Timing of auditor terminations and client firm risk

Abstract

Purpose The purpose of this study is to examine whether the timing of auditor terminations signals the riskiness of client firms. Design/methodology/approach This empirical study uses a sample of auditor switches during 2003-2014 to conduct univariate tests and multivariate regression analyses. Auditor switches occurring after the audit report date but before the shareholders’ meeting are classified as “planned” terminations and auditor switches that occur outside of this window are classified as “abrupt” terminations. Findings First, abrupt terminations are more strongly related to client risk factors than planned terminations. Second, relative to planned terminations, abrupt terminations are more likely to result from an auditor resignation rather than a client dismissal. Third, abrupt termination firms are more likely to have internal control weaknesses and experience delistings in the following year. Future operating performance is also worse after an abrupt termination. Finally, auditors and investors view abrupt terminations as riskier than planned terminations. Practical implications As the timing of the auditor termination is publicly available information, it can provide an important signal of deteriorating financial performance to shareholders and potential investors. Abrupt terminations could be costly to shareholders because those firms likely have lower quality financial reporting (due to internal control weakness) and deterioration of future operating performance. Originality/value While concurrent studies investigate the relation between the timing of new auditor appointment and audit quality, this is the first study to document the relation between the timing of auditor termination and the riskiness of client firms.

Auditor Exits and Firm Performance: Is There a Link?

“…The findings reveal that cumulative average market-adjusted stock returns are significantly negative over each holding period, being the lowest in the three-month time bucket, suggestive of a “flight to safety” (Beale et al, 2020). The negative stock response around auditor resignation has also been documented in previous studies (DeFond et al, 1997; Her et al, 2019). In the near term, auditor exits lead to a decline in returns by anywhere between 14% and 30%.…”

“…Similarly, the sign of the coefficient on TobinQ in columns (3) and (4) would indicate that auditors are more likely to associate themselves with high-growth firms. Based on column 4, we can infer that the likelihood of auditor exit is 43% higher for high-growth firms (Her et al, 2019).…”

“…Third, we augment the literature by assessing which category of auditor exit is most detrimental to firm performance. Most prior evidence has focused squarely on auditor resignations (Chang et al, 2010;Her et al, 2019;Johnstone & Bedard, 2004). In early studies, Johnstone (2000) shows that audit partners avoid risky clients.…”

Shareholders’ Perception of Auditor Type and Timing of Auditor Engagement: Evidence from Auditor Ratification

“…Although the auditor switching literature is well established and extensive, only a handful of studies have examined the timing of an auditor switch. These studies find that a late auditor switch is associated with longer reporting lags (Schwartz and Soo 1996), lower audit quality (Cassell et al 2020 ;Burks and Stevens 2022) and client firm risk (Her et al 2019). Another approach in the literature is to examine the time between dismissal/resignation of an incumbent auditor and the appointment of the new auditor (i.e., auditor search period).…”

“…Auditors face this time constraint because all public firms must file audited financial statements with the SEC by the filing deadline. 8 In addition to the time constraint, a late engagement itself may be indicative of client riskiness that can compromise audit quality (Her et al 2019). As the audit progresses, the predecessor auditor collects increasingly more information about the audit risk of their client, which increases the likelihood of discovering significant accounting issues that could not be resolved.…”