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    Market Reaction to Auditor Switching from Big 4 to...
    research summary posted November 10, 2014 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 11.0 Audit Quality and Quality Control, 11.04 Industry Experience, 11.08 Proxies for Audit Quality 
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    Title:
    Market Reaction to Auditor Switching from Big 4 to Third-Tier Small Accounting Firms
    Practical Implications:
    • Our results suggest that the market has confidence in companies choosing third-tier audit firms to enhance the economic benefit in terms of better audit services.
    • The results confirm the regulator’s encouragement of selecting smaller audit firms to improve competition, and the results will ease the reluctance that companies have in choosing a smaller audit firm.
    • The results confirm that the market viewed the regulatory changes in 2004 as an improvement to audit quality of the small audit firms, which included SOX 404 audits of internal controls over financial reporting, PCAOB inspections of audit firms, and a shorter filing deadline for Form 8-K.

    For more information on this study, please contact Kenneth J. Reichelt.

    Citation:

    Chang, H, C. S. A. Cheng, and K. J. Reichelt. 2010. Market reaction to auditor switching from big 4 to third-tier small accounting firms. Auditing: A Journal of Practice and Theory 29 (2): 83-114.

    Keywords:
    market reaction; auditor switching; Big 4; small accounting firms; audit quality.
    Purpose of the Study:

    After the demise of Arthur Andersen, the public accounting industry had witnessed a significant migration of public clients to second-tier (Grant Thornton and BDO Seidman) and smaller third-tier accounting firms. While prior literature documents that smaller auditors are perceived by the stock market as an inferior substitute for a Big 4 auditor, this perception appears to have changed in recent years. For instance, a 2006 Wall Street Journal article (Reilly 2006) reported that more IPOs are relying on smaller accounting firms. In this paper, we analyze stock market responses to auditor switching from Big 4 to smaller accounting firms from 2002 to 2006.

    We predict that three major regulatory changes likely improved investor perceptions of smaller third-tier auditors: 1) audits of internal controls over financial reporting under Section 404 of the Sarbanes Oxley Act of 2002 (SOX), 2) Public Company Accounting Oversight Board (PCAOB) inspections of audit firms, and 3) a tighter Form 8-K filing deadline. These regulatory changes were intended to improve audit quality for all firms, but the smaller audit firms had the most room to improve. Consequently, after these regulatory changes, switches to smaller audit firms were perceived more favorably by investors.

    Design/Method/ Approach:
    • We compare market adjusted returns of Big 4 to third-tier auditor switches between two periods: 1) February 1, 2002 to August 23, 2004 - when SOX was proposed and passed but when investor perceptions of smaller third-tier auditors were unlikely to have changed, and 2) August 24, 2004 to December 31, 2006 - when major regulatory changes occurred that likely improved investor’s perceived quality of third-tier auditors. 
    • We also perform multivariate analysis that compares the market reaction to switches from Big 4 to Third-tier auditors where audit quality changes are more noticeable by the market. For instance, 1) switches from Big 4 non-specialists to third-tier auditors when accruals quality of the Big 4 auditor was lower than normal, 2) switches from a Big 4 non-specialist auditor to a third-tier industry specialist auditor when accruals quality of the Big 4 auditor was lower than normal, and 3) switches from a Big 4 non-specialist auditor to a third tier auditor when audit fees decreased and when accrual quality of the Big 4 auditor was lower than normal.
    Findings:
    • We find that in the second period (after August 23, 2004), that the market responded more positively to auditor switches from Big 4 to third-tier auditors (BtS), as well as to switches form Big 4 to second-tier auditors and to Big 4 auditors, when compared to the first period (February 1, 2002 to August 23, 2004).
    • We find that the more positive stock market reaction to BtS switches occurred when the Big 4 predecessor did not warrant high audit quality (a non-specialist auditor and lower accruals quality), thus implying a low likelihood of an audit quality decrease.
    • We find that the more positive stock market reaction to BtS switches is not due to an audit fee decrease, but rather to engaging a third-tier industry specialist auditor that can provide better services.
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Industry Expertise – Firm and Individual, Proxies for Audit Quality