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    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 
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    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