lennox - audit quality and auditor switching - some lessons for policy makers

For mostcountries, this means that the rate of audit qualifications needs to be substantially higher.4Although most failing companies are not given qualified reports and most qualifiedre

Audit Quality and Auditor Switching:

Some Lessons for Policy Makers

CLIVE S LENNOX

Economics Department, Bristol University.

Address for Correspondence

Audit Quality and Auditor Switching:

Some Lessons for Policy Makers

1 Introduction.

This paper reviews the literature on audit quality and auditor switching to assess differentcountries’ policy regimes It argues that policy-makers should limit managerial influence overauditor switching rather than reduce auditors’ economic dependency on clients In particular,the paper advocates proper communication between shareholders and auditors, and a policy ofmandatory auditor retention In contrast, some countries have adopted policies of mandatoryrotation, and have banned non-audit services and introductory fee discounts It is argued thatsuch policies are less desirable on both theoretical and empirical grounds

A lack of audit quality is most often alleged when it is believed that auditors shouldhave warned investors about impending corporate failures (these are often termed “auditfailures”).1 The next section argues that audit failure is a significant cause for concern Section

3 explains how auditor switching can affect audit quality Section 4 describes regulatoryregimes aimed at increasing audit quality Sections 5 and 6 discuss the theoretical andempirical literature on auditor switching and audit quality Section 7 concludes with policyrecommendations

2 Audit Failure - Is it a Problem?

In the UK, an auditor who believes that a company is about to fail is required to signal this toinvestors by giving a going concern qualification in the audit report The Guideline on GoingConcern (1985) states, “The going concern concept identified in Statement of StandardAccounting Practice No 2 is ‘that the enterprise will continue in operational existence for theforeseeable future’ This means in particular that the profit and loss account and the balancesheet assume no intention or necessity to liquidate or curtail significantly the scale ofoperation.” The rationale for the existence of going concern qualifications is to warn investorsthat the company’s financial statements are reported under the assumption that the company

1

Congressman Wyden (1986) has stated before Congress, “In one financial disaster after another the disaster struck virtually on the heels of clean audit certificates issued by audit firms.”

will remain a going concern In the event of liquidation, the company’s value may be verydifferent to that reported in the accounts However, the auditor is required to ensure thatshareholders are warned, even if the reported value of the company corresponds to itsliquidation value.2 The Guideline states, “Where there is significant uncertainty about theenterprise’s ability to continue in business, this fact should be stated in the financial statementseven where there is no likely impact on the carrying value and classification of assets andliabilities”.

UK evidence indicates that audit reports are not accurate indicators of financialdistress Only 20-27% of failing companies receive qualified reports (Taffler and Tissaw,1977; Taffler and Tseung, 1984; Citron and Taffler, 1992) Moreover, in a sample of 40companies that received qualified reports, Taffler and Tseung (1984) found that only 10 failed

To illustrate this, Table 1 shows the correlation between audit reporting and company failure inthe UK (1987-94).3

Qit = 1 if company i received a qualified report in year t; = 0 otherwise

In addition, to going concern qualifications, qualified reports were given for non-compliance withStatements of Standard Accounting Practice, and due to uncertainty regarding provisions for bad debts,slow-moving stocks and litigation

GQit = 1 if company i received a going concern qualification in year t; = 0 otherwise

2

Altman (1982) has argued that the correlation between audit qualifications and corporate failure may not give an accurate measure

of audit quality This is because an auditor might choose to give an unqualified report to a company which is likely to fail, if the accounts give a true and fair view of the company’s liquidation value Whilst this argument holds for the US, it does not apply to the UK.

3

More details about this sample are given in Lennox (1998a).

Following Koh (1991), the accuracy of audit reports is measured in terms of type I and type IIerrors The type I error rate is equal to the proportion of failing companies that are givenunqualified reports; the type II error rate is equal to the proportion of non-failing companiesthat are given qualified reports The type I error rate is very large (approximately 80%)compared to the type II error rate (approximately 2%) - it is therefore unsurprising that auditfailure (a type I error) is perceived to be a significant problem Altman (1977) has estimatedthat type I errors are seven times more costly to accounts users than type II errors This impliesthat, as well as reducing the incidence of both type I and type II errors, policy should ensurethat there are approximately seven times as many type II errors as type I errors For mostcountries, this means that the rate of audit qualifications needs to be substantially higher.4

Although most failing companies are not given qualified reports and most qualifiedreports are not followed by bankruptcy, it does not necessarily follow that auditors are failing

in their responsibilities The low predictive power of most bankruptcy models suggests thatauditors may not accurately warn about impending failure when bankruptcy is anunforeseeable event However, there are three reasons for arguing that audit reports could bemore accurate First, reports are poor indicators of financial distress compared to thepredictions of bankruptcy models (Altman and McGough, 1974; Koh, 1991; Lennox, 1998a).Secondly, the number and scale of successful litigation cases suggest that auditors sometimesfail in their responsibilities towards shareholders (Palmrose, 1988) Finally, regulatoryinvestigations (by the Department of Trade and Industry (DTI) in the UK, and the StockExchange Commission (SEC) in the US) have often been critical of auditors (Firth, 1990;Wilson and Grimlund, 1990; Davis and Simon, 1992) Therefore, audit failure is a significantand important problem - the following section discusses how auditor switching affects thequality of audit reporting

4

In the US, Carcello et al (1995) report that type I error rates were approximately 48% between 1972-92 (evidence for type II error rates was not given).

3 The relationship between auditor switching and audit quality

It has been argued that companies use auditor switching to avoid receiving qualified reports.This argument assumes that managers dislike qualified reports and that managers influence theauditor appointment decision

The first assumption is relatively uncontroversial - a qualified report may signal toinvestors that managers are poor stewards of the company’s affairs, or that managers haveattempted to present an over-favourable view of the company’s performance In addition,qualified reports cause share prices to fall - this reduces managerial utility if managers ownshares or if their compensation is related to market value (Firth, 1978; Banks and Kinney,1982; Fleak and Wilson, 1994; Chen and Church, 1996; Jones, 1996) Therefore, there arestrong grounds for believing that managers dislike receiving qualified reports

The second assumption is more controversial because, de jure, auditors are appointed

by shareholders However, de facto, managers exert considerable influence over auditor

appointments For example, managers often dismiss incumbent auditors without consultingshareholders - shareholders merely vote on whether to accept their recommendation regardingthe appointment of a new auditor or the re-appointment of the incumbent auditor Thus, theright to dismiss an auditor lies mainly with managers Secondly, managers have some influenceover the appointment of a new auditor or the re-appointment of the incumbent auditor They setmeeting agendas when auditor appointments are proposed, and they typically have the proxyvotes of a large number of shareholders Thus, managers have considerable influence overauditor hiring and firing

If managers dislike qualified reports and have some influence over auditorappointment, they may try to use auditor switching to avoid receiving qualified reports Teoh

(1992) usefully identified two ways in which this could occur First, a manager may actively

use the auditor switch decision to avoid receiving a qualified report If a new auditor is lesslikely to give a qualified report compared to the incumbent auditor, the manager may choose to

switch; similarly, if a new auditor is more likely to give a qualified report compared to theincumbent, the manager may choose not to switch This active use of auditor switching iscalled ‘opinion-shopping’ in this paper Secondly, if auditors earn client-specific rents, a

manager may obtain a more favourable report from an incumbent auditor by threatening to

switch to a new auditor The next section describes regulatory safeguards that reduce the scopefor opinion-shopping and the switch threat

4 Regulatory Safeguards

Policies aimed at curbing opinion-shopping focus on reducing managerial influence overauditor switching On the other hand, policies aimed at reducing the potency of the switch

threat deal with both managerial influence and auditors’ economic dependency on clients First,

the discussion focuses on managerial influence over auditor switching

4.1 Managerial influence over auditor switching

4.1.1 Communication between an outgoing auditor and shareholders

Most countries require outgoing auditors to communicate with shareholders and/or regulatorybodies.5The aim of such communication is to prevent managers using switching to concealunfavourable information

In the US, the SEC must be informed of the reasons for a change in auditor, and theauditor is entitled to be heard by shareholders The SEC have introduced a number ofdisclosure requirements over the years seeking to increase communication between shareholdersand auditors (for example SEC, 1988 and 1989) More recently, the US Public OversightBoard (1994) recommended that auditors express judgements to boards of directors and audit

5

In the UK, a dismissed auditor has the right to make written representations to shareholders or to speak against the resolution for his removal at the company’s Annual General Meeting (AGM) In the UK, an auditor’s notice of resignation is not effective unless it contains either: (a) a statement to the effect that there are no circumstances connected with the resignation which should be brought to the notice of the members or creditors of the company, or (b) a statement of any such circumstances In Denmark, Ireland, the Netherlands, Spain and Sweden, auditors are required to disclose the reason for a change of auditor In all EU countries with the exception of Spain, auditors have the right to defend their positions if threatened with dismissal.

committees about the appropriateness of the financial statements, and that auditors meet withboards of directors and audit committees at least once a year.

However, in many countries outgoing auditors rarely communicate with shareholderseven when there is a genuine cause for concern.6 For example, the DTI’s investigation ofRamor Investments (1983) concluded, “We are critical of the auditors’ work and of the factthat when Price Waterhouse did resign they went too quietly.”7 One problem may be thatauditors do not wish to gain reputations as trouble-makers amongst the managers of othercompanies.8 In addition, auditors may be concerned that communication would reveal previousaudit errors and increase the likelihood of litigation

4.1.2 Communication between outgoing and incoming auditors

6

A problem in the UK is that the auditor’s statement must first be sent to the company’s managers, who are then required to send copies to all shareholders (Dunn, 1991) If managers fail to do this, the auditor has the right to read the statement at the AGM However, such meetings are often attended by few shareholders Therefore, scope for direct communication between auditors and shareholders is limited.

7

The inspectors found that Price Waterhouse had resigned because of: the intermingling of a director’s (Mr S) personal accounts with those of the company; a lack of co-operation from the same director; an instance of outright deception; and errors in a previous audit Rather than revealing these facts to shareholders at the company’s AGM, the partner in charge of the audit (Mr A) had written

to Mr S the following letter:

“Dear Mr S,

As arranged I am writing to let you know in advance of the Annual General Meeting the replies I will give if I am asked by a shareholder for the reasons why my firm is not seeking re-election as auditors If no questions are asked then, of course, no further information in addition to that contained in the Annual Report need be provided However, if a shareholder asks for further information I propose to reply as follows:

“In recent years we have experienced certain difficulties in obtaining the necessary information for our audit and being sure that all relevant explanations have been provided to us In the final outcome we have been satisfied that we have received all such information and explanations; otherwise this would have been reflected in our audit report However, the situation created by these difficulties caused us to agree with the directors that we would not seek re-election at this meeting, a step we are permitted to take under the provisions of the Companies Act.”

If there should be a follow-up question asking for more information about the difficulties referred to in the foregoing statement I would propose to reply as follows:

“There was no one matter which in itself caused us to reach this agreement with the directors In view of this, there is nothing more that can be added to the answer that has already been given.”

I would not intend to give any more information nor to respond to any other questions.

In theory, an auditor should wish to gain a reputation as a ‘whistle-blower’ so as to improve his reputation amongst shareholders.

In practice, this argument does not seem to be important For example, the Financial Times (23:1:97) has reported that an anonymous hotline has been set up for UK auditors to act as whistle-blowers to the pensions regulator The fact that the regulator believed the hotline needed to be anonymous suggests that auditors do not have an incentive to gain a reputation for being whistle-blowers This is consistent with the argument that managers rather than shareholders have most influence over auditor appointment.

In most countries, outgoing auditors are required to inform incoming auditors if there areworrying circumstances that prompted the change in auditor.9 The aim of this requirement is toprevent a manager concealing unfavourable information by switching to a less well-informednew auditor.

However, communication between incoming and outgoing auditors does not occur veryfrequently For example, the DTI’s investigation of Ramor Investments found that PriceWaterhouse had resigned because of matters relating to fraud However, Price Waterhouse didnot reveal this to the incoming auditors Norton Keen - rather they were told that the resignationdecision was based on commercial grounds These facts led the inspectors to conclude thatPrice Waterhouse’s conduct with regard to the incoming auditors was “indefensible”

More systematic evidence has been provided by Dunn et al (1994) who found that UKauditors only disclosed why resignations occurred in 19 out of 793 (2.4%) cases - this wasdespite a high incidence of audit qualifications before and after the resignations.10 Scope forcommunication between incoming and outgoing auditors appears to be greater in the US In

1975, the SEC introduced Accounting Series Release No 165 requiring auditor changes to bedisclosed when the incumbent auditor’s appointment was terminated rather than when a newauditor was appointed Smith (1988) found that the increased timeliness of information aboutauditor changes provided more useful information to investors This suggests that policiesaimed at improving disclosure about auditor changes can be effective More recently, theAmerican Institute of Certified Public Accountants (AICPA) issued SAS 84 (1997) whichincreased incoming auditors’ rights of access to outgoing auditors’ working papers.11

4.1.3 Mandatory rotation and retention of auditors

Mandatory rotation or retention of audit firms reduces managerial influence over auditorswitching, and therefore limits the use of opinion-shopping and the switch threat In addition,mandatory rotation reduces the potency of the manager’s switch threat by lowering theexpected period of incumbency and reducing expected rents.12 Voluntary rotation occurs veryinfrequently - in the US, the rate of auditor switching is only 1-6% per year with 75% of clientshiring the same auditor for 17 or more years (DeAngelo, 1981; Beck et al., 1988).13

Whilst Italian companies regulated by the Stock Exchange Regulatory Authority arerequired to rotate audit firms every nine years, no such provisions exist in other EU countries,the US or Australia.14 In the US, the Metcalf report (1976) recommended mandatory rotation

of audit firms but this was later rejected by AICPA (1978) and the SEC Practice Section(AICPA, 1992) Mandatory retention of audit firms has been adopted in Belgium, Spain andItaly (three years), Portugal (four years) and France (six years), but not in other EU countries,the US or Australia

Some policy-makers have argued that mandatory rotation could reduce audit qualitybecause incumbent auditors have greater knowledge of clients (AICPA, 1978; RyanCommission, 1992) Consistent with this, studies have shown that it takes time for newlyappointed auditors to become familiar with clients and shorter periods of incumbency reduceauditors’ incentives to invest in learning-by-doing (St Pierre and Andersen, 1994; Arrunadaand Paz-Ares, 1997) In a survey of European auditors, Ridyard and Bolle (1991) found that 1-

2 years were needed to gain client familiarity in industries where the auditor had no previousexperience; 2 years were needed for industries in which the auditor had experience

12

There is little systematic evidence for the view that long auditor-client relationships reduce auditors’ incentives to maintain independence, although there is some anecdotal evidence In the DTI’s investigation of Rotaprint (1991), the fact that Joselyne Layton-Bennet had been Rotaprint’s auditor for thirty years was identified as being a potential problem (although the reason why this was perceived to be a problem was not revealed).

The US Quality Control Inquiry Committee found that audit failure was three timesmore frequent in the first two years of auditor tenure (AICPA, 1992) Unfortunately, theCommittee did not clarify whether this correlation arose because shorter tenure increased theprobability of audit failure, or because companies prone to audit failure were more likely tochange auditor In addressing this causality problem, Lennox (1998b) controlled for the effects

of opinion-shopping and financial health on auditor switching and showed that short tenureincreases the likelihood of audit failure This supports the argument that mandatory rotation isnot a desirable policy

4.2 Reducing auditors’ client-specific rents

Concern over the switch threat has led some countries to maintain auditor independence byreducing auditors’ client-specific rents This section therefore focuses on policies aimed atreducing auditors’ economic dependency on clients

4.2.1 Non-audit services

Survey evidence indicates that audit firms earn much higher rents from non-audit services thanfrom statutory audits (Ridyard and De Bolle, 1992).15 Concerns have been expressed that rentsfrom non-audit services significantly increase the potency of the manager’s switch threat, andthat this could compromise auditor independence In addition, there have been concerns thataudit firms are unwilling to criticise work carried out by non-audit departments On the otherhand, non-audit services could improve audit quality by increasing auditors’ knowledge ofclients

Policies on non-audit services include laissez-faire, disclosure of non-audit fees, andprohibition Most EU countries ban the provision of some or all non-audit services.16 In

15

Restrictions on the maximum share an individual client’s audit fee may take of total audit revenue exist in Austria (30%), Denmark (20%), Germany (50%), Ireland (10%) and the UK (10%) However, such restrictions do not apply to non-audit fees received from audit clients.

16

Belgium, France and Italy ban the provision of all non-audit services - other EU countries allow tax and financial advisory services Bookkeeping services are banned in all EU countries except Denmark, Ireland, Luxembourg, Netherlands, Portugal, Sweden

contrast, the UK and Australia do not impose bans but do require the disclosure of non-auditfees.17 In the US, Accounting Series Release No 250 required public disclosure of the type andquantity of non-audit services as a percentage of the total audit fee - however, this requirementwas only in force between 1978-81 More recently, the US General Accounting Office (1996)has argued that non-audit services do not reduce audit quality, and there are currently no plans

to require disclosure

4.2.2 Low balling

Low balling occurs when an auditor wins a new client by offering an initial fee below cost, inthe hope of offsetting the initial loss by earning rents in subsequent periods Concerns havebeen expressed that these rents may increase the potency of the company’s switch threat Inaddition, low balling may give an auditor less incentive to qualify if the auditor believes that aqualification would precipitate bankruptcy and the loss of future rents

With respect to low balling, AICPA (1978) has stated, “An ethics ruling indicates thatwhen the preceding year’s audit fee remains unpaid, independence is impaired accepting anaudit engagement with the expectation of offsetting early losses or lower revenues with fees to

be charged in future audits represents the same threat to independence.” These concerns arealso highlighted in an EU Green Paper (1996), “The growing intensity of competition for audit

‘business’, and especially for the audit of large ‘prestige’ companies, is a cause of concern.There is no doubt that competition sometimes results in low-cost and perhaps even below-costtenders The procedure of calls for tenders should not have as a consequence that auditorsquote an audit fee which does not allow them to carry out their work in accordance with

which to judge the relationship between the company and its auditors.” (Hansard Parliamentary Debates, House of Lords 16th

January 1989, column 10) Belgium, Denmark and Norway also require disclosure of non-audit fees, whereas other EU countries do not (Buijink et al., 1996).