Lack of Disclosure Hinders Accountablility
Mark Grothe and Thomas R. Weirich
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.
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
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.
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.
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
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).
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.
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.
Shift to Smaller Firms
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.)
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).
Occurred in a Variety of Industries
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.
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.
65% of the cases, companies initiated the change by dismissing
their auditors. In the other 35%, auditors resigned.
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.
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.
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
Lay of the Audit Land
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.
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.
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.
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.
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
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.
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.
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.
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.
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.
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.)
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.
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.
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.
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.
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.
on Accounting Principles
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
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.
to Rely on Management
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
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.
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
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.
Firm Response-Letter Disagreements
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.
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
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%.
Firms’ Gains and Losses
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.
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.
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
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.
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.
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
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 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.
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.
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.
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.
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
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.
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.
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.
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.
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 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
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
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.
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
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
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.