Investigating the reasons for why firms change auditors Essay

The accounting literature offers several possible accounts for why houses change hearers ( i.e. hearer exchanging ) . These accounts include: alterations in company direction who may so prefer another hearer with whom they have some old association or to take an incumbent hearer associated with former direction ( Burton and Roberts, 1967 ) , companies having qualified audit sentiments bespeaking a struggle in the auditor-client relationship ( Chow and Rice, 1982 ; Levinthal and Fichman,1988 ) or disputes over accounting or coverage methods ( DeAngelo, 1982 ) , companies in fiscal hurt whose shift of hearers may be correlated with the accounts merely mentioned ( Schwartz, and Menon, 1985 ) , and companies traveling public who change hearers in order to retain a larger accounting house because of the prestigiousness it may add to the offering ( Menon and Williams, 1991 ) .

Throughout, the common variables related to auditor shift, and act uponing hearer choice, are audit fees and qualified audit sentiments ; nevertheless, in more recent surveies non-audit services and auditor-client relationships besides appear to be of import variables, and more so they have both come to be perceived to impact audit quality by making possible independency issues. It is the association between hearer switches and auditor-client relationships that is the focal point of this reappraisal.In footings of auditor-client relationships as a variable affecting audit quality, audit houses are by and large considered to be a major beginning of professionals for accounting places outside public accounting providing a big figure of alumnas to the market given their high turnover rates. Consequently, former employees of audit houses may go possible clients through their places as senior direction or audit commission members and these relationships have been proposed to hold an impact on audit independency ( and hence audit quality ) . However, regulative and academic involvement has chiefly focused on the impact on audit quality of those relationships where employees of audit houses ( alumnas ) were hired straight by their audit clients, a pattern that was at erstwhile non uncommon. The possible quality issues stemming from the pattern of engaging audit house alumni arise as the clients may be excessively familiar with the audit house ‘s methods and processs and the hearer may possibly be excessively comfy with his/her former co-workers. In the U.

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S. , the Sarbanes Oxley Act of 2002 attempted to curtail the pattern of engaging audit house alumna ( termed the ‘revolving door policy ‘ ) by enforcing a annual waiting period for audit house employees who leave their accounting house to go an executive or board ( including its commissions ) member for a former client. In the U.

K. , the Ethical Standards set Forth by the Auditing Practices Board in December 2004 have taken similar stairss by enforcing a biennial waiting period for audit spouses ( battle, quality control, or cardinal spouse ) who leave their accounting house for a manager or cardinal direction place with an audited entity. However, the effects of these waiting periods on inquiries of audit quality, including hearer switches, remain an empirical inquiry as do inquiries mostly overlooked by regulators focused on those relationships where employees of audit houses ( alumnas ) were hired in fiscal inadvertence places by houses who were non clients of their alma mater house at the clip of their going but who may hold become clients at some point afterwards.Besides functioning to turn to issues of audit quality, two of the audit commission regulations coming out of the U.S. Securities and Exchange Commission as a consequence of the Sarbanes Oxley Act of 2002 required that ( 1 ) all houses have an audit commission comprised of at least three members, including at least one fiscal expert, and composed wholly of members independent from direction and that ( 2 ) the audit commission have duty for naming the outside hearer.

In the U.K. , since November 2003, the Combined Code on Corporate Governance ‘s regulations for houses listed on the London Stock Exchange on the first point are indistinguishable to the U.S. ordinance.

However, on the 2nd point, the U.K. codification requires simply that audit commissions make recommendations in relation to the assignment of the outside hearer and that, and where the board does non accept the audit commission ‘s recommendation, the grounds for why the board has taken a different place should be disclosed in the one-year study. In both scenes, the primary function of the audit commission may be seen as to supervise the fiscal coverage procedure with the ultimate aim of guaranting high quality fiscal coverage, which might be achieved, among other things, through effectual monitoring of direction and a high quality audit.

Therefore the first regulation necessitating all audit commission members to be independent seems to follow from conventional wisdom that independent managers are better proctors of direction behaviour than non-independent managers. However, the impression of independency has frequently been fraught with jobs non merely due to the trouble in specifying what precisely the construct means but in how it can be observed and measured.While the corporate administration ordinances originating in the post-Enron environment lead to a definition of independency that excludes current or former employees of the house, members of an organisation that receives parts from the house, stuff concern dealingss such as those with clients, providers, or suppliers of professional services ( legal, consulting, fiscal ) to the house, relations of senior direction, or members interlocked on another board, these ordinances do non see less traditional, but possibly every bit influential, connexions between members which may take to impairment of independency at either the single member or board/audit commission group degree. As a consequence, the purpose of the 2nd regulation necessitating that the audit commission assume duty, full or otherwise, for naming the outside hearer, while stand foring an effort to set distance between senior direction and the external audit procedure due to possible struggles of involvement, may be compromised by houses replacing members missing traditional independency with members holding unregulated connexions to other members of the board and senior direction. This create an extra inquiry of independency in footings of the extent such unregulated connexions impact the inadvertence and monitoring duties entrusted to the board/audit commission either by detering closely connected members from disputing the group or by promoting members to hold a voice within a closely connected group.

Therefore, comparative to auditor shift, the inquiry becomes whether the connexions between the audit commission of the board of managers and senior direction will hold an impact on the audit commission ‘s support for or resistance to the choice of a house with ties to senior fiscal direction

Background and Theory

Theories sing economic exchange provide an initial model for measuring the battle of an external hearer. For case, Williams ( 1988 ) developed a theoretical theoretical account to explicate auditor switches rooted in the stewardship hypothesis as reflected in the bureau theory literature. The bureau literature explains the demand for scrutinizing as originating from conflicting involvements between directors, stockholders and stakeholders ( i.e. other entities undertaking with a client ) .

Under the stewardship hypothesis, a director, assumed to prosecute an hearer to fulfill his ain involvements, would make so by seeking an hearer who satisfies the stockholder ‘s demands for confidence and hence select an hearer of high quality ( Williams ) . Directors would prefer to choose an hearer with whom he or she has an accommodating relationship which will assist guarantee the director maintains a favourable image as the good steward of stockholder ‘s investings ( Williams ) . As bureau theory considers the auditor-client relationship to be a link of contracts, new contracts between directors and stockholders are formed whenever the client hires a new director or officer. When there is a alteration in senior direction, they may bespeak an hearer alteration because the old hearer is associated with the former direction or because they prefer to work with an hearer with whom they have had favourable traffics in the yesteryear ( Williams ) . However, the audit battle procedure is apparently more complex, and other subjects provide alternate positions which more easy let that determinations are made by both the prospective client and the proposing audit house. For illustration, Simunic and Stein ( 1990 ) usage portfolio theory to pattern the hearer ‘s client choice procedure which helps explicate the auditor-client committedness as a bipartisan relation instead than a simple buyer-seller relationship in that if houses have private information about client public presentation, they may be more selective in their pick of client companies and the degree of acceptable audit fees. This thought of a bipartisan relation is approached from a different position in the work by Levinthal and Fichman ( 1988 ) who view the association between hearer and client as a dyadic inter-organizational relationship following societal exchange theory.

Social exchange theory chiefly differs from economic exchange theory in the manner the histrions are viewed. Where economic exchange positions histrions as covering with a market, and reacting to assorted market features, societal exchange theory views the exchange relationship under imperfect market conditions as the relationships between specific histrions whose actions are each contingent on the actions of the other ( Emerson, 1987 ) . These relationships can besides be considered in footings of societal capital theory and techniques developed in societal web analysis to explicate how an histrion ‘s degree of connection contributes to entree to information, ability to organize actions, and efficaciousness as a monitoring agent. The theory of societal capital presumes that the actions of persons are facilitated and coordinated through societal organisation, via common trust, norms and webs ( Adler and Kwon, 2002 ) . These actions will change depending on the relationships an histrion has with other histrions, the construction of relationships among histrions within the web, or both.

Social web analysis and its techniques for mensurating ‘connectedness ‘ rely on this thought of shared features and experiences to ease communicating and ease common apprehension, surrogate personal connexions and hinder nonsubjective monitoring of direction. This survey will use the constructs of societal capital and societal web analysis to senior direction and board relationships to find their possible association with hearer shift.

Literature reappraisal

Relative to auditor-client relationships, early surveies of hearer alterations focused on the association between hearer shift and alterations in direction without looking at the inter-organizational or inter-personal nexus between them. These surveies reported no important association despite the impression that directors, and peculiarly new directors, may prefer another hearer with whom they have had some old association in order to command their proctors.

For illustration, Chow and Rice ( 1982 ) papers that a alteration in direction negatively affects the likeliness of hearer exchanging but that this association is non important and that making of the audit study is the lone important variable in explicating shift. Later, Schwartz and Menon ( 1985 ) focal point on motives for neglecting houses in peculiar to alter hearers, placing direction alterations as one of the factors that could act upon hearer exchanging. They find that, although failing houses have a greater inclination to exchange hearers than healthier houses, neither direction alterations nor audit makings were statistically important in this association. Finally, Williams ( 1988 ) theoretical account of hearer switches supported that hearer alterations are non triggered by senior direction ‘shopping ‘ for a lenient or suiting hearer which was reaffirmed by Archambeault and DeZoort ( 2001 ) in their survey demoing audit commission independency and fiscal expertness minimizes the incidence of leery hearer switches that signal sentiment shopping.

Despite these early consequences provided grounds refuting that senior direction seek hearer alterations in order to command the hearers who monitor them, perceptual experiences of this persist and, as noted by Lennox ) , policies that cut down managerial influence over hearer dismissal and choice determinations remain in the involvement of regulators. As such, their possible impact on audit quality has been addressed through surveies of accounting house alumni in senior direction and board of managers or audit commission independency.Accounting house alumni in senior directionOne line of research has investigated how accounting house ‘alumni ‘ in senior direction places of audit clients can potentially compromise audit quality through hearer shift. This line of research brings the inter-organizational nexus into the image, as seen in the survey by Iyer et Al.

( 1997 ) who find in a study U.S. accounting house alumni that alumnas are inclined to supply economic benefits to their former audit houses. One manner that alumni in senior direction places of audit clients have been seen to profit their former house is to act upon the assignment of that house as the company ‘s hearer thereby directing concern to their former audit houses. Additionally, the concern is that the acquaintance between accounting houses and their former employees may impair hearer incredulity and objectiveness if the hearer is responsible for scrutinizing a company whose senior direction was antecedently employed by the audit house. Finally, because alumnas have a good apprehension of their former accounting house ‘s audit methodological analysis, there is the possible for them to more easy deceive hearers.

These concerns are supposed to hold a function in certain limitations that came out of the Sarbanes Oxley statute law on the ‘revolving door ‘ of accounting steadfast forces to clients. Empirical surveies of the U.S.

market such as the one by Lennox ( 2005 ) find that hearers are less likely to publish modified audit studies for clients with accounting house alumni in top-level direction places and by Menon and Williams ( 2004 ) papers that unnatural accumulations are larger for clients with former accounting house spouses as employees connoting greater net incomes direction. These two surveies provide grounds that audit behaviour is more indulgent towards clients with extremely placed alumnas. While this provides grounds of lower audit quality, Lennox ( 2005 ) studies that merely 10 % of audits in his sample involve alumnas in senior direction places and merely 7 % of the sample in Menon and Williams ( 2004 ) have former audit spouses. Further, Geiger et Al.

( 2005 ) nowadayss consequences for U.S. informations which indicate that net incomes direction, in the signifier of increased accounting accumulations, is no greater instantly before or after engaging in the companies prosecuting in the pattern of engaging their fiscal coverage executives ( CFO, VP-Finance or Controller ) straight from their external audit signifier compared to three separate control groups engaging persons from other beginnings or retaining their incumbent fiscal describing executives.Despite the apparently low prevalence of alumnas in senior direction places and assorted consequences, Geiger et Al. ( 2008 ) continue on this topic finding the prevalence of the go arounding door hiring pattern and look intoing the market ‘s reaction to companies engaging their senior accounting and finance officers straight from their external audit houses. They find, consistent with the two surveies mentioned above, that the proportion of go arounding door hires is comparatively low at 6 % of their sample, but that when they did happen, the market valued the go arounding door assignments more positively than other assignments. So despite the impact of the ‘revolving door ‘ phenomenon may be less important than normally thought, there is indicant that auditor-client relationships may hold effects for fiscal coverage and audit quality.

Board and scrutinize commission independencyIn the 2nd line of research, refering surveies of board of managers or audit commission independency, the concern that audit quality can be impaired if the company is audited by a house that once employed one of the company ‘s senior officers is seen to be mitigated to the extent a company ‘s audit commission is independent, as an independent audit commission might comprehend these connexions as a possible menace to scrutinize quality, thereby forestalling the assignment of officers ‘ former houses. Prior U.S. research associating audit quality with the boards of managers, and the audit commissions of boards of managers, shows that audit quality is higher when boards and audit commissions are more independent ( i.e. holding more outside managers ) . For illustration, Carcello and Neal ( 2000 ) show that in the presence of more independent boards, hearers are more likely to publish traveling concern studies for financially hard-pressed houses and less likely to be replaced by the company following their issue. Abbott and Parker ( 2000 ) study grounds that boards who are more independent boards and who are more active ( i.

e. run into more often ) are more likely to demand higher audit quality, a demand which is met through engaging industry specializers as their hearers. And, eventually, Klein ( 2002 ) present a negative relation between board and audit commission independency and net incomes direction as step by unnatural accumulations.

Yet these surveies do non specifically see hearer alumni factors.More straight, empirical surveies such as the one by Lennox and Park ( 2007 ) find that an audit house is more likely to be appointed if the company has an officer who is an alumna of the house, particularly if the officer has late left the audit house. However, they besides find that this likeliness to be mitigated by the extent the company ‘s audit commission is independent ( i.e.

the more independent the company ‘s audit commission, the less likely the company is to name an officer ‘s former audit house ) . Finally, in a survey of alumnas audit spouses appointed to company audit commissions in the U.S. , Naiker and Sharma ( 2009 ) examine the association between internal control lacks reported under Section 404 of the Sarbanes Oxley statute law and the presence of former audit spouses on the audit commission who are affiliated and unaffiliated with the company ‘s external hearer happening a negative association for both attached and unaffiliated former spouses. Naiker and Sharma ( 2009 ) construe their findings to propose that both attached and unaffiliated former spouses on the audit commission are associated with more effectual monitoring of internal controls and fiscal coverage and that concerns about ‘revolving door ‘ assignments are less applicable to the audit commission puting because audit commission members are sensitive to the possibility of associations endangering audit quality.Board and scrutinize commission tiesRecently, the independency of the board and the audit commission has been considered in footings of its internal connection, an application of societal web analysis, which focuses on the professional and societal connexions within the board or between the CEO and other board members.

There are two dimensions to see in mensurating internal connexions: 1 ) the grade and 2 ) the type ( professional or societal ) . The grade can be defined at two degrees of connexion: a ) a first grade connexion, i.e. , two members know each other because they sit or have sat on another board together be it of a public or private company or of an organisation ( charitable, university, art, featuring, political, etc. ) , have been employed by the same company at the same clip or they have direct societal ties such as rank in the same organisations or attending at the same university, and B ) a 2nd grade connexion where two board members portion a common professional or societal tie with a 3rd individual or once more they portion a common backgrounds ( same alma mater, same nationality, same faith, same professional background ( e.g. , both are applied scientists, CA, served in the armed forces ) .

The literature in this country is concerned with issues of corporate administration such as the board ‘s impact on corporate determination devising or internal corporate administration patterns. For illustration, the Hwang and Kim ( 2009a ) survey expands on the work of Klein ( 2002 ) to see the impact of societal ties between the CEO and audit commission members demoing that these ties are associated with higher degrees of net incomes direction and higher CEO fillips. They besides suggest that internally connected audit commission members have been replacing financially or household connected members since the ordinances regulating audit commission independency were enacted. Using the same dataset, Hwang and Kim ( 2009b ) suggest that CEO compensation is lower and more sensitive to pay public presentation when boards are handily and socially independent from the CEO. Their step of societal ties is rather wide with the traditional definition of independency helping as a direct step ( current employee of the house, former employee of the house, member of an organisation that receives parts from the house, concern dealingss ( customer/supplier ) with the house, offers professional services ( legal, consulting, fiscal ) to the house, relation of the CEO, interlocked on another board ) every bit good as what is categorized above as 2nd grade features functioning as an indirect step ( CEO and member have serve in the armed forces, portion the same alma mater, same regional beginning, studied the same subject, worked in the same industry, common 3rd party connexion ) .Measuring these connexions, while possible utilizing biographic information found in one-year studies or proxy statements, is rather boring ( mention to Appendix B for more information on measuring ) .

More late, different database troughs have begun roll uping the information and leting broader research, one of these being BoardEx. Fracassi and Tate ( 2009 ) examine the external web connexions between the CEO and his board members utilizing BoardEx informations for the S & A ; P 1500 companies between 2000 and 2007. They look at the current and past employment web, the instruction web as the other activities web which they aggregate into a Social Network Index. They find that more powerful CEOs tend to name managers with whom they portion societal ties. Further, houses with higher internal connection have lower market ratings and prosecute in more value destructing acquisitions in the absence of counterbalancing administration mechanisms. Schmidt ( 2009 ) examines the cost and benefits of ‘friendly boards ‘ during amalgamations and acquisitions.

Using BoardEx informations, he defines friendly boards as those where greater Numberss of managers are connected to the CEO via nines, fraternities, not-for-profit organisations, background ( spiritual organisations, military ) , web organisations, or holding done their MBA together. He finds that friendly geting boards lead to higher unnatural proclamation returns when consultative demands are higher but the opposite when monitoring demands are greater.

4. Decision

Despite an bing literature on audit quality in footings of hearer shift and a turning literature on board and audit commission connexions in the finance and economic sciences subject ( refer to Appendix A sum uping the literature reviewed above ) , old surveies of audit quality and board connexions in the U.S.

have been limited to professional ( alumnas ) associations of the board of managers or senior direction of the company to the incumbent hearer and to board/audit commission independency issues but have non considered the possibility of association, and hence possible damage of independency of a different nature, through non-professional ( i.e. societal ) means. In add-on, there are few surveies looking at the relationship between hearer exchanging and auditor-client connexions through the intimacy of the client ‘s direction and audit commission members, in peculiar in the environment pre- and post-changes to the corporate administration ordinances on go arounding door hires and audit commission independency in the U.K.

In this survey, we propose to analyze whether connexions, in footings of auditor-client associations every bit good as professional and societal ties between senior direction and audit commission members, have an impact on hearer exchanging non in footings of doing the hearer exchange so much as act uponing the choice of the new hearer. In peculiar, this survey will reply the inquiries of ( 1 ) whether senior fiscal direction ( CEO and CFO being the most influential ) of the company name their former audit houses given a alteration in hearers and ( 2 ) whether the extent of senior direction and audit commission connexions facilitates or inhibits such assignments. These two inquiries will be considered in visible radiation of relevant alterations in the U.K. corporate administration codification designed to promote audit quality by advancing hearer independency.In a preliminary phase, we start with a sample of 563 hearer alterations in the U.K. between 1997 and 2009 and look into the function of auditor-client relationships in the hearer choice determination through the survey of former audit alumnas in fiscal inadvertence functions who select their alma mater house as hearers.

Subsequently, we may look into whether the intimacy of the senior direction and audit commission members, as measured by their professional and societal ties, has an impact on this choice. We examine the U.K. scene since 1 ) it represents a somewhat different corporate administration and institutional environment than that of the U.S. and 2 ) we expect greater connexions in the UK, at least anterior to the passage of alterations to the UK codification, due to its smaller size and hence smaller web.


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