Shannon Detling and Dr. F. Greg Burton, School of Accountancy
In the early 21st century, public confidence in corporate America faltered considerably following the demise of Enron, Inc., Arthur Andersen, LLP and other businesses. The United States government responded to the outbreak of corporate scandals with several legislative actions. The main thrust of legislative effort was the creation of the Sarbanes-Oxley Act of 2002 (SOX).
Since the passage of the Sarbanes-Oxley Act, there has been considerable debate about whether it has been effective in improving the quality of financial reporting and auditing. These new standards and others have drastically affected the amount of time, effort, and cost spent in the auditing process for a public company. Issuers have also been required to spend significant resources to comply with the legislation. Many feel that the SOX requirement to extensively document, test, and report on internal controls (section 404 of SOX) results in unnecessary and unreasonable costs. Also, the number of companies switching audit firms has increased dramatically.
This study examines factors associated with auditor switching after the passage of the Sarbanes-Oxley Act of 2002 including fees, financial risk, internal control problems, auditor tenure, and audit reports of client companies. While prior research has explored variables associated with auditor switching, little empirical research has been performed on auditor changes in the post-SOX era. This is significant due to the dramatic changes that have occurred since passage of the Act. In addition, the majority of prior research has not included information regarding internal controls of issuers or public audit fee disclosures because this information was not publicly available until recently.
This research is especially important in the post-SOX era because the number of auditor changes in 2003 and 2004 reached unprecedented levels. In addition, the stakes are much higher for audit failures due to increased oversight and public sensitivity.
The recent dramatic increase in audit fees combined with increased concern about litigation risk and the tremendous increase in the amount of work required by SOX 404 has substantially increased both the dismissal and resignation rates of audit firms. Many of the companies that switched auditors changed to a smaller size firm. Numerous prior studies have shown that there is a positive correlation between audit firm size and audit quality. Consequently, auditor switching from large to small firms may have implications on the quality of audits being performed and smaller audit firms may be taking on greater risk. Either of these possibilities could have negative effects on the already fragile public trust of American financial markets.
For this study I use variables similar to those which have been found to be significant determinants of auditor change in prior research. I also develop other variables to test for additional determinants of auditor change which have not been tested previously. I test the relationship of the various factors mentioned previously to auditor change and the size of the successor firm using a LOGIT regression model. Using the same LOGIT regression model I test using several different dependant variables.
Data for the study were obtained from both the WRDS Compustat database and AuditAnalytics.com in December 2005. Company records in each database were matched by ticker symbol, IRS employer identification number (EIN), and company name. The sample consisted of all companies in the WRDS Compustat database which had filed financial statements for the fiscal year ended 2003. Data included client companies listed in these databases and selected financial, fee, audit opinion, audit firm, and auditor change data. I test for auditor switching between the years 2003 and 2004 for purposes of recency and data availability since very few internal control disclosures (404 reports) were available prior to the year 2004.
I find several variables are significant when comparing companies that change to a smaller audit firm with companies that don’t change or that change but stay within the same size category. Companies that switched to smaller firms during their 2004 fiscal year typically are smaller and in poorer financial condition than non-switching companies. Moreover, switchers are more likely to have had a prior auditor resignation, a going concern opinion, a material weakness in internal controls, longer predecessor auditor tenure, and pay relatively lower audit fees after the switch.
The findings of this study may have serious implications for non-Big Four audit firms and for the impact of governmental regulation of the accounting profession. I find that numerous risk factors are more prevalent in those companies that switch to smaller audit firms relative to companies that don’t switch audit firms or that switch to audit firms in the same size category.
These risk factors suggest that the successor auditor should provide a higher level of assurance because the client is more risky. This greater level of assurance necessitates either a higher level of evidence gathering or a more qualified auditor. Neither one of these necessities appears to exist, however, for the companies in the study. The fees the successor auditors are charging are typically lower than the predecessor auditor and the successor auditor is not necessarily more qualified than the predecessor. The combination of switches to a smaller audit firm, lower audit fees, and the presence of the risk factors described above suggest that non-Big Four audit firms are now taking on more risk in their client portfolios. These results suggest an unintended consequence of the Act as audit quality for companies that change to smaller auditors may be decreasing.
This was a challenging project that tested my resolve as I had to completely redesign the project from my original plan after doing a substantial amount of work. I had initially planned to gather data using a survey of auditors’ perceptions of how SOX impacted audit quality. Due to a very low response rate, however, I had to change my research to analyze archival data. After overcoming this initial hurdle, however, I found that completing this project was invaluable to me. It has helped me to further develop my research, analytical, and writing skills. The complete results of this study are available in my honor’s thesis which can be found in the Harold B. Lee Library.