Auditor Realignments Accompanying Implementation of SOX 404 ICFR Reporting Requirements

Abstract

We examine the impact of adverse auditors’ opinions on clients’ internal control over financial reporting (ICFR), issued under SOX Section 404, on auditor dismissals. Companies receiving adverse ICFR opinions are more likely to subsequently dismiss their auditors. This association between adverse reports and dismissals persists over a four year period beginning with the initial year of SOX 404 reporting. Our evidence also suggests that these dismissals tend to be part of clients’ efforts to improve their overall financial reporting. Clients receiving adverse reports are more likely to switch to higher quality auditors, as proxied by Big 4 membership and two measures of industry specialization, than are clients receiving favorable reports. Further, adverse opinion clients that dismiss auditors and then hire new auditors that specialize in the client’s industry are more likely to receive an improved ICFR report in the next year.