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MAJ 26,1

Do audit delays affect client retention?

Vivek Mande and Myungsoo Son
California State University, Fullerton, California, USA
Abstract
Purpose The purpose of this study is to examine whether lengthy audit delays lead to auditor changes in the subsequent year. The paper hypothesizes that a lengthy interaction between clients and their auditors reects high audit risk factors relating to management integrity, internal controls, and the nancial reporting process. It argues that auditors are more likely to drop clients with long audit delays because they would like to avoid these types of audit risks. Design/methodology/approach Using logistic regressions, the paper rst tests whether a lengthy audit delay leads to an auditor change. It then examines whether as audit delays increase, auditor changes are more likely to be downward than lateral. Findings The results support the hypothesis that Big N auditor-client realignments occur following long audit delays. Further, as the length of the delay increases, the paper nds that there are more downward changes. Research limitations/implications An implication of our study is that a long audit delay represents a publicly observed proxy for the presence of audit risk factors that lead to an auditor change. Practical implications This study suggests that all else constant, investors should consider a lengthy audit delay as indicating that there has been deterioration in the quality of the client-auditor interaction. An audit delay also presents an observable proxy for successor auditors to consider while evaluating risks associated with a new client. Originality/value The results of our study increase our understanding of how Big N auditors manage their client portfolios to mitigate their exposure to risk factors. Keywords Auditing, Risk assessment, Customer retention Paper type Research paper

32
Received 7 October 2009 Revised 30 April 2010 Accepted 21 June 2010

Managerial Auditing Journal Vol. 26 No. 1, 2011 pp. 32-50 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686901111090826

1. Introduction Against the backdrop of Sarbanes-Oxley (SOX), this study examines whether lengthy audit delays, used as a proxy for audit risk, increase the likelihood of Big N auditor resignations in the subsequent year. In the years immediately following the passage of the SOX Act, audit rms experienced sharp increases in the demand for assurance staff (Rama and Read, 2006; Cenker and Nagy, 2008). Section 404 of SOX, in particular, led to shortages of skilled auditors (at least in the short run) and increases in audit fees (GAO, 2006). It is estimated that a typical audit took 40-60 percent more time to complete in the post-SOX than in the pre-SOX years (Koehn and DelVecchio, 2006). The paucity of staff resources was more pronounced in the Big N rms because Section 404 of SOX initially affected only the large (accelerated) lers, whose auditors were mostly the Big N rms. Facing severe stafng constraints, the Big N auditors adopted a more conservative stance on client retention by resigning from high risk engagements (Rama and Read, 2006)[1], and, as a result, Non-Big N audit rms gained signicant market share. Ettredge et al. (2007), for example, nd that the majority of

Big N clients who changed their auditors after SOX hired non-Big N rms as their new auditors a pattern contrary to pre-SOX trends in auditor changes (Landsman et al., 2009; Turner et al., 2005; Public Accounting Report, 2004)[2]. Audit rms conduct routine risk reviews of their client portfolios and resign from clients regarded as high risk (Jones and Raghunandan, 1998; Johnstone and Bedard, 2004; Winograd et al., 2000; Bell et al., 2002; Beneish et al., 2005; Krishnan and Krishnan, 1997; Shu, 2000). The above cited studies use litigation risk and nancial distress variables to proxy for risk factors considered by auditors in their client retention decisions. The proxy variables are computed using nancial and market data that are publicly available on research data bases. An exception to this stream of research is a study by Johnstone and Bedard (2004) who examine auditor resignations using proprietary auditors assessments of their clients audit risks[3]. They report that risk factors relating to clients internal controls, nancial reporting quality, and management integrity provide more useful measures of audit risks than do nancial risk factors. Johnstone and Bedard argue that their proprietary proxies are more comprehensive risk measures than nancial risk measures because they include qualitative risk factors. They nd that their risk measures are more strongly associated with auditors client retention decisions than are nancial and litigation risk variables. Their ndings suggest that more research is needed on how auditors incorporate risks relating to client controls, nancial reporting quality, and management integrity in their client retention decisions. This paper argues that audit delays, the time between the scal year end and the audit completion date, can be a potential candidate for measuring risk factors relating to clients internal controls, nancial reporting quality, and management integrity. A lengthy audit delay often occurs due to problems in the audit, disagreements between the auditor and client on accounting issues, and/or a general deterioration in the quality of auditor-client interaction. A long delay could also occur when a client rm has high inherent and/or control risk requiring more work by the auditor (Ireland, 2003). Thus, a lengthy audit delay could represent an observable proxy for the above non-public audit risk factors that affect client retention decisions. To investigate whether client risk factors are associated with Big N auditor resignations, we estimate a logistic regression that models auditor resignations as a function of audit delays and control variables identied by prior research. We also consider the direction of auditor switches: lateral (Big N to Big N) or downward (Big N to non-Big N). Finding another Big N auditor to replace the current auditor might not be a feasible option for all client rms, in particular for client rms with high audit risks. As the severity of audit risks increases, these client rms may have no alternative but to nd a non-Big N auditor (i.e. downward change). Therefore, we expect that there will be an ordered correlation between audit risks (i.e. audit delays) and auditor changes. We use different proxies for measuring audit delays. Because Section 404 altered Big N incentives to retain risky clients, we rst use the actual delays, proxying for the existing quality of auditor-client interaction, for predicting auditor changes. However, we also perform analyses using two alternative proxies: unexpected audit delays and industry-adjusted audit delays. Our empirical results are consistent with auditors managing their client portfolios to reduce their risk exposure. Specically, we nd results consistent with the hypothesis that auditor resignations occur in the year following lengthy audit delays.

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Furthermore, we nd that auditor resignations are more likely to result in downward rather than lateral changes as the length of audit delays increases. Our results also suggest that more than nancial distress, risk factors (proxied by audit delays) concerning clients internal controls, nancial reporting quality, and management integrity are related to subsequent auditor changes. These ndings increase our understanding of how Big N auditors use audit risk factors generally unobservable to the investing public in their client management strategy. From an investors perspective, a lengthy audit delay could suggest that there has been a deterioration in the quality of the client-auditor interaction, which could translate into a downward auditor change, and a negative stock price reaction (Krishnamurthy et al., 2006). While the client-auditor realignments examined in this study reduce Big N auditors risk, they may not necessarily reect a socially desirable outcome, since non-Big N rms must now audit the risky clients dropped by the Big N rms. Because Big N auditors possibly provide better monitoring of the nancial reporting process (Cassell et al., 2007), following the realignments, there could be a reduction in audit quality and an increased likelihood of audit failures. This could represent an unintended cost associated with Section 404 that has not been examined in the literature. It is noteworthy, however, that the Securities and Exchange Commission (SEC)s view on this issue is that audit quality is not impaired when dropped Big N clients are picked up by non-Big N auditors (Taub, 2004). While our focus is limited to the study of whether audit delays proxy for unobserved audit risks, whether or not overall audit quality is impaired due to these realignments is a topic that needs to be pursued by future work. The remainder of this study comprises ve sections. Section 2 reviews the relevant literature. Section 3 presents the research design, while Sections 4 and 5 discuss results of main tests and additional analyses, respectively. Section 6 concludes the study. 2. Literature and hypotheses development Prior research suggests that auditors take actions to mitigate their risk exposure when managing their client portfolios[4]. Jones and Raghunandan (1998), for example, nd that client portfolios of the Big 6 audit rms shifted towards having fewer nancial-distressed clients and fewer clients in high-tech industries during a period of increasing litigation. Choi et al. (2004) also report that there is a decrease in the magnitudes of nancial risk measures of Big 6 audit rms clients during a period when auditors exposure to litigation increased. Schwartz and Menon (1985) nd that clients who are in nancial distress are more likely to be dropped by a Big N audit rm when compared to a matched-pair sample of non-failing rms. Shu (2000) constructs two risk measures proxying for the likelihood of litigation and the probability of bankruptcy. Shu nds that there is a positive association between auditor resignations and the proxies. Finally, Krishnan and Krishnan (1997) nd that litigation risk, proxied by Stices (1991) litigation score, is positively associated with auditor resignations. The above-mentioned studies use publicly available nancial data to construct empirical proxies for the nancial and litigation risk factors. Following the passage of the Private Securities Litigation Reform Act of 1995, an auditor cannot be held liable in a class action lawsuit for bankruptcy or mismanagement by ofcers of the company, if there is no wrongdoing on the part of the auditor. Thus, nancial distress by itself does not constitute an audit risk factor. Consistent with this

idea, Johnstone and Bedard (2004) suggest that, more than nancial distress, audit risk factors relating to managements integrity, internal controls, and nancial reporting quality have a greater impact on auditors decisions to retain or dismiss clients. The authors support their hypothesis with tests using proprietary risk assessments obtained from auditing rms. However, despite the signicance of their ndings for auditing research, there has been little additional work on this issue. This study argues that audit delays can potentially provide an observable proxy for the proprietary audit risk factors used by Johnstone and Bedard in their study. Specically, we suggest that audit delays often occur when there are concerns about poor internal controls, low-quality nancial reports, lack of management integrity, and clients lack of attention to the external audit. For example, a lengthy audit delay can result when an auditor uncovers a problem in the nancial statements and needs to do additional work to give an opinion on the nancial statements. A long audit delay could also occur if a client-rm is attempting to apply aggressive or non-generally accepted accounting principles accounting treatments that the auditor is unwilling to accept. These risk factors result in auditors executing additional audit procedures and/or conducting longer negotiations with their clients. Consistent with this, a few prior studies have used audit delays as a proxy for risk factors. Ireland (2003) documents that the longer the audit lag, the more likely a company is to receive a modied audit report. Ireland argues that a long audit lag occurs when auditees have a high level of inherent and/or control risk which requires more audit work often resulting in a modied audit opinion. Furthermore, when auditors wish to modify their opinion, the result is often longer negotiations between the auditor and the client over the form of the nal accounts and the associated audit report that is the subject of their disagreement (Ireland, 2003)[5]. Another study is by Schloetzer (2007) who examines whether a lengthy ling delays lead client rms to switch from a Big N to a non-Big N auditor. Schloetzer uses the Form 10-K ling delay the time between the scal year end and SEC ling date as a proxy for the quality of client-auditor interaction[6]. He argues that the longer the ling delay, the lower is the overall quality of the client-auditor interaction which in turn leads to a change in auditors, from Big N to Non-Big N[7]. Schwartz and Soo (1996) also nd evidence suggesting that a lengthy audit delay constitutes a risk factor for auditors. Using a sample of auditor changes, they nd that clients who switched auditors late in the scal year (late switchers) are associated with more disagreements with the auditor than early switching rms and, in turn, experience lengthier audit delays. Knechel and Payne (2001) provide direct evidence that a lengthy audit delay is due to more audit hours being expended on an engagement. Using a proprietary database, they document that a lengthy audit delay occurs because more audit effort and audit hours than normally required are needed to complete the audit. Based on the discussion above, we formulate our rst hypothesis. H1 predicts that Big N auditors make client retention decisions based on the quality of the interaction with their clients during the preceding years audit, suggesting that long audit delays increase the likelihood of an auditor change in the following year: H1. There is a positive association between audit delays and auditor resignations in the following year.

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H1 does not distinguish between types of auditor changes: lateral (Big N to another Big N) or downward (Big N to a non-Big N). Research suggests that once a risky client leaves a Big N auditor, that rm may have no choice but to seek a non-Big N rm to serve as its auditor (Bockus and Gigler, 1998). Big N auditors have more to lose from litigation and suffer a greater loss of reputation from an audit failure than do non-Big N rms (Jones and Raghunandan, 1998). Big N auditors are also less dependent on any one clients fees (Watkins et al., 2004). This line of research suggests that Big N auditors are less likely to accept a client dropped by another Big N auditor because of the associated client risks that all Big N auditors are anxious to avoid. However, there is also some prior research which suggests that auditees dropped by a Big N auditor may be accepted as clients by another Big N auditor (i.e. a lateral auditor switch). Johnstone and Bedard (2004) suggest that otherwise unacceptable clients are sometimes accepted into another Big N audit rms portfolio conditional on the assignment of specialist personnel or the collection of higher engagement fees. Big N auditors also have a larger client base than non-Big N auditors which allows them spread a given clients risk over a well-diversied client portfolio ( Johnstone and Bedard, 2004). Finally, the risks facing the old and new auditors can differ (Landsman et al., 2009). For example, a Big N auditor who is also an industry expert may be able to accept a higher level of audit risk than another Big N auditor who has no such industry expertise. We empirically investigate whether risky rms dropped by a Big N auditor nd another Big N or a non-Big N auditor. If risky clients are more likely to be excluded from the Big N audit market, then downward switches will be more highly associated with client risk characteristics than lateral switches (Landsman et al., 2009). Further, while another Big N auditor may be willing to accept a risky client dropped by a Big N auditor, as the level of the audit risk increases, proxied using audit delays, the switch is more likely to be downward than lateral: H2. As audit delays increase, auditor changes in the following year are more likely to be downward than lateral. 3. Research design 3.1 Data Our initial sample includes all rms for which audit fees and auditor report dates were available on Audit Analytics for the period 2002-2006 (59,180 rm-years). Following Sengupta (2004), we delete observations (8,985 rm-years) where the audit report date was either within seven days of the scal year end or more than 90 days after the scal year end, in order to eliminate outliers and/or potential errors in report dates[8]. We require rms to have at least two consecutive years of nancial data because we use lagged independent variables in our tests. This criterion results in the elimination of 30,996 rm-years. We then only consider client rms audited by a Big N auditor in the previous year. As discussed, this is because resource constraints (e.g. shortage of assurance staff) were more pronounced for Big N auditors since some of the SOX provisions applied only to large clients, who make up the majority of the Big N auditors client base (GAO, 2006). We deleted an additional 2,412 observations consisting of non-accelerated lers who have a longer period to le their nancial statements and can, therefore, be expected to have a longer audit report lag. Finally, we deleted 665 observations where the auditor change was reported as a dismissal. The nal sample

consists of 11,307 rm-years for the period 2003-2006[9]. It is comprised of three mutually exclusive groups: (1) rms continuing with a Big N auditor (no change rms); (2) rms with lateral auditor changes in the following year; and (3) rms with downward auditor changes in the following year. Panel B of Table I exhibits the industry distribution of sample rms where industry is dened as in Frankel et al. (2002). Sample rms are widely distributed among industries, with some clustering of rms in the durable manufacturers and computer industries. Mean audit report lags (ARLs) vary across industries, with longest for agriculture (64 days) and the shortest for textile and printing (52 days), suggesting a need to control for industry effects. Panel C of Table I reports the distribution of sample rms by year. The rst column shows the number of rms which switched their auditors from Big N to non-Big N, while the second column reports the switches from Big N to another Big N. It is noteworthy that in all years, there are more downward auditor switches than lateral auditor switches in the post-SOX years. Consistent with our conjecture that Section 404 triggered Big N resignations, the panel shows that the largest number of resignations took place in the years 2004 and 2005. The last column represents the number of rms that retained their incumbent Big N auditors. 3.2 Regression model We model the likelihood of a Big N auditor resignation using ARLs and a set of control variables identied by prior studies. The following logistic regression is used (Table II): RESIGN t b0 b1 ARLt21 b2 GC t21 b3 MODOP t21 b4 TENURE t21 b5 AUDFEE t21 b6 ROAt21 b7 LOSS t21 b8 LVRGt21 b9 GROWTH t21 b10 DAt21 b11 SIZE t21 year dummies industry dummies 1

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3.3 Control variables used The control variables used have been identied by prior research as determinants of auditor resignations. Companies that do not receive a clean audit opinion are more risky, which increases the likelihood that there will be an auditor resignation (Krishnan and Krishnan, 1997; Johnstone and Bedard, 2004). Therefore, we predict positive coefcients on the variables GC and MODOP. Prior research suggests that client rms with long-tenured auditors are less risky than those with short-tenured auditors (Stice, 1991; Krishnan and Krishnan, 1997; Landsman et al., 2009). Therefore, we expect that TENURE will have a negative relation with the likelihood of an auditor resignation. The nature of the relationship between audit fees (AUDFEE) and auditor resignations is debatable. Bockus and Gigler (1998) contend that incumbent auditors might increase audit fees for riskier clients but once the level of risk crosses a certain threshold, the auditors will resign. This suggests that there could be a positive association between prior years audit fees and auditor resignations. On the other hand, it is possible that incumbent

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No. of rm-years Panel A: sample selection procedure Firm-years with audit fees and ARLs in Audit Analytics (2002-2006) Less: ARLs that are less than 7 days or more than 90 days Missing lagged ARLs, audit fee data, and nancial data on Compustat Firm-years having non-Big N as a previous auditor Non-accelerated lers Auditor dismissals Final sample (2003-2006) Panel B: distribution of sample by industry Auditor resignation 0 1 2 3 58 33 3 19 11 14 15 8 7 5 1 180 Mean ARL 64.06 58.07 53.78 55.43 53.25 54.65 61.06 58.44 56.93 54.92 59.51 52.07 60.74 58.62 59.95 59,180 8,985 30,996 4,815 2,412 665 11,307

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Industry Agriculture Mining and construction Food Chemicals Computers Durable manufacturers Extractive Financial Pharmaceuticals Retail Services Textile and printing/publishing Transportation Utilities Not classied Total Panel C: type of auditor change by year Year 2003 2004 2005 2006 Total

Total 18 247 263 281 1,731 2,248 423 1,481 765 1,102 993 481 774 462 38 11,307

% 0.00 0.02 0.02 0.02 0.15 0.20 0.04 0.13 0.07 0.10 0.09 0.04 0.07 0.04 0.00 1.00

Big N to nonBig N 31 56 42 18 147

Big N to Big N 9 12 8 4 33

No change 2,721 2,956 2,820 2,630 11,127

Table I. Sample selection and sample distribution

Notes: Agriculture (0100-0999), mining/construction (1000-1999, excluding 1300-1399), food (20002111), chemicals (2800-2824, 2840-2899), computers (7370-7379, 3570-3579, 3670-3679), durable manufacturers (3000-3999, excluding 3570-3579 and 3670-3679), extractive (2900-2999, 1300-1399), nancial (6000-6999), pharmaceuticals (2830-2836), retail (5000-5999), services (7000-8999, excluding 7370-7379), textiles (2200-2799), transportation (4000-4899), utilities (4900-4999), and not classied (2112-2199, 2837-2839, 2825-2829); ARL is the number of calendar days from scal year end to date of the auditors report

Variable Dependent variable RESIGN Test variable ARL Auditor characteristics GC MODOP TENURE AUDFEE Firm characteristics ROA LOSS LVRG GROWTH DA SIZE

Expected sign

Denition 1 if a Big N auditor resigns and 0 otherwise

Audit delays

2 /2 2 2

Number of days between the clients scal year end and the completion date of the audit 1 if the audit opinion is a going concern opinion and 0 otherwise 1 if the audit opinion is modied for any reason other than going concern and 0 if unqualied Number of years audited by the incumbent (old) auditor Natural logarithm of the preceding years audit fee Return on assets, dened as net income before extraordinary items divided by total assets 1 if earnings before extraordinary items is ,0 and 0 otherwise Ratio of long-term debt to total assets Percentage changes in total assets Performance-matched discretionary accrualsa Natural logarithm of the market value of equity

39

Notes: aWe calculate performance-matched discretionary accruals following Kothari et al. (2005). First, we obtain discretionary accruals from the Jones model, which requires regressing total accruals on variables that are expected to vary with normal accruals, such as changes in revenues and capital intensity; to obtain performance-matched discretionary accruals, we match each rm-year observation with an observation belonging to a rm from the same two-digit SIC code and year, with the closest return on assets (net income divided by total assets); then, we dene performance-matched discretionary accruals as each rms discretionary accruals minus its matched counterparts discretionary accruals

Table II.

auditors are less likely to resign from clients paying higher audit fees, suggesting a negative association between the two variables. We also include controls for clients nancial risks. Because less protable and more leveraged clients are considered more risky (Schloetzer, 2007), we predict a higher likelihood of an auditor resignation in these companies. We use the following three variables, ROA, LOSS, and LVRG, to proxy for nancial risks. These variables are expected to have negative, positive, and positive coefcients, respectively. Stice (1991) argues that high-growth rms pose additional risks for auditors because these rms tend to have less-effective internal control systems. Therefore, we include GROWTH in our regressions and expect this variable to be positively associated with the likelihood of an auditor resignation. Since positive discretionary accruals suggest that there is a higher risk of earnings management being present, we could expect more auditor resignations from client rms with larger positive discretionary accruals. This predicts that there will be a positive association between RESIGN and DA. Because large clients are less likely to fail, we predict a negative coefcient on SIZE. Finally, we include year and industry dummies in the models[10].

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4. Empirical test results 4.1 Descriptive statistics Table III presents descriptive statistics for the variables used in the regressions reported separately by the three categories: downward changes (Big N to Non-Big N), lateral changes (Big N to another Big N), and no changes. We winsorize all non-indicator variables at the 1 and 99 percent levels to reduce the effects of extreme values on the test results. Table III presents the means, medians, and SD of the variables according to each group. There are more downward switches when compared to lateral switches, which is consistent with Schloetzer (2007) who nds that auditor changes from a Big N to a non-Big N auditor became more frequent following the passage of SOX. The mean value of ARL for the downward switch group is 67.116, which indicates that it took a Big N auditor, on average, about 67 days to complete the audit of a client-rm that switched its auditor to a non-Big N auditor in the following year. The mean value of ARL of downward switch rms (67.116 days) is statistically signicantly longer than that for lateral switch rms (58.969 days). While the mean ARL of no switch rms (56.205 days) is shorter than that of lateral switch rms (58.969 days), the difference is not statistically signicant. The above univariate comparison of means is consistent with our hypothesis, H2, that rms with longer ARLs are likely to switch from a Big N to a non-Big N auditor, rather than change from a Big N to another Big N auditor or stay with incumbent Big N auditor. Firms that switch auditors downward (compared to other groups) tend to have more going concern opinions but fewer types of other modied opinions and relatively smaller audit fees in the year preceding the switch. They are also less protable and are smaller in size[11]. With the exception of other modied opinions (MODOP), these univariate results are consistent with expectations. Table IV presents correlations for the variables used in the regressions. Consistent with our prediction, RESIGN is positively correlated with one-year-lagged ARL. In addition, RESIGN is statistically signicantly correlated with all independent variables except for TENURE and LVRG. Interestingly, contrary to our expectation, RESIGN is negatively correlated with GROWTH and MODOP (modied opinion). Also, with the exception of MODOP, ARL is signicantly correlated with the following audit risk factors: going concern opinions, tenure, protability, leverage, and rm size. The direction of the correlations supports our argument that audit delays are signicantly related to audit risks. The largest correlation in the table is between rm size and audit fees (0.70). Tables III and IV, however, only show results obtained from univariate testing. Below we present results from estimation of multivariate models which are more powerful than the univariate tests. 4.2 Regression analyses Table V presents empirical results of estimations of our logistic regression models. The table reports results using data pooled over all years and separately using years before and after Section 404 of SOX went into effect[12]. For the post-Section 404 sample (2005-2006), we include a dummy variable that is coded 1 if a rm reports an internal control weakness and 0 otherwise. This is due to Ettredge et al. (2007) who

Variable 73.000 0.000 0.000 9.000 12.378 20.073 1.000 0.101 20.046 0.011 4.245 19.907 0.409 0.453 6.101 1.105 0.361 0.468 0.257 0.515 0.216 1.576 58.969 0.061 0.576 8.606 13.354 20.101 0.455 0.217 0.132 20.030 5.973 64.000 0.000 1.000 8.000 13.541 0.011 0.000 0.139 0.029 2 0.008 6.087 19.574 0.242 0.502 4.527 0.967 0.259 0.506 0.223 0.502 0.157 1.829 56.205 0.011 0.434 9.779 13.559 0.001 0.250 0.223 0.159 20.011 6.776 59.000 0.000 0.000 7.000 13.474 0.035 0.000 0.183 0.087 2 0.006 6.641 18.660 0.106 0.496 8.623 1.223 0.169 0.433 0.217 0.339 0.133 1.696

Big N to non-Big N (A) (n 147) Mean Median SD SD 2.13 * * 2.03 * * 2 3.26 * * * 1.20 2 3.54 * * * 2 2.09 * * 2.47 * * 2 0.35 2 0.73 1.27 2 5.16 * * *

Big N to Big N (B) (n 33) Mean Median SD

No changes (C) (n 11,127) Mean Median

t-test (A B) t-statistic

t-test (B C) t-statistic 0.85 2.64 * * * 1.64 2 0.78 0.96 2 3.43 * * * 2.71 * * 2 0.14 2 0.47 2 0.85 2 2.71 * * *

ARL GC MODOP TENURE AUDFEE ROA LOSS LVRG GROWTH DA SIZE

67.116 0.211 0.286 9.959 12.616 20.240 0.680 0.201 0.060 0.020 4.359

Notes: Signicance at: *10, * *5, and * * *1 percent; variable denitions: RESIGN, 1 if the auditor resigns from its auditor and 0 otherwise; ARL, number of days between the clients scal year end and the audit completion date; GC, 1 if the audit opinion is a going concern and 0 otherwise; MODOP, 1 if the audit opinion is modied for any reason other than going concern and 0 if unqualied; TENURE, number of years audited by the incumbent (old) auditor; AUDFEE, natural logarithm of the preceding years audit fee (old auditor); ROA, return on assets, dened as net income before extraordinary items divided by total assets; LOSS, 1 if earnings before extraordinary items is ,0 and 0 otherwise; LVRG, ratio of debt to total assets; GROWTH, percentage changes in total assets; DA, performance-matched discretionary accruals; SIZE, natural logarithm of the market value of equity

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Table III. Descriptive statistics

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RESIGN 0.063 (0.000) 0.182 (0.000) 2 0.024 (0.011) 2 0.001 (0.915) 2 0.082 (0.000) 2 0.153 (0.000) 0.111 (0.000) 2 0.011 ARL 0.088 (0.000) 2 0.070 (0.000) 2 0.088 (0.000) 0.142 (0.000) 2 0.065 (0.000) 0.072 (0.000) 0.092 GC 2 0.105 (0.000) 2 0.030 (0.001) 2 0.031 (0.000) 2 0.237 (0.000) 0.173 (0.000) 0.042 MODOP 0.028 (0.023) 0.122 (0.000) 0.057 (0.000) 2 0.039 (0.000) 0.136 TENURE 0.246 (0.000) 0.108 (0.000) 2 0.121 (0.000) 0.009 AUDFEE 0.186 (0.000) 2 0.176 (0.000) 0.171 ROA 2 0.664 (0.000) 2 0.010 LOSS 0.019 LVRG GROWTH DA

Notes: The p-values are in parentheses; see Table III for denitions of the variables; n 11,307

Table IV. Pearson correlation matrix of variables used in our tests

GC MODOP TENURE AUDFEE ROA LOSS LVRG (0.243) (0.000) (0.000) (0.000) (0.326) (0.000) (0.269) (0.041) GROWTH 2 0.032 0.001 2 0.026 2 0.076 2 0.103 2 0.119 0.036 2 0.081 2 0.077 DA (0.000) 0.020 (0.031) (0.946) 0.008 (0.405) (0.006) 0.019 (0.049) (0.000) 0.001 (0.896) (0.000) 0.028 (0.003) (0.000) 2 0.019 (0.039) (0.000) 0.021 (0.029) (0.000) 2 0.026 (0.005) (0.000) 0.029 (0.002) 0.016 (0.094) SIZE 2 0.155 2 0.129 2 0.164 0.111 0.251 0.703 0.346 2 0.357 0.089 2 0.037 2 0.043 (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)

ARL

Variable Intercept ARL GC MODOP TENURE AUDFEE ROA LOSS LVRG GROWTH DA SIZE MW Wald x2 Pseudo-R 2 n

Pooled years Coefcient p-value 0.9918 0.0170 1.1248 0.0086 0.0485 20.1067 21.1029 0.3091 20.1791 20.3393 0.6114 20.7294 0.4618 , 0.0001 0.0002 0.9630 0.3547 0.3218 0.0026 0.1587 0.6230 0.1074 0.1900 , 0.0001

2003-2004 Coefcient p-value 2 0.7841 0.0134 1.1351 2 0.0901 0.0486 0.0219 2 1.4152 2 0.0368 2 0.2658 2 0.8389 0.5650 2 0.8013 0.6820 0.0199 0.0028 0.7028 0.6824 0.8815 0.0018 0.9013 0.5572 0.0082 0.3583 ,0.0001

2005-2006 Coefcient p-value 4.3635 0.0555 0.0249 0.0256 1.0410 0.0516 0.0570 0.8529 0.0545 0.2275 20.3895 0.0286 20.9271 0.1788 0.7212 0.0311 0.2348 0.7099 0.3084 0.3074 0.5042 0.5145 20.6015 0.0001 1.5871 , 0.0001 167.89 * * * 0.3154 5,522

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43

387.89 * * * 0.2711 11,307

230.20 * * * 0.2959 5,785

Notes: Signicance at: *10, * *5, and * * *1 percent; see Table III for denitions of variables

Table V. Results of logistic regressions of auditor resignations

argue that SOX 404 reports provide a new measure of a clients audit risk[13] that potentially could lead to a realignment of the auditor-client relationship. All models are statistically signicant, explaining 27.11-31.54 percent of the variation in the dependent variable. In all models, we nd that the variable of interest, ARL, is positive and statistically signicant, which is consistent with H1 that auditor resignations occur more frequently following lengthy ARLs. Also, in all models, compared with rms that keep their auditor, audit rms are more likely to resign from client rms that are smaller in size and have going concern opinions (signicant at least at the 10 percent level of testing). Excepting for the period 2005-2006, auditors are less likely to resign from rms with high return on assets (ROA). However, a similar result holds for the years 2005-2006 where we nd that auditors are more likely to resign from rms with losses (LOSS). The variable MODOP (modied opinion) which, contrary to expectations, was signicantly and negatively correlated to audit delays in the univariate tests (Table IV) does not have a signicant association with ARL in the multivariate regressions. The coefcients on AUDFEE and GROWTH are statistically signicant only during 2005-2006 and 2003-2004, respectively. Importantly, in the post-Section 404 period (2005-2006), we nd a statistically positive coefcient of MW, which is consistent with Ettredge et al. (2007). It is interesting that our measure of audit risks, ARL, has a signicant explanatory power, over and above MW, for predicting auditor resignations. The coefcients on all other variables are statistically not signicant. To gauge economic signicance, we also estimate the logistic regression using a dummy variable that takes a value of 1 if the ARL is longer than the median ARL and 0 otherwise (results not reported). In the pooled sample, the coefcient on the dummy is 0.3539 (t-value: 3.56) which suggests that (compared to the control group) there is an approximately 42 percent greater chance of an auditor resignation taking place for rms with lengthier ARLs[14].

MAJ 26,1

44

Next, we test H2 by ordering our sample into three groups: downward auditor switches (coded 3), lateral auditor switches (coded 2), and no switches (coded 1). In the ordered logistic regression analyses in Table VI, we nd that the coefcient on ARL is positive and statistically signicant in all regressions which supports H2, namely that as audit risks increase not only does the likelihood of an auditor change increase but that clients are more likely to engage a smaller, non-Big N auditor in the subsequent year. The results on the remaining variables are virtually identical to those presented in Table V. 5. Additional analyses 5.1 Unexpected ARL An advantage of using audit delays in our tests is that they constitute a simple proxy for the quality of an auditor-client relationship. A more sophisticated proxy that could be used instead is unexpected audit delay. Unexpected audit delays can be interpreted as reecting changes in client-auditor interactions which in turn could result in auditor switches. (See Appendix for the model used to obtain predicted values of audit delays.) Unexpected ARLs get at the idea that something has changed for the client rms that has motivated the auditor change. However, a disadvantage of this proxy from an investors perspective is its complexity; in addition, measurement error from model misspecication could affect the test results. While we nd positive and statistically signicant coefcients on unexpected audit delays using both logistic and ordered logistic models (signicant at the 1 percent level in both models), it is worth noting that the simple proxy, audit delay does just as well in predicting auditor changes which is consistent with our conjecture that Section 404 of SOX altered auditors incentives to retain risky clients, as proxied by lengthy audit delays (results of these tests are untabulated).
Pooled sample Coefcient p-value 2.7748 2.9886 0.0177 1.1118 20.0895 0.0441 20.1151 21.1438 0.2268 20.1291 20.3737 0.5296 20.8779 0.0037 0.0018 , 0.0000 , 0.0000 0.4774 0.5621 0.1277 , 0.0001 0.1243 0.6042 0.0063 0.0943 , 0.0000 2003-2004 Coefcient p-value 0.6164 0.8402 0.0120 1.1274 20.1587 0.0403 20.0076 21.5429 20.0593 20.0741 20.9264 0.4090 20.9125 0.6534 0.5405 0.0015 ,0.0000 0.3129 0.2354 0.9419 ,0.0001 0.7621 0.8076 ,0.0001 0.3286 ,0.0001 2005-2006 Coefcient p-value 7.1352 , 0.0000 7.3600 , 0.0001 0.0317 , 0.0001 1.0932 0.0046 2 0.0318 0.8857 0.0545 0.8326 2 0.4549 0.0004 2 0.9053 0.0741 0.5857 0.0139 0.0304 0.9469 0.3376 0.0992 0.6818 0.2263 2 0.7758 , 0.0000 1.8587 , 0.0000 361.63 * * * 0.4392 5,522

Variable Intercept1 Intercept2 ARL GC MODOP TENURE AUDFEE ROA LOSS LVRG GROWTH DA SIZE MW Wald x2 Pseudo-R 2 n

Table VI. Results of ordered logistic regressions of auditor resignations

886.49 * * * 0.3694 11,307

522.99 * * * 0.3835 5,785

Notes: Signicance at: *10, * *5, and * * *1 percent; see Table III for denitions of variables

5.2 Industry-adjusted ARLs We also replace ARL with an industry-adjusted ARL. We calculate median values of ARL for each industry as dened in Frankel et al. (2002) and obtain industry-adjusted ARLs which are ARLs minus the median of the industry ARLs. We obtain qualitatively similar results to those documented (results of these tests are untabulated). 5.3 Non-audit service fees It is possible that auditors will be less likely to resign from clients that provide large amounts of non-audit service revenue (e.g. fees for tax services). We nd (results not tabulated) that the coefcient on non-audit service fees is negative and statistically signicant, suggesting that auditor changes are less likely to occur for clients requiring large amounts of non-audit services. The results on the other variables are qualitatively unchanged. 6. Conclusion This study uses audit delays to proxy for audit risk factors that measure the quality of auditor-client interactions. Our results are consistent with those of previous work showing that auditors respond to high audit risk factors by dropping risky clients. Our results show that more than nancial distress, the quality of the auditor-client interaction determines whether an auditor will stay with a client or resign. Auditor changes are important events that markets want to know about. However, companies often do not fully disclose reasons for auditor changes. Our research suggests that a long audit delay represents a publicly observed proxy for possible disagreements between auditors and their clients or the presence of audit risk factors that lead to an auditor change in the following year. This study suggests that all else constant, investors should regard a lengthy audit report lag as indicating that there has been a deterioration in the quality of the client-auditor interaction, which could translate into a downward auditor change in the following year. An audit delay also presents an observable proxy for successor auditors to consider while evaluating their risk exposure from the acceptance of a client whose auditor has resigned. As a proxy for client-auditor disagreement, audit delays are able to predict an auditor change just as well as our more sophisticated proxy (unexpected audit delays) that controls for known factors that affect audit delays. Finally, there is an important concern associated with auditor changes that follow long audit delays. Our results suggest that the successor auditors are likely to be of lower quality. Research suggests that capital markets react negatively to downward auditor changes (Krishnamurthy et al., 2006). This raises an important question for regulators as to whether the smaller accounting rms will be able to perform quality audits for these high-risk rms (Turner et al., 2005). An interesting question for future research would be to examine how non-Big N auditors manage their risk exposure following the acceptance of risky clients dropped by Big N rms.
Notes 1. There were 2,514 auditor changes during 2003 and 2004 affecting more than one-fourth of all US publicly traded companies (Taub, 2005). 2. For example, in 2004, BDO Seidman, LLP had a net gain of 71 clients, while Grant Thornton, LLP gained 17 clients, net (Koehn and DelVecchio, 2006).

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MAJ 26,1

3. Audit risk is the risk that an auditor may unknowingly fail to appropriately modify his/her opinion on nancial statements that are materially misstated (AICPA, 1983, AU 312.02). 4. Prior studies also suggest that auditors are proactive in managing their client portfolios. For example, Krishnan and Krishnan (1997) and Shu (2000) document that auditors are more likely to resign from riskier clients rather than simply wait to be dismissed. 5. That is, when there is a going concern issue, auditors may delay expressing an audit opinion or nalizing their report, in the hopes that the problem will be resolved and a modied opinion will be avoided (Ireland, 2003). 6. There are several differences between this study and Schloetzers (2007) study. First, we measure the reporting lag as the time between the scal year end and the audit completion date (audit report lag), while Schloetzer (2007) measures delays as the time between the scal year end and the SEC ling date (ling lag). In our sample, the correlation between these two lags is 0.418, which suggests that the two lags potentially represent different underlying events. Lee et al. (2009) argue that upon completion of an audit, managers exercise their discretion by determining the optimal time for announcing earnings or ling their nancial statements by considering the costs and benets of their timing decisions. For example, rms with good news are likely to announce earnings or le their nancials soon after the completion of an audit. The ling lag used by Schloetzer, therefore, captures both the nature of the auditor-client interaction (proxied by the audit report lag) and the client-managers discretionary timing decision (proxied by the discretionary lag). Second, we focus only on auditor resignations, while Schloetzers sample includes both resignations and dismissals. Client rms might dismiss their auditors for lengthy delays because lengthy audit delays could imply inefciencies in an audit. Therefore, focusing only on resignations might provide for a cleaner sample for testing our hypothesis. We thank an anonymous reviewer for this suggestion. Third, unlike Schloetzer (2007), we control for alternative explanations for an auditor change, including audit fees, growth opportunity, auditor tenure, and discretionary accruals (DeFond and Subramanyam, 1998; Johnson and Lys, 1990; Bockus and Gigler, 1998). Most importantly, we control for internal control weaknesses that have been shown to signicantly increase audit delay (Ettredge et al., 2007). Finally, we provide an additional new result showing that auditor-client realignments follow an ordered sequence as audit delays increase. 7. Another proxy for audit risk is a material weakness in internal control which is a required disclosure under SOX 404. Ettredge et al. (2006) show that the presence of a material weakness in internal controls over nancial reporting is associated with longer audit delays. This supports our assertion that audit delays proxy for audit risks. In a later section, we explore this issue in more detail. 8. While we lose a signicant number of rms (8,985 observations or 15 percent of the sample) due to this criterion, we found that a large number of these rms are not covered by Compustat. For example, we found that approximately half of these rms do not have data on total assets on Compustat (Krishnan and Yang, 2009). Coverage on Audit Analytics is much wider than on Compustat whose coverage is restricted to larger rms showing a survivorship bias. The results are qualitatively the same when we use 180 days for deleting extreme ARLs. 9. We lose the year 2002 because we use lagged variables in our tests. 10. We also include two more control variables: EXPERT, a dummy variable coded 1 if an auditor has 30 percent or more market share in an industry and 0 otherwise and MNA, a dummy variable coded 1 if the client had a merger or acquisition in the two previous years, and 0 otherwise. The above two variables are used to model auditor changes due to client-initiated reasons. These variables are included due to Lee et al. (2004) who argue that

46

sometimes the distinction between resignations and dismissals is blurry. Inclusion of these variables does not alter our inference. 11. Other than those discussed here, there are no statistically signicant differences in the other variables used in our tests. 12. The SEC reduced the 10-K ling period for large accelerated lers (i.e. equity public oat $700 M or more) to 60 days for year ends on or after December 15, 2006 (SEC, 2005). To control for this change, we include a dummy variable for large accelerated lers and an interaction term with audit delay for the years 2005-2006. Our main results (untabulated) remain unchanged. 13. The reports reveal auditors judgments about internal controls and accounting-related issues that are largely independent of a clients nancial conditions and provide a strong indicator (in contrast to bankruptcy or litigation risk metrics) for explaining client retention decisions (Ettredge et al., 2007). 14. The odds are computed as the exponent of 0.3539, which is 1.42 or a 42 percent larger chance.

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References AICPA (1983), Audit Risk and Materiality in Conducting an Audit, Statement on Auditing Standards No. 47, American Institute of Certied Public Accountants, New York, NY. Bamber, E., Bamber, L. and Schoderbek, M. (1993), Audit structure and other determinants of audit report lag: an empirical analysis, Auditing: A Journal of Practice & Theory, Vol. 12, pp. 72-80. Bell, T.B., Bedard, J.C., Johnstone, K.M. and Smith, E.F. (2002), RiskSM: a computerized decision aid for client acceptance and continuance risk assessments, Auditing: A Journal of Practice & Theory, Vol. 21, pp. 97-113. Beneish, M.D., Hopkins, P.E., Jansen, I.P. and Martin, R.D. (2005), Do auditor resignations reduce uncertainty about the quality of rms nancial reporting?, Journal of Accounting & Public Policy, Vol. 24, pp. 357-90. Bockus, K. and Gigler, F. (1998), A theory of auditor resignation, Journal of Accounting Research, Vol. 36, pp. 191-208. Cassell, C.A., Giroux, G., Myers, L.A. and Omer, T.C. (2007), The effect of the Sarbanes-Oxley Act of 2002 on the relation between the strength of corporate governance and auditor-client alignments, working paper, Texas A&M University, College Station, TX. Cenker, W.J. and Nagy, A.L. (2008), Auditor resignations and auditor industry specialization, Accounting Horizons, Vol. 22 No. 3, pp. 279-95. Choi, J.-H., Doogar, R. and Ganguly, A. (2004), The riskiness of large audit rm client portfolios and changes in audit liability regimes: evidence from the US audit market, Contemporary Accounting Research, Vol. 21 No. 4, pp. 747-85. DeFond, M.L. and Subramanyam, K.R. (1998), Auditor changes and discretionary accruals, Journal of Accounting and Economics, Vol. 25, pp. 35-67. Ettredge, M., Li, C. and Sun, L. (2006), The impact of SOX section 404 internal control quality assessment on audit delay in the SOX era, Auditing: A Journal of Practice & Theory, Vol. 25 No. 2, pp. 1-23. Ettredge, M., Heintz, J., Li, C. and Scholz, S. (2007), Auditor realignments accompanying implementation of SOX 404 reporting requirements, working paper, University of Kansas, Lawrence, KS.

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Frankel, R.M., Johnson, M.F. and Nelson, K.K. (2002), The relation between auditors fees for nonaudit services and earnings management, The Accounting Review, Vol. 77, pp. 71-105. GAO (2006), Sarbanes-Oxley Act: consideration of key principles needed in addressing implementation for smaller public companies, United States Government Accountability Ofce, available at: www.gao.gov/cgi-bin/getrpt?GAO-06-361 Henderson, B. and Kaplan, S. (2000), An examination of audit report lag for banks: a panel data approach, Auditing: A Journal of Practice & Theory, Vol. 19, pp. 160-74. Ireland, J.C. (2003), An empirical investigation of determinants of audit reports in the UK, Journal of Business Finance & Accounting, Vol. 30 Nos 7-8, pp. 975-1015. Johnson, W.B. and Lys, T. (1990), The market for audit services: evidence from voluntary auditor changes, Journal of Accounting and Economics, Vol. 12, pp. 281-308. Johnstone, K.M. and Bedard, J.C. (2004), Audit rm portfolio management decisions, Journal of Accounting Research, Vol. 42 No. 4, pp. 659-90. Jones, F.L. and Raghunandan, K. (1998), Client risk and recent changes in the market for audit services, Journal of Accounting & Public Policy, Vol. 17, pp. 169-81. Knechel, W. and Payne, J. (2001), Additional evidence on audit report lag, Auditing: A Journal of Practice & Theory, Vol. 20, pp. 137-46. Koehn, J.L. and DelVecchio, S.C. (2006), Revisiting the ripple effects of the Sarbanes-Oxley Act, The CPA Journal, Vol. 76 No. 5, pp. 32-9. Kothari, S.P., Leone, A.J. and Wasley, C.E. (2005), Performance matched discretionary accrual measures, Journal of Accounting Economics, Vol. 39, pp. 163-97. Krishnamurthy, S., Zhou, J. and Zhou, N. (2006), Auditor reputation, auditor independence, and the stock market impact of Andersens indictment on its client rms, Contemporary Accounting Research, Vol. 23 No. 2, pp. 465-90. Krishnan, J. and Krishnan, J. (1997), Litigation risk and auditor resignations, The Accounting Review, Vol. 72, pp. 539-60. Krishnan, J. and Yang, J.S. (2009), Recent trends in audit report and earnings announcement lags, Accounting Horizons, Vol. 23, pp. 265-88. Landsman, W.R., Nelson, K.K. and Rountree, B.R. (2009), Auditor switches in the pre- and post-Enron eras: risk or realignment?, The Accounting Review, Vol. 84 No. 2, pp. 531-58. Lee, H., Mande, V. and Ortman, R. (2004), The effect of audit committee and board of director independence on auditor resignation, Auditing: A Journal of Practice & Theory, Vol. 23 No. 2, pp. 131-46. Lee, H., Mande, V. and Son, M. (2009), Do lengthy auditor tenure and the provision of non-audit services by the external auditor reduce audit report lags?, International Journal of Auditing, Vol. 13 No. 2, pp. 87-104. Public Accounting Report (2004), Big Four shed smaller clients in Big Numbers, September 30. Rama, D.V. and Read, W.J. (2006), Resignations by the Big N and the market for audit services, Accounting Horizons, Vol. 20 No. 2, pp. 97-109. Schloetzer, J.D. (2007), Arthur Andersen, SOX section 404 and auditor turnover: theory and evidence, working paper, University of Pittsburgh, Pittsburgh, PA. Schwartz, K. and Menon, K. (1985), Auditor switches by failing rms, The Accounting Review, Vol. 60, pp. 248-61. Schwartz, K. and Soo, B.S. (1996), The association between auditor changes and reporting lags, Contemporary Accounting Research, Vol. 13 No. 1, pp. 353-70.

SEC (2005), Revisions to accelerated ler denition and accelerated deadlines for ling periodic report, Release No. 33-8644, Securities and Exchange Commission, Washington, DC, available at: www.sec.gov/rules/nal/33-8644.htm Sengupta, P. (2004), Disclosure timing: determinants of quarterly earnings release dates, Journal of Accounting & Public Policy, Vol. 23, pp. 457-82. Shu, S. (2000), Auditor resignations: clientele effects and legal liability, Journal of Accounting and Economics, Vol. 29, pp. 173-205. Stice, J.D. (1991), Using nancial market information to identify pre-engagement factors associated with lawsuits against public accountants, The Accounting Review, Vol. 66, pp. 516-33. Taub, S. (2004), Big Four seen shedding small clients: Sarbox rules stretch audit rms resources, E&Y Chief Executive claims, available at: www.cfo.com/ (accessed 24 September 2004). Taub, S. (2005), Auditors rotating at a dizzying pace, available at: www.cfo.com/ (accessed 18 February 2005). Turner, L.E., Williams, J.P. and Weirich, T.R. (2005), An inside look at auditor changes, The CPA Journal, pp. 12-21. Watkins, A.L., Hillison, W. and Morecroft, S.E. (2004), Audit quality: a synthesis of theory and empirical evidence, Journal of Accounting Literature, Vol. 23, pp. 153-93. Winograd, B.N., Gerson, J.S. and Berlin, B.L. (2000), Audit practices of PricewaterhouseCoopers, Auditing: A Journal of Practice & Theory, Vol. 19 No. 2, pp. 175-82. Further reading DeAngelo, L.E. (1981), Auditor size and audit quality, Journal of Accounting and Economics, Vol. 3, pp. 183-99. Elder, R., Zhang, Y., Zhou, J. and Zhou, N. (2007), Internal control weaknesses and client risk management, working paper, Syracuse University, New York, NY. Ettredge, M., Li, C. and Scholz, S. (2007), Audit fees and auditor dismissals in the Sarbanes-Oxley era, Accounting Horizons, Vol. 21 No. 4, pp. 371-86. SEC (2002), Acceleration of Periodic Report Filing Dates and Disclosure Concerning Website Access to Reports, Release No. 33-8128, Securities and Exchange Commission, Washington, DC, available at: www.sec.gov/rules/nal/33-8128.htm Appendix Following prior studies (Bamber et al., 1993; Henderson and Kaplan, 2000; Knechel and Payne, 2001), we estimate the following ARL model for obtaining the predicted or expected values of audit delays. Unexpected ARLs are actual ARLs minus their predicted values: ARLit a0 b1 TEN it b2 LNNAF it b3 FC it b4 SEGNUM it b5 ABFEE it b6 EXTRAit b7 LOSS it b8 AUOP it b9 YENDit b10 BIG4it b11 LNSIZE it b12 NEWS it b13 INSOWNRit industry dummies year dummies 1it where (expected sign is shown in parentheses): ARL TEN : number of calendar days from scal year end to date of the auditors report; : number of years working with current auditors (2 );

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A1

MAJ 26,1

LNNAF FC SEGNUM ABFEE

: natural log of non-audit service fees paid to incumbent auditors (2 ); : nancial condition measured as Zmijewskis nancial condition index (); : reportable segments of a client (); : abnormal audit fees ( ); : 1 if a rm reports extraordinary items and 0 otherwise (); : 1 if a rm reports negative earnings and 0 otherwise (); : 1 if the auditors opinion is modied or qualied and 0 otherwise (); : 1 if a rms scal year ends in December and 0 otherwise ( ); : 1 if an auditor is one of the Big N auditing rms and 0 otherwise (/2); : client rm size measured as the natural log of total assets (2 ); : clients unexpected earnings dened as the difference between current and prior years earnings per share (EPS), divided by the absolute value of prior years EPS (2 ); and

50

EXTRA LOSS AUOP YEND BIG4 LNSIZE NEWS

INSOWNR : ranked value of institutional ownership (2).

About the authors Vivek Mande is a Professor of Accounting at the Mihaylo College of Business and Economics at the California State University, Fullerton. He is also the Director of the Center for Corporate Reporting and Governance. His work has been published in Contemporary Accounting Research, Auditing: A Journal of Practice and Theory, Journal of Accounting and Public Policy, and numerous other journals. Myungsoo Son is an Associate Professor of Accounting at the Mihaylo College of Business and Economics at the California State University, Fullerton. His research interests include audit quality, auditor fees, and earnings management. Myungsoo Son is the corresponding author and can be contacted at: mson@fullerton.edu

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