Resignations and Dismissals
Their Effect on the Profession
Lisa A. Owens-Jackson, Diana R. Robinson, and Sandra Waller Shelton
- The auditing profession has seen tremendous change over the
last 10 years. The Big Five have become the Big Four, the profession
is now externally regulated, specific consulting services can
no longer be provided to audit clients, audit committee roles
and responsibilities have been expanded, management must assess
the effectiveness of internal controls, and auditors must render
an opinion on the effectiveness of internal controls. These changes
and others mandated by the Sarbanes-Oxley Act of 2002 (SOX) have
transformed how audit firms conduct business.
transformation is the skepticism with which audit firms evaluate
clients. Given the tremendous change in the auditing profession
and litigation cases that refer to the profession’s deep
pockets, Big Four audit partners claim to be more conservative
in their decisions on the initial assessment and retention of
clients. The recent trend in auditor resignations and movement
of SEC clients from Big Four to other national (the next seven
largest firms) and to regional and local firms provides support
for these claims. In 2004, the number of auditor resignations
and movement of SEC clients to national and regional audit firms
hit a 10-year high. Furthermore, an examination of resignations
from SEC audit clients by the Big Four and the movement of SEC
clients from the Big Four to local and other national firms reveals
a significant increase since the passage of SOX.
in Resignations and Dismissals
more stringent client-acceptance/retention policies of the Big
Four, the movement of SEC registrants to regional and other national
firms is expected. However, the volume and extent of audit firm–client
realignment is more aggressive than anticipated. The resignation
by a Big Four firm from a public company client may be driven
by concerns about reducing client-related business risks in the
wake of the increased resources needed in order to be SOX-compliant.
A joint SEC-PCAOB roundtable held in May 2006 to obtain feedback
on experiences with complying with SOX section 404 internal control
requirements revealed that audit staffing and audit firm internal
structure are still based on a bottom-up approach, as opposed
to the top-down, risk-based approach to the audit and section
404 recommended by the SEC and PCAOB. Accordingly, in the current
environment, the audit manager must review not only the audit
work, but also the section 404 work, in a timely manner so that
the filing of year-end or quarterly reports is not delayed. Furthermore,
an economic downturn may negatively impact the profession, because
riskier or more poorly performing clients are particularly susceptible
of a public company is frequently followed by a series of lawsuits.
Audit firms are typically included in such lawsuits because in
the aftermath of a corporate failure, the audit firm is generally
one of the few solvent parties. Many audit firms that have picked
up the smaller, riskier, or financially weaker registrants are
regional and local firms with comparatively limited resources.
The survival of these audit firms in the aftermath of corporate
failure and major lawsuit settlements is a concern to the profession.
last eight years, the number of auditor resignations and client
dismissals has grown significantly, and the trend picked up sharply
between 2001 and 2004. As shown in Panel A of Exhibit
1, Big Four resignations from public company clients rose
from 89 in 2001 to 139 in 2004, a 56% increase. The 89 resignations
in 2001 represented 0.7% of the total client base; whereas the
139 resignations in 2004 represented 1.5% of the total client
base. Similarly, public company clients’ dismissal of Big
Four audit firms rose from 152 in 2001 to 298 in 2004, a 96% increase
(Exhibit 1, Panel B). The pattern in dismissals of Big Four firms
by SEC registrants can be attributed in part to rising Big Four
audit fees in the wake of SOX, as indicated in Exhibit
2. Average Big Four audit fees increased by more than 144%
between 2001 and 2004. This is to be expected, given the nature
of the integrated audits that are now required. Similarly, audit
fees increased by 105% between 2003 and 2005, while the number
of audit engagements decreased by 22%.
Relocation of Big Four and National SEC Registrant Clients
The majority of Big Four and national firm public company clients
change auditors are moving to regional and local firms, according
to data from AuditAnalytics.com and Auditor+Trak (www.straffordpub.com/products/atr/).
An analysis of that data shows that 346 U.S. companies left Big
Four auditors in 2006, fewer than the 403 firms that left Big
Four auditors in 2005. In addition, it appears that 53.2% of the
companies moved downstream to non–Big Four firms in 2006.
3 shows the size of audit firms that have picked up clients.
Consistently over the last six years, non–Big Four firms
have acquired SEC registrant engagements from the Big Four firms.
In 2005, a total of 403 SEC audit clients left Big Four firms,
with 289 (72%) of those audit engagements going to non–Big
Four firms. Over the same period, 76 SEC registrant clients left
national firms, with 35 (46%) going to smaller audit firms. In
2004, a total of 437 public company clients left Big Four firms,
with 316 (72%) going to non–Big Four firms. In 2003, a total
of 332 public company clients moved from Big Four firms, of which
206 (62%) went to smaller firms.
Some of the
downstream movement of clients in 2003–2005 can be explained
by the secondary realignment of Arthur Andersen clients. Exhibit
4 shows that of the 922 SEC registrants that left Arthur Andersen
between 2001 and 2002, 167 moved to a different auditor by 2005.
This represents only 12% of the total resignations and dismissals
from Big Four and national firms during the same timeframe.
2000 and 2004 have almost exactly the same number of resignations
and dismissals among Big Four firms, the trend indicates significantly
larger movement to non–Big Four firms in 2004 than 2000.
Specifically, 2000 shows 55% of Big Four clients switching to
other Big Four firms; while in 2004 the percentage of Big Four
clients switching to other Big Four firms is almost cut in half,
down to 28%. Notably, 41% of SEC registrant client changes from
Big Four firms in 2005 went to local or regional firms. The increase
in the movement of SEC registrants from Big Four to national,
regional, or local audit firms suggests the need for smaller firms
to assess changes in litigation risk.
in Litigation Risk
have realized the extent of their potential liability and have
tried to protect themselves with malpractice insurance. Nevertheless,
the Economist (“Revenge of the Nerds,” May 31, 2003)
reports that “insurance firms are either refusing to cover
auditors for much, or are charging prohibitively expensive premiums.”
The problem has become so great that some insurance companies
are closing their doors to accounting firms. Insurers willing
to serve smaller accounting firms limit the maximum insurance
payments to between $10,000 and $100,000. The
annual cost of insurance and settlements is now more than 19%
of the large firms’ fee income. Interviews with a spokesperson
at AON Insurance Services in September 2006 indicated that this
percentage has grown considerably over the last five years for
against CPA firms are estimated to have increased, with many asserting
conflicts of interest and poor audit quality. As the national
economy slows, more businesses are likely to fail. In the past,
the number and size of lawsuit settlements have risen as the economy
declined. In times of hardship, investors and creditors will continue
to try to recoup their losses from the deep pockets of audit firms.
This should be a concern to the profession because, while the
Big Four audit firms have in-house legal staff and funds set aside
for settlements, regional and local firms will face similar liability
claims without the same resources to defend themselves.
recommends a three-tiered malpractice insurance program from AON
Insurance Services. Insurance providers recognize the litigation
risk and are recommending procedures to protect the interests
of the regional and local firms. The procedures include recommendations
on hiring partners with certain skill sets, and amendments to
engagement letters that mandate arbitration of client disputes.
SEC independence rules, however, prohibit any limitations on the
amount of exposure, and shareholder lawsuits cannot be affected
by such “amendments.” The auditing profession will
be negatively affected if the survival of Big Four firms is threatened
by lawsuit settlements and reduced insurance coverage. Furthermore,
the survival of regional and local firms will also be threatened
by the additional business risk they assume by accepting higher-risk
clients and the increased work mandated by SOX, given that smaller
firms possess more-limited resources.
A. Owens-Jackson, PhD, CPA, is an assistant professor of
accounting in the school of accountancy and legal studies at Clemson
University, Clemson, S.C.
Diana R. Robinson, PhD, CPA, is an assistant professor
of accounting in the department of accounting at North Carolina
A&T State University, Greensboro, N.C.
Sandra Waller Shelton, PhD, CPA, is an associate
professor of accounting in the school of accountancy and MIS at
DePaul University, Chicago, Ill.