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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
    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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  • Jennifer M Mueller-Phillips
    Auditor industry expertise and cost of equity
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, 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 industry expertise and cost of equity
    Practical Implications:

    The results of this study should be of interest to policymakers. An August 2011 Public Company Accounting Oversight Board (PCAOB 2011) concept release asked for comments on the advisability of using mandatory auditor rotation to enhance auditor independence. It aroused concerns from commenters that such rotation could adversely affect clients benefiting from auditor industry specialization. Although these comments did not elaborate on the nature of the benefits from industry specialization, this study’s evidence that equity investors value industry-expert auditors is relevant to the debate about the desirability of mandatory auditor rotation

    For more information on this study, please contact Jagan Krishnan.

    Citation:

    Krishnan, J., C. Li, and Q. Wang. 2013. Auditor industry expertise and cost of equity. Accounting Horizons 27(4): 667-691.

    Keywords:
    audit quality; cost of equity; auditor expertise; auditor change.
    Purpose of the Study:

    The study examines (1) the association between auditors’ industry expertise and their clients’ cost of equity capital, and (2) the change in cost of equity capital when companies switch from industry non-expert (expert) auditors to industry-expert (non-expert) auditors.

    Design/Method/ Approach:

    This study uses the city-national framework of auditor expertise, examine the effects of national-only, city-only, and joint city-national industry expertise on cost of equity.  The sample used in this study is derived from publicly traded companies employing Big N auditors. The period covers the years 2000 through 2008.     

    Findings:
    • Clients of city-only and joint city-national industry-expert auditors enjoy lower cost of equity capital. This is consistent with the assertion that investors’ positive perceptions about auditor reputation exist at the city level, either alone or jointly with national level.
    • Firms that move from non-experts to city-only and joint city-national industry experts experience a decline in cost of equity, and firms that switch from joint city-national experts to non-experts experience an increase in cost of equity. In addition, firms that switch from non-experts to experts issue more equity in the two years following the switch.
    • Further analyses suggest that, while the effects of national-only and city-only experts vary across some subsets of the sample, joint city-national experts enjoy lower cost of equity in the majority of subsamples.
    Category:
    Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise)
  • Jennifer M Mueller-Phillips
    Auditor Ratification: Can’t Get No &...
    research summary posted April 19, 2017 by Jennifer M Mueller-Phillips, 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 Ratification: Can’t Get No (Dis)Satisfaction
    Practical Implications:

    The results of this study are important for audit firms to consider given interest from regulators on the role of shareholder ratification on auditor selection.  The evidence indicates that proxy advisor recommendations significantly influence the number of dissenting auditor ratification votes.  Unfavorable recommendations are more likely when there are concerns regarding auditor independence rather than audit quality.

    Citation:

    Lauren M. Cunningham (2017) Auditor Ratification: Can't Get No (Dis)Satisfaction. Accounting Horizons: March 2017, Vol. 31, No. 1, pp. 159-175.

    Keywords:
    auditor ratification; corporate governance; proxy advisor; proxy disclosure; shareholder voting.
    Purpose of the Study:

    This study looks at the role of proxy advisor recommendations in shareholder voting on auditor ratification.  Given the importance of shareholder involvement and the influence of proxy advisors to influence other voting outcomes, the author investigates the characteristics of the company and audit firm that lead to an unfavorable recommendation on auditor ratification.

    Design/Method/ Approach:

    The author uses company-year observations for the Russell 3000 firms with shareholder voting on auditor ratification occurring during shareholder meetings from January 1, 2009 to June 30, 2012.  More than ninety percent of firms in their sample voluntarily include auditor ratification on the ballot.

    Findings:

    The author finds that:

    • On average, the percentage of dissenting votes on an Auditor ratification is 8.6 percent when proxy advisors issue an Against recommendation.
    • The dissenting votes are higher when there are concerns over auditor independence (non-audit service fees are higher, auditor tenure is longer) or when the proxy advisor’s recommendation is more influential (percentage of blockholders is lower and institutional ownership is higher).
    • Proxy advisors are less likely to issue an unfavorable recommendation when firms have stronger performance or a willingness to disclose internal control issues and are more likely to issue an unfavorable recommendation when the auditor tenure is longer or when the audit firm is a Big 4 Audit firm.
    • Proxy advisors issue more unfavorable recommendations when there are suspected concerns about auditor independence (69 to 85 percent) then when there are concerns regarding audit quality (4 to 12 percent).
    Category:
    Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise)
  • The Auditing Section
    Auditor Specialization, Auditor Dominance, and Audit Fees:...
    research summary posted May 7, 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 Specialization, Auditor Dominance, and Audit Fees: The Role of Investment Opportunities
    Practical Implications:

    The results may be useful to practitioners in developing a client portfolio and in determining bids for audit fees, as they provide empirical evidence on the consequences of investing in industry expertise under certain conditions.  For example, these results show that high industry IOS and high IOS homogeneity are associated with higher audit fees, which implies that auditors can benefit from investments to develop industry expertise in industries with such conditions.  However, these results also imply that it is more difficult to dominate industries with high IOS homogeneity, since companies in these industries have high incentives to protect proprietary information from other auditor clients. 

    The results of this study may also be relevant for company managers and audit committees in that they provide evidence on the determinants of audit fees and the possible within-industry transfer of proprietary knowledge to competitor firms through the firms' auditor.

    Citation:

    Cahan, S. F., J. M. Godfrey, J. Hamilton, and D. C. Jeter. 2008. Auditor Specialization, Auditor Dominance, and Audit Fees: The Role of Investment Opportunities. The Accounting Review 83 (6): 1393-1423.

    Keywords:
    auditor selection, auditor changes, auditor dominance, audit fees, investment opportunities, auditor concentration
    Purpose of the Study:

    The authors note that the GAO has expressed concerns related to audit firm competition in certain industries.  Namely, certain industries are dominated by few audit firms, resulting in reduced competition.  The authors investigate whether industry “investment opportunity set” (i.e., levels of growth options) explains why auditors choose to specialize in certain industries.  The authors suggest that when an industry investment opportunity set (IOS) is high, audit firms are willing to make costly investments in industry-specific knowledge.  In addition, when IOS is relatively homogeneous across clients in an industry, then auditors can easily transfer the knowledge they invested in across clients.  Below are three objectives that the authors address in their study: 

    • To investigate the impact of the investment opportunity set (IOS) in an industry on auditor industry specialization.
    • To investigate the effect of different levels of homogeneity of industry IOS on auditor industry specialization.
    • To investigate the effect of the industry IOS on audit fees.
    Design/Method/ Approach:

    The authors use a sample that includes 3,443 industry-years of data to determine whether auditor industry specialization is associated with audit clients’ Investment Opportunity Set (IOS) and/or the homogeneity of the IOS within an industry (HIOS).  The authors measure IOS for each industry using four firm-level variables: investment intensity (prior 2 years), growth in the market value of assets (prior 2 years), ratio of market value of assets to book value of assets, and the ratio of R&D expenditures to book value of assets. Further, the authors measure IOS homogeneity (HIOS) as the within-industry standard deviation of the IOS for all firms.  Finally, the authors measure auditor  industry specialization as the market share of client assets audited by the two largest auditors in an industry (defined using 3-digit SIC codes). 

    Findings:
    • Overall, industry IOS affects the structure of industry audit markets and the fees charged by auditors in these markets.
    • Auditors invest more in industry-specific specialization when the within-industry IOS is higher (to create barriers to entry for other auditors) and the IOS is more homogeneous (as auditors are able to transfer the expertise across client firms within the industry more easily).
    • However, auditor dominance (i.e. having one auditor dominate the industry) is negatively associated with IOS homogeneity as client firms will not want proprietary information to be transferred by the auditor to other client firms in the industry.
    • Industry IOS level and homogeneity are both positively associated with audit fees, either as payment for the investment in the IOS or as a premium for hiring the industry expert auditor.
    Category:
    Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise)
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  • Jennifer M Mueller-Phillips
    Does Audit Fee Homogeneity Exist? Premiums and Discounts...
    research summary posted October 29, 2013 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 05.0 Audit Team Composition, 05.03 Partner Rotation in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Does Audit Fee Homogeneity Exist? Premiums and Discounts Attributable to Individual Partners
    Practical Implications:

    The results of this study point to further complications that could arise from mandatory partner rotation policies. Because the assumption underlying this policy is that all partners from any given firm are interchangeable and that the benefits of enhanced auditor independence are not expected to lead to negative consequences for the client, this study creates a conflict. The author found that different partners from the same firm do provide different levels of quality in the eyes of the client which lead to discounts and premiums in audit fees. As a result, partner rotations could lead to unforeseen costs including clients having to switch audit firms to find the preferred level of quality as well as audit firms trying to poach partners from competitors in order to satisfy clients. These added costs should be considered when assessing the value of partner rotation policies.

    For more information on this study, please contact Stuart D. Taylor.
     

    Citation:

    Taylor, S. 2011. Does audit fee homogeneity exist? Premiums and discounts attributable to individual partners. Auditing: A Journal of Practice and Theory 30 (4): 249-272.

    Keywords:
    auditing; audit fees; audit partners; partner rotation.
    Purpose of the Study:

    Previous studies have suggested that client management chooses a level of audit quality and the related audit fees solely to satisfy the users of their financial statements. This study suggests that while satisfying financial statement users is an important factor in auditor selection, it is not the only reason for choosing a certain auditor. Furthermore, previous studies on auditor behavior imply that audit partners within the same firm provide statistically identical qualities of work, known as the “homogeneity assumption.” This study suggests that different auditors within the same firm provide differing levels of audit quality in the perception of client management and the audit partner plays a significant role in choosing an auditor.  There are costs and benefits of engaging different auditors, even different audit partners within the same audit firm, that exist in client management’s selection of auditors even if they are not valued by the financial statement users.

    Design/Method/ Approach:

    The author chose to conduct the research for this study using Australian publicly listed companies for the year 2005.  The Australian audit market was ideal for this research because disclosure of the name of the audit engagement partner in the audit report is required. The author used publicly available data to gather empirical evidence.

    Findings:
    • The empirical results indicate that individual audit partners earn individual audit fee premiums or discounts that can’t be explained by the firm they belong to.
    • Partners can earn significantly different levels of premiums and discounts at both Big 4 and non-Big 4 firms.
    • Cases of partners that receive fee premiums and discounts exist within the same audit firm.
    • Office level industry specialization where the partners are based does not explain the discounts and premiums.
    • Partners that receive audit fee premiums audit fewer clients and tend to have a shorter tenure than partners who receive a discount.
    • The author describes the partners that receive premiums with a shorter tenure as “rising stars” who are steadily moving from smaller to larger and more prestigious clients while the partners that receive discounts are not able to establish such a reputation and are only able to secure smaller clients.
    • If the audit market were to be solely driven by the financial statement users, one would expect that the market would consist of two completely separate classes of auditor, Big 4 and non-Big 4. However, the market price for audits is driven by both the demands of financial statement users and by the demand for a particular level of quality of audit process from client management.
    • Audit quality in the perspective of client management, apart from that for financial statement users, includes auditors that provide more efficient and less disruptive audits, will provide more informative management letters, or provide advice on certain matters.
    • The needs of financial statement users relate to the premiums and discounts to engaging a Big 4 as opposed to a non-Big 4 auditor. The demands of client management relate to the premiums and discounts paid for different audit partners. 
       
    Category:
    Audit Team Composition, Auditor Selection and Auditor Changes, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Auditor Qualifications (e.g. size - industry expertise), Partner Rotation
  • 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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  • Jennifer M Mueller-Phillips
    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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    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
  • Jennifer M Mueller-Phillips
    National Level, City Level Auditor Industry Specialization...
    research summary posted February 24, 2015 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 in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    National Level, City Level Auditor Industry Specialization and Cost of Debt
    Practical Implications:

    The results of this study are important for public companies to consider when choosing auditors.  The results clearly show that city-level industry specialist auditors are associated with lower cost of debt. Public companies which are thinking about engaging debt financing should seriously consider hiring city-level industry specialist auditors. The results of this study are also important for auditors. City-level industry specialist auditors can use this finding to promote themselves to existing and potential clients. Non city-level industry specialist auditors can consider the benefit of becoming city-level industry specialist auditors.

    For more information on this study, please contact Xie.

    Citation:

    Li, C., Y. Xie and J. Zhou. 2010. National level, city level auditor industry specialization and cost of debt. Accounting Horizons 24 (3): 395-417.

    Keywords:
    auditor industry specialization; national level industry specialist; city level industry specialist; credit rating; bond spread
    Purpose of the Study:

    Prior studies using industry specialist as a proxy for audit quality usually focus on two areas: (1) the relationship between auditor industry specialization and audit fees; and (2) the relationship between auditor industry specialization and client earnings quality. The findings from these two strands of literature generally indicate that clients of industry specialist auditors pay higher audit fees, and, in turn, are associated with higher earnings quality as measured by discretionary accruals. In sum, these studies show that auditor industry specialization matters in addition to the Big N versus non-Big N differentiation.

    Recent research has begun to explore differences in industry leadership at the national and city levels. Examining audit fees and earnings quality, recent research finds that audit quality is a city level phenomenon with joint city and national industry leaders having the highest quality, followed by city-only leaders. National-only leaders do not distinguish themselves from non-leaders. The city-only industry specialization is important because individual auditors’ deep industry knowledge at the office level is an important determinant of audit quality. However, the empirical evidence that links national-city level industry specialists to investors, especially debt holders, is limited. Therefore, we investigate whether higher audit quality associated with industry specialist auditors at the city level benefits clients in their debt financing.

    Design/Method/ Approach:

    The research sample is from 2001 to 2006 focusing on US public companies. The authors use regression methods to identify the relationship between national level, city level auditor industry specialization and cost of debt. The authors use two alternative methods to measure cost of debt: credit ratings and bond spreads. 

    Findings:

    Consistent with the assumption that higher audit quality is associated with lower information risk, which benefits clients in raising debt capital, we find that firms audited by city level industry specialist auditors, either alone or jointly with national level industry specialist auditors, enjoy significantly lower cost-of-debt financing measured by both credit rating and bond spread. Our results suggest that, compared to clients of non-industry specialists, firms’ odds of worse credit ratings are 0.859 (0.664) times lower, and their bond spreads are 17 (16) basis points lower if they are clients of city-level-only (joint national and city level) industry specialists. In addition, our evidence shows that, for joint national and city level industry specialists, both information and insurance roles are significant to reduce cost-of-debt financing.

    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Industry Expertise – Firm and Individual