Analyzing Auditor Changes
Lack of Disclosure Hinders Accountablility to Investors

By Mark Grothe and Thomas R. Weirich

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DECEMBER 2007 - In 2006, 1,322 U.S. public companies changed their independent auditor, including 66 that changed auditors at least twice. Investors were left to guess the reasons for about three-fourths (more than 1,000) of those changes. This is because a long-standing problem with the rules for auditor-change disclosures went uncorrected for yet another year.

The authors believe there is a simple fix for this problem: The SEC should require companies to provide a reason for all auditor changes. One of the largest accounting firms in the world, Grant Thornton LLP, has urged the SEC to do just that. Without such a rule change, companies and auditors will continue to remain mum whenever a change occurs.

Since Arthur Andersen LLP’s demise in 2002, at least 6,543 companies have changed auditors. Exhibit 1 presents scorecards for auditor changes in 2006 and a historical comparison over four years (2003 to 2006). With so many changes occurring absent a mandatory auditor rotation requirement, the authors believe audit firms and companies have shown that a mandatory audit-firm rotation every five to 10 years would be feasible, despite the small number of firms competing to audit large companies.

The authors view the “fresh-eyes” effect that auditor rotation would produce as a big benefit, especially within the context of uncovering corporate accounting frauds. Auditor changes often are linked to financial restatements and discoveries of weak accounting controls. Restatements and material-weakness disclosures occur almost three times as often within one year of an auditor change than they do for companies as a whole, according to Glass, Lewis & Co., LLC.

As for the predictive power of auditor changes to signal bad news that could lower stock prices, the authors have found a correlation with the time it takes audit firms to respond to companies’ initial filings announcing a change in auditor. That is, the longer it takes an auditor to say whether it agrees with the company’s statements, the more wary investors should be.

Auditor Turnover Slowdown

In 2006, 1,322 U.S. companies changed their independent auditor, down from 1,430 a year earlier. (In this article, the term “U.S. company” refers to any company publicly traded in the U.S. securities markets that filed periodic reports with the SEC, excluding foreign private issuers. The authors counted only those auditor changes reported on Form 8-K, Item 4.01. Foreign issuers are not required to file Form 8-Ks.) Of these 1,322, 66 companies changed auditors at least twice in 2006, compared with 77 in 2005. (In 2006, 61 companies changed auditors twice, 4 changed three times, and 1 changed four times. In 2005, 69 companies changed auditors twice, and 8 changed three times.)

In addition, there were 77 auditor changes at companies’ savings plans in 2006, down from 81 in 2005. It appears that companies have continued to switch their savings-plan audits to smaller accounting firms or savings-plan specialists in order to cut costs. This raises questions for the U.S. Department of Labor and the accounting profession as to whether these cheaper audits are in fact lower-quality audits. By the authors’ count, in the last three years, 3,673 U.S. public companies (about 29% of all U.S. public companies) changed accounting firms at least once (Source: Glass, Lewis).

Most auditor changes occurred in the months after a company’s fiscal year–end. Usually companies waited until their audits were completed. Some companies decided to announce auditor changes after their fiscal year-end but before the annual audit was completed. In these cases, the auditors stuck around long enough to complete the work, even though they already knew they would not be the company’s auditor once they were finished.

Of the 156 auditor changes in January 2006, 84 were by companies with fiscal years that ended on December 31, 2005—meaning these companies’ fiscal years were complete at the time of the changes, but their audits were not yet finished. In January 2005, calendar-year companies made the same number of changes. The January 2006 figures included at least 20 changes due to audit firm mergers or name changes.

In addition to the 2,304 companies that changed auditors in 2002 due to the demise of Arthur Andersen, 5,325 auditor changes occurred between 2003 and 2006. That is a total of at least 7,629 auditor changes since the collapse of Andersen made the Big Five the Big Four (Deloitte & Touche, Ernst & Young, KPMG, and Pricewater-
houseCoopers). Because some companies changed auditors more than once during that timeframe, it means that 6,543 companies changed auditors at least once after Arthur Andersen’s collapse. To put that in perspective, roughly 12,600 U.S. public companies were registered with the SEC during this time period. By the authors’ count, that means more than half of U.S. companies changed their auditors over the past five years.

The Shift to Smaller Firms

Most companies audited by Arthur Andersen switched to one of the Big Four, but the underlying trend among all companies has been to switch away from the Big Four. In the last four years, the number of companies audited by Big Four firms dipped from 6,229 as of December 31, 2002, to 5,199 as of December 31, 2006 (Exhibit 2). Over the same time, second-tier firms added 266 companies, and smaller firms realized a net gain of 588 companies. (A total of 176 companies did not disclose a successor audit firm, either because they ceased operations or had not yet found a replacement. Because these figures do not take into account companies that went public during the last four years, the Big Four firms’ decline is likely slightly overstated.)

Unsurprisingly, an analysis of the size of the companies that switched auditors shows that the auditor changes during the last four years were increasingly made by smaller companies. The authors’ analysis revealed that 3,309 companies with less than $75 million in market capitalization at the time of their changes made 4,207 of the changes, or 79% of the total. By comparison, 74 companies with $2.5 billion or more in market capitalization changed auditors. That is a turnover rate of 63% for companies with less than $75 million in market capitalization, compared with a turnover rate of 8% for companies with at least $2.5 billion in market capitalization, according to figures from Glass, Lewis; company filings; and Reuters (percentages are based on four-year totals).

Changes Occurred in a Variety of Industries

The analysis also examined industries that had at least 100 auditor changes during the last three years. (Industry data were available only for 2004–2006). Software and programming companies, biotechnology and drug companies, and banks accounted for the highest volume of auditor changes during 2004–2006. In terms of turnover, business-services companies had a turnover rate in excess of 50% during the last three years. Other industries with high turnover rates for 2004–2006 included communications services, and medical equipment and supplies.

Given the thousands of companies of all sizes, in all industries, that have changed auditors in the past five years, it has become apparent that the stigma previously attached to auditor changes has subsided, if not disappeared. The audit committees of these companies have, for whatever reason, found that making auditor changes is desirable. Clearly, the major audit firms have demonstrated that they have the expertise and competency to accept new audits of all kinds of companies, especially when the companies present no unnecessary risks. Accordingly, the authors applaud those audit committees that periodically rotate audit firms in an effort to ensure audit quality, not just cheap audits.

Who Left Who?

In about 65% of the cases, companies initiated the change by dismissing their auditors. In the other 35%, auditors resigned.

Companies choose to dismiss their auditors for a variety of reasons. It might be to switch to a firm that promises better service, to hire a firm that specializes in a particular industry or market segment, or to leave a firm because of changes in company management. Some companies have a policy of changing their audit firms every several years. Other companies might simply want to reduce their audit fees. Or, if auditors disagree with management on key areas of accounting, companies might shop around for an audit firm that agrees with their viewpoints.

Auditors that resign might have an assortment of possible reasons. For example, the auditors might decide that a company is not worth the risk, especially if it is prone to restatements and lacks sufficient internal controls over financial reporting. The auditors might simply not trust management, or they may feel that a company is trying to squeeze them on fees.

External factors could play a role, too. Smaller companies have recently dismissed Big Four auditors in favor of smaller firms that are more suitable or charge lower audit fees. For example, during the first year of implementation of section 404 of the Sarbanes-Oxley Act (SOX), many companies suggested that the Big Four had not properly tailored their audits, especially for smaller companies.

In some cases, small audit firms might decide that they no longer want to audit public companies. Possible reasons include a lack of necessary resources or competencies, or a desire to avoid the compliance requirements of the Public Company Accounting Oversight Board (PCAOB).

The Lay of the Audit Land

To fully understand the trends among auditor changes, it is helpful to look at the consolidation within the auditing marketplace. Exhibit 3 shows the profile of the eight largest accounting firms. The Big Four audit about 40% of all U.S. public companies. The four second-tier firms audit less than 10% of all public companies, and hundreds of smaller regional firms audit the other half of public companies—primarily smaller public companies. All but four companies in the Standard & Poor’s (S&P) 500 are audited by the Big Four. (Forest Laboratories Inc., Hercules Inc., Jones Apparel Group Inc., and Monster Worldwide Inc. are all audited by BDO Seidman.) The Big Four audit 991 of the 1,000 largest companies. The authors believe some of these companies could be served just as well by a second-tier firm.

Comparing the Big Four and second-tier firms shows the large disparity in size. On average, the Big Four reported U.S. revenues in excess of $6 billion in 2006, almost eight times higher than the $790 million average for second-tier firms. Big Four firms on average have more than 2,000 partners and more than 18,000 other professionals, compared with an average of less than 400 partners and less than 3,000 professionals at second-tier firms.

Large public companies often require an international capability in many foreign countries. A firm without sufficient international reach and breadth of expertise in the necessary locations will face barriers when competing for an audit.

The Big Four have already entered into affiliation agreements with the largest auditing firms in most foreign countries. That leaves only smaller and lesser-known firms with which non–Big Four firms could affiliate. Plus, starting a new audit firm or growing an existing one in those countries takes significant capital, an area where the large firms have a competitive advantage.

Companies Still Did Not Tell

In each of the last two years, more than 1,000 companies that changed auditors did not publicly disclose any reasons for the change. And why would they? The SEC’s rules do not require companies to be transparent when it comes to disclosing auditor changes.

In 2006, companies frequently failed to provide a reason for auditor changes to their investors, the ultimate beneficiary of such audits. In 1,011 instances, representing 72.5% of the changes, investors were given no information about why the changes were made. That is up from 71.6% the year before. While companies are required to submit a Form 8-K, Item 4.01, to disclose auditor changes within four days of the change, they are not always required to give a reason.

An audit firm is required to provide a standard letter within 10 days of a change, saying whether it agrees with the company’s 8-K statements. The auditor does not have to provide a reason; instead, companies go through a checklist of “reportable events” that, at best, dismisses some possible reasons. These include whether there were any disagreements on accounting principles and whether the auditors issued adverse or qualified opinions in the previous two years. Exhibit 4 shows the reasons companies provided in 2006 and 2005.

One audit firm, Grant Thornton, has been particularly vocal in calling for reform. In a March 2006 press release announcing its annual revenues, Grant Thornton noted it had endorsed the simplest solution to the problem with auditor-change disclosures: “Advocating increased transparency when companies report audit firm changes, we urged the SEC to revise 8-K rules to require reasons for all company dismissals of auditors, for all auditor resignations and for all instances in which the auditor chooses not to stand for reappointment.” That is the simplest way to improve transparency: Require companies to give a reason for all audit-firm changes.

The authors applaud Grant Thornton’s investor-friendly stance on this issue, and also urge other audit firms to follow its lead. Unfortunately, while some leaders in the accounting profession have asked the SEC to remedy this problem, the SEC staff has failed to do so.

The most frequently cited reason for changing auditors in 2006 was a change in company control or management, accounting for 6.7% of the changes. When companies merge, are acquired, or undergo a substantial change in management, auditor changes often follow.

The second most commonly cited reason in 2006 was audit-firm mergers. Changes due to audit firm mergers were up 78.4% in 2006. When accounting firms merge, their public-company clients are required to disclose that their independent auditors have changed to the new firm. In most cases, the only differences resulting from such auditor changes are the name and signature on the company’s audit report. Regional accounting firms that combined their operations led to 66 changes in 2006, up from 37 in 2005.

About 3% of changes in 2006 were caused by audit firms’ lack of compliance with PCAOB and SOX requirements, either because the firms could not comply or because they chose not to. Some audit firms resigned or were dismissed because they were not registered with the PCAOB. (SOX section 102 requires accounting firms that audit public companies to register with the PCAOB.)

Some audit firms simply said they were no longer going to audit public companies. Other auditors were forced out because they had so few audit partners they were unable to comply with SOX’s audit-partner rotation requirements. In 2006, these reasons were cited in 37 auditor changes, down from 61 changes in 2005 and 127 changes in 2004.

The companies most likely to provide no reasons for their auditor changes were those that changed from a Big Four firm. Of the companies that switched from Big Four firms, 86.3% provided no reason. This compares with 77.1% and 67.3% of the companies that changed from second-tier or smaller firms, respectively.

Another telling statistic is that companies that changed from smaller audit firms accounted for the majority that cited mergers or management changes as the reasons for their auditor changes. Among the 963 changes by companies that switched from smaller audit firms, 76 (7.9%) said it was because of changes in the company’s control. This would be expected, because smaller companies are more likely to be gobbled up by larger ones or to merge with other smaller companies in efforts to expand.

Cases where auditors said they were unable to rely on management were up 7.1% in 2006, after falling 22.2% in 2005. These are perhaps the biggest red flags found among auditor-change disclosures because the outgoing auditors are basically saying that they could not trust management.

Changes that resulted from accounting disagreements—at least the ones the companies disclosed—were down 53.6% in 2006. The authors suspect, however, that at least some companies that failed to disclose a reason for their changes parted ways with their auditors because of prior accounting- or auditing-related disagreements that they would rather not reveal.

Disagreements on Accounting Principles

When coupled with auditor changes, disagreements on the proper application of accounting principles are a major cause for concern to investors. In some cases, companies and auditors merely may “agree to disagree” and go their separate ways. When searching for new auditors, a company may seek a firm it thinks will bless their preferred accounting methods—a practice known as opinion shopping.

When companies switched auditors in 2006 after accounting disagreements, nearly half the time the disagreements were with smaller firms. When companies changed auditors after disagreements, they tended to choose new auditors from outside the Big Four. Of the 13 auditor changes last year in which the companies disclosed disagreements, smaller firms resigned or were dismissed in six cases. Big Four firms resigned or were dismissed in five of those changes. Following disagreements, companies engaged smaller firms eight times.

Inability to Rely on Management

Even more alarming than when companies and auditors disagree on proper accounting application is when auditors say they cannot rely on management’s representations. In these cases, the auditors basically do not trust a company’s executives. This usually arises from the auditors’ concerns over management’s integrity or competence.

In one example, Deloitte & Touche told Navistar International Corp. that the firm was not willing to rely on the representations of the company’s controller, and requested that the treasurer of the company’s finance subsidiary, Navistar Financial Corp., be reassigned and no longer serve as an officer of the company. Navistar complied with both requests. Navistar had to restate its financial statements for how it accounted for vendor rebates. The New York Stock Exchange delisted Navistar’s shares because it was more than 13 months late with its required SEC filings.

When announcing that it had dismissed Deloitte & Touche and engaged KPMG, Navistar said it also would restate its financial statements to correct its accounting for product-development programs, supplier rebates and warranty recoveries, truck-warranty work, and shifting of expense amounts between periods. Investors probably wondered why it took such an event to uncover these errors in the financial statements.

In another example, when Deloitte & Touche resigned as the auditor of Penn Traffic Co., Deloitte told the supermarket operator that it was unwilling to rely on the representations of the company’s general counsel. Penn Traffic’s audit committee conducted an investigation into the company’s premature recognition of promotional allowances. Deloitte said it had planned to significantly expand the scope of its audit prior to its decision to resign.

Audit Firm Response-Letter Disagreements

SEC rules require a company to furnish its outgoing auditors with copies of its auditor-change filings. The audit firm then must respond with its own letter, saying whether it agrees or disagrees with the company’s statements. A company is required to file this letter within 10 days of filing its 8-K.

In some cases, the response letters offer keen insights, especially when the former auditors disagree with the company. In only 12 cases in 2006 did an audit firm say it disagreed with the company’s statements, down from 20 in 2005. Disagreements can involve going-concern modifications or undisclosed material weaknesses, disputes over audit fees or services provided, the chain of events leading to dismissals or resignations, or the existence of disagreements over accounting principles.

Often, these response letters are not filed until weeks after the initial filings that announced the auditor changes. In the authors’ experience, the longer the time between the companies’ initial filings and their auditors’ responses, the more likely there are to be issues associated with the auditors’ resignations or dismissals. “Issues” mean things investors might care about, such as disagreements or insights into the character of management.

These auditor changes are where one might find something that could affect a company’s stock price. Consider a scenario where a company has announced an auditor change, but the auditor has not yet submitted its response letter. Investors might be able to prepare for a negative market reaction that could occur if some bad news comes to light once the auditor provides its response. The more time that passes, the more wary investors should become.

To be sure, just because an auditor takes a long time to respond, this does not always mean the auditor’s response letter will be negative. Last year, 86 companies took longer than 10 days to file their auditors’ response letters following dismissals or resignations. Of those 86, 13 audit firms disagreed with the companies’ original filings or provided additional clarifications. Of those 86, 26 had market capitalizations of greater than $25 million. The average stock price change for those companies, from five days before to five days after the date they filed their auditors’ response letters, was -- 4%. The market-adjusted return over that timeframe also was -- 4%.

Audit Firms’ Gains and Losses

Companies continue to switch from the Big Four to second-tier and smaller firms. Among 2006 auditor changes, 335 (24%) involved Big Four firms that were dismissed or chose to resign. A Big Four firm was named as a replacement in only 159 (12%) of all changes. Notwithstanding this shift, the Big Four firms’ revenues continue to grow, indicating that they are perhaps focusing more resources on larger, more profitable clients that are likely to need expanding services.

The shift to second-tier and smaller firms is not new. Second-tier and smaller firms apparently looked more appealing to most of the companies that changed auditors, continuing a trend that began after Arthur Andersen collapsed in 2002. In 2004, 34% of the auditor changes involved Big Four firms that resigned or were dismissed. Interestingly, Big Four firms were named as replacements only 10% of the time. The pattern held in 2005; 31% of the auditor changes were from Big Four firms, but only 12% were changes to Big Four firms.

In some cases, the company said it was switching to an audit firm that better suited its needs. Other times the company cited lower costs. While some companies may be finding better value, the authors suspect that in many cases lower-cost audits translate into lower-quality audits. In any case, the auditor changes that have occurred over the last few years have been a major boon for small and medium-sized accounting firms. In addition to their aggregate gains, these firms are picking up engagements that they would not have in the past, like the audits of Fortune 500 companies’ employee stock plans. For years, some lawmakers and regulators have said they wished there were more opportunities for smaller firms. Now, as these opportunities are coming to fruition, the question will be whether these smaller firms can provide the quality of work necessary to maintain investor confidence in the profession.

The significant increases in the number of companies audited by Grant Thornton, BDO Seidman, and the other second-tier firms certainly will contribute to their growth. But such growth also presents significant risks to the firms, regulators, and investors. For example, in recent years Grant Thornton accepted the contracts to perform audits for Refco and General Fremont, both of which were previously audited by larger firms. Not long after accepting these audits, Grant Thornton found itself embroiled in risky situations with these audits, which have raised questions about the risk-assessment process at second-tier firms. The authors wonder whether such firms are so hungry for the audits of larger companies that they are failing to adequately assess, manage, and audit the attendant risks.

Auditor Turnover Rates

A breakdown of dismissal and resignation rates in 2006 for the eight largest firms shows that PricewaterhouseCoopers had the highest dismissal rate among the Big Four (7.3% of the companies it audited dismissed the firm); second-tier firm BDO Seidman had a dismissal rate of 9.2%; Ernst & Young and Crowe Chizek had the lowest dismissal rates. (A graphc showing the data for all eight firms is online at www.cpajournal.com.) In general, firms with higher dismissal rates also had higher resignation rates. Last year, BDO Seidman resigned from 5.5% of the companies it audited. Ernst & Young, which stepped away from less than 1% of the companies it audited, had the lowest resignation rate.

Companies that parted ways with Big Four auditors during 2006 selected another Big Four firm as the successor roughly two out of five times. By comparison, only three in 20 companies going from a second-tier firm picked a Big Four firm. As for companies switching from smaller firms, just one in 50 companies picked a Big Four firm.
The distinct trend: When companies switch auditors, they tend to choose smaller firms as successors. Companies previously audited by the Big Four chose second-tier or smaller firms 62% of the time. Companies coming from second-tier firms decided to go with smaller firms 72% of the time. And companies previously audited by smaller firms stayed with smaller firms 94% of the time.

The fact that more companies are switching to smaller audit firms may raise concerns about the quality of their financial reporting. Glass, Lewis noted in its February 27, 2007, trend alert on restatements, The Errors of Their Ways, that smaller firms had a higher restatement rate than Big Four and second-tier firms. Companies audited by smaller firms restated at a rate of 13% in 2006, compared with a restatement rate of 9% for companies audited by the Big Four.

Even with their higher restatement rates, smaller audit firms are subject to fewer outside reviews and quality inspections. Annual PCAOB inspections are required for firms that audit more than 100 public companies. But firms that audit fewer than 100 public companies must be inspected only once every three years. The higher restatement rates, coupled with companies’ migration to smaller audit firms, lead the authors to believe that triennial inspections may not be frequent enough.

Risk Management

Litigation risk plays a role in audit firms’ decision-making. If an audit firm fails to detect material errors in a company’s financial statements that it should have caught, there is a significant risk it will face costly litigation and possibly even government investigations, especially in the event of a restatement. Each time an auditor takes on an engagement, it does so through the prism of its risk-management policies.

Exhibit 5 shows the number of companies each of the Big Four and second-tier firms picked up in 2006 that the authors would classify as risky, based on the companies’ previous disclosures of material weaknesses, as well as their restatements, disagreements with former auditors, or statements by former auditors that they were unable to rely on representations by the companies’ management.

In 2006, Ernst & Young added the most companies that the authors would classify as risky, including 25 companies that had previously disclosed material weaknesses and 20 companies that had recently filed restatements. By comparison, Pricewater-houseCoopers picked up only three companies that had disclosed material weaknesses and one that had recently restated its financials.

In 2006, Ernst & Young and Deloitte & Touche combined to pick up more risky companies than second-tier firms Grant Thornton and BDO Seidman. That was not the case in 2005, when the second-tier firms picked up more risky companies than the Big Four firms. The authors classified four out of five companies that Deloitte added in 2006 as risky pickups.

KPMG was the only one of the eight largest audit firms to pick up a company (Navistar International Corp.) where the former auditor had resigned because it could not rely on management. In this case, the former auditor indicated it did not have confidence in management’s ability, or that management had misled or lied to it. Perhaps the PCAOB should scrutinize such audits though its inspection process.

Other Financial Reporting Issues

If a company lacks adequate internal controls, has unreliable financial statements, or cannot file its annual and quarterly reports on time, these factors can influence whether its auditor leaves. Material-weakness disclosures, restatements, and late filings are closely connected to auditor changes.

Material weaknesses. Since the end of 2004, public accounting firms have been required to audit companies’ systems of internal control over financial reporting, as required by SOX section 404. In most cases, not until the independent auditors performed their own internal-control assessments did companies start to disclose material weaknesses. In some cases, the external-audit requirements of section 404 may have strained the relationships between companies and their auditors.

While some companies complain that auditors have gone overboard in their internal-control audits, the authors believe that external audits of companies’ internal controls have generally been good for investors. In many cases, audit firms have reported weaknesses that the companies’ management probably would not have disclosed before SOX section 404. This has led to natural tensions between auditors and corporate managers.

In such cases, companies may be faced with the decision of whether to disclose the same weaknesses the auditors identified in their reports, or whether to disagree with their independent auditors’ conclusions instead. In only a handful of cases have companies’ management teams publicly disagreed with their auditor’s opinion. This wrinkle in the relationship may have led some companies to dismiss their auditors.

On the other side of the relationship, one can imagine scenarios where auditors may have decided to resign because of the severity or sheer number of weaknesses in companies’ controls. In these cases, it may not be cost-effective for the auditor to continue trying to perform quality audits for companies with such poor controls. If auditors do not walk away, they may face increased litigation or reputational risk if the companies later need to correct errors in their financial statements.

In 2006, 200 auditor changes involved companies that had disclosed material weaknesses, compared with 225 in 2005. In about three-fifths of the changes involving companies with material weaknesses, Big Four firms resigned or were dismissed. Companies that disclosed material weaknesses seemed to find refuge among second-tier and smaller firms. About seven out of 10 companies that had disclosed material weaknesses and changed auditors last year switched to second-tier or smaller firms.

The connection between auditor changes and material weaknesses is twofold. In some instances, companies may disclose material weaknesses first, and part ways with their auditors afterward. In other cases, companies may not identify or disclose material weaknesses until after changing auditors—perhaps because the former auditors failed to identify the problems or because the weaknesses did not develop until after the new auditor was engaged.

Restatements. Restatements are nearly three times as likely to coincide with an auditor change than not. During 2006, 43 companies restated both within one year before and one year after changing auditors. Excluding these companies, 181 others restated within one year before changing auditors, and 157 companies restated within one year after auditor changes. All told, 27% of the companies that changed auditors in 2006 restated within one year of their switches, compared with a 10% restatement rate for all public companies during 2006.

When companies change auditors after restating, it may be because of dissatisfaction with previous audits. Conceivably, some companies may dismiss their auditors as retaliation or in hopes of finding another firm that might go easier on their books in the future. Auditors may be dumping higher-risk companies.

Restatements that follow auditor changes may stem from a ³fresh-look² effect. When a company gets a fresh set of eyes on its books, the new auditor may discover problems the previous auditor had missed or let slide. Also, a new firm may bring better testing or higher standards to an engagement. In other cases, restatements may occur after an auditor change simply because the errors did not occur until after the new auditor was engaged.

Late filings. Companies that change auditors are much more likely to be late in filing their quarterly or annual reports. These companies file late about twice as often as public companies as a whole, both before and after auditor changes. About 69% of the companies that changed auditors in 2006 were late in filing at least one annual or quarterly report within a year of their changes. By comparison, the late-filing rate for all public companies last year was 27%.

Among the companies that changed auditors last year, 530 were late with their filings during both the 12 months before and the 12 months after their auditor changes. Excluding these companies, there were 250 others that submitted late-filing notices during the 12 months before they switched auditors, and there were 183 companies that were late during the 12 months afterward.

When companies cannot file their financial reports on time after switching, the delay may be directly related to the auditor changes. Sometimes companies engage new audit firms just a few weeks before their filing deadlines, and cannot complete their financial statements on time. In cases where companies chose to dismiss their auditors, the companies should take the heat for their lateness rather than try to blame their outgoing auditor. Companies that miss filing deadlines before changing auditors usually have other reasons for filing late, such as poor internal controls or pending restatements.

Going-Concern Opinions

Under the SEC¹s 8-K disclosure requirements for auditor changes, companies must disclose whether any of their last two annual audit reports were modified. ³Going-concern² opinions are the most commonly mentioned modifications in auditor-change filings. When auditors modify their reports to include going-concern opinions, they have substantial doubt about a company¹s ability to continue in business through the next fiscal year.

In 2006, 563 (40%) of companies that changed auditors disclosed that their former auditors had modified their reports to include going-concern opinions. That was down from the 596 companies that made similar disclosures during 2005. Of the companies that changed auditors last year and disclosed that they had received going-concern opinions, 88% of those opinions were issued by smaller firms. Smaller audit firms also picked up 95% of the companies that hired new auditors after disclosing going-concern opinions.

Generally speaking, larger audit firms are not likely to continue auditing companies that received going-concern opinions because of their higher risk profiles and smaller size. Likewise, companies with financial issues probably cannot afford the services of larger audit firms. Of the 563 companies that changed auditors after receiving going-concern opinions, the auditors at 198 of them resigned. The other 365 companies dismissed their auditors, including 42 companies that had been audited by the Big Four or second-tier firms.

The companies most likely to receive going-concern opinions are those that lack sufficient revenue or cash flow, have negative retained earnings balances, or do not have strong enough operations to survive. It makes sense that, among the companies that changed auditors in 2006 and disclosed going-concern opinions, 96% had less than $75 million in revenue.

In 2006, 40% of companies that changed auditors previously had received going-concern opinions. By comparison, 18% of all public companies received going-concern opinions in 2005.

Recommendations

The authors believe it is advisable for audit committees to evaluate auditors annually and rotate and change auditors periodically. The volume of auditor changes in recent years has proved that the auditing profession has the expertise, breadth of experience, competency, and resources to allow for such changes.

The authors also believe there is a benefit to periodically having a fresh set of eyes examine the financial reporting, accounting, and disclosure practices of companies. A new audit firm can also bring to the table new ideas on how internal-control deficiencies or risks can be mitigated to the benefit of corporate boards, audit committees, and management. The ideas also benefit investors when they contribute to a better-run company and higher stock prices. In its 2007 report The Materially Weak, and in the previously cited The Errors of Their Ways, Glass, Lewis reported that the median one-year stock return of companies that reported restatements and material weaknesses underperformed the Russell 3000 index during 2006 by 18% to 20%. (The median one-year stock return of companies that filed restatements last year was ­6%, or 20 percentage points lower than the return of the Russell 3000 during 2006. The median one-year stock return of companies that disclosed material weaknesses last year was ­4%, or 18 percentage points lower than the Russell 3000.) This level of underperformance hurts investors in those companies.

If companies periodically rotated audit firms, say every five to 10 years, the authors believe that the current SEC rules requiring audit-partner rotation every five years could be discarded. In turn, audit firms would save money by not having to pay the expenses of rotating audit partners and managers on engagements. This would not only lessen the burden on auditors forced to relocate around the country, it also would save costs for audit firms, such as reimbursed moving expenses. And because those costs no longer would be passed on to companies, it would probably result in lower audit fees.


Mark Grothe is a research analyst at Glass, Lewis & Co., LLC. Thomas R. Weirich, PhD, CPA, is a professor of accounting at the Central Michigan University School of Accounting. His article "A Closer Look at Financial Statement Restatements: Analyzing the Reasons Behind the Trend" (The CPA Journal, December 2006), coauthored with CPA Journal Editorial Board member Lynn E. Turner, CPA, won The CPA Journal's Max Block Outstanding Article Award for 2006 as the Best Article in the Area of Technical Analysis.



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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