desir.

    Citation:

    Desir, R., J. R. Casterella, and J. Kokina. 2014. A Reexamination of Audit Fees for Initial Audit Engagements in the Post-SOX Period. Auditing: A Journal of Practice & Theory 33 (2):  59-78

    Keywords:
    Audit fees, auditor independence, lowballing, PCAOB
    Purpose of the Study:

    On August 16, 2011, the Public Company Accounting Oversight Board (PCAOB) issued a concept release seeking comments on ways to enhance auditor independence. The Board notes that higher failure rates in new audit engagements might be linked to unrealistic pricing. The Board’s concern is that a new auditor might be more susceptible to management pressure if initial-year audit fees are set artificially low.

    Prior to the passage of the Sarbanes-Oxley Act (SOX) of 2002, empirical evidence shows that auditors discounted their initial-year audit fees. This practice is known as lowballing and it occurs when auditors price initial-year audit fees lower for new clients with the expectation of increasing the fees substantially in later years in order to recoup their initial losses. Lowballing was expected to decrease significantly after the enactment of SOX.

    Indeed, findings of a study on audit pricing in initial-year audits seem to confirm that Big 4 auditors charged a fee premium on new auditor-client relationships in 2006. However, it is not clear if more recent post-SOX initial-year audits are free of lowballing. In the current study, the authors investigate whether lowballing exists in new auditor-client relationships in an ‘‘extended’’ post-SOX environment for the years 2007 to 2010. 

    Design/Method/ Approach:

    The authors analyze audit fee data for years 2006 through 2010 for publicly-traded companies that are Big 4 and non-Big 4 clients. The focus of the study is on initial audits following auditor dismissals as there are very few auditor resignations. The audit fee data were collected from Audit Analytics database and financial data – from Compustat.

    Findings:

    The results suggest that both Big 4 and non-Big 4 accounting firms discounted their initial-year audit fees during the sample period (2007–2010), with fee discounts ranging from 16 to 34 percent. In addition, the authors find no evidence of initial-year audit fee discounts (or premiums) in 2006. 

    Category:
    Auditor Selection and Auditor Changes, Client Acceptance and Continuance, Independence & Ethics
    Sub-category:
    Audit Fee Decisions, Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc
  • Jennifer M Mueller-Phillips
    Bringing Darkness to Light: The Influence of Auditor Quality...
    research summary posted June 2, 2014 by Jennifer M Mueller-Phillips, tagged 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, 13.0 Governance, 13.01 Board/Audit Committee Composition 
    Title:
    Bringing Darkness to Light: The Influence of Auditor Quality and Audit Committee Expertise on the Timeliness of Financial Statement Restatement Disclosures
    Practical Implications:

    This objective of this study is to determine whether auditor quality and audit committee financial expertise are associated with improved restatement disclosure timeliness as reflected in reduced dark periods. Recent actions by regulatory agencies suggest that the timeliness of financial reporting remains a top priority of investors and regulators. This study finds evidence that both the auditors and audit committees can provide significant value to clients and improve timely disclosure of restatement details. 

    Citation:

    Schmidt, J., and M. S. Wilkins. 2013. Bringing Darkness to Light: The Influence of Auditor Quality and Audit Committee Expertise on the Timeliness of Financial Statement Restatement Disclosures. Auditing 32 (1).

    Keywords:
    accounting expertise; audit committees; audit quality; financial expertise; financial reporting timeliness; financial statement restatements
    Purpose of the Study:

    Several recent regulatory actions suggest that the timely reporting of financial data is a top priority of investors and regulators. This study investigates whether auditor quality and audit committee expertise are associated with improved financial reporting timeliness as measured by the duration of a financial statement’s “dark period.” The restatement dark period represents the length of time between a company’s discovery that it will need to restate financial data and the subsequent disclosure of the restatement’s effect on earnings. This dark period restatement setting helps to address the fundamental question of whether better governance helps companies resolve financial reporting problems. 

    Design/Method/ Approach:

    The authors selected a sample of 154 firms announcing dark restatements disclosed between 2004 and 2009. This sample was used to test the following hypotheses:

    • H1: Restatement dark periods are shorter for clients of Big 4 auditors. 
    • H2a: Restatement dark periods are shorter when the audit committee contains a larger proportion of financial experts. 
    • H2b: Restatement dark periods are shorter when the audit committee contains a larger proportion of accounting financial experts.
    • H3: Restatement dark periods are shorter when the audit committee chair has accounting financial expertise. 

    A multivariate model was then used to investigate the determinants of the length of restatement dark periods of the selected sample. 

     

    Findings:
    • Dark periods are shorter in the presence of Big 4 auditors.
    • Restatement dark periods are shorter among clients that have audit committees with more financial accounting experts. 
    • The relationship between the audit committee financial expertise and restatement dark periods is primarily attributable to the presence of an audit committee chair who is an accounting financial expert. 
    • With these factors present, restatement disclosures are provided up to 38 percent faster
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes, Governance
    Sub-category:
    Board/Audit Committee Composition, Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements
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  • 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
    Damaged Auditor Reputation and Analysts' Forecast...
    research summary posted June 7, 2014 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers 
    Title:
    Damaged Auditor Reputation and Analysts' Forecast Revision Frequency
    Practical Implications:

    The results of this study are consistent with the idea that auditor reputation has an effect on analysts’ forecasts. The authors specifically examine on the collapse of Andersen, an event that was unprecedented in terms of its scope and scale. By focusing on analysts’ forecasts for this time period, audit quality concerns are the most plausible explanation for the results produced. The evidence found in this study extends upon prior research and contributes to the research on forecast revision frequency and forecast properties, as well as on the collapse of Andersen.

    Citation:

    Cahan, S. F., P. K. Chaney, D. C. Jeter, and Wei Zhang. 2013. Damaged Auditor Reputation and Analysts’ Forecast Revision Frequency. Auditing 32 (1).

    Keywords:
    analysts’ forecast revisions; Andersen; audit quality; auditor reputation; financial analysts
    Purpose of the Study:

    This study examines the reaction of financial analysts to the events associated with the collapse of Enron and Arthur Andersen. Analysts’ forecasts have often attracted significant interest in the accounting literature, but only recently have researchers begun to examine how audit quality may affect these forecasts. In this study, the authors attempt to determine whether news that damages an auditor’s reputation affects analysts’ forecast revision frequency for clients of that auditor, as well as the properties of subsequent forecasts. To test their hypotheses, the auditors specifically examine the events that surrounded the collapse of Enron and Arthur Andersen during the early 2000s. 

    Design/Method/ Approach:

    The authors examine the revisions of current quarter earnings forecasts for Andersen clients and matched sample of Big 4 clients. They used data from all Andersen and Big 4 client-period observations during the Enron period in which the client is covered by at least one analyst and where there is at least one revision. The Enron period is defined as the period from October 16, 2001 to June 30, 2002. Data was also collected from the “pre-Enron period” defined as October, 16, 2000 to June 30, 2001. All data analyzed was pulled from Compustat, I/B/E/S, and CRSP. This data was analyzed to determine how the Andersen-Enron events affected the forecast revision activity and forecast properties of financial analysts. 

    Findings:
    • Analysts revised their forecasts downward to a greater extent for Andersen clients than for the Big 4 clients during the Enron period. 
    • There is an abnormal increase in the forecast errors and forecast dispersion of Andersen clients relative to the control firms. 
    • Earnings response coefficients (ERCs) decreased for Andersen clients as the number of downward revisions increased, suggesting that the damage to Andersen’s reputation affected the market’s responsiveness to earnings for some clients. 
    • While evidence of a faster walk-down for Andersen clients exists, the results of this study indicate that affiliated analysts were slower to issue downward forecasts, consistent with affiliated analysts having less independence. 
    Category:
    Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc
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  • Jennifer M Mueller-Phillips
    Determinants and Market Consequences of Auditor Dismissals...
    research summary posted February 24, 2015 by Jennifer M Mueller-Phillips, tagged 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:
    Determinants and Market Consequences of Auditor Dismissals after Accounting Restatements
    Practical Implications:

    The results of this study are important for regulators and audit committee members who are concerned with the ability of the audit market to self-regulate. Specifically, the evidence suggests that firms with higher switching costs and fewer replacement auditor choices are less likely to dismiss their auditors after a restatement. This evidence informs the debates about the costs of mandatory auditor rotation and the limited competition in the audit market. Additionally, the evidence of a positive market reaction to dismissals after severe restatements is consistent with firms restoring financial reporting credibility by replacing their auditors, and this should be of interest to audit committee members considering various corrective actions after a misstatement.

    Citation:

    Hennes, K., A. Leone, and B. Miller. 2014. Determinants and Market Consequences of Auditor Dismissals after Accounting Restatements. The Accounting Review 89 (3): 1051­–1082.

    Keywords:
    restatements, auditor dismissals, corporate governance
    Purpose of the Study:

    Auditors play an integral role in assuring the integrity of financial reporting, and market participants continue to debate the ability of the audit market to self-regulate adequately. One of the challenges in evaluating audit performance is that audit quality is difficult to observe and measure. Restatements, however, provide a visible signal of poor audit quality that can impose significant costs on firms. Firms respond to restatements with a variety of corrective actions, including the possible reconsideration of the external auditor. The purpose of this study is to provide evidence on the circumstances under which boards dismiss auditors in response to restatements and to examine how the market responds to those dismissals. 

    Design/Method/ Approach:

    This study examines a sample of public-company restatements occurring between 1997 and 2010. The authors focus only on restatements where the incumbent auditor opined on at least one annual period prior to the restatement announcement. Firm and restatement characteristics and executive and auditor turnover data is gathered from publicly available information.

    Findings:
    • The authors find that auditors are more likely to be dismissed after more severe restatements but that the severity effect is primarily attributable to the dismissal of non-Big 4 auditors rather than Big 4 auditors.
    • The authors document that among corporations with Big 4 auditors, those that are larger and more complex operationally are less likely to dismiss their auditors.
    • The study also examines contemporaneous executive turnover and finds evidence that boards view auditor dismissals as complementary rather than substitute responses to restatements.
    • Lastly, the study documents that the market reaction to an auditor dismissal (with a contemporaneous engagement of a comparable-sized auditor) is significantly more positive following more severe restatements (5.9%) than less severe restatements (0.6%). 
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements
  • Jennifer M Mueller-Phillips
    Do Clients Avoid “Contaminated” Offices? The Economic Con...
    research summary posted January 20, 2016 by Jennifer M Mueller-Phillips, tagged 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:
    Do Clients Avoid “Contaminated” Offices? The Economic Consequences of Low-Quality Audits.
    Practical Implications:

    The results of this study are important to audit regulators and auditors as the PCAOB considers disclosure of additional audit quality indicators. The results of this study indicate that clients do respond to publicly available indications of audit quality as they avoid audit firm offices that are associated with restatements. Additionally, auditors may be interested in the findings of this study as it relates to the economic implications of contaminated offices. The findings of this study provide evidence about the importance of local office reputation as client retention and new client additions decrease when offices are associated with audit failures.

    Citation:

    Swanquist, Q.T. and R.L. Whited. 2015. Do Clients Avoid “Contaminated” Offices? The Economic Consequences of Low-Quality Audits. The Accounting Review 90(6): 2537-2570.

    Keywords:
    auditor reputation, audit offices restatements
    Purpose of the Study:

    Audit firms have an incentive to protect their reputational capital in order to maintain and improve their economic circumstances. A client restatement is a common public signal that may negatively impact the audit firm’s reputation for audit quality. Previous research suggests that office-level characteristics in particular contribute to audit quality. Therefore, when restatements occur, the audit firm office involved in the restatement is likely to be “contaminated” and suffer the most from reputational and economic damage. Specifically, the authors:

    • Examine the effect of local office contamination (measured as client restatement announcements) on local office market share.
    • Examine the effect of local office contamination on client retention and client acquisition in the local office.
    • Examine the relationship between contamination and changes in local office market share in the face of differing levels of competition.

    Additionally, the authors use their findings to demonstrate how clients perceive and react to public information related to audit quality which is a recent focus of the PCAOB.

    Design/Method/ Approach:

    The authors proxy for contamination within an office using the number of restatements announced by an office’s clients during the year. They collected office location, audit fees, restatement announcements, and auditor dismissals from several Audit Analytics databases. Client financial reporting data were obtained from Compustat, and the metropolitan statistical area information was obtained from the U.S. Census Bureau’s website. The information collected on these audit offices and related clients was for years 2003-2011.

    Findings:
    • The authors find that contaminated offices lose market share following client restatement announcements. In addition, there are significant economic penalties associated with signals of audit failure.
    • The authors find that the percentage of clients dismissing their auditor increases with office contamination (both for clients that had a restatement and those that did not have a restatement). Similarly, clients selecting a new auditor are less likely to select one from a contaminated office. This suggests that the reduction in market share is a result of the auditor’s impaired ability to both retain and attract clients.
    • The authors find that the negative consequences of contamination are reduced in geographies where there is low competition among auditors and for larger clients.
    • The authors provide some evidence that though Big 4 and non-Big 4 offices are affected by contamination; the impact is diminished for Big 4 offices.
       
    Category:
    Accountants' Reporting, Auditor Selection and Auditor Changes
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Restatements
  • 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
  • The Auditing Section
    Financial Restatements and Shareholder Ratifications of the...
    research summary posted April 23, 2012 by The Auditing Section, tagged 03.0 Auditor Selection and Auditor Changes, 03.02 Dismissal Decisions – impact of restatements, disagreements, fees, mergers, 13.0 Governance, 13.05 Board/Audit Committee Oversight 
    Title:
    Financial Restatements and Shareholder Ratifications of the Auditor
    Practical Implications:

    The authors’ results show that restatements are viewed by investors as audit failures and restatements reflect negatively on investor perceptions of the external auditor. The study also suggests that audit committees’ decisions to change auditors are not influenced by shareholder ratification voting.  The authors state that the results support “efforts to require SEC registrants to submit auditor selection for a shareholder ratification vote.”

    Citation:

    Liu, L., K. Raghunandan, and D. Rama. 2009. Financial Restatements and Shareholder Ratifications of the Auditor. Auditing: A Journal of Practice & Theory 28 (1): 225-240.

    Keywords:
    restatements; shareholder voting; auditor ratification
    Purpose of the Study:

    The purpose of this study is to examine the impact that client restatements have on shareholder ratification votes for the external auditor.  Restatements have been widely recognized as an indicator of low audit quality and as such may influence shareholder perceptions of the external auditor.  Shareholder ratification of the external auditor is not required by state or federal laws; however, many firms maintain the practice as a measure of good governance.  This ratification vote is the only opportunity shareholders have to comment on their approval/disapproval of the audit firm and/or audit quality.  Furthermore, some investor advocate groups (e.g., CalPERS) have withheld votes against audit committee directors of firms that did not offer shareholders an opportunity to vote on auditor ratification.                                                                                                                           

    The authors expect that firms will have a higher proportion of shareholders not voting for the appointment of the auditor following a restatement.

    Design/Method/ Approach:

    The authors collect data on firms that restate 2004 or 2005 financial statements and compare shareholder ratification votes for the restating firms to shareholder ratification votes for a control sample of firms that did not restate their 2004 or 2005 financial statements.

    Findings:
    • The authors find that shareholders are more likely to vote against auditor ratification after a client restatement relative to firms that do not restate their financial statements and relative to shareholder voting prior to the restatement.
    • There were 19 of 97 restatement firms that had more than 5 percent of shareholder votes not in favor of ratifying the auditor; only 2 of these 19 firms subsequently changed auditors the following year.
    Category:
    Auditor Selection and Auditor Changes, Governance
    Sub-category:
    Dismissal Decisions – impact of restatements - disagreements - fees - mergers etc, Board/Audit Committee Oversight
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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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  • 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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