Do markets react to required and voluntary disclosures associated with auditor realignments?

Advances in Accounting, incorporating Advances in International Accounting 25 (2009) 1–12

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Advances in Accounting, incorporating Advances in International Accounting j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / a d i a c

Do markets react to required and voluntary disclosures associated with auditor realignments? George R. Aldhizer III ⁎, Dale R. Martin, James F. Cotter Wake Forest University, The Calloway School of Business and Accountancy, Kirby Hall, Wingate Road, Winston-Salem, NC, 27106-7285, United States

a r t i c l e

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Keywords: Controls Cumulative abnormal returns (CARs) Disagreements Earnings restatement 8-K Going concern Non-reliance Required disclosures Resignation Verifiable Voluntary disclosures

a b s t r a c t This manuscript investigates whether required and voluntary Form 8-K (Item 4.01) auditor realignment disclosures in 2004 and 2005 convey information content to investors in a post SOX era. Unlike prior research, our results indicate that internal control material weakness and non-reliance on management representation disclosures convey negative information content, while audit scope limitation, earnings restatement and client–auditor disagreement disclosures do not convey information content in a post SOX era. Also, unlike prior research, voluntary disclosures such as fee disputes do not convey information content. Similar to prior research, auditor resignation disclosures convey information content. Our results also indicate that other required disclosures such as when an auditor realignment occurs after a company has received a going concern opinion and when a company switches to a larger audit firm (e.g., from a local/ regional firm to a Big 4 firm) are associated with positive CARs. © 2009 Elsevier Ltd. All rights reserved.

1. Introduction The purpose of this study is to examine whether required and voluntary disclosures in auditor realignment 8-Ks (Item 4.01) convey meaningful information to investors in a post Sarbanes–Oxley Act (SOX) era. Our a priori belief is that investors will react negatively to some required disclosures and will react positively to some voluntary disclosures as companies try to put a positive spin on auditor changes. For example, required disclosures such as an auditor's inability to rely on management representations may convey negative information, while voluntary disclosures such as a client's desire to receive better audit service may convey positive information. Whisenant, Sankaraguruswamy, and Raghunandan (2003) examined a relatively large number of auditor realignment 8-Ks in the mid 1990s and found that many required disclosures, excluding internal control material weaknesses, convey negative information to investors. Sankaraguruswamy and Whisenant (2004) found that many voluntary disclosures convey positive information to investors in the mid 1990s. However, recent accounting scandals, the demise of Andersen, and the passage of SOX in 2002 have all dramatically changed the audit environment and the perception of the value of an audit. Thus, does it make sense to reexamine auditor realignment 8-Ks in the context of a post SOX era? For example, as investors

⁎ Corresponding author. E-mail addresses: [email protected] (G.R. Aldhizer), [email protected] (D.R. Martin), [email protected] (J.F. Cotter). 0882-6110/$ – see front matter © 2009 Elsevier Ltd. All rights reserved. doi:10.1016/j.adiac.2009.02.002

become more aware of the importance of required internal control material weakness disclosures as an early warning sign for management fraud, are they more likely to convey negative information (Internal Auditing Report, 2007)? Are other required disclosures, such as client–auditor disagreements, fewer in number and less severe because of more proactive audit committees and top management's financial statement “certification” requirements1 and thus no longer transmitting negative information to investors? Are voluntary disclosures, such as fee disputes, viewed less favorably as investors change their perception of an external audit's importance as a result of recent accounting scandals and thus no longer value cost savings resulting with these disputes over possible reductions in audit effectiveness? Turner, Williams, and Weirich (2005) examined the reasons behind many recent U.S. public company auditor changes and found that stock prices often decline substantially after an auditor change. However, they stated that since it is difficult to attribute a significant stock price reaction to just one event (e.g., an internal control material weakness disclosure) that further research is necessary to assess the impact on stock prices of reported reasons for auditor realignments. The number of auditor realignments increased significantly in 2004 and 2005, and yet most of the 8-Ks provide no reason(s) for the change. Glass Lewis & Co., Grant Thornton and the U.S. Treasury have

1 Sarbanes–Oxley Act, Section 302: Corporate responsibility for financial reports, H.R. 3763, June 2002.

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urged the SEC to require all U.S. public companies to provide reason(s) for every auditor change (Glass Lewis & Co., 2007; U.S. Treasury, 2008). Would this requirement provide more meaningful information to investors or would the additional disclosures have little impact on investor decisions? To help answer this question, we examine investors' reactions to current auditor realignment disclosures to determine whether they convey meaningful information. If the current disclosures are impacting investors' decisions, then the above recommendation may be warranted and may help remove the shroud of secrecy that currently surrounds many auditor realignments. For these reasons, we examined detailed descriptive data for all 3201 auditor realignments in 2004 and 2005 (1607 in 2004 and 1594 in 2005). Since stock price data is not available for over-the-counter (OTC) companies, our statistical sample is reduced to 713 companies. Our examination of the information content within required and voluntary auditor realignment disclosures focuses on the cumulative abnormal returns (CARs) surrounding the 8-K (Item 4.01) filing date. Unlike prior research conducted in a pre SOX era, internal control material weakness and auditor non-reliance on management representation disclosures are associated with negative CARs, while audit scope limitation, earnings restatement and client-auditor disagreement disclosures are associated with non-significant CARs in a postSOX era. Also, unlike prior research, all voluntary disclosures including fee disputes are associated with non-significant CARs. Similar to prior research, auditor resignation disclosures are associated with negative CARs. We believe that this is the first study to analyze the impact of required 8-K going concern disclosures on CARs. Results indicate that auditor realignments that occur after a company has received a going concern opinion are associated with positive CARs. Further analysis reveals that investors react negatively to initial 10-K going concern disclosures, but then view subsequent auditor changes as an opportunity for a troubled company to be exposed to a fresh set of eyes that may provide value added recommendations that can help turn around the company. Companies that switch to a larger audit firm (e.g., from a local/ regional firm to a Big 4 firm) also are associated with positive CARs. We believe that this is the first study to report this relationship which provides some support for the product differentiation hypothesis (Dopuch & Simunic, 1982). The remainder of the paper is organized as follows. Section 2 provides background information on auditor realignment 8-K (Item 4.01) disclosures, while Section 3 reviews the relevant literature and summarizes the research hypotheses. Section 4 discusses the research methodology and Section 5 reports the descriptive and statistical data results. Section 6 discusses the study's implications, limitations and possible areas for future research, while Section 7 presents the study's conclusions. 2. 8-K disclosures In 1971, the Securities and Exchange Commission (SEC) began requiring registrants to disclose details of auditor realignments in a timely manner in their Form 8-K, Item 4, filings (SEC, 1971). Required 8-K disclosures have evolved over time to provide expanded information about auditor realignments within the following categories: reportable events, other required disclosures and voluntary disclosures. 2.1. Reportable events One of the most significant changes occurred in 1988 when the SEC enacted Financial Reporting Release (FRR) No. 31 (SEC, 1988) which requires the disclosure of the following four reportable events: (1) internal controls that are not adequate to generate reliable financial statements (e.g., material weaknesses); (2) a substantial expansion of

audit scope (or a scope limitation) resulting from the discovery of information that potentially impacts the reliability of financial statements (that may be subsequently withheld by the client); (3) the auditors inability to rely on management's representations or their unwillingness to be associated with the financial statements based on recently obtained information; and (4) earnings restatement(s) resulting from information that materially impacts the reliability of current and/or prior year financial statements. Internal control material weakness disclosures are required when auditors discover a deficiency, or combination of deficiencies, within a client's internal control over financial reporting, such that there is a reasonable possibility that a material misstatement within the financial statements will not be prevented or detected on a timely basis (PCAOB, 2007). The second reportable event involves audit scope disclosures that are required when auditors discover one or more material misstatement “red flags” that in their judgment require substantial increases in audit testing. Prior to completing this additional testing, however, clients may dismiss their auditors to hopefully obtain a less skeptical successor auditor or a predecessor auditor may resign without issuing an audit opinion because of concerns about being associated with potentially materially misstated financial information. Auditors also may encounter management that appears to be limiting their ability to conduct necessary audit procedures. For example, management may attempt to prevent auditors from discovering material misstatements by withholding key documents or providing misleading documents. Auditors may respond by resigning from these engagements without issuing an audit opinion (or by issuing a disclaimer of opinion) and disclosing a scope limitation within their Form 8-K. The third reportable event involves the auditors' inability to rely on managements' representations. Auditors who state that they can no longer rely on management's representations may have discovered at least one of the following: material misstatements that have not yet triggered an earnings restatement, integrity issues surrounding individuals within the financial reporting function, contradictory or misleading statements by management, etc. These concerns may be so egregious that they result in auditors withdrawing all previous audit reports and opinions and stating that they are unwilling to be associated with any financial statements prepared by management. The fourth reportable event involves whether an earnings restatement(s) has occurred in the current and/or prior fiscal year. Auditors who resign after the release of earnings restatements may be signaling concerns about issues such as the tone at the top or the control environment that may increase the risk of additional restatements in the future. Companies who dismiss their auditors after the release of earnings restatements may be retaliating against the auditors' demands to disclose the restatement and may be hoping to obtain more sympathetic successor auditors. However, since many of these earnings restatements may be previously disclosed in the company's current and/or prior year 10-K, the market impact of the 8-K restatement disclosure may be significantly eroded by the potential long lag between the earliest disclosure and the subsequent 8-K disclosure. 2.2. Other required disclosures The SEC also mandates that companies disclose the following other required disclosures (SEC, 1989): (1) whether the predecessor auditor resigned; (2) whether there are any disagreements with the predecessor auditor (e.g., GAAP issues); and (3) whether there are modifications to the audit report in the previous two years, including going concern opinions. Although other forms of audit report modification exist (e.g., emphasizing the adoption of newly issued GAAP), going concern disclosures are more likely to be viewed negatively by investors since

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auditors indicate “substantial doubt” about a company's ability to continue as a “going concern” in the foreseeable future.2 The SEC, however, requires companies to disclose any modifications to their audit report in either of the two preceding years. Thus, similar to earnings restatements, the market impact of going concern disclosures may be significantly eroded by the potential long lag between their initial disclosure in a 10-K and their subsequent 8-K disclosure. 2.3. Voluntary disclosures The SEC encourages registrants to voluntarily disclose any additional reasons for audit realignments. These disclosures may be divided into the following three categories: (1) client-service related reasons, (2) fee disputes and (3) verifiable or previously disclosed reasons. Client-service related reasons may be defined as nonverifiable or more subjective realignment reasons, such as a client's desire to receive better audit service. Fee disputes indicate that the client or the firm has initiated an auditor change due to dissatisfaction with the fee structure. Verifiable disclosures are those that have been previously announced such as auditor consolidations resulting from company mergers. 3. Research hypotheses 3.1. Impact of reportable events on abnormal returns As discussed in Section 2, the four reportable events include internal control material weaknesses, auditors' desire to expand their audit scope (or a client-imposed scope limitation), auditors' inability to rely on management representations, and earnings restatements in either of the two preceding years. Few studies have investigated the market reaction to reportable events as required under FRR No. 31 in Form 8-K (Item 4.01). Krishnan (2002) found negative information content after combining all four reportable event disclosures into a single explanatory variable, but only when the predecessor auditor's exhibit letter is not filed concurrently with the initial Form 8-K. However, Whisenant et al. (2003) examined a relatively large number of reportable events (n = 118) in the mid 1990s and found negative information content when they combined three reportable event disclosures into a single explanatory variable (audit scope concerns, non-reliance on management's representations and earnings restatements) within both nonconcurrent and concurrent exhibit letter samples.3 However, the authors did not find a significant association between internal control material weakness disclosures and CARs in the mid 1990s. The PCAOB recently stated that internal control material weaknesses are intended to act as an early warning system for management fraud (Internal Auditing Report, 2007). In addition, recent surveys of professional fraud examiners indicate that strong internal controls are among the most effective means for preventing and/or detecting management fraud. Specifically, a strong tone at the top or control environment is considered to be the most effective means for preventing management fraud4, and strong control procedures are considered to be the third most effective means (Oversight Systems, 2 Besides going concern disclosures, disclaimers of opinion also are likely to be viewed negatively by investors; however, because disclaimers of opinion are rare, they are not emphasized in this study. 3 Similar to Whisenant et al. (2003), our univariate relationship between CARs and the three remaining reportable event disclosures (audit scope concerns, non-reliance on management's representations and earnings restatements) when combined into a single explanatory variable were statistically significant (p-value b 0.05); however, when this variable is incorporated into our more expansive multivariate regression model, it is not statistically significant. 4 Beasley, Carcello and Hermanson (1997) found that 83.0% of material fraudulent financial reporting addressed in SEC Accounting and Auditing Enforcement Releases (AAERs) from 1987 to 1997 were perpetrated by top management (e.g., the CEO and/ or the CFO).

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2005). The Association of Certified Fraud Examiners (ACFE, 2006) reports that strong internal controls are more than four times as likely to detect management fraud within public companies as external auditors. If this is true, then we would expect that the disclosure of internal control material weaknesses would imply an increased risk of management fraud and thus convey negative information content to investors. Based on the above discussion, the reportable events research hypothesis is as follows: H1. When an auditor realignment occurs, required 8-K reportable event disclosures convey negative information to investors.

3.2. Impact of other required disclosures on abnormal returns In addition to reportable events, other required Form 8-K (Item 4.01) disclosures include whether the predecessor auditor resigned (or is dismissed), whether there are any disagreements (e.g., GAAP issues) with the predecessor auditor and whether there are any going concern audit report modifications in either of the two preceding years. Several prior studies have examined whether auditor resignations (versus client dismissals) convey negative information to investors (DeFond, Ettredge, & Smith, 1997; Krishnan & Krishnan, 1997; Shu, 2000; Whisenant et al., 2003; Wells & Loudder, 1997). Each study's results provide at least some support for the hypothesis that auditor resignations generate negative market reactions since they signal an auditor's private information about the true state of a company's financials and/or its management. The second other required disclosure involves disagreements with the predecessor auditor. Several prior studies have examined whether client–auditor disagreements convey negative information to investors (DeFond & Jiambalvo, 1993; Dhaliwal, Schatzberg, & Trombley, 1993; Smith & Nichols, 1982; Sankaraguruswamy & Whisenant, 2004; Whisenant et al., 2003). Except for Sankaraguruswamy and Whisenant (2004), each prior study's results support this hypothesis. This fairly consistent result appears to be driven by material GAAP disputes involving such contentious issues as improper revenue recognition and expense incurrence resulting in an increased risk of material misstatements that may adversely affect earnings. The final other required disclosure involves going concern audit report modifications in either of the two preceding years. We believe that this is the first study to investigate the association between audit report modifications disclosed in Form 8-Ks (Item 4.01s) and CARs. Based on the above discussion, the other required disclosure research hypothesis is as follows: H2. When an auditor realignment occurs, other required 8-K disclosures convey negative information to investors.

3.3. Impact of voluntary disclosures on abnormal returns As discussed in Section 2, our study separates voluntary realignment disclosures into the following three categories: (1) clientservice related reasons, (2) fee disputes and (3) verifiable or previously disclosed reasons.5 Sankaraguruswamy and Whisenant (2004) separated the voluntary auditor change disclosures into non-verifiable and verifiable reasons. The authors found that non-verifiable or more subjective realignment reasons, such as a desire for greater auditor industry expertise, indicates a company's desire to receive better service from its auditor and signals “good news” to investors about a company's 5 We use similar voluntary disclosure classifications as Sankaraguruswamy and Whisenant (2004).

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future prospects. Thus, the authors contend that client service-related disclosures should generate positive CARs. Sankaraguruswamy and Whisenant (2004) contended that client fee-related reasons signal their ability to obtain fee concessions from successor auditors. This conveyed positive information to investors in the mid 1990s since they appeared to value cost savings over perceived audit effectiveness in a “loss leader” or “commoditized” audit environment (Craswell, Francis, & Taylor, 1995). Sankaraguruswamy and Whisenant (2004) further stated that verifiable or previously disclosed reasons do not provide information content. The authors contend that verifiable reasons can be surmised from previous media disclosures or other verifiable reasons, such as the need (for a) bigger audit firm, can be revealed through significant pre-alignment company growth (Healy & Lys, 1986). Based on the above discussion, the voluntary disclosure research hypothesis is as follows: H3. When an auditor realignment occurs, voluntary 8-K disclosures convey positive information content to investors. 3.4. Impact of change in firm type on abnormal returns Dopuch and Simunic (1982) contended that the audit industry's monopolistic tendencies can be explained by the product differentiation hypothesis. More specifically, they hypothesized that different firms provide auditing services that are perceived by investors to be of different quality, and in particular, that Big 8 firms were perceived as being more credible than non-Big 8 firms. Nichols and Smith (1983), Whisenant et al. (2003), and Sankaraguruswamy and Whisenant (2004) tested this hypothesis by examining whether a change to a larger audit firm is associated with positive information content to investors (and vice versa). In contrast to Nichols and Smith's two categories (Big 8 versus non-Big 8), Whisenant et al. (2003) use a three category variable (e.g., a value of “1” if the change was from a non-Big 6 to a Big 6 firm; a value of “−1” if the change was from a Big 6 to a non-Big 6 firm; and a value of “0” if there was no change in the predecessor/successor auditor type). Although the direction of the market's reaction is consistent with the above hypothesis, the statistical results are not significant within these studies.6 Our study differs from prior research by examining three categories of predecessor/successor changes in firm type (e.g., Big 4 to 2nd Tier, Big 4 to local/regional, 2nd Tier to local/regional and vice versa). By establishing a separate category for 2nd Tier firms (BDO, Grant Thornton and RSM McGladrey), our study may be more likely to identify significant differences in market returns based on changes in firm type since investors also may perceive that 2nd Tier firms are more credible than local/regional firms. This may be due, in part, because most local/regional firms are significantly smaller than the 2nd Tier and often do not have many public company clients. Thus, local/regional firms may not be able to devote as many resources to their public company clients as the 2nd Tier and may not have enough public company clients to afford their auditors the benefits of industry specialization. Since different industries have unique audit risks, investors may perceive that 2nd Tier firms are better equipped to detect and report material misstatements. Based on the above discussion, the final research hypothesis is as follows: H4. When an auditor realignment occurs, changes in firm type convey information content to investors. 6

Boone and Raman (2001) report a significant association between updates to a Big 6 firm from a non-Big 6 firm and downgrades to a non-Big 6 firm from a Big 6 firm and cumulative abnormal trading activity (CATA) five days after the 8-K auditor change announcement date. The CATA are significant for trading initiated by individual investors, but not for trading initiated by institutional investors. The authors, however, did not test for a significant association between upgrades and downgrades and CARs.

4. Data and methodology We obtained auditor change data for 2004 and 2005 from GlassLewis & Co., LLC and from the SEC's website (www.sec.gov). We focused on data after 2003 because we were concerned that 2002 and 2003 data might be distorted by former Andersen clients changing auditors and by the initial impact of SOX requirements such as implementing new corporate governance initiatives. We found 3,201 instances of auditor changes over the two-year period including 21 companies who changed auditors in both 2004 and 2005. In contrast, only 1338 companies changed auditors in 2003 (Read, Rama, & Raghunandan, 2004), and in the mid 1990s (1993 to 1996), an average of only 726 companies changed auditors each year (Whisenant et al., 2003). Table 1 reports the sample attrition. We deleted 2488 observations from our statistical sample for the following reasons: (1) stock price data was not available on Center for Research in Security Prices (CRSP, 2005) for 2095 small public companies that were traded on the overthe-counter market (OTC), instead of the NYSE/AMEX/NASDAQ; (2) sufficient data was not available to compute financial distress (the probability of bankruptcy per Altman's z-score) for 163 companies, especially financial institutions; (3) financial data from the Standard & Poor's 2005 COMPUSTAT Industrial and Research files were not accessible for an additional 134 companies; and (4) financial data from CRSP was not available for 96 companies over the event window. Thus, a final sample size of 713 companies was used for each of our statistical tests. The dependent variable, the cumulative abnormal return (CAR), is the sum of the abnormal returns surrounding a company's initial 8-K filing date. The abnormal return is the company's daily stock return minus the market model adjusted market return. Per Table 1 (Panel A), the mean and median stock price reaction during our sample period for CAR (−1,+1) is −0.99% and −0.55%, respectively. Fig. 1, that plots average CARs (−20,+ 3) surrounding all auditor realignment events in 2004 and 2005, supports our contention that a three-day announcement interval captures the primary impact of Form 8-K (Item 4.01) disclosures. For example, CARs (−20,−6) indicate a modest positive stock price reaction during this 15-day interval, while CARs (−5,−2) indicate a modest negative stock price reaction during this four-day interval leading up to the event date. Table 1 Sample selection criteria and descriptive statistics. Year

2004

2005

'04 and '05

Population CRSP stock price data missing (Traded on OTC) Z-score data missing Compustat financial data missing CRSP financial data missing Sample

1607 1063

1594 1032

3201 2095

87 97

76 37

163 134

46 314

50 399

96 713

Mean

Median

Panel A—Average stock price reaction for the 713 companies Cumulative abnormal returns (− 20,− 6) 1.10% Cumulative abnormal returns (− 5,− 2) − 0.17% Cumulative abnormal returns (− 1,1) − 0.99%⁎⁎⁎

0.18% − 0.37% − 0.55%⁎⁎⁎

Panel B—Client characteristics SIZE (total assets in millions) Financial distress (Altman's z-score)

112.10 3.17

1504.00 4.27

⁎,⁎⁎,⁎⁎⁎Denotes significantly different from zero in a two-tailed test at p b 0.10, 0.05, and 0.01, respectively. Variable definition Cumulative Abnormal Returns (CARs)

= the sum of the abnormal returns surrounding a company's initial 8-K filing date; the abnormal return is the company's daily stock return minus the market model adjusted market return.

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Fig. 1. Daily average cumulative abnormal returns surrounding all auditor realignment events in 2004 and 2005.

These results are not significantly different from zero. However, CARs (− 1,+ 1) indicate a negative stock market reaction that is supported by our t-test results (see Table 1, Panel A). Thus, not only is the primary impact of 8-K (Item 4.01) disclosures concentrated around the three-day interval (−1,+ 1), but also there appears to be an absence of information leakage prior to the issuance of auditor realignment disclosures. Thus, Table 6 reports only the three-day interval results. We used multivariate regression to examine stock market reactions to auditor realignment disclosures in 2004 and 20057; these 8-K disclosures were analyzed and sorted into the following four categories: (1) reportable events, (2) other required disclosures, (3) voluntary disclosures and (4) changes in predecessor/successor firm type. To ensure that each auditor change disclosure was properly categorized, two of the authors examined each 8-K filing and independently coded the data. The authors resolved any differences jointly by doing an additional reading of the relevant 8-K filings. We estimated the following multivariate regression equation to examine our research questions: CAR = βo + β 1 SIZE + β2 FINANCIAL DISTRESS + β3 YEAR 2004 + β4 NO REASON = REASON + β5 CONTROLS + β6 SCOPE + β 7 NON − RELIANCE + β8 RESTATEMENT + β 9 RESIGNATION + β10 DISAGREEMENT + β11 GOING CONCERN + β12 SERVICE + β13 FEES + β 14 VERIFIABLE + β15 Δ TO SMALLER FIRM + β16 Δ TO LARGER FIRM + e

4.1. Control variables Unlike prior studies, the above regression equation includes four variables to control for the following: (1) SIZE or the logarithm of company total assets, (2) FINANCIAL_DISTRESS or the probability of bankruptcy based on Altman's z-score, (3) YEAR_2004 to control for any differences in results between 2004 and 2005,8 and (4) 7 Non-reliance on management's representations is considered so important that it is not only disclosed in Item 4.01, but also it is disclosed within a separate Item 4.02, effective 2004 (SEC, 2004). 8 We considered a fifth variable to control for the disclosure of multiple realignment reasons; however, only 54 out of 713 statistical sample companies disclosed multiple reasons and this variable was significantly correlated (variance inflation factor or VIF N 10) with two explanatory variables (CONTROLS and RESTATEMENTS); also, since this variable had little effect on the overall model, we excluded it from our final analyses.

NO_REASON/REASON to control for companies that disclose a “reason” for their realignment versus those that do not. Our a priori belief is that larger public companies should experience greater market reactions to auditor change announcements since there are more investment dollars at risk and thus more financial analysts following these companies.9 We also expect companies that have a greater risk of bankruptcy (e.g., Altman's zscore b 1.8) to generate significantly larger CARs in response to auditor change disclosures than those companies with a lesser risk of bankruptcy since disclosures by companies that are suspected of being in severe financial distress are likely to have more impact on investors' decisions. The mean and median values for the client characteristic control variables (SIZE and FINANCIAL_DISTRESS) are included in Table 1 (Panel B). 5. Results Table 2 provides a summary of the auditor realignment disclosures reported by all 3201 companies that changed auditors in 2004 and 2005, and the disclosures reported by the 713 companies included in our statistical sample. Of the 3201 companies that changed auditors, 40.2% provided “no reason” for their auditor change. In our statistical sample, the percentage of companies providing “no reason” for their auditor change increased to 57.8%. This is due, in large part, to the dramatic decline in the percentage of companies that reported a going concern audit report modification (GOING_CONCERN) in our statistical sample. A little over a third (36.4%) of all 3201 companies that changed auditors during 2004 and 2005 had a GOING_CONCERN disclosure, while the number in our statistical sample was only 4.5%. The reason for the dramatic decline in GOING_CONCERN disclosures was that most GOING_CONCERNS were issued to smaller companies traded on the OTC, instead of the NYSE/ AMEX/NASDAQ. Whisenant et al. (2003) reports that only 9.3% of their statistical sample disclosed reportable events (CONTROLS, SCOPE, NON9 We also considered the number of sell-side analysts covering a given stock to ascertain if this was a better proxy for a company’s information environment relative to company SIZE. However, since median total assets within our statistical sample were only $112 million (Table 1, Panel B), we concluded that the majority of our sample companies would not be covered by analysts who normally do not follow companies with less than $2–3 billion in total assets.

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Table 2 Summary of auditor change disclosures. 8K disclosures Reportable events: CONTROLS SCOPE NON-RELIANCE RESTATEMENT Subtotal-Reportable Other required disclosures: RESIGNATION DISAGREEMENT GOING_CONCERN Subtotal—Other Total Voluntary disclosures: SERVICE FEES VERIFIABLE Total voluntary No reason given Total number of disclosures/No reasona Total number of companies

2004 populat.

2005 populat.

'04 and '05 population

% of companies in populat.

Sample

% of companies in sample

123 12 23 40 198

224 14 13 81 332

347 26 36 121 530

10.8 0.8 1.1 3.8 –

164 5 6 44 219

23.0 0.7 0.8 6.2 –

605 28 569 1202 1400

553 24 596 1173 1505

1,158 52 1,165 2375 2905

36.2 1.6 36.4 – –

225 20 32 277 496

31.6 2.8 4.5 – –

120 50 240 410 642 a 2452 1607

39 31 175 246 645 a 2396 1594

159 81 415 656 1,287 a 4848 3201

5.0 2.5 13.0 – 40.2 a 151.5 100.0

31 37 33 101 412 a 1009 713

4.3 5.2 4.6 – 57.8 a 141.5 100.0

Variable definitions Reportable events CONTROLS = internal controls are not adequate as evidenced by the reporting of at least one material weakness in the Form 8-K filing (1 if reported, 0 otherwise). SCOPE = expanded audit scope (or scope limitations) due to potentially unreliable financial information reported in Form 8-K filing (1 if reported, 0 otherwise). NON-RELIANCE = the logarithmic non-reliance on management's representations reported in Form 8-K filings (1 if reported, 0 otherwise). RESTATEMENT = financial restatement reported in Form 8-K filing (1 if reported, 0 otherwise). Other required disclosures RESIGNATION = auditor resignation or client dismissal reported in the Form 8-K filing (1 if a resignation, 0 if a dismissal). DISAGREEMENT = client–auditor disagreement over GAAP and/or internal control issue reported in the Form 8-K filing (1 if reported, 0 otherwise). GOING_CONCERN = going concern audit report modification in either of the two preceding fiscal years as reported in the Form 8-K filing (1 if reported, 0 otherwise). Voluntary disclosures SERVICE = client audit service concerns (e.g., auditor needs to be located closer to the company, auditor independence concerns, etc.) reported in the Form 8-K filing (1 if reported, 0 otherwise). FEES = client and auditor fee-based disputes reported in the Form 8-K filing (1 if reported, 0 otherwise). VERIFIABLE = the voluntary disclosure of auditor consolidation resulting from a merger, the need for a bigger auditor, etc. reported in the Form 8-K filing (1 if reported, 0 otherwise). Changes in firm type Δ_TO_SMALLER_FIRM = change from a Big Four to a 2nd Tier firm or a change from a Big Four to a local/regional firm or a change from a 2nd Tier to a local/regional firm (1 if reported, 0 otherwise). Δ_TO_LARGER_FIRM = change from a 2nd Tier to a Big Four firm or a change from a local/regional to a Big Four firm or a change from a local/regional firm to a 2nd Tier firm (1 if reported, 0 otherwise). a

Several companies had multiple disclosures when they announced their auditor change. Therefore, the auditor change disclosures are greater than the number of auditor changes.

RELIANCE and RESTATEMENT) in the mid 1990s, while Rama and Read (2006) reports that 15.5% and 23.6% of their statistical sample disclosed reportable events in 2001 and 2003, respectively.10 In contrast, 30.7% of our statistical sample disclosed reportable events (219 reportable events out of 713 companies). This dramatic growth in reportable event disclosures over the past few years is due primarily to the increase in the number of companies that reported internal control material weaknesses (CONTROLS).11 Much of this increase in CONTROL disclosures appears to be caused by the implementation of SOX 404 for U.S. public companies with a market capitalization of at least $75 million. This is supported by a significant increase in CONTROLS reported in 2005 (versus 2004) when these larger public companies were required to issue their first-ever SOX 404 opinions (see Table 2). The elimination of many smaller companies, that were traded on the OTC (and thus not required to comply with SOX 404), caused the percentage of companies that reported CONTROLS to increase dramatically from 10.8% (for all 3201 companies) to 23.0% (for the statistical sample).

10 Rama and Read (2006) exclude 2002 data because of the unusually large number of auditor changes associated with the death of Andersen. 11 While Whisenant et al. (2003) reports an average of 21 CONTROLS per year within their statistical sample in the mid 1990s, our study reports an average of 82 CONTROLS per year in 2004 and 2005 within our statistical sample.

Due to the exploratory nature of this study, detailed descriptive data are presented for three explanatory variables (CONTROLS, SERVICE and changes in predecessor/successor firm type). The descriptive data are followed by multivariate regression results. 5.1. Internal control material weaknesses Table 3 provides interesting information about the types of CONTROLS, in both absolute and % terms, reported by all 3201 companies that changed auditors in 2004 and 2005.12 The most common types of CONTROLS reported are (in rank order): (1) weak control environment or entity-level controls (e.g., inferior anti-fraud program, weak Board oversight and/or audit committee that lacks financial expertise, no documented and communicated companywide accounting policies and procedures, etc.),13 (2) weak asset12 The relative percentages within the 3201 companies (per Table 3) are comparable to those within the statistical sample. 13 A weak control environment or entity-level controls is a serious concern since a strong tone at the top is considered by some to be the most effective means for preventing and/or detecting management fraud (Oversight, 2005). Auditing Standard (AS) No. 5 (PCAOB, 2007) emphasizes more prominently the importance of evaluating the control environment or entity level controls as a basis for assessing fraud risk relative to superseded AS No. 2 (PCAOB, 2004). Thus, as auditors evaluate entity level controls more rigorously in compliance with AS No. 5, companies are more likely to devote more time and attention to this critical issue.

G.R. Aldhizer III et al. / Advances in Accounting, incorporating Advances in International Accounting 25 (2009) 1–12 Table 3 Descriptive statistics for internal control material weaknesses. Types of material weaknesses (CONTROLS) Control environment Asset misstatements (Current, P,P&E, Investment, Intangible) Revenue recognition Manual JEs and approval of complex JEs L-T debt and Equity equity cycles Segregation of duties Expenditure cycle Deferred tax assets/Liabilities and provision Reconciliations Timely and accurate F/S reporting Inter-company, Consolidation consolidation and JV accting Lack of supporting documentation General computer controls Account misclassifications (e.g., Asset vs. Exp) Closing process Other Totals

2004 2005 '04 and '05 % of population population population populat. 45 27

109 75

154 102

16.9 11.2

34 24

57 56

91 80

10.0 8.8

25 28 15 10

38 30 39 39

63 58 54 49

6.9 6.4 5.9 5.4

19 17 13

27 26 28

46 43 41

5.0 4.7 4.5

15 17 8

22 22 15

37 39 23

4.1 4.0 2.5

3 4 590

19 10 909

2.1 1.1 100.0

16 6 319

a

b

a 123 companies reported a total of 319 (or 2.6 per company) internal control “material weaknesses” in 2004. b 224 companies reported a total of 590 (or 2.6 per company) internal control “material weaknesses” in 2005.

7

We also found a significant increase in the time for a change category. This increase may be an indication of client frustration over additional SOX-related internal control inquiry, documentation and testing requirements in 2004 and 2005. There is a significant decrease in the number of company decisions to dismiss their auditors and hire successor auditors (who are) located closer to the company in 2004 and 2005 relative to the mid 1990s. This type of disclosure may be viewed positively by investors since audit efficiency and effectiveness may improve as audit teams no longer have to travel long distances to service these clients.17 Future research may be needed to verify these conclusions. 5.3. Changes in firm type In Table 5, we examine the impact of auditor realignments that resulted in changes in audit firm type/category. Some changes to smaller successor firms are associated with negative CARs, while some changes to larger successor firms are associated with positive CARs. For example, changes from the Big 4 to the 2nd Tier and the 2nd Tier to local/regional firms are associated with negative CARs, while changes from local/regional firms to the Big 4 are associated with positive CARs. Most of the companies in our statistical sample that changed auditors switched to a smaller firm (n = 470) of which 416 changed from the Big 4 to a smaller firm. In contrast, only 66 companies switched to a larger firm of which only 23 changed to the Big 4. 5.4. Multivariate impact of realignment disclosures on abnormal returns

related controls (e.g., contributing to misstated current assets such as overstated cash receipts, understated accounts receivable allowance, understated inventory obsolescence and overstated prepaids; overstated investments; overstated intangibles due to understated goodwill impairments; and understated property, plant and equipment due to unrecognized capital leases), and (3) weak revenue recognition-related controls (e.g., contributing to understated sales discounts/sales returns and allowances and Staff Accounting Bulletin No. 101 violations including no evidence of customer receipt of goods).14 5.2. Service In Table 4, we summarize the types of client service-related (SERVICE) disclosures within all 3201 companies who changed auditors. Interestingly, we found dramatic shifts in the types and frequencies of SERVICE categories compared to Sankaraguruswamy and Whisenant (2004).15 In 2004 and 2005, the most frequent SERVICE disclosure is auditor independence concerns such as a change resulting from a violation of the “one-year cooling off period” requirement that may cause a financial expert to be suddenly terminated.16 In contrast, Sankaraguruswamy and Whisenant (2004) do not report any auditor changes due to auditor independence concerns in the mid 1990s. Thus, auditor independence has become a more contentious issue since the passage of SOX.

14 Revenue recognition-related CONTROLS are of serious concern since Statement on Auditing Standards (SAS) No. 99 contends that auditors should conclude that revenue recognition is high risk for fraudulent reporting on every audit (AICPA, 2001). Weak controls over revenue recognition create greater opportunities for management to manipulate this account to overstate reported earnings. As a result of the disclosure of weak revenue recognition controls, in accordance with SOX 404, controls should be strengthened over this material balance and reduce the risk that management can successfully manipulate this account in the future. 15 Comparable SERVICE categories and frequencies are noted within all 3,201 companies and the statistical sample. 16 Sarbanes–Oxley Act, Section 206: Conflicts of interest, H.R. 3763, June 2002.

In Table 6, we examine the relation between our control and explanatory variables and CARs surrounding the 8-K filing date.18 As expected, the log of total assets (SIZE) and Altman's z-score (FINANCIAL_DISTRESS) have a positive association with CARs (p b 0.05). In contrast, the REASON/NO_REASON19 and YEAR_2004 control variables have a non-significant association with CARs. 5.4.1. Impact of reportable events on abnormal returns The only reportable event that is initially found to have negative information content is an auditor's non-reliance on management's representations (NON_RELIANCE; p b 0.01). We originally concluded that CONTROL disclosures generated a non-significant CAR; however, after separately analyzing 2004 and 2005 data, we found that CONTROL disclosures do convey negative information content in 2004 (p b 0.05), but not in 2005. Since larger U.S. public companies (e.g., market capitalization of at least $75 million) had to disclose SOX 404 internal control opinions for the first time in their 2005 10-Ks, we wondered if the 2005 nonsignificant result was due to these previous disclosures. Thus, for these

17 The frequency of better service desired disclosures increased significantly in our study (relative to Sankaraguruswamy and Whisenant (2004); however, this result likely contributes to a positive association between SERVICE and CARs, thus partially offsetting some of the frequency differences within other SERVICE categories that likely contribute to a negative associate between SERVICE and CARs. 18 Our multivariate model adjusted R-squares of 8% to 10% are significantly higher than prior studies whose adjusted R-squares are between 1% and 4%. This appears to be due, in part, to our expanded use of control variables and expanded number of explanatory variables; for example, Whisenant et al. (2003) does not use any control variables and only analyzes required disclosures within their models; Sankaraguruswamy and Whisenant (2004) includes several control variables, but only analyzes voluntary disclosures within their models. 19 Although the association between the REASON/NO_REASON control variable and CARs was non-significant within the multivariable regression models (Table 6), the univariate results are significant. Specifically, both the companies that disclosed a REASON (p-value b 0.01) and the companies that disclosed NO_REASON (p-value b 0.10) experienced significant negative CARs; however, companies that disclosed a REASON generated significantly larger CARs than companies that disclosed NO_REASON (p-value b 0.10).

8

G.R. Aldhizer III et al. / Advances in Accounting, incorporating Advances in International Accounting 25 (2009) 1–12

Table 4 Descriptive statistics for client service-related voluntary disclosures. Types of SERVICE disclosures

Our study

n Auditor independence concerns Auditor located closer to company Prior experience with new auditor Time for a change/new top mgmt request Greater industry/international expertise Better service desired Mandatory partner rotation Excellent proposal from successor auditor High staff turnover of predecessor auditor Totals

Sankaraguruswamy and Whisenant (2004) %

n

%

33 32

20.8⁎⁎⁎ 20.1⁎⁎⁎

0 54

0.0⁎⁎⁎ 35.8⁎⁎⁎

31

19.5

24

15.9

27

17.0⁎⁎⁎

19

11.9

15 2 0

9.4⁎⁎⁎ 1.3 0.0⁎⁎⁎

9

6.0⁎⁎⁎

20

13.2

4 0 33

2.6⁎⁎⁎ 0.0 21.9⁎⁎⁎ 3.3⁎⁎⁎

0

0.0

5

159

100.0

151

100.0

⁎,⁎⁎,⁎⁎⁎ Denotes significantly different from zero in a two-tailed test at p b 0.10, 0.05, and 0.01, respectively.

companies, the subsequent disclosure in their 8-Ks would not convey new information content. To test this hypothesis, we eliminated all companies with a market capitalization of at least $75 million from our 2005 statistical sample (n = 79). We found that the remaining companies (n = 26) with 8-K CONTROL disclosures were associated with negative CARs (p-value b 0.05).20 We then identified the earliest CONTROL disclosure dates for the 79 companies in 2005 that had a market capitalization of at least $75 million. We then analyzed the market's reaction to these CONTROL disclosures and found negative CARs (p b 0.10). Results indicate a non-significant relation between audit scope (SCOPE) and CARs. In contrast, NON-RELIANCE is significant at the 0.01 level with the expected negative sign (see Table 6); however, similar to SCOPE (n = 5), there are a small number of NON_RELIANCE disclosures (n = 6). Further analysis of the six companies with NONRELIANCE disclosures uncovered that three had earnings restatements, three had NASDAQ/AMEX de-listings and one had a de-listing warning within 12 to 18 months of the NON-RELIANCE 8-K disclosure date. Further analysis also revealed that four out of the six NON_RELIANCE disclosures generated negative CARs, while three out of the five SCOPE disclosures generated negative CARs; however, the NON_RELIANCE negative CARs were of greater magnitude than the SCOPE negative CARs.21 Thus, investors appear to react more negatively to NON_RELIANCE disclosures because they imply that the financial statements may contain one or more material misstatements and thus can no longer be trusted. We find that earnings restatement (RESTATEMENT) disclosures generate non-significant CARs. As previously discussed, this appears 20 Companies with a market cap of less than $75 million will release their first-ever management internal control report for fiscal years ending after December 15, 2007 and will release their first-ever auditor internal control opinion for fiscal years ending after December 15, 2008 (SEC, 2007). 21 In ascending order, the 5 CARs for the SCOPE variable are as follows: 0.002, 0.001, − 0.005, − 0.046, and − 0.190; in ascending order, the 6 CARs for the NON_RELIANCE variable are as follows: 0.007, 0.001, − 0.027, − 0.125, − 0.190, and − 0.515. To test whether the − 0.515 CAR is a potential outlier, we calculated Cook's Distance (D) Measure; specifically, Cook's D measures whether the − 0.515 CAR is significantly influencing the regression coefficient for not only the NON_RELIANCE variable, but also all other explanatory variables. Cook's D for this observation was only 0.622 or the 13th percentile per F-distribution tables; in other words, we have only 13% confidence that the − 0.515 CAR is significantly influencing the explanatory variable's regression coefficient(s). In contrast, a Cook's D of 0.958 represents a 50% confidence level, while a Cook's D of 1.661 represents a 95% confident level.

to result from the 8-K requirement to disclose all RESTATEMENTS in the current and/or prior fiscal year. Thus, the market impact of RESTATEMENTS is likely to be significantly diminished by the lag between their original disclosure and their subsequent 8-K disclosure. Thus, their subsequent disclosure in the 8-K does not provide new information content to investors.

5.4.2. Impact of other required disclosures on abnormal returns The multivariate regression results in Table 6 indicate that there is negative information content within the auditor resignation (RESIGNATION) variable (p b 0.01), while there is positive information content within the going concern report modification (GOING_ CONCERN) variable (p b 0.01). However, there is no information content within the client–auditor disagreements over GAAP and/or internal control material weaknesses (DISAGREEMENT) variable. Originally, we were surprised that investors reacted positively to a company disclosing that it had previously received a GOING_ CONCERN (p b 0.01).22 However, interviews with several Big 4 firm partners indicated that they were not surprised by this result. The partners stated that investors normally react very negatively to the initial 10-K going concern disclosure because they assume the worst case scenario. In their experience, investors view a subsequent auditor change as an opportunity for a troubled company to be exposed to a fresh set of eyes that may provide value added recommendations that can help turn around the company. We also had some concern that this unexpected result may be due to significant multicollinearity between the FINANCIAL_DISTRESS and GOING_CONCERN variables. However, the nominal Pearson coefficient between these two variables dispelled this concern (−0.11). Future research may be needed to verify this study's results. We then identified the initial disclosure dates for the 32 companies in our statistical sample that reported a GOING_CONCERN (see Table 2) and found that, on average, 535 days had passed between the initial disclosure date and the 8-K disclosure date.23 We then analyzed the market's reaction to the initial GOING_CONCERN disclosure and found negative CARs (p b 0.01). Results indicate that DISAGREEMENTS do not convey negative information to investors. The small number of DISAGREEMENTS, however, is somewhat surprising given that external auditors appear more willing to “stand up” to top management on less material issues than in the 1990s, in part, out of fear of becoming the next Andersen. 5.4.3. Impact of voluntary disclosures on abnormal returns The multivariate regression results indicate that the non-verifiable voluntary disclosures (SERVICE and FEES) and the VERIFIABLE disclosures are not associated with positive CARs (see Table 6). 5.4.4. Impact of firm type on abnormal returns We find that market reactions to auditor realignments vary significantly with changes in firm type, especially a Δ_TO_LARGER_ FIRM per Model 1, Table 6 (p b 0.10). The positive information content associated with a Δ_TO_LARGER_FIRM appears to be driven primarily by changes from local/regional firms to the Big 4 per Model 2, Table 6 (p b 0.05). In general, a Δ_TO_SMALLER_FIRM does not convey negative information content to investors. Similar to Table 5, the one exception 22 Besides GOING_CONCERN audit report modifications, three disclaimers of opinion resulting from SCOPE concerns (two related to a significantly expanded audit scope and one related to a scope limitation) are identified within the 3201 companies that changed auditors; however, none of these OTC traded companies are included in the statistical sample. 23 The median number of days between the initial GOING_CONCERN disclosure and the 8-K disclosure date is 382.

G.R. Aldhizer III et al. / Advances in Accounting, incorporating Advances in International Accounting 25 (2009) 1–12 Table 5 Audit firm changes and average cumulative abnormal returns. Predecessor firm

Successor firm

N

Sample (− 1,+ 1)

Big Four Big Four 2nd Tier

2nd Tier Local/Regional Local/Regional

209 207 54

− 1.05%⁎⁎⁎ − 0.68% − 3.98%⁎⁎⁎

Change to smaller firm 2nd Tier Local/Regional Local/Regional

Big Four Big Four 2nd Tier

470 15 8 8

2.01% 3.30%⁎⁎ − 1.31%

Change to larger firm Big Four 2nd Tier Local/Regional No change in firm category Total number of companies

Big Four 2nd Tier Local/Regional

31 138 8 66 212 713

− 0.56% − 0.63% − 1.38%⁎

⁎,⁎⁎,⁎⁎⁎Denotes significantly different from zero in a two-tailed test a p b 0.10, 0.05, and 0.01, respectively. Variable definitions Big Four 2nd Tier Local/Regional

= Deloitte, E&Y, KPMG and PwC. = BDO, Grant Thornton and RSM McGladrey. = All other CPA firms not included in the above two categories.

is the change from the 2nd Tier to a local/regional firm.24 In this case, the change does generate negative CARs in Model 2, Table 6 (p b 0.01).

6. Implications, limitations and directions for future research 6.1. Implications This study's results provide several contributions to the existing literature. In general, this study extends prior research by examining all required and voluntary Form 8-K (Item 4.01) auditor realignment disclosures to assess whether they convey information content to investors in a post SOX-era.

6.1.1. Reportable events In contrast to Whisenant et al.'s (2003) non-significant result, we believe that this is the first study to report that CONTROL disclosures convey negative information to investors. This finding appears to provide some cost justification for the implementation of SOX 404 requirements and enhances the transparency of corporate reporting. Although not justifying causality, CONTROL disclosures also exhibit a positive correlation with RESTATEMENTS (Pearson coefficient of 0.30 and p b 0.01).25 This relationship is supported by Reilly (2006) who contends that greater SOX 404 internal control documentation and testing triggered an unprecedented level of restatements in 2004 and 2005 compared to the 2000 to 2003 time period. More specifically, all public companies, not just those with auditor realignments, reported 1195 restatements in 2005 and 613 restatements in 2004 during a period of economic prosperity (Reilly, 2006) versus an average of only 289 restatements from 2000 to 2003 during a period of economic recession and market upheaval (Huron, 2005). This finding appears to provide some additional justification for the costs associated with implementing SOX 404. 24 Unlike Table 5's univariate results, our regression model results do not support a significant relation between CARs and changes from the Big 4 to the 2nd Tier. 25 Sixty-four (64) % of the companies who reported a RESTATEMENT in their 2004 and/or 2005 Form 8-Ks also reported an internal control material weakness (CONTROLS); interestingly, in 2004, only 49% of companies who reported a RESTATEMENT also disclosed a CONTROL; in 2005, 73% of companies who reported a RESTATEMENT also disclosed a CONTROL as first-ever SOX 404 opinions were required for larger public companies.

9

As previously discussed, Whisenant et al. (2003) found negative information content when they combined the three remaining reportable event disclosures into a single explanatory variable (SCOPE, NON_RELIANCE and RESTATEMENTS). However, we were interested in uncoupling these three reportable events and examining their unique information content. Our model results indicate that NON-RELIANCE is the only one of these three remaining reportable event disclosures that has a negative CAR. Thus, infrequent, but egregious NON-RELIANCE disclosures may have been the primary driver behind Whisenant et al.'s (2003) combined reportable events significant variable. 6.1.2. Other required disclosures Unlike prior studies, we find that DISAGREEMENTS do not convey negative information to investors. In a post-SOX era, more proactive and independent boards of directors including the requirement that audit committees have two financial experts26 and top management's financial statement “certification” requirement27 (and the related risk that a subsequent earnings restatement may trigger their dismissal and/or personal liability)28 may have reduced the number and severity of GAAP disputes in 2004 and 2005. The non-significant association between DISAGREEMENTS and CARs also appears to result, in part, from an increase in disputes over whether control weaknesses rose to the level of a CONTROL. Specifically, nearly one-quarter of the statistical sample's DISAGREEMENTS relate to CONTROL disputes. This more prevalent dispute in 2004 and 2005 may be viewed by investors more positively than DISAGREEMENTS over material revenue recognition and expense incurrence issues. 6.1.3. Voluntary disclosures In contrast to Sankaraguruswamy and Whisenant's (2004) positive results, we find that non-verifiable voluntary disclosures (SERVICE and FEES) do not convey positive information to investors.29 We believe that this conflicting result may be due, in part, to the dramatic shift in the types and frequencies of SERVICE categories in a post-SOX era (see Table 4). For example, auditor independence issues (e.g., a realignment so that different firms provide audit and tax services) may be viewed as increasing costs without increasing audit effectiveness and thus may actually convey negative information to investors. Investors also may have changed their perception of an external audit's importance as a result of recent accounting scandals and thus may no longer value cost savings resulting from FEES over possible reductions in audit effectiveness.30 Similar to prior studies, we find that VERIFIABLE disclosures (such as consolidating auditors following a merger and the need (for) a bigger audit firm) do not convey information content to investors. Even though the types of VERIFIABLE disclosures have changed in 2004 and 2005 relative to the 1980s and mid 1990s (e.g., smaller audit firms announcing that they are not registering with the PCAOB), the nonsignificant results appear to be still due to their previous announcement in other media. 26 Sarbanes–Oxley Act, Section 301: Public company audit committees and section 407: Disclosure of audit committee financial expert, H.R. 3763, June 2002. 27 Sarbanes–Oxley Act, Section 302: Corporate responsibility for financial reports, H. R. 3763, June 2002. 28 For example, over the past 18 months, nearly 200 companies have disclosed federal or internal stock option “backdating” investigations resulting in nearly 70 senior executives, Board member and in-house legal counsel departures. Several senior executives also have been charged with criminal misconduct, and three senior executives have been found guilty of multiple fraud charges. 29 Non-significant results are found whether SERVICE and FEES are analyzed as separate explanatory variables or as a combined explanatory variable. 30 Comparable non-significant results are found when the combined FEE variable is divided into client initiated fee disputes and auditor initiated fee disputes; also, similar to prior studies, FEES are significantly associated with changes to smaller audit firms (p b 0.01).

10

G.R. Aldhizer III et al. / Advances in Accounting, incorporating Advances in International Accounting 25 (2009) 1–12

Table 6 The association between cumulative abnormal returns (CARs) and reportable events, other required disclosures and voluntary auditor realignment disclosures. Dependent variable—CARs (− 1,+ 1) Control variables Intercept β0 SIZE β1 FINANCIAL DISTRESS β2 Year = 2004 β3 NO_REASON/REASON β4 Explanatory variables Reportable events CONTROLS β5 (−) SCOPE β6 (−) NON-RELIANCE β7 (−) RESTATEMENT β8 (−) Other required disclosures RESIGNATION β9 (−) DISAGREEMENT β10 (−) GOING_CONCERN β11 (−) Voluntary disclosures SERVICE β12 (+) FEES β13 (+) VERIFIABLE β14 (+) Auditor type Δ_TO_SMALLER_FIRM β15 (−) Δ_TO_LARGER_FIRM β16 (+) Big 4 to 2nd Tier (−) Big 4 to Local/Regional (−) 2nd Tier to Local/Regional (−) 2nd Tier to Big 4 (+) Local/Regional to Big 4 (+) Local/Regional to 2nd Tier (+) Adjusted R2 Model P value Number of observations

Model 1

Model 2

− 0.018 0.004⁎⁎ 0.001⁎ − 0.007 0.003

− 0.016 0.003⁎⁎⁎ 0.001⁎⁎ − 0.007 0.002

− 0.001a − 0.013 − 0.112⁎⁎⁎ − 0.009

− 0.001a − 0.017 − 0.115⁎⁎⁎ − 0.009

− 0.026⁎⁎⁎ 0.006 0.039⁎⁎

− 0.026⁎⁎⁎ 0.011 0.040⁎⁎⁎

− 0.009 − 0.002 0.006

− 0.011 − 0.002 0.006

− 0.004 0.021⁎

0.089 b .0001 713

− 0.003 0.001 − 0.028⁎⁎⁎ 0.023 0.048⁎⁎ − 0.011 0.100 b0001 713

⁎,⁎⁎,⁎⁎⁎ Denotes significantly different from zero in a two-tailed test at p b 0.10, 0.05, and 0.01, respectively. Model 1: CAR = βo + β1SIZE + β2FINANCIAL_DISTRESS + β3YEAR_2004 + β4NO_REASON/REASON + β5CONTROLS + β6SCOPE + β7NON-RELIANCE + β8RESTATEMENT + β9RESIGNATION + β10DISAGREEMENT + β11GOING_CONCERN + β12SERVICE + β13FEES + β14VERIFIABLE + β15Δ_TO_SMALLER_FIRM + β16Δ_TO_LARGER_FIRM + ε. Variable definitions Cumulative Abnormal Returns (CARs) Control variables SIZE FINANCIAL_DISTRESS YEAR_2004 NO_REASON/REASON Reportable events CONTROLS SCOPE NON-RELIANCE RESTATEMENT Other required disclosures RESIGNATION DISAGREEMENT GOING_CONCERN Voluntary disclosures SERVICE FEES VERIFIABLE Changes in firm type Δ_TO_SMALLER_FIRM Δ_TO_LARGER_FIRM

= the sum of the abnormal returns surrounding a company's initial 8-K filing date; the abnormal return is the company's daily stock return minus the market model adjusted market return. = the logarithm of company total assets. = the probability of bankruptcy per Altman's z-score (e.g., z-scores less than 1.8, suggest substantial risk of bankruptcy, while z-scores greater than 3.0 suggest limited risk of bankruptcy). = to control for any differences in results between 2004 and 2005 (1 if 2004, 0 otherwise). = to control for companies that disclose a “reason” for their realignment versus those that do not (1 if no reason reported, 0 if a reason reported). = internal controls are not adequate as evidenced by the reporting of at least one material weakness in the Form 8-K filing (1 if reported, 0 otherwise). = expanded audit scope (or scope limitations) due to potentially unreliable financial information reported in Form 8-K filing (1 if reported, 0 otherwise). = non-reliance on management's representations reported in Form 8-K filings (1 if reported, 0 otherwise). = financial restatement reported in Form 8-K filing (1 if reported, 0 otherwise). = auditor resignation or client dismissal reported in the Form 8-K filing (1 if a resignation, 0 if a dismissal). = client–auditor disagreement over GAAP and/or internal control issue reported in the Form 8-K filing (1 if reported, 0 otherwise). = going concern audit report modification in either of the two preceding fiscal years as reported in the Form 8-K filing (1 if reported, 0 otherwise). = client audit service concerns (e.g., auditor needs to be located closer to the company, auditor independence concerns, etc.) reported in the Form 8-K filing (1 if reported, 0 otherwise). = client and auditor fee-based disputes reported in the Form 8-K filing (1 if reported, 0 otherwise). = the voluntary disclosure of an auditor consolidation resulting from a merger, the need for a bigger auditor, etc. reported in the Form 8-K filing (1 if reported, 0 otherwise). = change from a Big Four to a 2nd Tier firm or a change from a Big Four to a local/regional firm or a change from a 2nd Tier to a local/regional firm (1 if reported, 0 otherwise). = change from a 2nd Tier to a Big Four firm or a change from a local/regional to a Big Four firm or a change from a local/regional firm to a 2nd Tier firm (1 if reported, 0 otherwise).

a The CONTROLS variable is statistically significant in 2004 (p b 0.05); it also is statistically significant in 2005 when early adopters of SOX 404 (e.g., greater than $75 million in market cap) are excluded (p b 0.05).

G.R. Aldhizer III et al. / Advances in Accounting, incorporating Advances in International Accounting 25 (2009) 1–12

6.1.4. Firm type Unlike prior studies, we find that market reactions to auditor changes vary with changes in firm type, especially a Δ_TO_LARGER_FIRM. We believe that this is the first study to report this relationship and thus provide some support for the product differentiation hypothesis (Dopuch & Simunic, 1982). 6.2. Limitations As is true of all research, this study has limitations that may affect the results obtained or the applicability of the results. One potential limitation is that we do not control for all other events that are not reported in 8-K filings that may also impact CARs. We believe that this limitation, however, is minimized through the use of a shortened event window (−1,+1). This shortened event window is due, in part, to the accelerated timeframe for reporting 8-K related events beginning in 2004.31 Another limitation is potential bias within our statistical results since a large percentage of auditor realignments provide no stated reason for the change. Because auditor switches are a costly event (e. g., substantial audit fees may be lost by the firm and substantial upfront costs are incurred by client personnel to educate a new firm on company policies and procedures, etc.), this decision is not taken lightly by either party. Thus, we contend that a legitimate reason(s) should exist for every auditor change. As a result, similar to Glass Lewis & Co., Grant Thornton and the U.S. Treasury, we urge the SEC to require all U.S. public companies to provide a reason(s) for every auditor change (Glass Lewis & Co., 2007; U.S. Treasury, 2008). The Advisory Committee on the Auditing Profession contends that explicitly stating the reason(s) for an auditor realignment will assist investors in determining financial reporting quality and in making investment decisions (U.S. Treasury, 2008). 6.3. Future research Implications of this study's results for future research are as follows: (1) whether CONTROLS will still provide information content after Auditing Standard (AS) No. 5′s top down, risk-based SOX 404 approach is adopted by SEC registrant companies (PCAOB, 2007); (2) whether this study's positive association between GOING_CONCERN and CARs and this study's non-significant association between DISAGREEMENTS and CARs is supported by future research; (3) whether many client dismissals are, in reality, auditor resignations; discussions with several accounting firm partners resulted in admissions that they planned to resign from some audit engagements, but allowed the clients to report them as 8-K dismissals. 7. Conclusions The purpose of this study was to investigate whether required and voluntary Form 8-K (Item 4.01) auditor realignment disclosures in 2004 and 2005 convey information content to investors in a post SOX era. Although prior research has examined similar disclosures in the 1980s and mid 1990s, we were interested in determining whether recent accounting scandals, the demise of Andersen and the passage of SOX in 2002 have significantly affected investors' perceptions of the relative importance of these disclosures. Unlike prior research, our results indicate that internal control material weakness and nonreliance on management representation disclosures convey negative information content, while audit scope limitation, earnings restatement and client–auditor disagreement disclosures do not convey information content in a post SOX era. Also, unlike prior research, voluntary disclosures such as fee disputes do not convey information 31 Effective August 2004, the SEC (2004) implemented a four business day deadline for filing 8-K related events with no extension provision.

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content. Similar to prior research, auditor resignation disclosures convey information content. Other required disclosures such as when an auditor realignment occurs after a company has received a going concern opinion and when a company switches to a larger audit firm (e.g., from a local/ regional firm to a Big 4 firm) are associated with positive CARs. We believe that this is the first study to analyze the impact of 8-K going concern disclosures on CARs, and we believe that this is the first 8-K disclosure study whose results provide some support for the product differentiation hypothesis. Acknowledgements The authors gratefully acknowledge the assistance of Glass Lewis & Co., LLC and its Managing Director of Research (and former SEC Chief Accountant), Lynn E. Turner, for his insights. The paper also benefited from comments from Stephen Bryan, John Campbell and workshop participants at Wake Forest University. References American Institute of Certified Public Accountants (AICPA) (2001). Statements on auditing standards no. 99: Consideration of fraud in a financial statement audit. New York: AICPA. Association of Certified Fraud Examiners (ACFE) (2006). Report to the nation on occupational fraud and abuse Austin, TX: ACFE. Beasley, M., Carcello, J., & Hermanson, D. (1997). Fraudulent financial reporting: 1987– 1997: An analysis of U.S. public companies. New York: COSO. Boone, J., & Raman, K. (2001). Auditor resignations versus dismissals: An examination of the differential effects on market activity and trading liquidity. Advances in Accounting, 18, 47−76. Craswell, A. T., Francis, J. R., & Taylor, S. L. (1995). Auditor name brand reputation and industry specializations. Journal of Accounting and Economics, 20(3), 297−322. DeFond, M., Ettredge, M., & Smith, D. (1997). An investigation of auditor resignations. Research in Accounting Regulation, 11, 25−45. DeFond, M., & Jiambalvo, J. (1993). Factors related to auditor–client disagreements over income-increasing accounting methods. Contemporary Accounting Research, 9, 414−431 (Spring). Dhaliwal, D., Schatzberg, J., & Trombley, M. (1993). An analysis of the economic factors related to auditor–client disagreements preceding auditor changes.Auditing: A Journal of Practice & Theory, 12, 22−38 (Fall). Dopuch, N., & Simunic, D. (1982). Competition in auditing: An assessment. Symposium on Auditing Research IV (pp. 401−450). Urbana: University of Illinois. Healy, P., & Lys, T. (1986). Auditor changes following big eight takeovers of non-big eight audit firms. Journal of Accounting and Public Policy, 251−265 (Winter). Huron (2005). 2004 Annual review of financial reporting matters. Boston: Huron. Glass Lewis & Co. (2007, May 21). Speak no evil: Mum's still the word when public companies part ways with their outside auditors. Trend Alert, New York. Internal Auditing Report (2007, February). PCAOB proposes revised internal control standard. New York: WG&L. Krishnan, J., & Krishnan, J. (1997, October). Litigation risk and auditor resignations. The Accounting Review, 72, 539−560. Krishnan, J. (2002, March). The timing and information content of auditors' exhibit letters related to auditor changes. Auditing: A Journal of Practice & Theory, 21, 29−46. Nichols, D., & Smith, D. (1983). Auditor credibility and auditor changes.Journal of Accounting Research, 21, 534−544 (Autumn). Oversight (2005). The 2005 oversight systems report on corporate fraud. Oversight, Atlanta, GA. Public Company Accounting Oversight Board (PCAOB) (2004). An audit of internal control over financial reporting performed in conjunction with an audit of financial statements (auditing standard no. 2) New York: PCAOB. Public Company Accounting Oversight Board (PCAOB) (2007). An audit of internal control over financial reporting that is integrated with an audit of financial statements and related independence rules and conforming amendment (auditing standards no. 5) New York: PCAOB. Rama, D., & Read, W. (2006, June). Resignations by the big 4 and the market for audit services. Accounting Horizons, 97−109. Read, W., Rama, D., & Raghunandan, K. (2004, December). Local and regional audit firms and the market for SEC audits. Accounting Horizons, 241−254. Reilly, D. (2006, March 2). Sarbanes–Oxley changes take root. The Wall Street Journal, B3. Sankaraguruswamy, S., & Whisenant, J. (2004, March). An empirical analysis of voluntarily supplied client–auditor realignment reasons. Auditing: A Journal of Practice & Theory, 23, 107−121. Shu, S. (2000, April). Auditor resignations: Clientele effects and legal liability. Journal of Accounting and Economics, 29, 173−206. Smith, D., & Nichols, D. (1982, October). A market test of investor reaction to disagreements. Journal of Accounting & Economics, 11, 109−120. Turner, L., Williams, J., & Weirich, T. (2005, November). An inside look at auditor changes. CPA Journal, 12−21.

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