tanyi - 2010 - audit report lags after voluntary and involuntary auditor changes

Electronic copy available at: http://ssrn.com/abstract=1806345 Electronic copy available at: http://ssrn.com/abstract=1806345 Audit Report Lags after Voluntary and Involuntary Auditor Changes Paul Tanyi, K. Raghunandan and Abhijit Barua Forthcoming in Accounting Horizons Contact Author: K. Raghunandan School of Accounting Florida International University Miami, FL 33199 Tel: 305-348-2582 Email: raghu@fiu.edu Paul Tanyi is a Ph.D. student, K. Raghunandan is a Professor, and Abhijit Barua is an Assistant Professor, all at Florida International University. We thank two anonymous reviewers, and the Associate Editor (Karla Johnstone), for their many useful and constructive comments on earlier versions of this paper. Electronic copy available at: http://ssrn.com/abstract=1806345 Electronic copy available at: http://ssrn.com/abstract=1806345 Audit Report Lags after Voluntary and Involuntary Auditor Changes Abstract We find that the audit report lag is significantly higher for former Andersen clients (that did not follow their Andersen partner to the new audit firm) than for clients voluntarily changing auditors from another Big 5 predecessor for the fiscal year ended December 31, 2002 (the first year with the new auditor for ex-Andersen clients). The differences in audit reporting lags between the two groups are not significant for fiscal years ended December 31, 2000 (the last year before Andersen’s Enron related problems surfaced) or 2003 (the second year with the successor auditor). We also find that clients with voluntary (i.e., non-Andersen) auditor changes have only marginally higher audit reporting lags compared to clients without auditor changes. Our results, focusing on a cost component of involuntary auditor changes, thus provide relevant empirical evidence for debates surrounding mandatory auditor rotation. We also find that ex- Andersen clients that followed the Andersen partner to the new audit firm had shorter audit report lags than ex-Andersen clients that did not follow their Andersen partner. Our findings highlight the importance of individual relationships in the auditing process, and suggest new avenues for future research. Audit Report Lags after Voluntary and Involuntary Auditor Changes Section 207 of the Sarbanes-Oxley Act (SOX) (U.S. House of Representatives 2002) requires the Comptroller General of the United States to “conduct a study and review of the potential effects of requiring the mandatory rotation of registered public accounting firms.” This requirement was spurred by concerns that the “independence of a public accounting firm … is adversely affected by a firm’s long-term relationship with the client and the desire to retain the client” (GAO 2003). Some recent studies have sought to derive implications about the effect of mandatory rotation by investigating the association between auditor tenure and various measures of audit quality. These studies examine measures such as earnings management by clients (Johnson et al. 2002; Myers et al. 2003), forecast errors (Ghosh and Moon 2005), and the likelihood of issuing going-concern modified audit opinions (Geiger and Raghunandan 2002; Choi and Doogar 2005). Generally, these studies have concluded that contrary to the concerns expressed by legislators and regulators auditor tenure has a positive association with audit quality and that the empirical evidence does not support calls for mandatory rotation. The auditor tenure studies note that their results may be relevant to the debate about mandatory auditor rotation. The studies cited above have examined instances where auditor tenure has been impacted by voluntary decisions of the client (to dismiss the auditor) or the auditor (to resign from a client). The controversy about auditor tenures, fueled by legislators’ and regulators’ comments and actions, relates to mandatory auditor turnover. While relevant, the findings of auditor tenure studies noted above do not directly provide evidence about the consequences of involuntary auditor changes because of the endogenous nature of the decision in voluntary auditor changes (Nagy 2005; Krishnan et al. 2007). The auditor changes that occurred following the collapse of Arthur Andersen in 2002 provide a unique situation of involuntary auditor changes. The indictment of the firm in March 2002 created considerable uncertainty about the ability of Andersen to survive which led to forced auditor changes for the vast majority of Andersen’s clients. The forced auditor changes that occurred after the demise of Arthur Andersen reflect some elements of the mandatory auditor changes advocated by legislators and regulators. This unique setting enables researchers to provide empirical evidence about auditor decisions and audit quality in the context of involuntary auditor changes. Some prior studies have examined if successor auditors treated former Andersen clients differently than other clients by focusing on accruals quality and audit opinions (Nagy 2005; Cahan and Zhang 2006; Krishnan et al. 2007). These studies compare former Andersen clients with other continuing clients of other Big 4 firms. The latter group typically includes only a small proportion of clients that had a voluntary auditor change in the same period as the forced change from Andersen. In this paper we compare the effects of mandatory versus voluntary auditor changes by examining audit report lags—that is, the time lag between the fiscal year end and the date of the audit report. We focus on audit report lag (admittedly an imperfect proxy) because it is the only publicly observable quantitative proxy for the extent of auditors’ work. 1 Audit report lag, and the associated financial reporting lag, has recently been an issue of significant concern to regulators and the auditing profession (SEC 2002b, 2002c). 1 Audit fees also are publicly observable after February 5, 2001, but audit fees represent a product of both quantity (audit work) and price (dollars per unit of work). We recognize that clients changing auditors—voluntarily or involuntarily—are quite different from other (continuing) clients. Hence, we compare the audit report lags for former Andersen clients and other clients voluntarily changing auditors during 2002. We argue that mandatory auditor changes would lead to higher reporting lags than voluntary auditor changes; hence, the audit reporting lag would be greater for ex-Andersen clients than other clients that voluntarily changed auditors, in the initial year with the successor auditor. Our tests thus examine a cost component of mandatory auditor changes. Some recent studies have sought to differentiate between former Andersen clients by classifying such firms into “followers” (i.e., those that followed their former Andersen partner to a new audit firm) and “non-followers.” Blouin et al. (2007) find that discretionary accruals are greater (that is, higher levels of earnings management are present) for companies that followed their former Andersen partner; further, non-followers were likely to have greater agency and switching related costs. Kohlbeck et al. (2008) and Vermeer et al. (2008) find that audit fees are lower for “follower” former Andersen clients than for non-follower former Andersen clients in the first year with the new auditor. In the non-profit sector, Vermeer (2008) finds that switching costs, the financial condition of a non-profit, and the size of the market are associated with the likelihood of a non-profit audit client being a “follower.” Following prior research, we argue that “follower” former clients of Andersen would be treated differently than the “non-follower” former Andersen clients. Further, we argue that “follower” switches by ex-Andersen clients represent auditor changes in form, but perhaps not in substance. This suggests that for a proper examination of the differences arising from voluntary versus involuntary auditor changes the comparisons should be between “non-follower” ex- Andersen clients and non-Andersen clients that switched auditors during the same period. In addition, we also examine the “partner change effect” by comparing the two types of ex- Andersen clients: we argue that the audit reporting lag will be smaller for “follower” ex- Andersen clients than for “non-follower” ex-Andersen clients. The latter tests, examining differences between ex-Andersen clients that did or did not follow their Andersen partner to the new audit firm, are also relevant in the context of the mandatory audit partner change rules of SOX. Section 203 of SOX states that: “It shall be unlawful for a registered public accounting firm to provide audit services to an issuer if the lead (or coordinating) audit partner (having primary responsibility for the audit), or the audit partner responsible for reviewing the audit, has performed audit services for that issuer in each of the 5 previous fiscal years of that issuer.” Thus, we also provide empirical evidence about the costs associated with the mandatory audit partner rotation rules of SOX. We test our hypotheses by comparing the audit report lags for the following three groups: ex-Andersen clients that followed their partner to the new audit firm (“followers”), ex-Andersen clients that did not follow their Andersen partner to the new audit firm (“non-followers”) and clients that switched auditors during 2002 from a Big 5 predecessor other than Andersen (“non- Andersen switchers”). Given the rapid demise of Andersen, we limit our analysis to firms with fiscal year ends of December 31, 2002. We find that non-follower ex-Andersen clients had longer audit report lags (62.57 days vs. 56.08 days) than clients of other Big 5 auditors who switched to a new auditor in 2002. This provides empirical evidence related to the differences between mandatory and voluntary auditor changes. Further, we find also that audit report lags are, on average, 4.56 days (7.8 percent) lower for “follower” clients than for “non-follower” clients. This finding quantifies some of the benefits associated with partner familiarity, or the costs associated with mandatory audit partner changes. Finally, we compare clients without an auditor change against the three types of clients with an auditor change discussed above. We find that clients with voluntary auditor changes have only marginally higher audit reporting lags (p = .10) compared to clients without auditor changes; in contrast, both types of clients with mandatory auditor changes (ex-Andersen “followers” and ex-Andersen “non-followers”) have significantly higher (p < .01) audit report lag than clients without auditor changes. Overall, our results provide evidence that voluntary auditor changes lead to modest increases in audit report lags, and that mandatory auditor changes significantly increase the audit report lag when compared with voluntary auditor changes. We recognize that the post-Andersen auditor changes are different from those under a mandatory auditor rotation regime. First, under mandatory rotation, everyone knows ahead of time when a change is scheduled. Second, incoming auditors following mandated changes also would know that their tenure is limited to a maximum period specified by the rotation regime rules. Yet, the failure of Andersen represents a unique situation that captures some elements of a mandatory auditor rotation regime in that the clients were involuntarily required to go with a new auditor at a specified time. Our paper adds to the auditing literature along several different streams. First, given the interest of legislators and the public in mandatory auditor rotation, we provide empirical evidence about differences in audit report lags arising from voluntary and involuntary auditor changes. Second, audit report lags have been of recent interest to the SEC, auditors, and public companies; we provide empirical evidence about audit report lags following three different types of auditor changes: voluntary auditor changes (by clients of other Big 5 firms), involuntary auditor changes in form, but perhaps not in substance (“follower” ex-Andersen clients), and involuntary auditor changes in form and substance (“non-follower” ex-Andersen clients). Third, our paper adds to research about the personal nature of auditing relationships—namely, clients’ associations with specific audit partners and the production efficiencies arising from such relationships. The next section discusses the background and develops the hypotheses. This is followed by a discussion of data and method. The results follow, and the paper ends with a summary and discussion. BACKGROUND AND HYPOTHESES Mandatory Rotation of Auditors More than a quarter century before SOX, the Metcalf Committee report had expressed similar concerns about the effects of long tenure on auditor judgments. The Staff Report of the Committee on Government Affairs (U.S. Senate 1976) noted: “Long association between a corporation and an accounting firm may lead to such close identification of the accounting firm with the interests of its client’s management that truly independent action by the accounting firm becomes difficult. One alternative is mandatory change of accountants after a given period of years…” (p. 21). Even earlier, nearly 50 years ago, Mautz and Sharaf (1961) suggested that long associations with the same client can lead to problems with independence. Though Mautz and Sharaf (1961, 208) did not call for mandatory auditor rotation, they noted that “the greatest threat to his [the auditor’s] independence is a slow, gradual, almost casual erosion of his ‘honest disinterestedness’.” Periodically, the SEC continued to express its concerns about the possible adverse effects from long auditor tenures (SEC 1994; Turner and Godwin 1999). However, the SEC did not take any regulatory action related to mandatory auditor rotation. Proponents of auditor rotation suggest that long-term relationships between the auditor and the client could undermine perceptions of auditor independence (U.S. Senate 2002). Since the incentives associated with keeping a particular client are smaller, and since there would be another audit firm reviewing the work within a specified period of time, auditors “might be less likely to succumb to management pressure” (GAO 2003). The opposition to mandatory auditor rotation is based on the fact that effective audits require a thorough understanding of the client’s business and processes; such understanding develops over time and there is a steep learning curve that lasts a year or more. Hence, audit quality is likely to be lower in the initial years of an audit (GAO 2003). Along these lines, Loebbecke et al. (1989) find that irregularities are more likely in the initial years of an audit engagement. A related point is that the disruption to the client caused by rotation leads to non-trivial commitment of resources (personnel and financial) in educating the auditor about the client’s operational and accounting matters. In addition, Geiger and Raghunandan (2002) note an incentive-related argument: incumbent auditors earn quasi-rents due to the start-up costs associated with audits and low-balling (the pricing of initial-year audits below economic cost) arises as a natural phenomenon. Hence, auditors would be interested in recouping their initial- year losses in the future; consequently, the threats to auditor independence may in fact be higher in the initial years of an audit engagement. Legislators considered imposing mandatory auditor changes during the hearings that preceded SOX; many former SEC chairs supported such a rule (U.S. Senate 2002). Nevertheless, in the face of opposition from auditors and others, the final rules adopted a compromise. With respect to audit firm rotation, Section 207 of SOX required the GAO to “conduct a study and review of the potential effects of requiring the mandatory rotation of registered public accounting firms” and report back to Congress within one year of enactment of the law. However, Section 203 of SOX (cited earlier) required mandatory rotation of the audit partner every five years. Related Research Some recent studies have examined the association between auditor tenure and various measures of audit quality. Johnson et al. (2002) and Myers et al. (2003) use clients’ abnormal accruals as a measure of audit quality and document a positive association between tenure and audit quality. Davis et al. (2009) find that firms with both short and long tenure are more likely to use discretionary accruals to meet or beat earnings forecasts, suggesting that audit quality is lower in firms with short or long tenures. Ghosh and Moon (2005) show a positive association between auditor tenure and investors’ perceptions of earnings quality (as measured by the earnings response coefficient). Geiger and Raghunandan (2002) find, for a sample of bankrupt firms, that going-concern modified audit opinions are positively associated with auditor tenure. However, Choi and Doogar (2005) use a general sample of stressed firms and find that there is no association between auditor tenure and the likelihood of a going-concern opinion. The auditor tenure variable in all of the above studies is impacted by voluntary decisions made by the clients (to dismiss the auditor) or the auditor (to resign). Voluntary auditor changes are quite different from involuntary auditor changes, such as those arising from mandatory auditor turnover (Nagy 2005; Krishnan et al. 2007). It is this difference which makes the auditor changes that occurred in the aftermath of Andersen’s failure unique. The forced auditor change for ex-Andersen clients provides a unique opportunity to empirically examine issues related to involuntary auditor changes. [...]... some elements of mandatory auditor rotation, and thus enable researchers to provide empirical evidence about various issues (such as, auditor decisions, audit cost, and audit quality) arising from involuntary auditor changes Opponents of mandatory auditor rotation argue that involuntary auditor changes impose significant costs and that there is a steep learning curve associated with new audit engagements,... the no-change and non-Andersen change clients, but is highly significant (p < 01) in the regression comparing the no-change clients and either type of ex-Andersen (follower or non-follower) clients Overall, the results indicate that voluntary auditor changes have a marginal effect on audit report lags The effects are magnified when the changes are involuntary, and are highest when the mandatory auditor. .. comparing the audit reporting lags for ex-Andersen clients that did not follow their Andersen partner against audit reporting lags for other clients that changed auditors during the same period This leads to the first hypothesis (in the null form): H1: There would be no differences in audit reporting lag, in the first fiscal year with the new auditor, between “non-follower” ex-Andersen clients and non-Andersen... rotation Further Analysis: Comparing No-Change Clients with Change Clients We compare audit report lags for clients without an auditor change in 2002 against the three types of clients with auditor changes discussed above (non-Andersen changes, ex-Andersen “non-followers,” and ex-Andersen “followers”) The no-change sample includes all other clients of the other Big 5 (non-Andersen) firms that meet the same... FY2000) p-value Coefficient p-value Coefficient p-value . that voluntary auditor changes lead to modest increases in audit report lags, and that mandatory auditor changes significantly increase the audit report lag when compared with voluntary auditor. legislators and the public in mandatory auditor rotation, we provide empirical evidence about differences in audit report lags arising from voluntary and involuntary auditor changes. Second, audit report. voluntary auditor changes (by clients of other Big 5 firms), involuntary auditor changes in form, but perhaps not in substance (“follower” ex-Andersen clients), and involuntary auditor changes