Sign up

Adverse internal control over financial reporting opinions and auditor dismissals/resignations.
Abstract:
This paper studies the factors that affect a firm's choice to dismiss or remain with their incumbent auditors when faced with adverse auditor opinions on the design and effectiveness of their internal controls. The study focuses on a unique sample of firms that received an adverse opinion in one year, followed by an unqualified opinion in the following year, thereby isolating a critical time in the client/auditor relationship. We find that the severity of the internal control problems, the auditor-related fees, the length of auditor-client relationships and the presence of a Big Four auditor affect the probability that a firm switches auditors. Further analysis examines the factors that affect auditor dismissals versus resignations, and switches from Big Four auditors to smaller audit firms or to other Big Four auditors. The existence of non-switching behavior among firms facing adverse internal controls over financial reporting opinions is supported by embeddedness theory, whereby client/auditor relationships demonstrate positive duration dependence and develop relationship-specific assets.

Subject:
Financial disclosure (Laws, regulations and rules)
Internal control (Accounting) (Laws, regulations and rules)
Financial management (Laws, regulations and rules)
Authors:
Thevenot, Maya
Hall, Linda
Pub Date:
10/01/2011
Publication:
Name: Academy of Accounting and Financial Studies Journal Publisher: The DreamCatchers Group, LLC Audience: Academic Format: Magazine/Journal Subject: Business Copyright: COPYRIGHT 2011 The DreamCatchers Group, LLC ISSN: 1096-3685
Issue:
Date: Oct, 2011 Source Volume: 15 Source Issue: 4
Topic:
Event Code: 900 Government expenditures; 930 Government regulation; 940 Government regulation (cont); 980 Legal issues & crime Advertising Code: 94 Legal/Government Regulation Computer Subject: Government regulation
Product:
Product Code: 9108628 Financial Regulation & Reporting; 9915410 Reporting & Disclosure; 9915100 Financial Management; 9915500 Financial Systems & Controls NAICS Code: 92615 Regulation, Licensing, and Inspection of Miscellaneous Commercial Sectors
Organization:
Government Agency: United States. Securities and Exchange Commission
Geographic:
Geographic Scope: United States Geographic Code: 1USA United States
Legal:
Statute: Sarbanes-Oxley Act of 2002
Accession Number:
274409723
Full Text:
INTRODUCTION

The Sarbanes-Oxley Act (SOX) enacted into law in 2002 is considered one of the most significant pieces of legislation since the Securities Acts of 1933 and 1934. An important change to the existing regime came with Sections 302 and 404 which require management to provide an assessment of the design and effectiveness of firms' internal controls, as well as auditors to provide an opinion on management's assessment of controls. In addition, Auditing Standard No. 2 now requires that auditors provide a separate opinion on firms' internal controls based on an independent evaluation. As a result of these mandates and the corresponding increase in scrutiny of internal controls, a number of companies received adverse opinions on their internal controls, which likely impacted to some extent the relationship with their auditors. Despite internal control problems, a client and an auditor may decide to continue their engagement and work through the problems together. Alternatively, a client may change audit firms because of irreparable damage to the relationship due to the conflict, or in order to seek another firm that may help the client earn an unqualified opinion. This study contributes to the growing literature on internal controls and the impact of SOX by investigating the factors that affect the decision to switch auditors, either by dismissal or resignation, following the issuance of an adverse opinion on internal controls over financial reporting (ICOFR) by auditors.

Prior research shows that auditor switches are related to the issuance of qualified audit opinions and going-concern reports (Chow & Rice, 1982; Mutchler, 1984). In addition, auditor turnover is more likely given internal control deficiencies disclosure pursuant to Section 302 and 404 of SOX (Ashbaugh-Skaife, Collins & Kinney Jr., 2007; Ettredge, Heintz, Li & Scholz, 2007). We extend this line of research by focusing on a sample of firms that received an adverse opinion on internal controls, and examine the specific factors that affect auditor turnover, including the severity and nature of the internal control deficiencies, the amount of auditor-related fees, the length of the auditor-client relationship, and the type of audit firm that expressed the negative opinion.

Deficiencies in internal controls have been associated with poor accrual quality (Ashbaugh-Skaife, Collins, Kinney Jr. & LaFond, 2008), poor board and audit committee quality (Krishnan, 2005; Zhang, Zhou & Zhou, 2007; Hoitash, Hoitash & Bedard, 2009), firm risk (Ashbaugh-Skaife, Collins, Kinney Jr. & LaFond, 2009), and the cost of equity capital (Ogneva, Subramanyam & Raghunandan, 2007; Ashbaugh-Skaife, Collins, Kinney Jr. & LaFond, 2009). In addition, firms with more severe internal control weaknesses tend to be smaller, financially weaker, have more complex operations and fewer resources (Ge & McVay, 2005; Ashbaugh-Skaife, Collins, & Kinney Jr., 2007; Doyle, Ge & McVay, 2007). These firms also experience a higher drop in share price when control problems are disclosed (Hammersley, Myers & Shakespeare, 2008). These prior studies suggest that firms with disclosed deficiencies in internal controls are significantly disadvantaged relative to other firms in their access to audit services because they pose risks that auditors may be unwilling to take. Consistently, Raghunandan and Rama (2006) and Hogan and Wilkins (2008) find that firms with internal control deficiencies pay higher audit fees. Such firms have a strong incentive to change auditors, and auditor switches have been shown to be associated with a decrease, or less of an increase in audit fees (Simon & Francis, 1988; Ettredge & Greenberg, 1990). However, a majority of firms with internal control deficiencies remain with their incumbent auditors (Hall & Bennett, 2010), posing the question: what are the factors that prompt firms with internal control weaknesses to switch auditors? In this paper, we further examine what motivates a firm to dismiss their auditor or the auditor to resign from an engagement. We also explore the factors that affect firms' decisions to switch from one Big Four auditor to another, versus switching from a Big Four to a non-Big Four auditor.

We find that the number of material weaknesses in internal controls disclosed in an ICOFR examination, which are the most severe internal control deficiencies, increases the likelihood of an auditor switch. When the effect of the type of control weakness is examined, we find that only entity-level weaknesses, perceived to be more severe than account-specific deficiencies, affect auditor switching. Our results show that the amount of auditor-related fees, the length of the client-auditor relationship and the presence of a Big Four auditor also affect the probability of an auditor change. When auditor dismissals and resignations are examined separately, some interesting results emerge. First, only resignations are affected by the severity of the internal control weaknesses, implying that auditors shift away from potentially risky firms, while clients do not seem to dismiss auditors solely in light of severe problems. Second, high audit fees are an important factor in dismissals, which is not surprising considering the weak incentive for auditors to resign when a client is paying high fees. Interestingly, we find that the number of disclosed material weaknesses affects the likelihood of a switch from a Big Four to a non-Big Four auditor, but not the change from one Big Four to another Big Four auditor. This suggests that firms with more severe problems turn to smaller auditors potentially looking for less conservative treatment. Moreover, we find that firms are likely to switch from a Big Four to a non-Big Four auditor when the auditor-related fees are high, perhaps to decrease their future audit cost.

The results of this study should be of interest to audit firm managers, audit committee and board members, investors, regulators and other stakeholders. Following SOX, a large number of firms switched auditors, and researchers and professionals alike have been trying to explain this trend (Turner, Williams & Weirich, 2005). The new internal controls requirements enacted in Sections 302 and 404 spurred a great deal of research and debate about the effects of the disclosure of significant control deficiencies. This study contributes to the literature on this topic because it is the first of its type to focus on a unique set of firms with internal control deficiencies and the factors that affect the decision of these firms to switch auditors.

The remainder of the paper proceeds as follows. Section II describes the contextual and institutional background and develops the hypotheses to be tested. Section III describes the sample characteristics. Section IV presents descriptive statistics and results of univariate statistical analysis. Section V presents the models utilized and provides results of multivariate analyses. Section VI and VII describe our findings with respect to dismissals versus resignations, and the effects of the presence of a Big Four audit firm on the analyses. The final section offers our conclusions based on this study and considerations for future research.

BACKGROUND AND HYPOTHESIS DEVELOPMENT

Internal control over financial reporting is defined by the Public Company Accounting Oversight Board (PCAOB) as a process purported "to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles" (AS No. 2, PCAOB, 2004, para. 7). Prior to the enactment of SOX in 2002, the reporting requirements for internal control deficiencies were limited. The only statutory regulation over all SEC registrants that required companies to maintain a system of internal controls to ensure financial reporting according to GAAP and to safeguard corporate assets was the Foreign Corrupt Practices Act (FCPA) of 1977. However, this Act did not require managers to evaluate and report on the effectiveness of existing internal controls. The only required public disclosure of internal control problems before SOX was in the firm's 8-K when disclosing a change in auditors (SEC, 1988). Similarly, auditors were not obliged to publicly disclose any problems with their clients' internal controls, although auditing standards required that if the auditor discovered any deficiencies, referred to as "reportable conditions", such problems should be communicated to the audit committee or someone else with similar authority (Krishnan, 2005). These communications were disclosed publicly only if the firm changed auditors within two years of the discovery of control problems.

Therefore, SOX substantially changed public disclosure requirements of internal control deficiencies for both the client and the auditor. First, Section 302 of SOX requires that a firm's CEO and CFO evaluate and provide in periodic filings "their conclusions about the effectiveness of their internal controls based on their evaluation" (302 (a) (D)). In addition, the officers should disclose to the auditor and the audit committee "all significant deficiencies in the design or operation of internal controls" (302 (a) (5) (A)). Section 404 goes one step further and requires a formal internal control report from auditors, which should "contain an assessment ... of the effectiveness of the internal control structure and procedures of the issuer for financial reporting" (404 (a) (2)). In addition, "each registered public accounting firm that prepares or issues the audit report for the issuer shall attest to, and report on, the assessment made by the management of the issuer" (404 (b)). Auditing Standard (AS) No. 2, which was later superseded by AS No. 5, adds an additional requirement for a separate opinion on the issuer's internal controls based on the auditor's independent review.

Three types of internal control weaknesses are defined by the PCAOB in AS No. 2 based on the likelihood that a misstatement of a particular magnitude will not be prevented or detected: control deficiency, significant deficiency, and material weakness. Each of these weaknesses has a different level of severity with control deficiencies being the lowest and material weaknesses being the most severe. Only material weaknesses are required to be disclosed under Sections 302 and 404, and they are automatically accompanied by an adverse opinion on internal controls by the auditor. Therefore, firms with such deficiencies are the focus of our study.

A number of researchers have examined the effects of audit, financial, and litigation risk on audit engagements. For example, Johnstone and Bedard (2004) analyze a single large audit firm and find that this auditor substitutes high-risk clients for low-risk clients, and that audit risk factors, including factors related to internal controls, are more important in the auditor's client portfolio management decisions than financial risk factors, such as factors related to the client's overall economic condition. In addition, Shu (2000) and Krishnan and Krishnan (1997) find that litigation risk is an important factor affecting auditor resignations, and Jones and Raghunandan (1998) find that in a period of increasing litigation risk, larger audit firms are less likely to audit high-risk firms. However, Landsman, Nelson and Rountree (2009) find evidence that auditor switches in the post-Enron era are less likely to be associated with higher client risk and are more likely to be due to misalignment between the auditor and the client firm. Therefore, it is important to examine separately the effect of disclosed material weaknesses in internal controls on auditor dismissal or resignations.

Adverse audit opinions on internal controls are likely to create conflict between auditors and clients, and the resolution of the conflict may depend on the severity of the internal control issues. On one hand, the client firm may try to work with the auditor, relying on the audit team's expertise to resolve the control problems. On the other hand, the client may disagree with the auditor, and may blame the auditor for being too conservative. Consistent with this idea, Krishnan (1994) finds evidence that switching companies receive more conservative treatment from their successor auditor than non-switching firms, and that the switch rate is higher when the predecessor's audit opinion is based on more conservative standards. This suggests that if a firm believes it is treated unfairly, it will choose to change auditors and look for less conservative treatment elsewhere. However, in the presence of a great number of material weaknesses, the auditor may perceive the client to be too risky and choose to resign from the engagement. Hence, our first hypothesis tests whether the number of reported material weaknesses affects the probability of auditor turnover (all hypotheses are stated in the alternative form):

H1 Firms are more likely to switch auditors after receiving an adverse ICOFR opinion if they report a high number of material weaknesses in internal controls.

Internal control weaknesses may be classified as account-specific and entity-level deficiencies. Account-specific weaknesses are considered less severe because they are related to specific financial statements accounts, such as inventory, receivables and intangibles. In contrast, entity-level deficiencies affect broader areas, such as revenue recognition and segregation of duties and indicate an organization-wide weak control environment. We expect both types of weaknesses to increase the probability of auditor turnover, but the degree of their incremental effect is an empirical question, tested with the following hypotheses:

H1a Firms are more likely to switch auditors after receiving an adverse ICOFR opinion if they report a high number of account-specific weaknesses in internal controls.

H1b Firms are more likely to switch auditors after receiving an adverse ICOFR opinion if they report a high number of entity-level weaknesses in internal controls.

In the presence of an adverse ICOFR opinion, the conflict between the client and the auditor may be exacerbated by the amount of fees charged by the auditor. Therefore, fees may be an additional factor that affects the likelihood of auditor realignment. Prior research by Hogan and Wilkins (2008) shows that the presence of internal control deficiencies is associated with higher audit fees prior to the disclosure of the deficiencies, which they interpret as evidence of audit firms exerting higher effort when auditing a client with weak internal controls.

Raghunandan and Rama (2006) show that audit fees have increased post-SOX, and they find some evidence that firms with material weaknesses pay higher audit fees than firms without internal control problems. Ettredge, Li and Scholz (2007) use early post-SOX data and find that firms paying higher audit fees are more likely to dismiss their auditor. In addition, Simon and Francis (1988) and Ettredge and Greenberg (1990), among others, show that audit fees decrease following an auditor switch. Hence, we surmise that firms may be willing to change auditors following an adverse ICOFR opinion to decrease their auditor-related costs. This leads to our second main hypothesis:

H2 Firms are more likely to switch auditors after receiving an adverse ICOFR opinion if their auditor-related fees are higher.

While the strength and nature of the relationship between a client and an auditor may not be observed or measured, it is likely that longer lasting engagements are associated with the auditor having better knowledge of the client's operations and organizational environment. Prior research suggests that a company's financial statements are affected by negotiations between auditors and their clients, which are affected by the auditor-client history (Gibbins, Salterio & Webb, 2001; Hatfield, Agoglia & Sanchez, 2008). Moreover, accounting disclosures may be viewed as being the product of the joint efforts of the auditor and the client (Antle & Nalebuff, 1991).

Management theorists and sociologists have studied professional service provider/client relationships in an effort to understand the dynamics affecting behaviors exhibited between and within the exchange agents. The ties between audit firms and clients go beyond the contractual relationship, because professional accountants possess a specific body of knowledge outside the technical capacity of the client, whose output is intangible but quite valuable. These ties are strong because one or both parties make investments in human and social capital to enhance the longevity of the relationship (Levinthal & Fichman, 1988). Embeddedness theory holds that the various economic actors or exchange agents are embedded in social affiliations that create economic value. This value is enhanced as the parties build trust and share private information. Embeddedness theory acknowledges that people often guide their choices based on past interactions and continue to deal with those they trust, while economic theory holds that behavior is affected primarily by the forces of the market (Granovetter, 1985; Uzzi & Lancaster, 2004). This implies that the nature of the auditor-client relationship is likely to affect the decision to change auditors even in the presence of an adverse ICOFR opinion (Hall & Bennett, 2010). The longer this relationship lasts, the stronger the bond between the client and the auditor and the more likely that the firms stays with the incumbent auditor. Therefore, the length of the client-auditor relationship is likely to have a negative effect on the probability of an auditor change, even when the auditor gives an adverse audit opinion. Hence, we test the following hypothesis:

H3 Firms are less likely to switch auditors after receiving an adverse ICOFR opinion if they have a longer relationship with their auditor.

Shu (2000) finds that firms are more likely to employ a small (versus Big Four) auditor following an auditor resignation if the resignation is due to increased litigation risk. This suggests that higher risk clients, including firms with internal control weaknesses, may be more likely to shift away from Big Four auditors. In addition, Ettredge, Heintz, Li and Scholz (2007) find that smaller firms tend to dismiss their Big Four auditors and subsequently, hire a smaller auditor. However, it is not clear ex ante how the presence of a Big Four auditor affects switching within the sample of firms that received an adverse internal controls opinion. Therefore, we test the following hypothesis in our sample:

H4 Firms are more likely to switch auditors after receiving an adverse ICOFR opinion if their auditor is one of the Big Four.

SAMPLE

The sample for this study was collected from Audit Analytics and includes firms that received an adverse internal control opinion in one reporting year, followed by an unqualified opinion in the next year. We restrict the sample in this way to avoid firms with continuing internal controls issues. The sample period includes adverse ICOFR opinions from year 2004, when Section 404 reporting requirements first went into effect for accelerated filers, to year 2007. This procedure yields a total of 765 valid firms, of which 649 remained with their auditor and 116 switched auditors in the year after the adverse opinion. The two categories of firms are labeled "loyal" and "switcher". Tables 1 through 3 provide relevant sample characteristics for each of these groups.

Panel A of Table 1 lists the number of firms that received adverse ICOFR opinions by fiscal year. The table shows that year 2007 is underrepresented in the sample, relative to the other years, 5.5 percent vs. 28.9 percent for both 2004 and 2006 and 36.7 percent for 2005, which is due to the limited availability of data for 2008 at the time the sample is collected. We include these firms in the sample since the set of years examined has no direct bearing on the hypotheses being tested. When the sets of fiscal years are examined with respect to the behavior of clients (loyal versus switcher), the data show that the majority of firms remain with their auditors; 649 remain loyal, while 116 switch. In addition, there seems to be a slight increase in loyalty from 2004 to 2007. Namely, the percent of firms experiencing first an adverse and then an unqualified opinion on ICOFR that remained with their existing auditors increased from 80.9 percent in 2004 (179 of 221) to over 88 percent in 2006 (196 of 221) and 2007 (37 of 42).

Panels B and C of Table 1 provide information about size, measured by average market capitalization and average total assets between the year of the adverse ICOFR opinion and the year of the clean opinion. While all size brackets are well-represented in the sample, both panels suggest that loyal companies tend to be larger than switchers, 42.1 percent and 46.3 percent of loyal firms are in the largest bracket (more than $750 million of average market capitalization and average total assets, respectively), while only 21.1 percent and 27.9 percent of switcher firms are in this bracket. At the same time 46.8 percent and 45.0 percent of switching firms tend to be smallest in terms of market capitalization and average total assets, respectively, compared with only 27.8 percent and 24.7 percent of loyal firms. Overall, switching firms in the sample are smaller than loyal firms.

Table 2 presents the client company sample by industry under the SIC code system. Client companies in manufacturing represent the largest portion (37.1 percent) of the sample, followed by Services (19.6 percent) and Finance, Insurance and Real Estate (17.6 percent). Overall, there does not seem to be a concentration of loyal or switcher firms within industry.

Table 3 presents the sample distribution based on auditor in the year of the adverse ICOFR opinion (Panel A) and new auditor in the year following the adverse opinion for switcher firms (Panel B). The table shows that 592 (77.4 percent) of sample firms employ a Big Four auditor in the year of the adverse opinion, although a lesser percentage of these firms change their auditor in the following year (16.0 percent switch vs. 84.0 percent remain loyal). However, the switch rate of firms with non-Big Four auditors is even lower at 12.1 percent. Interestingly, within the switcher sub-sample, 61.0 percent of firms that were originally with a Big Four auditor switch to a non- Big Four auditor. In addition, from the firms that change auditors but remain with a Big Four, the majority (83.8 percent) dismiss the auditor, while only 16.2 percent have their auditor resign. In the total sample of switchers only 21 (18.1 percent) firms were with a non-Big Four auditor in the year of the adverse ICOFR opinion and most (61.9 percent) switched to another non-Big Four auditor.

DESCRIPTIVE STATISTICS AND UNIVARIATE RESULTS

Descriptive statistics for the variables of interest are presented in Panel A of Table 4. In addition, the panel presents the results of univariate tests that assess the comparisons between loyal and switcher firms. Variable definitions are found in Appendix A. The results show that switcher firms have, on average, a higher number of material weaknesses, a mean of 2.19 for switchers and 1.67 for loyals, and the difference is statistically significant, providing initial support for H1. Moreover, these firms have higher numbers of both account-specific and entity-level weaknesses, as H1a and H1b predict, and the difference in the number of entity-level weaknesses is highly statistically significant (t-statistic of 2.88), although the t-test for a difference in means shows only marginal significance for account-based weaknesses (t-statistic of 1.90). Switcher firms also pay higher fees to their former auditor as a percentage of total assets and the differences are statistically significant, providing preliminary support for H2. Loyal firms have longer relationships with their auditors, a mean of almost 65 months by the end of the adverse ICOFR opinion year, versus a mean of 51 months for switcher firms. The difference is significant at the 0.01 level, lending support to H3. While more switchers employ Big Four auditors (81.9 percent versus 76.6 percent for loyal firms), the difference is not statistically significant. Finally, as suspected from the sample descriptive statistics, loyal firms are larger than switchers. Therefore, with the exception of the variable Big Four Auditor, the descriptive statistics in Table 4, Panel A, support our predictions about the factors that affect auditor switching behavior.

Panel B of Table 4 provides Pearson correlation coefficients among the variables of interest. There are several interesting insights that stand out from this panel. First, Material Weak is significantly negatively associated with Tenure, which suggests that firms with longer relationships with their auditors tend to have a lower number of material weaknesses. This is interesting because it may suggest that auditors with a stronger relationship with their clients may apply less conservative standards in their evaluation of internal controls. Alternatively, auditors may tend to stay longer with clients that are less risky, or those with stronger internal controls. Firms with Big Four auditors have a higher number of account-specific weaknesses, perceived to be of lower severity, while company size is not correlated with the number of account-specific weaknesses. In contrast, the correlation between a Big Four auditor and entity-level weaknesses is only marginally significant at the 0.10 percent level, while client company size is significantly correlated with the number of entity-level weaknesses. This suggests that firms employing Big Four auditors are more likely to have account-specific weaknesses, and larger clients are more likely to have a higher number of entity-level weaknesses but not necessarily a higher number of account-specific weaknesses. Overall, the univariate results are consistent with our hypotheses outlined in Section II. Next, we test our predictions using multivariate analysis.

MULTIVARIATE ANALYSIS

We model a firm's decision to change its audit firm using logistic regression including the following constructs. Additional factors that may be associated with auditor changes were considered, including growth, leverage, distress, management change and unfavorable audit opinions. To control for the potential confounding effect of these variables, we repeated the analyses including these constructs (none of these variables are significant in any of the model specifications and the results presented in this paper are unaffected). We construct the following regression model to test our hypotheses:

Prob(Switch) = f([[beta].sub.0] + [[beta].sub.1] MaterialWeak + [[beta].sub.2] PctTotalfees + [[beta].sub.3] Tenure + [[beta].sub.4] BigFourAuditor + [[beta].sub.5] AveMcap + [[summation].sup.K.sub.k=1] [[gamma].sub.k]Industry), (1)

where Switch is an indicator variable that is equal to one if the firm changes its auditor, and zero otherwise; MaterialWeak is the number of material internal control weaknesses; PctTotalfees is total fees paid to the auditor, including audit and non-audit fees, divided by total assets; Tenure is the log of the length of the relation in months between the firm and the auditor until the end of the year of the adverse ICOFR opinion; BigFourAuditor is equal to one if the audit firm is one of the Big Four, zero otherwise; and AveMCap is the log of the average market capitalization in the year of the adverse opinion and the following year. In addition, nine industry indicator variables are included in the model. All variables are summarized in Appendix A.

Equation (1) includes the variable MaterialWeak for the number of material internal control weaknesses, both account-specific and entity-level. To gain insight into which internal control weakness has an effect on the decision to change the audit firm, we run a model with two separate variables for the number of account-specific and entity-level weaknesses:

Prob(Switch) = f([[beta].sub.0] + [[delta].sub.1] AccruleReasons + [[delta].sub.2] EntityReasons + [[delta].sub.3] PctTotalfees + [[delta].sub.4] Tenure + [[delta].sub.5] BigFourAuditor + [[delta].sub.6] AveMcap + [[summation].sup.K.sub.k=1] [[gamma].sub.k]Industry), (2)

where AccruleReasons is the number of account-specific weaknesses and EntityReasons is the number of entity-level weaknesses as specified by Audit Analytics. In its detailed list of internal controls deficiencies reasons, Audit Analytics includes issues that are classified as material weaknesses as well as those that are less severe. Hence, the account-specific and entity-level weaknesses may add up to a number that is higher than the number of material weakness. All other variables are as defined above and in Appendix A.

We present the results of our main analysis in Table 5. The first column presents the results from Equation (1) and the second column displays the results from Equation (2). Consistent with H1, the coefficient on MaterialWeak is positive and statistically significant at the 0.05 level, suggesting that firms that have a higher number of material weaknesses are more likely to change auditors after an adverse ICOFR opinion. When examining account-specific and entity-level weaknesses separately, only the coefficient on EntityReasons is significant, but only marginally, with a p-value of 0.06. Therefore, there is no support for H1a that firms with a higher number of account-specific weaknesses are more likely to switch auditors and only limited support for H1b that the number of entity-level weaknesses increases the probability that the firm changes its auditor.

The second hypothesis of this study posits that higher auditor-related fees increase the probability that a firm switches auditors after an adverse ICOFR opinion. Table 5 provides support for this hypothesis. The importance of this variable is examined by measuring the relative magnitude of fees as a percentage of total assets. Specifically, the coefficient on PctTotalfees is positive and statistically significant at the 0.05 level, suggesting that higher fees increase the probability of a change in audit firm subsequent to an unfavorable ICOFR opinion, in support of H2.

Further, H3 predicts that the longer the relation between a firm and its auditor, the less likely that the company will switch auditors when an adverse opinion on internal controls is issued. The coefficient on Tenure is negative and highly statistically significant, suggesting that this is indeed the case. Finally, H4 suggests that firms that employ a Big Four auditor and receive an adverse ICOFR opinion are more likely to change their auditor. The coefficient on BigFourAuditor is positive and highly significant, providing support to H4.

AUDITOR DISMISSALS AND RESIGNATIONS

Next, we examine sub-samples of firms that dismiss their auditors, and firms whose auditors resign, since Krishnan and Krishnan (1997) suggest that factors affecting resignations and dismissals may differ. In the first two columns of Table 6, the test sample includes firms that dismissed their auditor after receiving adverse ICOFR opinion (Dismiss sample) and the control sample includes the loyal firms. In the last two columns, the firms that had their auditor resign are examined (Resign sample). Hence, the dependent variable in Table 6 is equal to one if the firm dismissed its auditor (Columns 1 and 2) or the auditor resigned (Columns 3 and 4), and zero if the firm remained loyal. Several interesting results emerge from the analysis of dismissals versus resignations. First, the number of reported material weaknesses affects only the probability that the auditor resigns and not the probability that the audit firm is dismissed. The coefficient on MaterialWeak is positive and highly significant at the 0.001 level for the Resign sample, while it is negative and insignificant for the Dismiss sample. Moreover, when the weaknesses are separated into account-specific and entity-level, the coefficient on EntityReasons is positive and highly significant (p-value 0.006) suggesting that the auditor is more likely to resign when the firm has more entity-level internal control issues, while the number and nature of material weaknesses do not appear to affect the decision of the firm to dismiss their auditor. This also suggests that the results in Table 5 for EntityReasons are driven by the Resign sample. Overall, the results suggest that firms do not seem to blame the auditor for disclosing their internal control issues and therefore, do not appear to subsequently dismiss the auditor, although auditors seem to prefer to avoid firms with multiple material weaknesses by resigning, due likely to the significant legal risks associated with such clients.

Second, fees do not have an effect on the probability that the auditor resigns, although higher fees increase the probability that the auditor is dismissed. The latter result is consistent with the evidence found by Ettredge, Li and Scholz (2007), who examine a wider population of firms in the early post-SOX era. The coefficient on PctTotalfees is insignificant for the Resign sample and is positive and statistically significant at the 0.05 level for the Dismiss sample. This implies that higher relative fees increase the probability that the auditor is dismissed after an adverse ICOFR opinion is expressed. Perhaps an adverse internal controls opinion creates an irreparable conflict when the auditor-related fees are high, which may lead to engagement termination. This is an interesting result worthy of further investigation.

Third, the results in Table 6 also show that after the effect of the severity and nature of internal controls issues is taken into consideration, Big Four auditors are more likely to be dismissed after unfavorable ICOFR opinions, while Big Four auditors are not more likely to resign, all else equal. This suggests that in the presence of a weak internal controls environment, firms are more likely to dismiss a Big Four auditor. Big Four auditors do not seem to resign from a client following the disclosure of internal controls weaknesses, however, this may be due to the fact that the sample is restricted to firms receiving adverse internal controls opinions, which may limit the power of the test in this sample. Another reason for the lack of significance of BigFourAuditor in the Resign sample may be that Big Four auditors have a large number of clients and they may be able to afford the opportunity to minimize the additional risk associated with clients experiencing internal control problems.

FIRMS WITH BIG FOUR AUDITORS

Next, we analyze the subset of firms that had a Big Four auditor in the year of the adverse opinion and then switched either to another Big Four or to a non-Big Four auditor. Again, the control sample includes firms that did not switch auditors. Two interesting results are shown in Table 7. First, the number of material weaknesses affects only the probability that the client switches from a Big Four to a non-Big Four and not to another Big Four firm. The coefficient on MaterialWeak is positive and highly statistically significant with a p-value of 0.002. This implies that firms with a higher number of material internal control weaknesses are more likely to turn to a smaller auditor subsequent to an adverse ICOFR opinion, possibly looking for more lenient treatment in future years, since Big Four auditors are considered to be more conservative. This result is consistent with Shu (2000) who find that high-litigation risk firms are more likely to be dropped by a large audit firm and to subsequently engage a smaller audit firm, and Raghunandan and Rama (1999) who show that a large audit firm is less likely to become a successor auditor when the predecessor has resigned.

Second, the coefficient estimates for PctTotalfees provide contrasting results for the two sub-samples. On the one hand, the higher the fees, the higher the probability that the client goes from a Big Four to a non-Big Four audit firm, which suggests that the client may be trying to lower its audit cost subsequent to receiving an adverse ICOFR opinion. This result is consistent with Ettredge, Heintz, Li and Scholz (2007) who find that smaller firms that pay higher audit fees tend to dismiss their Big Four auditor and subsequently hire a non-Big Four auditor. On the other hand, the coefficient on this variable in the sub-sample of firms that switch from one Big Four auditor to another is negative and marginally significant (p-value 0.054), implying that the higher the fees, the lower the probability that the client switches from one Big Four to another Big Four firm. This suggests that when internal controls have been assessed as weak and the audit fees are high, the client is better off not changing its auditor. This is an interesting result that should be examined more extensively in future research. However, it should be noted that the sample size of switcher firms is quite small and the results should be interpreted with caution.

CONCLUSION

Recent changes in the regulatory environment have significantly expanded the disclosure requirements pertaining to firms' internal controls. On one hand, Sections 302 and 404 of SOX require that managers provide an assessment of the design and effectiveness of their firms' internal controls and auditors express an opinion on this assessment. On the other hand, Auditing Standard No. 2 requires that auditors provide a separate opinion on internal controls based on their independent examination. Disclosing internal control problems is not looked upon favorably in the market (Hammersley, Myers & Shakespeare, 2008), and hence, adverse ICOFR opinions are likely to impact auditor-client relationships negatively, which may result in engagement termination. In this paper, we study the factors that affect auditor switches following adverse ICOFR opinions. This study is unique in that it focuses on firms that received adverse opinions in one year, followed by an unqualified opinion in the next, isolating the sample from firms with longstanding or endemic internal control weaknesses.

We find that the probability of firms switching auditors in the year following an adverse ICOFR opinion increases with the number of material weaknesses, which are the most severe problems in internal controls. An examination of the type of internal control issues firms face shows that only entity-level and not account-specific weaknesses increase this probability. This suggests that firms with more severe internal controls issues are more likely to change auditors in an effort to achieve an unqualified opinion. In addition, the amount of auditor-related fees and the presence of a Big Four audit firms also increase the probability of a switch, while the length of the auditor-client relationship decreases the probability of a switch.

Several interesting results emerge when dismissals and resignation are examined separately. First, severe internal control issues affect only the probability of an auditor resigning, implying that auditors try to stay away from risky firms. Second, the magnitude of auditor-related fees and the presence of a Big Four auditor only increase the probability of an auditor dismissal. This suggests that when faced with an adverse internal controls opinion, firms tend to dismiss their auditor when they are paying high fees and their incumbent auditor is one of the Big Four. Dismissal may be due to a firm's desire to decrease their audit costs and/or look for less conservative treatment from a smaller audit firm. Auditor tenure decreases the probability of both auditor dismissal and resignation, although its effect on dismissals is much stronger. This implies that clients and auditors have an investment in their relationship that is strengthened over time and is less likely to be terminated as a result of an adverse opinion.

An examination of the switches from a Big Four to another Big Four or to a non-Big Four audit firm reveals that the number of material weaknesses and the amount of auditor-related fees increase the probability of a switch to a smaller auditor. This is consistent with the idea that firms tend to switch from large audit firms to smaller auditors, either to get less conservative treatment or to decrease their audit cost. In addition, firms tend to stay loyal, rather than switch to another Big Four firm when they have a longer tenure with their current auditor.

Overall, the results suggest that the number and severity of the internal control deficiencies, the amount of auditor-related fees, auditor tenure, and the presence of a Big Four auditor affect the probability of an auditor switch in the year following an adverse ICOFR opinion. However, these factors affect auditor dismissals and resignations differently suggesting that it is important to consider the underlying reason for the switch. Switching from one Big Four audit firm to another or to a non-Big Four auditor is also affected by the severity of internal control weaknesses, audit costs, and the length of the client/auditor relationship.

The results of this study are relevant and useful to a variety of audiences. First, the results provide evidence of the significant effects of the Sarbanes-Oxley legislation, especially the effects of Sections 302 and 404 on client-auditor relationships. The sample is current and unique, focusing the results on the critical point in the client-auditor relationship where a decision to switch or not is likely to occur. Therefore, these findings should be useful to audit firm managers, audit committee and board members, investors, regulators and other stakeholders interested in the impact of SOX on firm behavior. In addition, the study provides insight into auditor switching behavior, prompted either by the client or the audit firm. It also draws attention to the prevalence of loyal or non-switching behavior which can be best explained by embeddedness theory. This is important because while clients may engage in opinion-shopping or audit cost-minimizing behavior, and audit firms may take on risk-reducing actions, some relationships are maintained and sustain throughout adverse conditions.

REFERENCES

Antle, R., & B. Nalebuff (1991). Conservatism and auditor-client negotiations. Journal of Accounting Research, 29(Supplement), 31-54.

Ashbaugh-Skaife, H., Collins, D., Kinney Jr., W. R., & R. LaFond (2009). The effect of SOX internal control deficiencies on firm risk and cost of equity. Journal of Accounting Research, 47(1), 1-43.

Ashbaugh-Skaife, H., Collins, D., Kinney Jr., W. R., & R. LaFond (2008). The effect of SOX internal control deficiencies and their remediation on accrual quality. The Accounting Review, 83(1), 217-250.

Ashbaugh-Skaife, H., Collins, D., & W. R. Kinney Jr. (2007). The discovery and reporting of internal control deficiencies prior to SOX-mandated audits. Journal of Accounting and Economics, 44(1-2), 166-192.

Chow, C., & S. Rice (1982). Qualified audit opinions and auditor switching. The Accounting Review, 57(2), 326-335.

Doyle, J., Ge, W., & S. McVay (2007). Determinants of weaknesses in internal control over financial reporting. Journal of Accounting and Economics, 44(1-2), 193-223.

Ettredge, M., & R. Greenberg (1990). Determinants of fee cutting on initial audit engagements. Journal of Accounting Research, 28(1), 198-210.

Ettredge, M., Heintz, J., Li, C., & S. Scholz (2007). Auditor realignments accompanying implementation of SOX 404 reporting requirements. Working paper, University of Kansas.

Ettredge, M., Li, C., & S. Scholz (2007). Audit fees and auditor dismissals in the Sarbanes-Oxley era. Accounting Horizons, 21(4), 371-386.

Ge, W., & S. McVay (2005). The disclosure of material weaknesses in internal control after the Sarbanes-Oxley Act. Accounting Horizons, 19(3), 137-158.

Gibbins, M., Salterio, S., & A. Webb (2001). Evidence about auditor-client management negotiation concerning client's financial reporting. Journal of Accounting Research, 39(3), 535-563.

Granovetter, M. (1985). Economic action and social structure: The problem of embeddedness. American Journal of Sociology, 91, 481-510.

Hall, L., & V. Bennett (2010). Client/auditor loyalty, embeddedness, and adverse internal control opinions. The BRC Academy Journal of Business, 1(1), 1-24.

Hammersley, J., Myers, L., & C. Shakespeare (2008). Market reactions to the disclosure of internal control weaknesses and to the characteristics of those weaknesses under Section 302 of the Sarbanes Oxley Act of 2002. Review of Accounting Studies, 13(1), 141-165.

Hatfield, R., Agoglia, C., & M. Sanchez (2008). Client characteristics and the negotiation tactics of auditors: Implications for financial reporting. Journal of Accounting Research, 46(5), 1183-1207.

Hogan, C., & M. Wilkins (2008). Evidence on the audit risk model: Do auditors increase audit fess in the presence of internal control deficiencies? Contemporary Accounting Research, 25(1), 219-242.

Hoitash, U., Hoitash, R., & J. Bedard (2009). Corporate governance and internal control over financial reporting: A comparison of regulatory regimes. The Accounting Review, 84(3), 839-867.

Johnstone, K., & J. Bedard (2004). Audit firm portfolio management decisions. Journal of Accounting Research, 42(4), 659-690.

Jones, F., & K. Raghunandan (1998). Client risk and recent changes in the market for audit services. Journal of Accounting and Public Policy, 17(2), 169-181.

Krishnan, J. (1994). Auditor switching and conservatism. The Accounting Review, 69(1), 200-215.

Krishnan, J. (2005). Audit committee quality and internal control: An empirical analysis. The Accounting Review, 80(2), 649-675.

Krishnan, J., & J. Krishnan (1997). Litigation risk and auditor resignation. The Accounting Review, 72(4), 539-560.

Landsman, W., Nelson, K. K., & B. Rountree (2009). Auditor switches in the pre- and post- Enron eras: Risk or realignment? The Accounting Review, 84(2), 531-558.

Levinthal, D.A., & M. Fichman (1988). Dynamics of interorganizational attachments: Auditor-client relationships. Administrative Science Quarterly, 33(3), 345-369.

Mutchler, J. F. (1984). Auditors' perceptions of the going-concern opinion decision. Auditing: A Journal of Practice & Theory, 3, 17-30.

Ogneva, M., Subramanyam, K. R., & K. Raghunandan (2007). Internal control weakness and cost of equity: Evidence from SOX Section 404 disclosures. The Accounting Review, 82(5), 1255-1298.

Public Company Accounting Oversight Board (PCAOB) (2004). An audit of internal control over financial reporting performed in conjunction with an audit of Financial Statements Auditing Standard No. 2. Washington, D.C.: PCAOB.

Raghunandan, K., & D. Rama (1999). Auditor resignations and the market for audit services. Auditing: A Journal of Practice & Theory, 18(1), 124-134.

Raghunandan, K., & D. Rama (2006). SOX Section 404 material weakness disclosures and audit fees. Auditing: A Journal of Practice & Theory, 25(1), 99-114.

Securities and Exchange Commission (SEC) (1988). Disclosure amendments to Regulation S-K, Form 8-K and Schedule 14A regarding changes in accountants and potential opinion shopping situations Financial Reporting Release No. 31 (April). SEC Docket 1140-1147. Washington, D.C.: SEC.

Shu, S. (2000). Auditor resignations: Clientele effects and legal liability. Journal of Accounting & Economics, 29(2), 173-205.

Simon, D. T., & J. R. Francis (1988). The effects of auditor change on audit fees: Tests of price cutting and price recovery. The Accounting Review, 63(2), 255-269.

Turner, L., Williams, J., & T. Weirich (2005). An inside look at auditor changes. The CPA Journal, 75(11), 12-21.

Uzzi, B. & R. Lancaster (2004). Embeddedness and the price formation in the corporate law market. American Sociological Review, 69(3), 319-344.

Zhang, Y., Zhou, J., & N. Zhou (2007). Audit committee quality, auditor independence, and internal control weaknesses. Journal of Accounting and Public Policy, 26(3), 300-327.

Maya Thevenot, SUNY Fredonia

Linda Hall, SUNY Fredonia
Appendix A: Variable Definitions

Variable         Definition

MaterialWeak     Number of material weaknesses identified in
                 assessment of internal controls as reported by Audit
                 Analytics.

AccruleReasons   Number of accounting rule (GAAP/FASB) application
                 failures identified in assessment of internal
                 controls as reported by Audit Analytics.

EntityReasons    Number of entity-level weaknesses identified in
                 assessment of internal controls as reported by Audit
                 Analytics.

PctTotalfees     Sum of total audit and non-audit fees divided by
                 total assets in the year of the adverse ICOFR
                 opinion.

Tenure           Log of the number of months the firm maintained the
                 same auditor until the end of the year of the adverse
                 ICOFR opinion.

BigFourAuditor   Coded one if the firm engaged one of the Big Four
                 audit firms in the year of the adverse ICOFR opinion.

AveMcap          Log of the average market capitalization from the
                 year of the adverse ICOFR opinion to the year of the
                 clean opinion.

AveTotalAssets   Log of the average total assets from the year of the
                 adverse ICOFR opinion to the year of the clean
                 opinion.


Table 1: Sample Characteristics

Panel A:           Loyal              Switcher           Total
Opinion years
                 n    Percentage    n    Percentage    n    Percentage

2004            179     27.6%      42      36.2%      221     28.9%

2005            237     36.5%      44      37.9%      281     36.7%

2006            196     30.2%      25      21.6%      221     28.9%

2007             37      5.7%       5       4.3%       42      5.5%

Total           649    100.0%     116     100.0%      765    100.0%

Panel B:           Loyal              Switcher           Total
Average Market
Capitalization   n    Percentage    n    Percentage    n    Percentage

Less than $250
million         168     27.8%      51      46.8%      219     30.7%

$250-$500
million         111     18.3%      26      23.9%      137     19.2%

$500-$750
million          71     11.7%       9       8.3%       80     11.2%

More than $750
million         255     42.1%      23      21.1%      278     38.9%

Total           605    100.0%     109     100.0%      714    100.0%

Panel C:           Loyal              Switcher           Total
Average Total
Assets           n    Percentage    n    Percentage    n    Percentage

Less than $250
million         155     24.7%      50      45.0%      205     27.7%

$250-$500
million         107     17.0%      18      16.2%      125     16.9%

$500-$750
million          75     11.9%      12      10.8%       87     11.8%

More than $750
million         291     46.3%      31      27.9%      322     43.6%

Total           628    100.0%     111     100.0%      739    100.0%

The sample was collected from Audit Analytics and includes firms
that received an adverse opinion on internal controls over
financial reporting (ICOFR) in one reporting year, followed by an
unqualified opinion in the next year. The sample period includes
adverse ICOFR opinions from year 2004 to the beginning of year
2007. Year 2007 is underrepresented in the sample due to the lack
of available data for year 2008 at the time the study was
conducted. Firms with missing data were excluded. Loyal and
Switcher designate firms that continue to employ their incumbent
auditor and firms that change auditors in the year following the
adverse ICOFR opinion, respectively.

Table 2: Industry Distribution

SIC Code by          Loyal             Switcher          Total
Division
                    n   Percentage    n   Percentage    n   Percentage

Agric.,
Forestry,           0      0.0%       2      1.7%       2      0.3%
Fishing 01-09

Mining 10-14       29      4.5%       3      2.6%      32      4.2%

Construction
15-17               7      1.1%       2      1.7%       9      1.2%

Manufacturing
20-39             239     36.8%      45     38.8%     284     37.1%

Trans, Comm,
Electric, Gas      59      9.1%       9      7.8%      68      8.9%
40-49

Wholesale Trade
50-51              14      2.2%       3      2.6%      17      2.2%

Retail Trade
52-59              62      9.5%       6      5.2%      68      8.9%

Finance, Ins.,
Real Estate       115     17.7%      20     17.2%     135     17.6%
60-67

Services 70-89    124     19.1%      26     22.4%     150     19.6%

Total             649    100.0%     116    100.0%     765    100.0%

Industry classification is based on the SIC code system.

Table 3: Auditor Statistics

Panel A: Auditor distribution in the year of the adverse opinion

Auditor           Loyal              Switcher           Total

                 n    Percentage    n    Percentage    n    Percentage

Big Four        497      76.6%      95      81.9%     592      77.4%

Non-Big Four    152      23.4%      21      18.1%     173      22.6%

Total           649     100.0%     116     100.0%     765     100.0%

Panel B: Auditor Characteristics of switching firms

Year-to-Year      Dismiss            Resign             Switcher
Auditor
                 n    Percentage    n    Percentage    n    Percentage

Big Four to
Big Four        31      37.8%       6      17.7%      37      31.9%

Big Four to
Non-Big Four    40      48.8%      18      52.9%      58      50.0%

Non-Big to
Non-Big Four     5       6.1%       8      23.5%      13      11.2%

Non-Big to
Big Four         6       7.3%       2       5.9%       8       6.9%

Total           82     100.0%      34     100.0%     116     100.0%

Panel A shows the sample distribution based on the type of audit firm
that expressed an adverse ICOFR opinion. Big Four includes the four
largest audit firms.

Panel B shows the sample distribution of firms that switched auditors
in the year after receiving an adverse ICOFR opinion. Dismiss and
Resign designate firms that dismissed their auditors and firms whose
auditors resigned, respectively.

Table 4: Descriptive Statistics Panel A: Summary Statistics

                               Loyal           Switcher

Variable              Mean    Median     SD      Mean

Material Weak        1.670    1.000    1.414    2.190

AccruleReasons       2.020    2.000    1.503    2.353

EntityReasons        3.125    3.000    1.384    3.603

PctTotalfees         0.004    0.003    0.005    0.007

Tenure (in months)  64.978   74.000   27.616   50.862

Tenure (log)         4.040    4.304    0.583    3.754

Big Four Auditor     0.766    1.000    0.424    0.819

AveMcap
(in billions)        2.661    0.581   16.465    0.920

AveTotalAssets
(in billions)        7.906    0.671   54.732    1.744

AveMcap (log)       20.276   20.181    1.400   19.678

AveTotalAssets
(log)               20.448   20.325    1.749   19.760

                         Switcher     Mean Difference

Variable             Median     SD     t-stat

Material Weak        1.000    1.851    -2.88    ***

AccruleReasons       2.000    1.775    -1.90    *

EntityReasons        3.000    1.693    -2.88    ***

PctTotalfees         0.004    0.010    -2.70    ***

Tenure (in months)  56.000   23.463     5.80    ***

Tenure (log)         4.025    0.722     4.04    ***

Big Four Auditor     1.000    0.387    -1.34

AveMcap
(in billions)        0.274    2.063     2.49    **

AveTotalAssets
(in billions)        0.291    4.652     2.77    ***

AveMcap (log)       19.428    1.175     4.74    ***

AveTotalAssets
(log)               19.488    1.577     4.17    ***

***, **, * Significant beyond the 1, 5, and 10 percent levels,
respectively of a two-tailed test.

Variable definitions are summarized in Appendix A.

Panel B: Pearson correlations

               Material   AccruleReas   EntityReas   PctTotalfees
                 Weak

Switch          0.124        0.077        0.119         0.161
               (0.001)      (0.033)      (0.001)       (<.001)

Material                     0.541        0.640         0.132
Weak                        (<.001)      (<.001)       (<.001)

AccruleReas                               0.468         0.056
                                         (<.001)       (0.123)

EntityReas                                              0.057
                                                       (0.121)

PctTotalfees

Tenure

BigFourAud

               Tenure    BigFourAud   AveMCap

Switch         -0.167      0.046      -0.155
               (<.001)    (0.208)     (<.001)

Material       -0.102     -0.041      -0.064
Weak           (0.005)    (0.263)     (0.087)

AccruleReas    -0.048      0.087       0.020
               (0.184)    (0.016)     (0.597)

EntityReas     -0.034      0.067       0.083
               (0.343)    (0.062)     (0.026)

PctTotalfees   -0.098     -0.112      -0.361
               (0.007)    (0.002)     (<.001)

Tenure                     0.475       0.207
                          (<.001)     (<.001)

BigFourAud                             0.363
                                      (<.001)

Correlation coefficients that are significant beyond the 5 percent
level are presented in bold. Variable definitions are summarized in
Appendix A.

Table 5: Logistic Regression Results

Dependent Variable = 1 if Switch, 0 if Loyal

Independent Variable            Logit     p-value    Logit     p-value
                               Estimate             Estimate

Intercept                       7.425      <.001     7.599      <.001
MaterialWeak                    0.135      0.034
AccruleReasons                                       0.005      0.949
EntityReasons                                        0.152      0.068
PctTotalfees                    40.296     0.049    41.878      0.048
Tenure (log)                   -1.013      <.001    -1.011      <.001
BigFourAuditor                  1.588      <.001     1.544      <.001
AveMcap (log)                  -0.353      <.001    -0.373      <.001
Industry indicator variables   Included             Included
Number of switch firms           109                  109
Number of total observations     713                  713
Likelihood ratio               75.1597              76.0047
                                <.0001               <.0001
Pseudo R-square                10.00%               10.11%

Parameter estimates that are significant beyond the 5 percent level
are presented in bold.

Variable definitions are summarized in Appendix A.

Table 6: Logistic Regression Results by Dismiss and Resign

Dependent Variable = 1 if Dismiss or Resign, respectively, 0 if Loyal

                                       Dismiss Sample

Independent Variable  Logit     p-value    Logit     p-value
                     Estimate             Estimate

Intercept             6.768      0.005     6.763     0.005

MaterialWeak         -0.018      0.855

AccruleReasons                            -0.033     0.746

EntityReasons                              0.035     0.748

PctTotalfees          44.868     0.048    44.592     0.049

Tenure (log)          -1.093     <.001    -1.099     <.001

BigFourAuditor         1.981     <.001     2.000     <.001

AveMcap (log)         -0.329     0.004    -0.331     0.004

Industry indicator
variables            Included             Included

Number of Dismiss
or Resign firms         75                   75

Number of total
observations           679                  679

Likelihood ratio     56.3271              56.4324
                      <.0001               <.0001
Pseudo R-square       7.96%                7.98%

                                       Resign Sample

Independent Variable  Logit     p-value    Logit     p-value
                     Estimate             Estimate

Intercept             6.614     0.063      6.586     0.062

MaterialWeak          0.349     <.001

AccruleReasons                             0.057     0.627

EntityReasons                              0.334     0.006

PctTotalfees         12.240     0.775     22.001     0.593

Tenure (log)         -0.721     0.036     -0.672     0.052

BigFourAuditor        0.886     0.099      0.654     0.220

AveMcap (log)        -0.413     0.012     -0.441     0.008

Industry indicator
variables            Included             Included

Number of Dismiss
or Resign firms         34                   34

Number of total
observations           638                  638

Likelihood ratio     44.8277              43.1699
                      <.0001               <.0001
Pseudo R-square       6.79%                6.54%

Parameter estimates that are significant beyond the 5 percent level
are presented in bold. The first four columns present result for the
sample of firms that dismissed their auditor and the sample of firms
that did not change auditors serve as a control group. The last four
columns present the results for the sample of firms whose auditors
resigned and the same control group.

Variable definitions are summarized in Appendix A.

Table 7: Logistic Regression Results by Switch

Dependent Variable = 1 if Switch to the respective auditor, 0 if Loyal

                               Switch from Big 4    Switch from Big 4
                                  to Big 4             to non-Big 4

Independent Variable            Logit     p-value    Logit     p-value
                               Estimate             Estimate

Intercept                      -1.647     0.580      7.097     0.018
MaterialWeak                    0.055     0.648      0.243     0.002
PctTotalfees                  145.100     0.054     63.947     0.014
Tenure (log)                   -0.642     0.019     -0.193     0.435
AveMcap (log)                   0.095     0.491     -0.483     0.001
Industry indicator variables   Included             Included
Number of switch firms            35                   53
Number of total observations     639                  657
Likelihood ratio               19.7103              54.2924
                                0.0728               <.0001
Pseudo R-square                 3.04%                7.93%

Parameter estimates that are significant beyond the 5 percent level
are presented in bold. The first column presents the results for the
sample of firms that switched from one Big Four to another Big Four
audit firm and the sample of firms that did not change auditors serve
as a control group. The last column presents the results for the
sample of firms that switched from a Big Four to a non-Big Four audit
firm and the sample control group.

Variable definitions are summarized in Appendix A.
Gale Copyright:
Copyright 2011 Gale, Cengage Learning. All rights reserved.