Professional institutions and the public press have reported a dramatically higher increase of auditor changes in the post-SOX periods than in the pre-SOX periods (Jean 2004; Williams 2005; Yoon 2004). However, few attempts have been made to explore the possible reasons underlying this increase. Following the framework of earnings management literature, I focus on auditor dismissals and posit that the non-Big 4’s audit quality has increased after SOX.
A comprehensive sample of 3,373 auditor dismissals between fiscal years 2001 and 2007 is collected and analyzed. Descriptive statistics show that downgrade and changes within the non-Big 4 account for 31.38 and 46.30 percents of all auditor dismissals after SOX. Auditor dismissal companies are generally smaller, less profitable, having more debts and higher growth opportunities, engaging in more merger and acquisition activity, and suffering lower operating cash flows than companies that do not dismiss auditors. To control for
10There is no difference in the mean size between auditor change firms (measured by total assets) and non-change firms, suggesting that I have successfully matched on firm size. To conduct a model that is consistent with the model in the full sample analyses, I include firm size as a control variable in the matched sample analyses. If I exclude the firm size from matched sample analysis, I obtain the similar results.
22
potential self-selection bias resulting from auditor dismissals, I adopt Heckman’s (1979) two-stage estimation procedure. Two important findings are documented. First, companies dismiss their auditors before SOX so that they can use both discretionary accruals and real earnings activities to manage earnings. More importantly, auditor dismissal companies appear to shift their earnings management method from traditional accruals in the pre-SOX period to real manipulation activities in the post-SOX period. Second, after decomposing auditor dismissals into four categories, the empirical results show that, for downgrade and changes within the non-Big 4, earning management occurs only in the pre-SOX period. After SOX, non-Big 4 successor auditors show the greatest ability to mitigate companies’ artificial and real earnings management. These conclusions remain valid when downgrade and changes within non-Big 4 samples are examined separately.
Some features of the study point to several directions for future research and caveats. First, further work is warranted on testing how the capital market interprets the dramatic increase of downward auditor changes in the post-SOX periods. To the extent that the capital participants can really “monitor” these downgrade auditor change companies, companies’ opportunistic behavior shall be mitigated. Second, reasons other than earnings management may also explain the remarkable increase of auditor changes in the post-SOX periods. An understanding of these other reasons may provide the regulators with insights into the effectiveness of SOX in improving audit quality. Finally, I focus on auditor dismissals. Therefore, the empirical results could not be applied to explain the huge increase in auditor resignations brought by the Big 4 vs. non-Big 4 auditors. Since SOX has changed the legal environment imposed on the auditing profession, more studies are needed to further investigate resignation decisions made by CPA firms with differential audit quality in the post-SOX periods.
23 REFERENCE
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28
TABLE 1
Sample Selection Procedure
All auditor dismissals during fiscal year 2001 to 2007 are collected from the Audit analytics database 9,791
Less: All auditor dismissal cases involving Arthur Andersen (2,377)
Less: Financial institutions (SIC codes 6000-6999) (2,169)
Less: Observations missing in the Compustat (1,872)
Final sample 3,373
29
TABLE 2
Frequencies of Auditor Changes in the Sample (N = 3,373) By Year and Auditor Change Types Sample Year Upgrade to
Big 4 a
Downgrade to non-Big 4
Switch within Big 4
Switch within non-Big 4
Total Number of Auditor Changes
Percentage of Auditor Changes in the Sample Panel A: Full Auditor Change Sample (Years 2001 ~ 2007)
2001 34 88 141 111 374 11.09%
2002 30 84 68 169 351 10.41%
2003 24 113 77 197 411 12.18%
2004 24 239 96 271 630 18.68%
2005 18 219 98 252 587 17.40%
2006 28 154 127 236 545 16.16%
2007 36 106 63 270 475 14.08%
Total Number of
Auditor Changes 194 1,003 670 1,506 3,373
Percentage of Auditor Changes in
the Sample
5.97% 38.06% 19.78% 36.19%
Panel B: Auditor Change Sample in the Post-SOX period (Years 2003 ~ 2007) Total Number of
Auditor Changes
130 831 461 1,226
Percentage of Auditor Changes in
the Sample
4.91% 31.38% 17.41% 46.30%
aBig 4 CPA firms include Deloitte Touche, Ernst Young, KPMG, and PricewaterhouseCoopers. All other CPA firms are classified as non-Big 4.
30
TABLE 3
Descriptive Statistics for the Full Sample (Sample Period 2001 ~ 2007) No-Auditor Change Companies
(N = 44,941)
Auditor Change Companies
(N = 3,373) Differences Variablea Mean Median Std. Dev. Mean Median Std. Dev. Parametric
t testsb
Mann-Whitney z testsb
DA -0.025 -0.016 0.231 0.000 -0.025 0.413 -5.730*** 5.446***
RPROD -0.126 -0.034 0.593 -0.233 -0.055 1.012 9.486 *** 10.951***
SIZE 5.570 5.715 2.756 3.730 3.391 2.408 37.493 *** 37.423***
LEVERAGE 0.419 0.200 0.749 1.059 0.306 1.393 -44.326 *** -18.724 ***
MB 9.387 5.043 9.443 11.487 7.435 10.677 -12.353 *** -8.692 ***
OCF -0.232 0.030 1.366 -0.702 -0.013 1.927 18.864*** 18.484 ***
LEADER 0.285 0.000 0.452 0.476 0.000 0.500 -23.540*** -23.408***
INDSHARE 0.003 0.004 0.009 0.003 0.004 0.009 -0.139 0.027
LOSS 0.380 0.000 0.485 0.596 1.000 0.491 -24.932 *** -24.776 ***
SHAREDECR 0.113 0.000 0.316 0.099 0.000 0.299 2.343** 2.343**
SHAREINCR 0.237 0.000 0.425 0.301 0.000 0.459 -8.412*** -8.406***
ROA -0.175 0.013 1.835 0.197 0.009 3.429 -10.547*** -0.130
M&A 0.006 0.000 0.075 0.030 0 .000 0.171 -14.251*** -16.121***
FEE 0.825 0.165 12.517 0.866 0.779 14.403 -23.241*** -24.667***
GC 0.001 0.000 0.033 0.099 0.000 0.299 -10.29*** -12.26***
aThe definitions of the variables reported in this table are: DA= performance adjusted discretionary accruals; RPROD=abnormal production costs; SIZE = Natural log of total assets at end of year t; LEVERAGE = Total debt divided by total assets; MB = Market value to book value of equity; ROA = Return on assets, defined as net income before extraordinary items divided by total assets; LOSS = 1 if operating income is less than 0 in year t, and 0 otherwise; GC = 1 if a firm received a going concern opinion, and 0 otherwise in year t-1; FEE = the ratio of audit fees divided by the total fees in year t-1; INDSHARE = The percentage of the square root of total assets that the auditor audits for all companies in the client’s industry; M&A = 1 if the firm experiences a merger or acquisition in the preceding two years, and 0 otherwise; OCF = Cash flows from operating activity deflated by beginning total assets; LEADER = 1if the successor auditor (or incumbent auditor for no-auditor change companies) industry expertise falls into the classification presented in Hogan and Jeter (1999), and zero otherwise;
SHAREDECR = 1 if a company has a decline of more than 10 percent of total outstanding shares during the year, and 0 otherwise; SHAREINCR = 1 if a company has a increase of more than 10 percent of total outstanding shares during the year, and 0 otherwise.
bAsterisks *, **, and *** indicate two-tailed significance at the 0.10, 0.05, and 0.01 levels, respectively.
31 TABLE 4
Two-stage Regression Results for Full Sample - Using One Auditor Change Dummya
Stage 1 Model: CHANGEi t, 0 1SIZEi t, 2MBi t, 3LEVERAGEi t, 4ROAi t, 5LOSSi t, 6GCi t, 7FEEi t, 8INDSHAREi t, 9M&Ai t, (3) Stage 2 Model: DA RPRODi t,/ i t, 0 1SIZEi t, 2MBi t,3LEVERAGEi t, 4CFOi t, 5CHANGEi t, 6SOXi t, 7SOXi t,CHANGEi t, 8LEADER9SHAREDECRi t, 10SHAREINCRi t, 11Lambdai t, (4) First-Stage Second-Stage (two earnings management measures: DA and RPROD)
Probit Model Absolute DA Positive DA Negative DA Absolute RPROD Positive RPROD Negative RPROD Variableb Coeff. z-stat.c Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
INTERCEPT -1.295 -43.03*** -0.090 -6.8*** 0.238 7.80*** -0.115 -14.26*** -0.007 -0.28 0.070 2.88*** -0.026 -0.84
SIZE -0.101 -23.51*** -0.002 -1.90* -0.012 -14.15*** 0.017 29.81*** 0.063 33.38*** -0.033 -17.98*** 0.079 34.49***
MB 0.005 5.17*** 0.001 6.10*** -0.001 -5.82*** 0.001 18.84*** 0.003 11.37*** -0.001 -3.84*** 0.003 9.88***
LEVERAGE 0.218 24.29*** -0.007 -3.57*** 0.075 17.24*** -0.044 -38.09*** -0.154 -41.07*** 0.044 11.01*** -0.182 -41.23***
ROA 0.009 0.53
LOSS 0.077 3.48***
GC 3.062 28.26***
FEE -0.007 -1.82*
INDSHARE -0.112 -0.11 M&A 0.742 9.59***
OCF 0.001 9.62*** 0.000 3.97*** 0.002 12.44*** 0.003 4.85*** -0.002 -1.14 0.001 3.70***
CHANGE 0.045 4.68*** 0.184 6.36*** -0.029 -4.25*** 0.010 0.49 0.288 11.27*** -0.077 -2.93***
SOX 0.071 24.33*** -0.098 -9.85*** 0.081 40.50*** 0.002 0.40 0.031 3.99*** -0.032 -4.16***
SOXCHANGE -0.020 -1.86* -0.056 -1.76* 0.010 1.33 -0.005 -0.22 -0.076 -2.78*** 0.010 0.35
LEADER -0.024 -7.67*** -0.040 -4.61*** 0.004 1.87* 0.045 6.26*** -0.006 -0.90 0.059 6.62***
SHAREDECR 0.023 8.29*** -0.039 -3.41*** 0.048 16.97*** -0.013 -1.50 0.064 6.85*** -0.061 -5.65***
SHAREINCR 0.027 6.94*** 0.068 9.08*** -0.010 -5.41*** -0.079 -12.33*** 0.073 12.52*** -0.141 -17.99***
Lambda 0.007 0.97 -0.091 -6.78*** -0.061 -13.64*** -0.200 -13.88*** 0.067 5.14*** -0.232 -13.07***
Pseudo/Adj. R2 0.1613 0.017 0.117 0.153 0.086 0.157 0.128
F-statistic 3887*** 79.12*** 98.78*** 357.40*** 267.15*** 133.41*** 338.96***
N 48,314 48,314 11,893 34,001 48,314 9.991 37,848
32
aOutliers are winsorized using the 1% and 99% percentiles.
bThe definitions of the variables reported in this table are: DA= performance adjusted discretionary accruals; RPROD=abnormal production costs; SIZE = Natural log of total assets at end of year t;
MB = Market value to book value of equity; LEVERAGE = Total debt divided by total assets; ROA = Return on assets, defined as net income before extraordinary items divided by total assets;
LOSS = 1 if operating income is less than 0 in year t, and 0 otherwise; GC = 1 if a firm received a going concern opinion, and 0 otherwise in year t-1; FEE = the ratio of audit fees divided by the total fees in year t-1; INDSHARE = The percentage of the square root of total assets that the auditor audits for all companies in the client’s industry; M&A = 1 if the firm experiences a merger or acquisition in the preceding two years, and 0 otherwise; OCF = Cash flows from operating activity deflated by beginning total assets; CHANGE = 1 if a company changes audit firm in year t, and 0 otherwise; SOX= 1 for all firm-year observations in 2003 and latter and 0 for observations in 2002 and 2001; SOXCHANGE = 1 if a company changes audit firm in the post-SOX period and 0 otherwise; LEADER = 1if the successor auditor (or incumbent auditor for no-auditor change companies) industry expertise falls into the classification presented in Hogan and Jeter (1999), and zero otherwise; SHAREDECR = 1 if the firm has a decline of more than 10 percent of total outstanding shares during the year, and 0 otherwise; SHAREINCR = 1 if the firm has a increase of more than 10 percent of total outstanding shares during the year, and 0 otherwise; Lambda = inverse Mills ratio.
cAsterisks *, **, and *** indicate two-tailed significance at the 0.10, 0.05, and 0.01 levels, respectively.
33
TABLE 5
Second-stage Regression Results for Full Sample - Using Four Auditor Change Dummiesa
, , 0 1 , 2 , 3 , 4 , 5 , 6 , , 8 , 9 , 10 , , 11 , ,
DA RPROD SIZE MB LEVERAGE CFO UP DOWN WINB NWINB SOX SOX UP SOX DOWN
SOX WINB
Absolute DA Positive DA Negative DA Absolute RPROD Positive RPROD Negative RPROD Variableb Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
INTERCEPT -0.084 -6.38*** 0.362 10.40*** -0.204 -21.42*** -0.234 -7.66*** 0.095 3.54*** 0.062 25.61***
34
aOutliers are winsorized using the 1% and 99% percentiles.
bThe definitions of the variables reported in this table are: DA= performance adjusted discretionary accruals; RPROD=abnormal production costs; SIZE = Natural log of total assets at end of year t; MB = Market value to book value of equity; LEVERAGE = Total debt divided by total assets; OCF = Cash flows from operating activity deflated by beginning total assets; UP = 1 if a company with a non-Big 4 auditor switched to Big 4 in year t, and 0 otherwise; DOWN = 1 if a company with a Big 4 auditor switched to a non-Big 4 in year t, and 0 otherwise;
WINB4 = 1 if a company with a Big 4 auditor switched to a Big 4 in year t, and 0 otherwise; NWINB4 = 1 if a company with a non-Big 4 auditor switched to a non-Big 4 in year t, and 0 otherwise; SOX= 1 for all firm-year observations in 2003 and latter and 0 for observations in 2002 and 2001; LEADER = 1if the successor auditor (or incumbent auditor for no-auditor change companies) industry expertise falls into the classification presented in Hogan and Jeter (1999), and zero otherwise; SHAREDECR = 1 if a company has a decline of more than 10 percent of total outstanding shares during the year, and 0 otherwise; SHAREINCR = 1 if a company has a increase of more than 10 percent of total outstanding shares during the year, and 0 otherwise; Lambda = inverse Mills ratio.
cAsterisks *, **, and *** indicate two-tailed significance at the 0.10, 0.05, and 0.01 levels, respectively.
35
TABLE 6
Two-stage Regression Results for “Downgrade” Sample - Using Four Auditor Change Dummiesa
Stage 1 Model: DOWNi t, 0 1SIZEi t, 2MBi t, 3LEVERAGEi t, 4ROAi t, 5LOSSi t, 6GCi t, 7FEEi t, 8INDSHAREi t, 9M&Ai t, (6) Stage 2 Model: DA RPRODi t,/ i t, 0 1SIZEi t, 2MBi t,3LEVERAGEi t,4CFOi t, 5DOWNi t, 6SOXi t, 7SOXi t,DOWNi t, 8LEADER9SHAREDECRi t, 10SHAREINCRi t, 11Lambdai t, (7) First-Stage Second-Stage (two earnings management measures: DA and RPROD)
Probit Model Absolute DA Positive DA Negative DA Absolute RPROD Positive RPROD Negative RPROD Variableb Coeff. z-stat.c Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
INTERCEPT -1.295 -43.03*** 0.015 0.44 0.445 4.34*** -0.140 -7.15*** 0.162 2.2** 1.211 3.31*** 0.068 0.82 SIZE 0.014 1.18 -0.005 -1.2 -0.033 -3.07*** 0.011 4.88*** 0.032 3.82*** -0.108 -7.64*** 0.061 6.62***
MB 0.002 1.10 0.002 2.78*** 0.003 1.21 0.000 0.86* -0.002 -1.18 0.001 0.48 -0.006 -3.36***
LEVERAGE 0.000 -0.01 -0.008 -1.28 0.022 1.22 -0.007 -1.82 0.007 0.48 0.020 0.99 0.016 1.05 ROA 0.028 2.88***
LOSS -0.128 -2.37***
GC 0.002 0.03
FEE -0.039 -3.63***
INDSHARE 0.015 0.01
M&A -0.305 -2.04**
OCF 0.008 1.58 -0.035 -2.25** 0.024 7.52*** 0.052 4.56*** 0.002 0.10 0.044 3.35***
DOWN -0.019 -0.48 0.180 1.34# -0.039 -1.80* -0.055 -0.64 0.316 2.37** -0.075 -0.80 SOX 0.076 3.56*** -0.125 -2.09** 0.106 8.50*** -0.024 -0.53 -0.041 -0.58 -0.091 -1.76* SOXDOWN -0.052 -1.44# -0.164 -1.34# 0.029 1.51# 0.174 2.25** -0.231 -1.89* 0.274 3.23***
LEADER -0.015 -0.85 -0.044 -0.89 0.001 0.14 0.033 0.89 -0.035 -0.72 0.063 1.48 SHAREDECR 0.090 3.26*** 0.159 2.28** 0.060 3.72*** -0.148 -2.53** 0.091 1.16 -0.319 -4.70***
SHAREINCR 0.048 2.69*** 0.203 4.14*** -0.036 -3.53*** -0.020 -0.53 0.273 5.10*** -0.158 -3.61***
Lambda -0.052 -3.81*** -0.010 -0.24 -0.077 -9.23*** -0.369 -12.73*** -0.477 -1.62 -0.429 -13.31***
Pseudo/Adj. R2 0.031 0.021 0.068 0.209
0.121 0.135 0.128
F-statistic 6.56*** 7.14*** 6.82*** 56.13*** 42.09*** 10.54*** 56.74***
N 3,373 3,373 1,078 2,295 3,373 843 2,530
36
aOutliers are winsorized using the 1% and 99% percentiles.
bThe definitions of the variables reported in this table are: DA= performance adjusted discretionary accruals; RPROD=abnormal production costs; SIZE = Natural log of total assets at end of year t;
MB = Market value to book value of equity; LEVERAGE = Total debt divided by total assets; ROA = Return on assets, defined as net income before extraordinary items divided by total assets;
LOSS = 1 if operating income is less than 0 in year t, and 0 otherwise; GC = 1 if a firm received a going concern opinion in year t-1, and 0 otherwise; FEE = the ratio of audit fees divided by the
LOSS = 1 if operating income is less than 0 in year t, and 0 otherwise; GC = 1 if a firm received a going concern opinion in year t-1, and 0 otherwise; FEE = the ratio of audit fees divided by the