Predecessor Auditors Research Articles

Internal control opinion shopping: Does initial audit fee discounting matter?

Both regulators and researchers are concerned that the lowballing of initial year audit fees may impair auditor independence (U.S. Senate 1977, 2002; American Institute of Certified Public Accountants (AICPA), 1978; Securities and Exchange Commission [SEC], 2000; Huang et al. 2015). Using a full sample of 1373 U.S. firm-year observations for which the client’s predecessor auditor reports an adverse SOX Section 404 internal control opinion, we find that in the following year a successor auditor who lowballs audit fees is more likely to issue a clean internal control opinion. The results hold when the predecessor auditors are dismissed, but not when the predecessors resign. We also find that firms are no more likely to succeed in opinion shopping when the proportion of audit committee financial experts is high. In addition, we find internal control opinion shopping occurs with initial fee discounting only in competitive audit markets and the period of a few years following the adoption of SOX (since 2007).

Multimarket Contact and Mutual Forbearance in Audit Markets

ABSTRACTCompetition in audit markets is an important topic but direct tests of market competition have been limited. In this paper, we examine how audit firms behave when they are confronted with competition from another firm in a wide range of industry segments in a local market. Sharing a large number of market segments can lead to mutual forbearance among audit rivals. Such mutual forbearance is likely to manifest as higher audit fees in a market because rivals are hesitant to aggressively compete in the face of potential competitive retaliation. Using a sample of 25,662 observations from 2004 to 2015, we find evidence that supports this argument as proxied by the extent that audit firms compete in the same industries in the same locations. This result persists after controlling for several tight fixed‐effects specifications based on time, location, industry, and market segments. In supplementary tests, we also find that the likelihood of client switching is negatively associated with the multi‐industry contact of the incumbent, but clients that do switch are more likely to choose an alternative audit firm that confronts the predecessor auditor in fewer market segments. Our evidence is consistent with mutual forbearance among rival audit firms when confronted with the same competitor in different market segments.

Audit committee quality indices, reporting quality and firm value

AbstractWe investigate the relation between audit committee (AC) quality indices, financial reporting, internal control quality and firm value using a US dataset for the period 2002–12. The indices are developed by linking firm value with principal component analysis (PCA) factors based on a broad set of 82 AC variables, some of which influence the quality of the AC, but are not addressed in prior literature. Significant AC factors include ‘overlapping directors’, ‘busyness’ and ‘foreign director’, and we use these factors to develop ‘high’ and ‘low’ AC quality indices. We show that low AC quality firms are more likely to manage earnings, be external auditor dependent with respect to non‐audit tax services, and switch to a lower quality auditor. Low AC quality firms are also more likely to have internal control concerns disclosed by predecessor auditors, including accounting issues, financial restatements, audit opinion concerns and deficiencies that undermine internal control effectiveness. Further, they are more likely to receive an audit report containing additional explanatory notes. Conversely, high AC quality firms are significantly less likely to have these concerns. Our findings highlight the value of using AC quality indices in delivering greater oversight of the financial reporting process.

Auditor-Client Disagreements, Auditor Resignations, And Audit Fees Charged By Successor Auditors

This paper investigates the effects of auditor-client disagreement disclosure on auditor resignations and audit fee charged by successor auditors. Using a matched sample of auditor changes over the period 2003-2016, we find that auditor resignations are more often accompanied by auditor-client disagreements. We also find that Big 4 auditors are more likely to resign from their engagements when they disagree with their clients. Further, we document that successor auditors charge higher audit fees for firms that have disagreements with their predecessor auditors. Relative to non-Big 4 auditors, Big 4 successor auditors charge even higher audit fee for disagreement firms.

Do Managers Successfully Shop for Compliant Auditors? Evidence from Accounting Estimates

Existing research on opinion shopping focuses primarily on managers’ attempts to switch auditors in order to avoid the receipt of an unfavorable audit opinion. We extend this literature by examining whether managers successfully shop for auditors who will allow questionable accounting practices, as evidenced by opportunistic changes in accounting estimates following auditor switches. Using manually collected data from SEC filings, we find an increase in the frequency and magnitude of discretionary income-increasing changes in accounting estimates (DICE) following auditor switches. We further find that companies reporting DICE following an auditor switch are more likely to subsequently restate earnings downward, receive fewer goingconcern opinions, experience lower abnormal stock returns in the years following the switch, and tend to switch auditors during the fourth quarter or following a disagreement with the predecessor auditor. These findings provide ex-post evidence that managers successfully shop for more lenient auditors. We also find that managers’ switch decisions maximize the ex-ante likelihood of reporting income-increasing changes in estimates, and that companies are more likely to switch to auditors whose clients have a greater likelihood of reporting income-increasing changes in estimates. Taken together, we provide both ex-ante and ex-post evidence that auditor-switch companies shop for compliant auditors that will allow the use of opportunistic accounting that meets management’s reporting objectives.

When predecessor and successor accounting firms disclose inconsistent reasons for auditor changes

ABSTRACTSince 2011, China has required that both the predecessor and successor auditors of public companies disclose their reasons for auditor changes. However, we observe that for some companies there are significant discrepancies between the reasons reported by their predecessor auditors and those reported by their successor auditors. This phenomenon has attracted attention from regulators such as the Chinese Institute of Certified Public Accountants (CICPA). Therefore, we conduct an exploratory analysis of this phenomenon. First, the results show that investors consider 35% of the reasons disclosed by the predecessor and successor auditors to be inconsistent; second, if neither the predecessor nor the successor is a Big 4 audit firm, the reasons disclosed by the two firms are more likely to be inconsistent; third, as for the inconsistency between the reasons, investors respond negatively in that they are more prone to sell the stocks; and fourth and finally, the inconsistent reasons disclosed are likely to be followed by poorer financial reporting quality in the next year.

Audit Committee Indices, Firm Value, and Accounting Outcomes

We investigate the relation between audit committee (AC, hereafter) quality indices derived from a principal component analysis (PCA) and firm value using a sample of 12,301 firms over the period 2002 to 2012. We also examine the usefulness of the indices in predicting the quality of a firm’s internal controls, financial reporting, and audit quality. We report a significant positive (negative) relation between ‘high’ (‘low’) AC quality firms and future firm value, measured as industry-adjusted Tobin’s q, supporting the view that AC characteristics have a significant impact on firm value. We show that low AC quality firms are significantly more likely to have internal control concerns disclosed by predecessor auditors, including accounting standard issues, financial restatements, audit opinion concerns, and deficiencies that undermine internal control effectiveness. We also show that low AC quality firms are more likely to manage earnings, be external auditor dependent with respect to non-audit tax services, and switch to a lower quality auditor. Further, they are also more likely to receive an audit report containing additional explanatory notes, consistent with a higher likelihood of future financial misstatements. Conversely, high AC quality firms are less likely to have accounting issues, dismiss an auditor after disagreements, have adverse restatements, and receive an audit report containing additional explanatory notes. Taken together, our findings support the view that the AC plays an important role in monitoring the financial reporting process. The results are robust to several econometric concerns primarily related to endogeneity, and to controls that capture broader firm-level governance characteristics, suggesting that AC quality has incremental value in driving better financial reporting, and internal control outcomes and, more importantly, firm value.

The Timing of Auditor Hiring: Determinants and Consequences

SYNOPSISRegulators and legislators have long been interested in the auditor change process and in auditors' learning curves. We find that auditor changes closer to the year-end are associated with longer reporting lags and lower audit quality. We find that both audit fees and audit report lags are higher when there is a hiring lag between announcements of the predecessor auditor's dismissal and the hiring of the successor auditor. We also find that the appointment of new executives is associated with the timing of the auditor change, suggesting that client executives have a significant role in the auditor-hiring process.

Factors Associated With and Long Term Stock Price Performance of Firms Making Disclosures of Auditor-Client Frictions

Financial Reporting Release (FRR) No. 31 (SEC 1988) changed the disclosure requirements about auditor-client frictions (i.e., disagreements and reportable events) in auditor change announcements. The first goal of the study is to document factors associated with an auditor change sample disclosing auditor-client frictions compared with an auditor change sample not making such disclosures in auditor change announcements. We use 5,128 observations of auditor changes obtained from a sample period following enactment of FRR No. 31. In the fiscal periods in which the frictions are reported to have occurred, firms disclosing auditor-client frictions tend to have (1) higher levels of audit risk, (2) deteriorating financial condition, (3) higher levels of growth, (4) higher incidence of new going-concern audit opinion, (5) more auditor resignations, (6) greater incidence of Big 5/6 predecessor auditors, and (6) lower incidence of Big 5/6 successor auditors. We also find that auditor change firms with disclosures of auditor-client frictions tend to be (7) younger firms, (8) exhibit higher audit risk, and interestingly, occur in (9) larger firms with (10) increasing levels of institutional ownership. The second goal of the study is motivated by a growing body of empirical evidence from a variety of contexts that indicates market participants under-react to certain disclosures. Also, the SEC (1988) suggests that both types of auditor-client frictions may be potential early warning signs of trouble. We find that firms disclosing auditor-client frictions exhibit long-run drift in stock prices in the same direction as the initial price reaction. Stock prices indicate that investors under-react to disclosures about auditor-client frictions in auditor change announcements. The evidence of under-reaction to the auditor change sample disclosing auditor-client frictions is robust to alternative asset pricing models and tests suggested by the literature documenting appropriate research design choices for long-run stock price tests.

Shopping for Accounting Accruals and Restatements

We examine whether companies change their auditor to shop for accounting accruals and whether these shopped accruals are related to financial restatements. The results show that the negative discretionary accruals audited by successor auditors (1) are significantly higher than those audited by predecessor auditors and (2) increase the likelihood of income-decreasing restatements, suggesting understatements for these shopped negative discretionary accruals. These results are salient in companies switching from a Big 4 to a non-Big 4 auditor. Overall, companies shop for accounting accruals successfully, especially from a Big 4 to a non-Big 4 auditor, and consequently restate downward their reported earnings.

Auditor Resignation and Risk Factors

SYNOPSIS Although auditor litigation risk is considered as a leading explanation for auditor resignations, audit risk and business risk might also trigger resignations. Auditor litigation risk is defined as the risk of the auditor being involved in a lawsuit, audit risk is defined as the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated and, finally, business risk is defined as the risk associated with the client's survival and profitability. Because the three risk factors are not mutually exclusive, we examine their relevance and incremental importance using measures from the pre- and post-resignation periods. Using summary indices from the pre-resignation period, we find that all of the three ex ante risk indices are incrementally important for resignations, especially when the predecessor auditor is a Big 4 firm. Because the ex ante risk factors are prone to measurement errors and are less likely to capture the auditor's proprietary information about the client, we analyze data from the post-resignation period when the auditor's proprietary information is likely to become publicly known. We find that within a three-year period following an auditor's resignation, clients are more likely to (1) be involved in class-action lawsuits (ex post litigation risk), (2) have internal control problems (ex post audit risk), and (3) to be delisted from a national stock exchange (ex post business risk). Our research demonstrates that auditors consider all three risk factors, and not just litigation risk, in resignation decisions.

Fiscal year-end and non-lateral auditor switches

Purpose – The purpose of this paper is to examine the potential effect of busy season resource constraints on the selection of a new auditor, conditioned upon the status of the prior auditor. Design/methodology/approach – The paper employs multivariate logistic regressions for a sample of firms that changed auditors between 1979 and 2005 to explore the empirical correlations between having a December fiscal year-end (FYE) and non-lateral switches. Findings – The paper finds that non-BigN clients with December FYEs are less likely to switch to BigN auditors than those with non-December FYEs prior to the enactment of the Sarbanes-Oxley Act (SOX). This trend subsides after SOX. For firms with BigN predecessor auditors, fiscal year-end appears to have insignificant influence on auditor switching. Research limitations/implications – The findings suggest that upwardly mobile clients face greater audit supply constraints compared to clients already being audited by a BigN firm during the traditional busy season. However, the curbing influence on switching upwards erodes after SOX. Practical implications – This study is to show the impact of supplier capacity constraints on audit production and structural changes within the auditing profession. Originality/value – The findings can further the understanding of the determinants of auditor-client realignment, given that the paper identifies and explores the effects of having a December FYE on subsequent auditor appointments, conditioned upon the status of the prior auditor.

Pricing of Risky Initial Audit Engagements

SUMMARYWe reexamine the association between audit fees and risky initial engagements by developing an ex ante client-risk metric that is based on auditor change 8-K filings. We concentrate on auditor-client disagreements and other reportable events (restatement, management integrity, scope limitations, illegal acts, reaudits) disclosed in the 8-K auditor change filings. We find that audit fees are significantly higher for clients reporting disagreements and other reportable events in their 8-K auditor change filings for the initial year of engagement. However, the fee premium is only attributable to Big 4 auditors. While the Big 4 charge 45 percent higher fees when clients have disagreements or other reportable events, there is no such fee premium associated with non-Big 4 clients. More importantly, Big 4 predecessor auditors increase fees prior to the auditor switch as clients develop problems. Big 4 successor auditors continue to charge significantly higher fees for at least three years following adverse 8-K disclosures. Our results provide evidence on how successor and predecessor auditors incorporate risk in the pricing of audit fees, where risk is based on the information contained in auditor change 8-K reports.

An Ex Post Examination of Auditor Resignations

SYNOPSIS The auditor change literature has generally concluded that clients from whom an audit firm resigns are risky clients, yet little is known about the period after a predecessor auditor has resigned from an engagement. We investigate a sample of resignations to determine why an audit firm chooses to accept the role of successor auditor on a presumably risky engagement and whether this decision is associated with a future adverse outcome. Consistent with prior studies, our results indicate that, relative to Non-Big N firms, Big N firms are more selective in accepting the successor auditor role when the predecessor auditor has resigned. Incremental to these prior studies, we find that Big N firms factor in two variables to help mitigate their potential risk—the timing of the predecessor audit firm's resignation and their own firm's expertise. Our analysis of future outcomes indicates that the resigned clients engaged by Non-Big N successor auditors are associated with weaker long-term financial ratios, shorter survival tenures, and a greater proportion of adverse outcomes compared with the resigned clients engaged by Big N successor auditors. Data Availability: Data are available from the sources indicated in the text.

An Ex Post Examination of Auditor Resignations

The auditor change literature has generally concluded that clients from which an audit firm resigns are risky clients, yet little is known about the period after a predecessor auditor has resigned from an engagement. We investigate a sample of resignations to determine why an audit firm chooses to accept the role of successor auditor on a presumably risky engagement and whether this decision is associated with a future adverse outcome. Consistent with prior studies, our results indicate that, relative to Non-Big N firms, Big N firms are more selective in accepting the successor auditor role when the predecessor auditor has resigned. Incremental to these prior studies, we find that Big N firms factor in two variables to help mitigate their potential risk – the timing of the predecessor audit firm’s resignation and their own firm’s expertise. Our analysis of future outcomes indicates that the resigned clients engaged by Non-Big N successor auditors are associated with weaker long-term financial ratios, shorter survival tenures, and a greater proportion of adverse outcomes compared with the resigned clients engaged by Big N successor auditors.

Risk Shifts in the Market for Audits: An Examination of Changes in Risk for “Second Tier” Audit Firms

SUMMARY: The market for audit services has been affected in recent years by significant changes like the demise of Andersen and the implementation of the Sarbanes-Oxley Act of 2002. One impact of these market changes has been an increase in the frequency of auditor switches, and in particular, the frequency of clients switching from Big 4 auditors to smaller audit firms. We examine whether this switching activity has resulted in changes in the risk characteristics of publicly traded clients of Second Tier audit firms. This analysis is important as regulators are concerned about audit market concentration and would like to see the Second Tier audit firms expand their share of the publicly traded client market. Results indicate that Second Tier firms are accepting clients with potentially increased audit and client business risk characteristics relative to their existing client base, but they also appear to be “shedding” clients that have increased audit and client business risk characteristics relative to their existing client base. Some of the differences in risk characteristics for those departing clients are more pronounced in the period after 2000, when we expect the most significant changes in the audit market occurred. Second Tier auditors are increasingly exposed to more business risk as they accept larger clients coming from Big 4 predecessor auditors, which may increase their exposure to litigation.

Auditor switching, earnings manipulation and auditor independence: Evidence from A-share listed companies in China

Based on data from Chinese A-share listed companies between 1999 and 2004, this paper examines the causes of auditor switching and its effects on the independence of successive auditors from the perspective of earnings manipulation. Results show that: (1) listed companies manipulate their earnings through replacing their auditor and the successive auditor fails to exercise necessary prudence; (2) for companies reporting profit in the year of auditor change, the formerly low discretionary accruals usually increase significantly after the switch mostly resulting from assets devaluation and adjustments to non-recurring items; (3) In contrast, for companies reporting losses in the year of auditor change, they take a “big bath” to adjust lower earnings of the same year. These findings indicate that auditor change is related to the conservatism of predecessor auditors and it damages the independence of successive auditors.

Auditor changes and audit satisfaction: Client perceptions in the Sarbanes-Oxley era of legislative restrictions and involuntary auditor change

This study investigates responding executives’ reported levels of satisfaction with their current, and where applicable, predecessor independent auditor. This research is conducted during the period following the demise of Arthur Andersen and the implementation of sweeping changes set forth by Sarbanes-Oxley. We survey Audit Committee chairpersons, CEOs, and CFOs of the S&P 500. We find significant differences in perceived levels of satisfaction with their current independent auditor between executives who have experienced a recent change in independent auditors and those not experiencing a recent change, though we find no significant difference in the perceived value for fees provided by the independent auditor between the two groups. For respondents experiencing a recent auditor change, our findings suggest a lower perception of value for fees with the successor auditor than with the predecessor, though we find no differences in perceived level of professional services satisfaction between the successor and predecessor auditor.

Does Opinion Shopping Impair Auditor Independence and Audit Quality?

This study investigates how companies' threats to dismiss auditors and their engagement in opinion shopping influence auditor independence and audit quality, which in turn affect misstatements in financial statements. It also examines how outsiders' reactions to auditor switching influence opinion shopping. The results indicate that neither the predecessor auditor's nor the successor auditor's independence is compromised by dismissal threats and opinion shopping. Further, the successor auditor's audit quality exceeds the predecessor auditor's audit quality. In addition, auditor switching decreases potential understatements and increases potential overstatements in financial statements, and the capital market's and the successor auditor's reactions to auditor switching reduce the benefits of opinion shopping to companies. Additionally, the study sheds some light on the potential effects of both the Sarbanes-Oxley's restriction on non-audit services and mandatory auditor rotation or retention. The paper also derives a rich set of empirical implications.

Pricing on Andersen's FIS and internal audit services by successor auditors

PurposeTo examine whether or not new auditors of former Andersen clients perceive prohibited non‐audit services from Andersen as a business risk indicator and, therefore, adjust for the effects of this important risk factor in their audit pricing.Design/methodology/approachUtilizing a significant number of involuntary auditor switches in the US as a result of the collapse of Andersen in late 2002, this study uses regression analyses to examine the hypothesized associations between two types of non‐audit services and successor auditors' audit pricing.FindingsThis study finds that the provision of financial information systems (FIS) design and implementation services and internal audit outsourcing services are positively associated with audit fees charged by successor auditors. This study supports the recent prohibition on the provision of FIS and internal audit services mandated by the Sarbanes‐Oxley Act of 2002.Originality/valueThis study adds to the recent body of work on the association between the provision of certain non‐audit services and the predecessor auditor independence or audit quality perceived by the successor auditor and provides valuable information for policy makers.