An Inside Look at Auditor Changes

By Lynn E. Turner, Jason P. Williams, and Thomas R. Weirich

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NOVEMBER 2005, SPECIAL ISSUE - Auditor changes have been an object of scrutiny recently as the profession and regulators seek to understand the reasons behind such changes and what they might portend about a company’s health. A study of auditor changes over the last two years yielded interesting results that should be of both interest and concern to investors and regulators. Auditors should also know more about the causes for such changes and take appropriate action.

A change in auditors can be the result of either a dismissal by the company or the auditor’s resignation. Auditor resignations often occur in the context of grave financial circumstances, and they can be accompanied by a significant drop in stock price. Regardless of the reason, the SEC must be notified of auditor changes through a Form 8-K filing. The SEC views an auditor resignation differently than a dismissal, and investigates accordingly. Various recent academic studies have found that there are more auditor resignations when litigation risk increases and a company’s financial health deteriorates. Research indicates that client-initiated auditor changes occur more frequently over disagreements about such issues as internal control weaknesses and the reliability of financial reporting.

Because it is difficult to attribute a stock price reaction to just one event, such as the release of information about a material internal control weakness, the stock price reactions reported below should be interpreted cautiously. Further research is warranted about the impact on stock price of the reported reasons for an auditor change.

Summary of Auditor Changes

The upward trend in auditor changes continued in 2004, with over 1,600 companies making a switch. Over 2,500 companies have changed auditors in just the last two years (2003 and 2004). (This information was obtained by examining SEC Form 8-K, Items 4.01 and 4.0, for 2004. For 2003, SEC Form 8-K, Item 4, filings were searched for “resigned,” “dismissed,” “terminated,” and “ceased,” in conjunction with “accountants.” Changes from Arthur Andersen in 2002 were excluded.) In 2004, 1,609 companies changed auditors, compared to 905 in 2003. Investors and auditors should continue to focus on what catalyzed the changes and whether this trend portends any potential negative impact on shareholder value. In addition, 59% of the companies provided no explanation to their shareholders of the reason for the change, leaving them in the dark.

An analysis of these changes reveals major issues for 2004, summarized as follows:

  • Companies have not made adequate disclosures. In 2004, 59% of companies (947) did not disclose a reason for changing auditors, compared to 69% of companies (630) in 2003.
  • The number of companies reporting that their internal controls were inadequate nearly doubled, from 58 in 2003 to 102 in 2004, despite an earlier requirement that the CEO and the CFO disclose such weaknesses, beginning in August 2002. Small companies (under $25 million in revenue) accounted for 48% of those with control problems.
  • Of the companies reporting changes in auditors, 35% (558) reported going-concern problems, compared to 29% in 2003. A going-concern opinion indicates that the auditor thinks the company may not avoid bankruptcy during the next 12 months. Nearly all (92%) of the registrants that received a going-concern report were small companies, which carry a much greater risk.
  • Non–Big Four auditors gained market share in terms of absolute numbers. Big Four firms had a net loss of 400 audits, as they gained 164 while losing 564. Second-tier firms had a net gain of 117 audits, as they gained 233 and lost 116. All other accounting firms gained 1,146 audits while losing 929, for a net gain of 217.
  • The Big Four continued to drop smaller companies from their list of audit clients. The Big Four ceased auditing a net of 280 companies with less than $100 million in revenues. Forty-six of the 53 companies with revenues greater than $1 billion that changed auditors had previously been audited by a Big Four firm; 32 of them chose another Big Four firm as the replacement.
  • Thirty companies reporting auditor changes restated financial statements in 2004, more than double the 14 in 2003. Over half of these companies also had internal control weaknesses. Of these companies, 16 had revenues under $25 million.
  • Companies disclosing disagreements with their auditors over accounting or auditing matters decreased from 27 in 2003 to 19 in 2004. Companies with revenues under $25 million accounted for eight (42%) of these disagreements.
  • Nineteen auditors concluded they could no longer rely on management representations, compared to six in 2003. Small companies accounted for nine (47%) of these nonreliance disclosures.
  • Fifty-five companies cited fee reductions as their motive for changing auditors, more than double the number in 2003. Of these companies, 22 (40%) had revenues under $25 million.
  • There was an increase in the number of changes due to the inability (or unwillingness) of accounting firms to meet SEC requirements for auditing public companies. In 2004, 133 such changes occurred, compared to 57 in 2003.
  • There was a rise in the number of changes due to accounting firm mergers. Eighty-three such changes took place in 2004, compared to 22 in 2003.

Reporting Auditor Changes

The reported reasons for changes in auditors sometimes provide insight into a company’s financial statements, as well as an indication of the quality of the audit. Under SEC rules (summarized in the Sidebar), companies are required to disclose certain information when they change auditors. These disclosures can provide the first glimpse into potential problems in a company’s financial statements. Companies do not necessarily have to disclose a specific reason for the auditor change; investors can be left to wonder about the real reason for the change. Investors should always be cautious when a company announces an auditor change, as it may be related to underlying but undisclosed problems in the company’s financial reporting and accounting practices.

The aspects of a company’s required disclosure that can provide insight into its financial reporting and accounting practices include the following:

  • Whether the company or the auditor terminated the relationship;
  • The type of opinion issued within the past two years;
  • Any disagreements in accounting principles;
  • Any internal control weaknesses or deficiencies, or any reference to the company’s ability (or inability) to meet Sarbanes-Oxley Act (SOA) section 404 requirements;
  • The auditor’s inability to rely on management’s representations;
  • Reference to illegal acts;
  • Any prior consultation with the new auditor about accounting principles or the type of audit opinion that might be issued; and
  • Whether the auditor agrees with the company’s statements about its termination in its SEC response letter.

Focusing on these issues is likely to provide better understanding of an auditor change, as well as insight into a company’s state of affairs. Companies often attempt to hide the real reason behind an auditor change, and investors may have to read the disclosure carefully to “ferret out” the reason behind the change. The real reason may be disclosed in another filing before or after the actual 8-K auditor-change filing. The auditor’s response letter itself may not provide greater detail, as the auditor may want to avoid controversy and lawsuits. In some cases the auditor’s response may create more confusion.

When an auditor is informed by a company that it has been terminated, or informs the company that it will no longer serve as the independent auditor, the auditor is required to send a form letter directly to the Office of the Chief Accountant of the SEC. This letter must be sent within four business days, and is matched with the Form 8-K filings.

A breakdown of the 78% increase in auditor changes in 2004 reveals that companies with revenues greater than $100 million were responsible for a minority of the changes, 15% of the total (238 changes, compared to 115 in 2003). As in 2003, companies with revenues under $100 million dominated the number of changes, with 85% of total changes (1,371 changes), compared to 87% in 2003. The Big Four accounted for 564 auditor changes in 2004, 35% of the total. Second-tier firms accounted for 116, or 7%, while other firms accounted for the remaining 929, or 58%. This is consistent with 2003, when the percentages were 36%, 9%, and 55%, respectively.

Of the Big Four and second-tier firms, BDO Seidman gained the greatest number of new clients, 109, followed by Grant Thornton (80) and Deloitte & Touche (68). Conversely, Ernst & Young lost 200 clients, followed by PricewaterhouseCoopers (138) and KPMG (125).

Reasons for Auditor Changes

A number of circumstances might cause a company and its auditor to end their relationship. When a company chooses to provide a reason, investors and auditors should mainly be concerned about the following: “internal control weaknesses,” “restatements,” “disagreements on accounting,” “inability to rely on management,” “scope limitation,” “unauthorized opinion,” and “illegal acts.” These types of reasons may point to deficiencies in a company’s accounting function, and may ultimately affect the reported financial results. “Independence impaired” and “cost reductions” reasons could have implications for the quality of the audit both before and after the change. Exhibit 1 provides a summary of reasons given for auditor changes for 2003 and 2004.

Internal Control Problems

Effective internal controls are necessary to obtain reliable financial information. Without good internal controls, it is likely that management will make faulty decisions due to unreliable data. For the same reason, investors will not be able to adequately analyze a company’s financial statements and make the right investment decisions.

Since the passage of the Foreign Corrupt Practices Act in 1977, all SEC registrants, including small companies, have been required to maintain adequate internal accounting controls. SOA section 404 further mandates that a company’s management assess the effectiveness of these internal controls and that the auditors attest to, and report on, this assessment.

Exhibit 2 classifies by revenues the companies that reported material weaknesses in their internal controls for 2004. It illustrates that internal control problems are more prevalent at smaller companies. Of companies with revenues under $25 million, 49 reported internal control problems, representing 48% of all companies reporting internal controls problems, a significant increase from 25 (43%) in 2003. Companies with revenues between $25 million and $100 million were again the second-highest group. Of these companies, 30 (29%) reported internal control problems, compared to 18 (31%) the previous year. Only two companies with revenues between $100 million and $500 million and five companies with revenues greater than $1 billion reported internal control problems (compared to one and six such companies, respectively, in 2003). These figures indicate that larger companies are more likely to have more-effective internal control systems, an intuitive result not only because larger companies need such systems in order to function, but also because larger companies usually have more financial resources to implement and maintain them and to attract higher-quality financial personnel. Exhibit 3 lists the internal control problems reported by companies with revenues greater than $100 million.

The total number of companies reporting internal control problems increased from 58 in 2003 to 102 in 2004, a jump of 76%. This increase may be related to SOA section 404 compliance by accelerated filers, because auditors may have applied greater scrutiny before issuing a clean opinion on internal controls effectiveness. Given that small companies do not have to comply with SOA until July 2006, it may also be indicative that yet another wave of such disclosures is forthcoming. Because auditors were not specifically required to issue opinions on management’s reports on internal controls in the past, it is likely there were weaknesses that were not reported. The new rules require auditors to give independent opinions on management’s assertions to the shareholders about internal control.

On average, the stock price decreased less than 1% in 2004 for those companies with revenues greater than $100 million that reported a material weakness in internal controls in connection with a change in auditor. The stock prices of companies with revenues less than $100 million decreased an average of 1.8% in 2004, compared to an increase for the S&P 500 of 9%.

As SOA section 404 takes effect, companies will eventually correct their deficiencies in internal controls and report fewer deficiencies. In the next few years, SOA section 404 should lead to improved internal controls and more-reliable financial information.

The most common reasons for reporting internal control weaknesses were related to personnel. Reasons cited included lack of qualified accounting staff, insufficient segregation of duties, and lack of proper training and supervision. Another common problem was related to the inadequacies of companies’ accounting information systems. All of these are important to the proper functioning of a company’s internal control system; until they are at appropriate levels, companies are likely to continue to have problems.

The Big Four are more likely to identify internal control problems. These firms are also less likely to continue as auditors for a company after internal control problems are disclosed. This may raise questions as to whether smaller accounting firms are taking on increased risks.

Going Concern

A number of companies reported in their filings that their auditor had rendered a going-concern opinion. Of the companies reporting changes in auditors, 35% reported going-concern problems, an increase from 29% in the previous year. Often auditors may have resigned from these engagements due to a perception of increased risks. In cases where the auditors were fired, it may be that the company was displeased with the going-concern opinion, and was in effect “shopping” for a more favorable opinion.

Restatements

Of those companies changing auditors, 30 restated their financial statements in 2004, up from 14 in 2003. Restatements may be a sign of other problems in a company’s accounting function. Over half of the companies filing restatements also reported internal control deficiencies. For these companies, the auditor changes all took place after the restatements, and appeared to be related. In 11 cases the auditors resigned, and in five the company dismissed them. The auditors may have perceived increased risks from clients with internal control weaknesses, which may have led to their resignation. In cases where the auditors were dismissed, the relationship might have been strained by weaknesses uncovered by the auditors that led to the restatements.

Of the companies reporting a restatement, seven were audited by Deloitte & Touche, four by Ernst & Young, seven by KPMG, and five by PricewaterhouseCoopers. Three were audited by second-tier firms, and four by smaller firms. Seven of the restating companies, including Network Associates, United Pan Am Financial, and Fannie Mae, had revenues greater than $100 million.

For the companies reporting restatements with no material weaknesses, the auditor changes appear to be unrelated to the restatement. These companies may have had some form of internal control deficiency that led to the restatement, but failed to disclose the problem. If this is the case, full information about the state of the company’s internal control system was not disclosed publicly. Companies that reported restatements saw their stock price decrease by an average of 3% in 2004.

Accounting Disagreements

A public disagreement between a company and its independent auditor is likely to have a very negative and direct impact on its reported financial results. Such a disagreement may be an indication that the company is attempting to apply improper, aggressive, or non-GAAP accounting that the auditor is unwilling to accept. A company will sometimes fire an auditor that disagrees with it and subsequently hire a more conciliatory one.

Companies and their auditors are required to report disagreements on accounting matters, even if the disagreement is subsequently resolved to the auditor’s satisfaction. During 2004, only 1% (19) of companies surveyed reported disagreements, compared to 3% (27) in 2003. Six of these companies had revenues greater than $100 million, five had revenues between $25 million and $100 million, and eight had revenues under $25 million. Exhibit 4 presents a summary of the disagreements of the six companies with revenues greater than $100 million.

Strengthening the financial expertise of audit committees may reduce accounting disagreements, but it is unlikely to eliminate them completely. Of the six large companies mentioned above, three had a CPA on their board.

The data indicate that the Big Four were more likely to be involved in disagreements, and less likely to be the successor firm after a disagreement. Of the 19 companies reporting disagreements in 2004, the Big Four were predecessors 13 times, or in 68% of the cases. Conversely, the Big Four were successors six times, or 32%. The Big Four could be more reluctant to become the successor auditor after a disagreement, especially for audits of smaller companies. Four of the 19 reported disagreements were related to revenue recognition problems. Apart from this, there was no significant pattern related to the reasons for disagreements.

The six companies with revenues over $100 million in revenues that reported disagreements saw their stock price increase an average of 4% in 2004.

Nonreliance on Management

Nineteen companies disclosed that their auditors concluded they could no longer rely on management representations for the purposes of conducting their audits, compared to six in 2003. The Big Four audited 10 such companies, three were audited by second-tier firms, and smaller accounting firms audited six.

When an auditor is unable to rely on information provided by management, doubt is cast on the integrity of the financial statements, as well as on management. It also raises a serious question about possible lack of oversight by the audit committee.

When an auditor is unable to rely on management, it means that something has occurred to cause suspicion about the integrity of management or of the board of directors. Auditors may have learned that they had been provided with false or misleading information, or found that information had been withheld. In some cases, auditors might refuse to rely on management because of actions not taken, such as the proper investigation of improprieties.

The six companies with over $100 million in revenues that reported their auditor was no longer willing to rely on management saw their stock price increase an average of 14% in 2004.

Audit Scope Expansion

A request to expand the scope of an audit is usually an indication that the auditor has uncovered a problem in the financial statements and needs to do additional work to arrive at a conclusion. If an auditor’s resignation or dismissal was related to a scope limitation, investors should be wary of the reported financial results. The auditor may have been fired to prevent further exposure, or may have resigned to avoid any possible fallout. Five companies reported scope limitations associated with an auditor change in 2004, compared to six in the previous year. The low level of reported scope limitations may indicate that auditors are being allowed to do their jobs—a positive outcome.

Three of the five companies whose auditor indicated they needed to expand the scope of the audit saw their stock price increase by an average of 30% in 2004.

Illegal Acts

Section 10A of the Securities and Exchange Act of 1934 requires auditors to report potential illegal acts to the board of directors and the audit committee. If the matter is not resolved in a timely manner, it must then be reported to the SEC in a “Section 10A letter.” Section 10A letters are rare occurrences. Auditors referred to illegal acts in their SEC response letters for two companies, Lancer Corporation and Rosedale Decorative Products. Lancer Corporation was the subject of an SEC investigation concerning the potentially illegal acts.

Unauthorized Opinions

Auditors can withdraw their opinions for a number of reasons. Companies may take it upon themselves to file their own reports with an audit opinion, even if the auditors had not completed the work and had not given them permission to do so. In other cases, auditors sometimes uncover additional information after they have issued an opinion, and subsequently withdraw it. In most cases, the companies had other accounting and auditing issues, such as accounting disagreements, scope limitations, or material weaknesses. Sometimes these accounting issues delayed the audit, and companies may have issued unauthorized reports to avoid late filing. Audit committees are responsible for ensuring that companies are not issuing unauthorized reports.

Seven companies issued reports with unauthorized audit opinions. All of them were small companies, and all had other accounting and auditing issues. In the case of Industries International, the company stated that it had received correspondence from the auditors indicating that the financial statements had been reviewed. In its response letter, the auditor asserted that the company’s statement was “factually incorrect and misleading.” In such a situation, questions arise about the integrity of a company’s financial statements, its management team, and the oversight of its board of directors.

Audit Fee Reductions

Of the 55 companies that disclosed they changed auditors due to fee reductions, 60% had been previously audited by the Big Four, 16% by second-tier firms, and 24% by small accounting firms. Of these companies, 9% ended up choosing a Big Four firm, 42% a second-tier firm, and 45% a smaller firm; two companies had yet to name a successor. When a company discloses that it changed auditors for cost considerations, investors should closely monitor the amount of audit fees disclosed in the subsequent proxy statement, to assess whether this may have a negative impact on the quality of the audit.

Although few companies specifically mentioned increased costs due to compliance with SOA section 404 requirements, this may be part of the reason for the increased number of changes due to fee reductions. Only one company stated that it changed auditors due to increased costs related to auditing its internal controls, but several others said they changed auditors to reduce costs related to SEC compliance, which likely also refers to section 404 requirements. Companies with poor internal control systems will likely find it more expensive to comply with SOA section 404, and their auditors will be required to perform more-extensive testing procedures.

The 55 companies that reported an auditor change in 2004 to reduce their audit fees saw their stock price increase an average of 33%.

Opinion Shopping

“Opinion shopping” refers to the practice of changing auditors in order to get a desired opinion on an accounting matter or on the financial statements as a whole. Opinion shopping is usually evident when a company changes auditors frequently. In some cases, companies return to auditors they had recently dismissed.

Sixty-one companies changed auditors at least twice during 2004, and four changed auditors three times. Most of the companies changing auditors more than once were small companies. Fourteen companies with revenues greater than $25 million changed auditors more than once.

Resigning from SEC Registrants

In 2004, there were a total of 133 auditor changes related to SEC registration requirements for audit firms. In 2003, there were 57 such changes. Under SOA, auditors must register with the Public Company Accounting Oversight Board (PCAOB) in order to audit SEC registrants. About 70 small audit firms, most of which audited fewer than three SEC companies, decided not to register with the PCAOB or comply with other requirements.

It is extremely difficult for a small accounting firm, with limited resources, to stay up to date with the developments affecting public companies. As a result, SEC enforcement actions often involve small firms. Accordingly, it should not be a concern to investors if a company changes auditors as a result of the auditor’s decision to no longer audit public companies.

Perhaps surprisingly, many audit firms with no public company clients have registered with the PCAOB. From public statements made by PCAOB staff, approximately 400 of the 1,415 registered firms do not audit public companies. Firms may choose to register with the PCAOB because of a perception of increased credibility in the eyes of potential clients. Nonetheless, these companies are not subject to PCAOB inspections of their audits, because they do not audit public companies. These companies may benefit from the reputation bestowed by PCAOB registration without being subject to its inspections of their audits. This could lead to the public’s misunderstanding the level of oversight implied by PCAOB registration.

Mergers

Companies also change auditors as a result of changes in control or mergers. Investors need be concerned only to the extent that the outgoing auditor discloses any information that might cast doubt on the company’s financial reporting system. There were 102 auditor changes related to company mergers in 2004. Only two companies’ auditors noted any material weaknesses in the last two fiscal years prior to their dismissal. Most of the companies had going-concern problems, which might have prompted the mergers in the first place.

The number of changes related to the merger of audit firms more than tripled last year, from 22 in 2003 to 83 in 2004. The mergers of Madsen & Associates with Sellers & Andersen; of Chisholm & Associates with Bierwolf, Nilson & Associates; and of Follmer Rudzewicz with Urbach Kahn & Werlin resulted in most of the changes.

Resource Constraints

Ten cases, less than 1% of auditor changes, involved auditor resignation due to resource constraints. Five of the changes involved the resignation of a small accounting firm, one a second-tier firm, and four a Big Four firm. In all but two of the cases, the incoming auditors were small firms. Only one of the 10 companies had revenues greater than $100 million. These types of resignations are likely to increase as auditors’ workloads increase due to companies somewhat belatedly implementing the section 404 requirements for adequate internal controls.

Companies and Auditors: Predecessors and Successors

In 2004, auditor changes increased dramatically at companies of all sizes. Nevertheless, companies with revenues in excess of $1 billion changed auditors 53 times, more than double the number in the previous year. The number of auditor changes among companies with revenues between $100 million and $1 billion also more than doubled, from 90 in 2003 to 185. Small-company changes increased significantly, from 790 in 2003 to 1,371 in 2004.

Small companies accounted for a disproportionately high percentage of auditor changes. Companies with revenues under $100 million comprised 53% of the FactSet database of SEC-registered companies, yet they accounted for 85% of auditor changes. Companies with revenues over $100 million comprised 47% of the FactSet database, while accounting for just 15% of auditor changes.

The large accounting firms and the AICPA have long argued that rotation of auditors would reduce the quality of audits. The principal rationale of proponents of auditor rotation has been concern over the “coziness” with management that comes from long-term association. Observing the outcomes from the large number of recent changes in auditors may provide insights into the effects of auditor change on audit quality.

Of the 238 companies with revenues over $100 million that changed auditors, 207 dropped Big Four firms and 13 dropped second-tier firms. On the other hand, only 87 (38%) retained another Big Four firm to replace the outgoing auditor. This compares to a 64% retention rate for the Big Four firms in 2003. In contrast, 81 (35%) retained a second-tier firm, and 63 (27%) retained a smaller firm. Seven companies have yet to name a successor.

For companies with revenues under $100 million, the Big Four lost 357 clients (26%) in 2004, compared to 227 (29%) in 2003. On the other hand, they gained only 77 small clients, or 6%. Second-tier firms lost 103 small clients (8%) in 2004, compared to 74 (9%) in 2003. Small audit firms accounted for 911 (66%) of small-company changes in 2004, compared to 489 (62%) in 2003.

Overall, the Big Four experienced a net loss of 400 clients in 2004, compared to 201 in 2003. Small audit firms were the chief beneficiaries of this change, as they gained 217 clients in 2004, compared to 71 in 2003. Second-tier firms gained 117 clients in 2004, compared to 30 in 2003.

While the disclosures do not provide enough information to definitively state the reason for the change to smaller firms, there are a number of likely interpretations. One might be that the Big Four are applying stricter guidelines in selecting their clients, a change they have stated publicly. These firms might be ridding themselves of “riskier” clients (usually translated to mean smaller clients). A number of companies have also changed auditors in order to reduce their audit costs. In these instances, the data show that companies are more likely to switch from a larger to a smaller firm. A third possibility is that a number of small firms have merged their operations and have, therefore, become more competitive with some of the larger firms. While smaller audit firms have increased their number of small audit clients, the largest companies continue to rely on the Big Four. Of the 90 companies with revenues over $500 million changing auditors, 58% chose a Big Four firm as a replacement.

Overall, Big Four firms lost 35% of all audits, second-tier firms lost 7%, and other accounting firms lost 58%. At the same time, Big Four firms were successors 11% of the time, second-tier firms won 15% of the audits, and other accounting firms won 74%. Exhibit 5 details the 2004 changes by auditors.

Performance After a Change

As seen in Exhibit 6, 82 companies with revenues greater than $100 million changed auditors in 2003. More than half of them (56%) outperformed the S&P 500, by an average of 56 percentage points in the 12 months leading up to the date of the change. The rest (44%) underperformed the S&P 500, by an average of 32 percentage points. The year after the auditor change, 30% of companies with revenues greater than $100 million underperformed the S&P 500, by an average of 16 percentage points the year after the change, while 70% outperformed the S&P 500, by an average of 121 percentage points the year after the change.

Although those companies with over $100 million in revenues that reported a weakness in internal controls in 2004 saw their stock price decline on average less than 1%, companies may see an uptick in their stock price after reporting a material weakness in internal control. Of the 11 companies that reported a material weakness at the time of a change in auditors in 2003, seven saw their stock value rise and four saw it fall; the average result was an increase of 44% after the change. For example, K-Mart reported internal control weaknesses in 2003, and its stock price increased by over 200% a year after the auditor change.

Impact on Audit Fees

Audit fees do not always decline when there is a change in auditors. The audit fees of the 38 companies with revenues over $100 million that changed auditors in 2003 increased by an average of $130,000 per company. Fees declined for 16 of the companies in this group, and rose for 22 of them.

Audit-related fees also declined by an aggregate of $5 million. The total payments to auditors therefore remained the same. The increased audit fees may be due to the incoming auditors increasing fees for the additional work required for SOA section 404 compliance. The reduction in other fees may have occurred because the companies are relying less on auditors for other services that may impair independence.

Significant Auditor Changes in 2004

Two high-profile auditor changes in 2004 highlight the need for proper oversight of companies’ financial statements.

Fannie Mae’s dismissal of KPMG is probably the most significant auditor change that occurred in 2004. A report by the Office of Federal Housing Enterprise Oversight (OFHEO) questioned the company’s application of SFAS 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, and SFAS 133, Accounting for Derivative Instruments and Hedging Activities. The SEC subsequently confirmed that the company had applied the standards incorrectly. The company will restate its financial statements for the last three years, resulting in losses that may be in excess of $9 billion. The CEO and the CFO were forced to resign. Fannie Mae’s stock fell by 7% in one day when it disclosed these accounting irregularities.

Another significant auditor change in 2004 was American Express’ dismissal of Ernst & Young, which had audited American Express since 1975. In 2003, the company paid Ernst & Young $23 million in audit fees and $3.5 million for other services. The dismissal may have been related to an SEC investigation into whether Ernst & Young violated auditor independence rules by entering into a profit-sharing agreement with the company’s travel service unit. The company did not make any reference to this investigation in its auditor change disclosure. This investigation was part of a larger one by the SEC into Ernst & Young’s auditor independence compliance procedures. Based upon the outcome of the findings, Ernst & Young was barred from accepting new clients for six months. American Express’ stated reason for the auditor change is that its audit committee charter required it to review its external auditor every 10 years. American Express did not publicly disclose such information until 2004, which raises questions about the apparent and the real reasons for the change.

Need for Transparency

The number of changes in auditors in 2003 and 2004 has escalated significantly, over 2,500 companies in all. Disclosures regarding auditor changes may provide investors with a useful glimpse into a company’s financial reporting system. The authors believe investors should pay close attention to these disclosures, as the impact on a particular company’s stock price is unique and specific. The authors believe that a major concern is a lack of disclosure of adequate information in auditor change–related filings. Companies provided no reasons for 59% of the changes in auditors in 2004, leaving investors in the dark. If the SEC revised its rules, it could bring greater transparency and a better understanding of the reasons behind auditor changes.


Lynn E. Turner, CPA, is managing director of research at Glass Lewis & Co., LLC, and senior advisor to Kroll, Inc.
Jason P. Williams, MBA, ACCA, is a research analyst at Glass Lewis & Co., LLC.
Thomas R. Weirich, PhD, CPA, is a professor of accounting, Central Michigan University, Mount Pleasant, Mich.
 

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