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  • The Auditing Section
    An Analysis of Forced Auditor Change: The Case of Former...1
    research summary posted May 7, 2012 by The Auditing Section, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 04.0 Independence and Ethics, 04.07 Audit Firm Rotation in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    An Analysis of Forced Auditor Change: The Case of Former Arthur Andersen Clients
    Practical Implications:

    The results of this study suggest that the auditor changes resulting from the demise of Andersen did not result in improved financial reporting quality and transparency for the former Andersen clients that parted ways with their former audit practice.  This implies that the mandatory rotation of auditors may not yield an increase in financial statement quality.  This result should be of interest to audit regulators and standard setters, as well as practitioners seeking to comment on proposed mandatory rotation regulations. 

    Additionally, the results indicate that switching costs in non-forced auditor change settings likely outweigh agency benefits of changing auditors in many cases.  This result may be of interest to shareholders, managers, and audit committees in their respective roles related to auditor selection.

    Citation:

    Blouin, J., B. M. Grein, and B. R. Rountree. 2007. An Analysis of Forced Auditor Change: The Case of Former Arthur Andersen Clients. The Accounting Review 82 (3): 621-650.

    Keywords:
    auditor selection, auditor change, mandatory auditor rotation, audit quality, earnings quality, Arthur Andersen
    Purpose of the Study:
    • To investigate the factors that contributed to firms' decisions to either retain their Andersen audit team who migrated to another audit firm, or engage a new auditor, after the collapse of Andersen.
    • To investigate the effect of forced auditor change on client firms' financial statement quality.
    • To examine the costs (switching costs and agency costs) a company faces in switching to a new auditor.
    Design/Method/ Approach:

    The authors use a sample of 407 Andersen clients.  The authors classify companies as retaining their Andersen audit team if the audit report in the year after Andersen's collapse indicates the new auditor within a city acquired the Andersen audit practice in that same city. Companies that did not adhere to this were classified as having switched to a different auditor.  In performing this analysis, the authors examine “Switching costs” (i.e. Andersen industry expertise, auditor tenure, auditee size, auditee complexity, and discretionary accruals) and “Agency Costs” (i.e. auditee size, auditee complexity and transparency, insider ownership, leverage, presence of a blockholder, and audit committee expertise and independence.

    Findings:
    • Companies faced with greater switching costs were more likely to stay with their Andersen audit team.  (Note: Greater switching costs include aggressive accruals, a financial expert on the audit committee, and Andersen industry specialization)
    • Companies with greater agency concerns (higher monitoring costs faced by outside shareholders) were more likely to sever ties with their Andersen audit team and hire a new auditor.
    • Companies in the highest quintile of performance-matched discretionary accruals that followed Andersen curbed their accrual behavior in the year after Andersen’s collapse, while there was no change for those that did not follow Andersen.
    • Overall company governance characteristics were not associated with the decision to retain or switch.
    • Overall, the evidence suggests that switching costs likely often outweigh benefits of changing auditors, which explains why we observe infrequent auditor changes for most companies.
    • Evidence in the study suggests mandatory rotation may not be effective in improving client firms' overall financial statement quality.
    Category:
    Auditor Selection and Auditor Changes, Independence & Ethics
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Audit Firm Rotation, Audit Firm Rotation
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  • The Auditing Section
    The Pricing of National and City-Specific Reputations for...
    research summary posted May 7, 2012 by The Auditing Section, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Pricing of National and City-Specific Reputations for Industry Expertise in the U.S. Audit Market
    Practical Implications:

    This study has practical audit client portfolio management implications for audit firms seeking to earn audit fee premiums for reputations of industry expertise. For example, auditors’ reputations for industry expertise are neither strictly national nor strictly local.  One interpretation with practical implications for such firms is that national level or city level reputations for industry expertise are not individually sufficient to maximize fee premiums.  Rather, auditors can most effectively earn fee premiums when they establish both city-level and national-level reputations for industry expertise.

    Citation:

    Francis, J. R., K. Reichelt, and D. Wang.  2005.  The Pricing of National and City-Specific Reputations for Industry Expertise in the U.S. Audit Market.  The Accounting Review 80 (1): 113-136.

    Keywords:
    Auditor industry expertise, Big 5 accounting firms, audit fees
    Purpose of the Study:

    The purpose of this study is to examine the pricing of Big 5 industry expertise in the United States based on national and city level reputations for industry expertise.  

    Industry knowledge and expertise help auditors build reputations that auditors can use to negotiate fee premiums.  Prior research suggests that industry knowledge and expertise is developed by investments in accounting professionals and their experiences in serving clients out of city-based practice offices.  However, auditors can build national reputations for industry expertise that may enable them to negotiate audit fee premiums as well.  The authors argue that the central issue in the “national” vs. “city” perspective on industry expertise is the degree to which office-specific expertise is transferrable throughout a firm. Specifically, the national perspective assumes accounting firms capture the industry expertise of its office-based professionals and distribute it throughout the entire firm.  Conversely, the city perspective assumes that auditor expertise is indelibly tied to individual professionals and cannot be distributed throughout the firm.  This study examines industry specialization audit fee premiums at the city level and national level to analyze how auditor reputations for industry expertise are viewed.  Specifically, the authors use U.S. fee disclosures to investigate audit pricing in the U.S.  audit market in order to determine: 

    • whether there is evidence that Big 5 auditor industry expertise is priced in the U.S. audit market 
    • whether the market for audit fees prices a Big 5 firm’s national (firm-wide) reputation or city-specific (local-office) reputations for industry expertise
    Design/Method/ Approach:

    The study uses data on U.S. non-financial publicly-traded companies with Big 5 auditors during the fiscal years 2000 and 2001.  The authors investigate audit fee premiums resulting from:

    • National specialization only,
    • City specialization only, and
    • Combined city and national specialization.
    Findings:
    • There is evidence of a fee premium of 19% on engagements where Big 5 auditors are both the nationally top-ranked auditor and the city-level industry leader in the city where the client is headquartered. The authors argue this indicates that national and city-specific industry leadership jointly impact auditor reputation and pricing. 
    • The magnitude of the premium for joint national-city leadership is bigger for larger clients (22 percent) than for smaller clients (7 percent).  
    • There is evidence of a fee premium of 8% on engagements where Big 5 auditors are the city-specific industry leader but not the national industry leader.  The authors argue this may indicate that auditor industry expertise is tied to individual professionals. However, the result is sensitive to test methods so the evidence is inconclusive on this point. 
    • There is no evidence of a fee premium for auditors that are national industry leaders alone without also being city-specific industry leaders.  The authors argue this indicates that national leadership alone does not result in a premium. 

    The authors argue these findings suggest that an auditor’s reputation is priced into audit fees as if both firm-wide (national) and city-specific (local) reputations are jointly relevant.

    Category:
    Client Acceptance and Continuance, Auditor Selection and Auditor Changes
    Sub-category:
    Audit fee decisions, Auditor Qualifications (e.g. size - industry expertise)
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  • The Auditing Section
    Are the Reputations of the Large Accounting Firms Really...
    research summary posted April 23, 2012 by The Auditing Section, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Are the Reputations of the Large Accounting Firms Really International?
    Practical Implications:

    This study provides an important implication for audit firms in maintaining their worldwide brand name reputation. The results suggest that, for global audit firms, the damage to auditor reputation in one country may spill over and cause concern among investors about the quality of their services in other countries. Further, the damage to reputation is greater where the demand for auditing and assurance is higher.

    Citation:

    Cahan, S. F., D. Emanuel, and J. Sun. 2009. Are the Reputations of the Large Accounting Firms Really International? Evidence from the Andersen-Enron Affair.  Auditing: A Journal of Practice and Theory 28 (2):  199-226. 

    Keywords:
    Auditor reputation, international audit markets, Arthur Andersen, Enron, auditor selection and auditor changes
    Purpose of the Study:

    The Big 4 accounting firms market themselves as global firms that deliver a uniform level of service across countries. While such a global reputation helps build worldwide demand for high-quality audits, it also creates risks if service quality becomes questionable in one of the countries in which a firm operates. Questionable audit practices in one of the countries, especially in the home jurisdiction, may  raise doubts as to whether sub-standard audits also occur in other countries. 

    This study examines whether the damage to the name brand of Arthur Andersen following the Andersen-Enron scandal in the U.S. spilled over into other countries. The study focuses on two key event dates leading up to Andersen’s demise: (1) January 10, 2002, when Andersen announced it had shredded documents related to the Enron audit, and (2) February 4, 2002, when Enron’s board released the Powers report that was critical of Andersen and when Andersen announced the establishment of an Independent Oversight Board (IOB) to investigate the firm’s audit policies and procedures. This study investigates the market reaction to Andersen’s clientele base around these two dates to determine whether: 

    • the events caused investors to reassess the reputation of Andersen’s non-U.S. audit units. 
    • investors’ reevaluation of Andersen’s reputation is more pronounced in cases where there is a higher demand for audit quality or credible financial statements. 
    • the effect is due to the perceived assurance or insurance value of an audit. The assurance value relates to an auditor’s ability to communicate with investors about the overall quality of client financial statements, while the insurance value relates to an auditor’s legal and financial liability for an audit failure.
    Design/Method/ Approach:

    The authors use data on publicly-traded companies audited by Arthur Andersen in 2001 to examine whether there is a negative market reaction to Andersen’s non-U.S. clients around the two event dates discussed above.

    Findings:
    • The authors document that an adverse market reaction to Andersen’s clients exists in non-U.S. countries, which suggests that the damage to Andersen’s reputation and audit quality in the U.S. spilled over to other countries.  
    • The market reaction is more negative in countries where there is a greater demand for high-quality auditing and credible financial reporting. More specifically, more-pronounced adverse market reactions are observed in common law (compared to code law) countries where investor protection is higher, ownership is more dispersed, and conflicts of interest between owners and managers are more likely to occur. 
    • The authors find that the market reaction for the shredding event is more negative for Andersen’s non-U.S., cross-listed clients than for Andersen’s non-U.S., non-cross-listed clients. This suggests that the shredding event may have been anticipated by the U.S. market as triggering lawsuits against Andersen and reducing its ability to pay for possible legal claims. 
    • The authors also report a similar market reaction for Andersen’s non-U.S., cross-listed clients and Andersen’s U.S. clients, suggesting similar levels of perceived audit quality across Andersen as a whole.
    Category:
    Auditor Selection and Auditor Changes, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Litigation Risk
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  • The Auditing Section
    Auditor Change and Auditor Choice in Nonprofit Organizations
    research summary posted April 16, 2012 by The Auditing Section, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Auditor Change and Auditor Choice in Nonprofit Organizations
    Practical Implications:

    The results of this study confirm the importance of management reputation issues in auditor change decisions, while also extending our understanding of nonprofit organizations.  For nonprofits, a change in auditor is more likely when the organization’s operational structure changes.  As the organization grows and becomes more reliant on federal funding, the likelihood of changing auditors, particularly to bigger audit firms, increases.

    Citation:

    Tate, S. L., 2007. Auditor changes and auditor choice in nonprofit organizations.  Auditing:  A Journal of Practice & Theory 26 (1): 47-70.

    Keywords:
    Auditor switching, auditor choice, nonprofit organizations
    Purpose of the Study:

    Accounting frauds of the early 2000’s coupled with the passage of the Sarbanes-Oxley Act of 2002 (“SOX”) resulted in increased focus on the role of the independent auditor in monitoring public companies.  Although the new SOX rules were not directed at nonprofit organizations, the public support of these organizations suggests that adequate levels of monitoring are also important in this sector.  This study specifically evaluates the auditor choice decisions of nonprofit organizations.

    Design/Method/ Approach:

    The author uses publicly available data for the years 1998 through 2002 to examine the effects of operational structure, management reputation and contracting, and audit fees on a nonprofit organization’s choice of auditor and decision to change auditors.

    Findings:
    • Consistent with prior research from other sectors, the author finds that management reputation and audit fees are important in the decision to change auditors. 
    • The author finds that changes to the organization’s operational structure, including revenue sources and resource uses, are important factors in the decision to change auditors.
    • The author also finds that organization size is an important factor in selecting a large audit firm over another smaller audit firm.  Changes in revenue sources, resource uses, leverage, and management contracting as well as management reputation may also be factors in the selection of the auditor.
    Category:
    Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise)
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  • The Auditing Section
    Does Auditor Industry Specialization Matter? Evidence from...
    research summary posted April 16, 2012 by The Auditing Section, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 05.02 Industry Expertise – Firm and Individual in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Does Auditor Industry Specialization Matter? Evidence from Market Reaction to Auditor Switches
    Practical Implications:

    This study offers an important implication for audit firms that industry specialization, in addition to brand name, is perceived as valuable by investors. The results are also useful for regulators when examining auditor switching by firms. Finally, the results are useful to investors in that they show significant market reactions to various types of auditor switching.

    Citation:

    :  Knechel, R. W., V. Naiker, and G. Pacheco. 2007. Does Auditor Industry Specialization Matter? Evidence from Market Reaction to Auditor Switches.  Auditing: A Journal of Practice and Theory 26 (1):  19-45. 

    Keywords:
    Industry specialist auditors, auditor switching, market reaction, financial reporting quality, auditor selection and auditor change.
    Purpose of the Study:

    Accounting regulators are interested in auditor switching by client companies because of a concern over opinion shopping. However, companies may also switch auditors in order to search for a higher-quality level of assurance provided by the audit. Prior research indicates that auditor brand name represents an audit quality differentiation and that investors recognize this  differentiation, as reflected in market reactions to changes to or from a brand name auditor. 

    Knowledge of a client's industry is one of the essential components of auditor expertise. Besides brand name, audit firms employ industry specialization as a method to differentiate their services and structure themselves along industry lines. This study examines whether: 

    • auditor industry expertise, in addition to brand name, reflects a form of service differentiation that is considered valuable by capital market investors. 
    • investor reactions, if any, are caused by changes in the market perception of audit quality or changes in the perceived costs of hiring auditors with varying levels of audit quality.
    Design/Method/ Approach:

    The authors use data on publicly-traded companies from 2000 to 2003 to investigate the market reaction to firms switching to (from) industry specialist auditors.

    Findings:
    • Switching within the Big 4 group of auditors -  the authors document that firms switching to an industry specialist experience a positive market reaction while those switching to a non-industry specialist experience a negative market reaction. The authors find that the observed market reactions are more likely to be caused by changes in perceived audit quality rather than the differential costs of using specialist auditors.  
    • Switching from a Big 4 to a non-Big 4 auditor - investors react most negatively when a company switches from a specialist Big 4 auditor to a non-Big 4 auditor. This suggests that the market is concerned with the reduction in perceived audit quality represented by brand name and industry expertise.  
    • Switching from a non-Big 4 to a Big 4 auditor - the market reacts most positively when a company switches from a non-Big 4 auditor to a Big 4 auditor who is not a specialist. However, there is no significant reaction for a switch from a non-Big 4 auditor to a Big 4 auditor who is a specialist. The authors speculate that the absence of a significant positive market reaction to the latter switch may be caused by increases in the perceived costs of using specialist auditors.
    Category:
    Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise)
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