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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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  • Jennifer M Mueller-Phillips
    The Contagion Effect of Low-Quality Audits at the Level of...
    research summary posted June 26, 2017 by Jennifer M Mueller-Phillips, tagged 03.01 Auditor Qualifications, 11.07 Attempts to Measure Audit Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Contagion Effect of Low-Quality Audits at the Level of Individual Auditors
    Practical Implications:

    This study highlights the importance of individual auditor identification in audit reports. The results are also useful for financial information users, regulators, and policymakers to help them understand the impact of an auditor’s characteristics on an audit. The results are especially helpful for firms trying to understand the reasons behind audit failures and subsequently, to mitigate audit failures in the future.

    Citation:

    Li Baolei Qi Gaoliang Tian, Liuchuang, and G. Zhang. 2017. “The Contagion Effect of Low-Quality Audits at the Level of Individual Auditors”. The Accounting Review 92.1 (2017): 137.

    Keywords:
    contagion effect; individual auditors; audit failures; audit quality; auditors’ personal characteristics
    Purpose of the Study:

    This study examines whether there is a relation between audit failure by an individual auditor and the quality of other audits performed by this individual, and if the audit failure creates a rippling effect onto the rest of the office’s audit quality. In China, unlike most other countries, the identity and personal profile of signing auditors are disclosed in the public domain. This allows for the authors to determine the role of an individual auditor in an audit failure. The authors also consider whether or not qualitative characteristics (experience, gender, education) of an auditor can decrease the contagion effect of audit failure within an office location.

    Design/Method/ Approach:

    The sample consists of 11,706 audit decisions and 3,357 of which were audited by failed auditors from 1999-2011. The China Securities Markets and Accounting Research (CSMAR) database was used to find financial information and information about the financial restatement reports were found on the China Information website. The qualitative characteristics of auditors used were age, gender, education level, major, CCP membership, and experience. This data was gathered from the CICPA website.

    Findings:

    The authors find the following:

    • Auditors who experience audit failure are more likely to have further failures in the subsequent four years. Additionally these auditors are more likely to have higher levels of abnormal accruals in other audits as well, indicating an overall lower audit quality. This combination suggests that there is a contagion effect between individual audit failure and future audit quality.
    • Offices that experience audit failures and offices that do not have no significant differences in failed audits in subsequent years or audit quality. This suggests that contagion does not seem to occur across different auditors in the same office.
    • The contagion effect can be decreased based on certain qualitative characteristics of the auditor. Specifically, it is decreased for female auditors, auditors holding a master’s degree, and auditors with more auditing experience.
    Category:
    Audit Quality & Quality Control, Auditor Selection and Auditor Changes
    Sub-category:
    Attempts to Measure Audit Quality, Auditor Qualifications (e.g. size - industry expertise)
    Home:

    http://commons.aaahq.org/groups/e5075f0eec/summary

  • 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)
  • Jennifer M Mueller-Phillips
    Small Audit Firm Membership in Associations, Networks, and...
    research summary posted May 31, 2016 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 05.0 Audit Team Composition, 05.08 Impact of Office Size in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Small Audit Firm Membership in Associations, Networks, and Alliances: Implications for Audit Quality and Audit Fees
    Practical Implications:

    The results of this study are important for regulators concerned about the lack of competition in the audit market for large publicly-traded companies.  These data indicate that audit firm associations can increase competition in this sector of the market by providing small firms with the necessary resources to adequately audit large, global, and complex audit clients.  These findings should also be of interest to small audit firms interested in better serving larger audit clients.  Lastly, these results should be of interest to corporate governance bodies and investors interested in the relationship between audit firm type and audit quality.

    Citation:

    Bills, K. L., L. M. Cunningham, and L. A. Byers. 2016. Small Audit Firm Membership in Associations, Networks, and Alliances: Implications for Audit Quality and Audit Fees. The Accounting Review 91 (3): 767-792.

    Keywords:
    associations; networks; small audit firms; audit fees
    Purpose of the Study:

    Small audit firms are often restricted in their ability to audit large public companies because these companies often have global operations and complex business and financial reporting environments which demand a level of resources difficult for smaller firms to provide.  Many of these small firms seek membership in accounting firm associations in an effort to overcome these barriers.  Accounting firm associations are autonomous organizations in which all firm members are independent in legal name and structure, but membership affords participating firms access to resources provided by the association itself as well as fellow association members.

    Because accounting firm associations can pre-screen affiliate members and provide access to resources that would otherwise be more difficult or costly for small audit firms to obtain, audit quality for the clients of these affiliate members is likely to be higher than the clients of unaffiliated small audit firms.  Addressing this issue is important because over half of all publicly traded companies are audited by small audit firms and little accounting research to date examines differences in audit quality across the clients of small audit firms.  Below are three objectives the authors address in their study:

    • Examine whether audit quality is higher for clients of affiliated audit firms relative to the level of quality provided by nonmember firms.  The pre-screening process and access to additional resources is expected to result in higher quality for affiliated small audit firms relative to unaffiliated small audit firms.
    • Examine whether clients who choose to engage an affiliated small audit firm pay a fee premium.  If membership in an accounting firm association is associated with a perceived reputation for higher audit quality, then audit fees for affiliated small audit firms should be higher relative to unaffiliated small firms.
    • Examine whether the potential increase in audit quality associated with membership in an accounting firm association affects the extent to which audit quality differs between Big 4 firms and small, but affiliated audit firms. While prior research indicates audit quality is lower for small audit firms relative to Big 4 firms, affiliation in an accounting firm association may provide small firms with the additional resources necessary to close this gap.
    Design/Method/ Approach:

    The authors use hand-collected audit firm association membership data from 2010-2013, along with financial statement data for publicly traded firms, to examine whether audit quality and audit fees for publicly traded clients differs between small audit firms affiliated with an audit firm association and small firms with no such affiliation.  Audit quality was measured using PCAOB inspection findings, financial statement misstatement rates, and differences in levels of client discretionary accruals.

    Findings:
    • Affiliated small audit firms provide on average higher quality audits to their publicly traded clients relative to small, un-affiliated audit firms.  In particular affiliated small audit firms are less likely to receive accounting related deficiencies, or audit related deficiencies in their PCAOB inspection reports.  In addition, the clients of affiliated members report fewer annual financial statement misstatements, and less extreme discretionary accruals.  In addition, the findings indicate that when a small audit firm joins an accounting firm association, audit quality increases in subsequent years.  Lastly audit quality is increasing in the size of the audit firm association.  This indicates that the increase in audit quality is driven by an increased access to valuable resources provided by the affiliation.
    • Affiliated small audit firms receive an audit fee premium from their clients relative to unaffiliated small audit firms and this premium is increasing in the size of the audit firm association. 
    • The researchers observe no significant differences in audit quality between affiliated small audit firms and Big 4 firms.  This indicates that affiliated small audit firms provide high-quality audits to large publicly-traded companies.  In addition, while affiliated small audit firms experience a fee premium relative to unaffiliated firms, these fee premiums remain lower than those experienced by Big 4 firms.
    Category:
    Audit Team Composition, Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Impact of Office Size
  • Jennifer M Mueller-Phillips
    Non-Big 4 Local Market Leadership and its Effect on...
    research summary posted May 31, 2016 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:
    Non-Big 4 Local Market Leadership and its Effect on Competition
    Practical Implications:

    The results of this study are important to audit policymakers, academics, and practitioners. Though Non-Big 4 firms audit fewer publicly traded companies, the results indicate that they are still able to develop a reputation on their full book of business that enables them to become market leaders. In addition, policymakers’ efforts to increase Non-Big 4 market share may not work nationwide. The authors show that certain local characteristics impact the likelihood of Non-Big 4 local leadership, which suggests that targeted efforts may be more beneficial than nationwide efforts. Finally, the results imply that though the presence of a Non-Big 4 local market leader creates downward fee pressure on audit firms, Big 4 and Non-Big 4 firms are not substitutes as Big 4 firms still earn a fee premium in these markets. 

    Citation:

    Keune, M.B., B.W. Mayhew, and J.J. Schmidt. 2016. Non-Big 4 local market leadership and its effect on competition. The Accounting Review. 91(3): 907-931.

    Keywords:
    local audit market; Big 4 market competition; audit fee premium
    Purpose of the Study:

    Non-Big 4 public accounting firms in many major metropolitan areas are as large as or larger than the Big 4 firms present in the market. However, prior academic research has assumed that little competition exists between Big 4 and Non-Big 4 public accounting firms. As a result of this supposed lack of competition, policymakers in the U.S. and Europe have suggested that they step in to grow Non-Big 4 firms. Regulatory intervention may be unwarranted though given a Government Accountability Office study from 2008 that shows that though large publicly traded companies are limited in their choice of auditor, they still obtain competitive fees. This paper investigates whether and how these seemingly contradictory findings can be accurate. Specifically, the authors:

     

    • Examine the local factors associated with Non-Big 4 local market leadership from both the demand and supply sides.

     

    • Examine the relationship between Non-Big 4 local market leadership and competition.

     

    The authors also introduce a new measure of market leadership based on overall office size. 

    Design/Method/ Approach:

    The authors collected the accounting firm rankings from local business publications for the top 50 largest U.S. Metropolitan Statistical Areas. The accounting firm rankings are based on the number of employees, professional staff, or CPAs in the local office. Audit fees, local market characteristics, and other variables were obtained from the Audit Analytics database and Compustat. The information collected on these firms was for years 2005-2010. 

    Findings:
    • The authors find that Non-Big 4 market leadership is less likely in markets that have more Fortune 1000 clients and more initial public offerings.

     

    • The authors find that Non-Big 4 market leadership is more likely in markets without a large airport hub, with lower litigation costs, and with lower average educational attainment of the labor pool.

     

    • The authors find that, on average, audit fees are 18% lower in markets with Non-Big 4 firm leadership. Fees are lower the closer the Non-Big 4 leaders are in size to the Big 4 firms in the market.

     

    • The authors find that the Non-Big 4 leader firms are able to earn a fee premium, but that the Big 4 firms in those markets still earn a fee premium above and beyond the Non-Big 4 leader’s fee premium. 
    Category:
    Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise)
  • Jennifer M Mueller-Phillips
    The Value of Big N Target Auditors in Corporate Takeovers.
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications, 05.0 Audit Team Composition, 05.02 Industry Expertise – Firm and Individual in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Value of Big N Target Auditors in Corporate Takeovers.
    Practical Implications:

    The findings provide new evidence confirming the role of Big N auditors in corporate takeovers. In addition, the evidence suggests a positive association between deal completion and Big N target auditors. This information is critical to acquirer managers and investors, as ex ante acquirers can expect a lower deadweight loss associated with a failed M&A deal if the target firm employs a Big N auditor. Fund managers may find the discovery of the positive association between the target likelihood and engaging a Big N target auditor to be useful. Given recent evidence recommending a portfolio selection strategy based on the probability that a firm becoming a target in an M&A generates premium returns, auditor information might be utilized to screen a low cost M&A.

    Citation:

    Xie, Y., H. S. Yi, and Y. Zhang. 2013. The Value of Big N Target Auditors in Corporate Takeovers. Auditing: A Journal of Practice & Theory 32 (3): 141-169.

    Keywords:
    Big N auditors, M&A targets, mergers and acquisitions, auditor selection
    Purpose of the Study:

    While prior literature examines the value of Big N auditors in various corporate financing activities, there is only limited evidence documenting the value of Big N auditors in one of the biggest investment decisions a company ever makesmergers and acquisitions (M&As). This paper documents the value of Big N target auditors by examining whether acquirers screen target firms based on, and whether subsequent M&A deal completion depends upon, the target firm’s auditor reputation (i.e., proxied by Big N auditor).

    The authors argue that acquirers have at least two reasons to value Big N target auditors in corporate takeovers. First, an acquirer’s ex ante assessment of the viability of M&As critically hinges on the quality of the target’s firm-specific information. Acquirers are more likely to appreciate high-quality assurance provided by Big N auditors for target firms (the assurance value perspective). Second, it is not uncommon for acquirers to charge target auditors with misrepresenting the viability of the business being sold. Given this litigation risk, acquirers are likely to prefer target firms with Big N auditors due to their deep pockets. This insurance value of target auditors also likely motivates acquirers to value Big N auditors of potential target firms (the insurance value perspective).

    Design/Method/ Approach:

    The authors identify firms being targeted in M&As from the Securities Data Corporation’s (SDC) data ranging from 1987 to 2006. They retain observations for both takeover targets and non-takeover targets, and there are 96,902 firm-year observations with complete data on variables for the first test. Among them, 3,000 observations are takeover targets. Note that the sample only includes public bidder/target companies. The final sample used for the second test consists of 2,130 firm-year observations.

    Findings:
    • The likelihood of a company becoming an M&A target is higher when it engages Big N auditors.
    • Conditioning on being targeted, the likelihood of a target being eventually acquired is higher when it engages a Big N auditor.
    • To provide further evidence of the assurance and insurance values of Big N auditors in M&As, the authors examine whether the main findings are more pronounced for firms with higher information risk. The results of these cross-sectional tests reveal that the effects of Big N target auditors on the likelihood of companies becoming targets and on deal completion rates are more pronounced for firms with low accruals quality (the proxy for high information risk).
    • The results indicate that Big N target auditors facilitate M&A deals by lowering a target’s information risk and expected litigation costs.
    Category:
    Audit Team Composition, Auditor Selection and Auditor Changes
    Sub-category:
    Auditor Qualifications (e.g. size - industry expertise), Industry Expertise – Firm and Individual
  • 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
    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
  • 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
    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