The Ultimate Form of Mandatory Auditor Rotation: The Case of Former Arthur Andersen Clients Jennifer Blouin University of Pennsylvania Barbara Grein Drexel University Brian Rountree Rice University This Draft: February 2005 Abstract: The collapse of Arthur Andersen provides a unique quasi-experimental setting to study the implications of mandatory auditor rotation for public firms. Consistent with the extant literature on mandatory auditor rotation, we hypothesize the selection of a new auditor is a function of agency and switching costs. Using a unique dataset identifying whether or not former Andersen clients followed their audit team to a new auditor, we are able to find support for both hypotheses. Further, we find firms with greater performance adjusted discretionary accruals were more likely to follow their Andersen audit team to a new auditor, consistent with these firms trying to mitigate the costs of switching auditors. However, tests of accruals in the subsequent year reveal the most aggressive firms who followed Andersen staff were no longer aggressive in the following year relative to the group who chose new non-Andersen auditors. This is inconsistent with mandatory auditor rotation directly improving financial reporting since we expect the non followers to exhibit the greatest degree of accrual correction. However, our results must be interpreted with caution since the rotation described in the paper is quite atypical. Further, whether the benefits outweigh the costs is still difficult to determine since we cannot empirically quantify these aspects. Keywords: mandatory rotation, audit quality, earnings quality, Arthur Andersen Data Availability: Data are available from public sources * We would like to thank Kevin Raedy, Stefanie Tate, and workshop participants at Drexel University and the University of Massachusetts at Lowell for constructive criticisms and suggestions. 1 I. INTRODUCTION Mandatory auditor rotation policies have been considered since at least the early 1900s. Zeff (2003) documents intra-firm correspondence at E.I. du Pont de Nemours & Company (Dupont) dating back to 1922 concerning the company’s policy of switching auditors every year. The primary force underlying the auditor rotation policy was to insure the independence of the public accountant. Similar reasoning has resurfaced after the recent business scandals (e.g. Enron, WorldCom, Tyco) as part of the national debate on mandatory auditor rotation and the quality of financial statements. 1 The primary tradeoff involved in the debate on mandatory auditor rotation involves agency benefits relative to switching costs. Switching costs have been defined as the start-up costs incurred by both client and auditor for a new audit engagement, as well as the increased risk of audit failure in new audits (GAO 2003). Commonly cited benefits of auditor rotation are an increase in auditor independence, which may lead to improved audit and financial statement quality. The relative magnitude of the costs and benefits of switching auditors is central to this debate. We use the unique setting created by the collapse of Arthur Andersen (AA) to examine these costs that are inherently captured by a firm’s selection of a new auditor. Specifically, we examine which costs/benefits explain a client’s decision to follow their former AA audit team (follow firms) or to choose an entirely new audit firm (not-follow firms). We also examine the relative quality of financial reporting before and after the change in auditor for the follow and not-follow firms. Typically, a change in auditor involves two actions: dismissal/resignation of the current audit firm and the selection of a new auditor. Most prior research on auditor changes has been 1 A summary of the mandatory auditor rotation debate appears in the GAO report entitled “Public Accounting Firms: Required Study on the Potential Effects of Mandatory Audit Firm Rotation.” 2 unable to examine the two actions separately and therefore has focused on the joint action (see for example Nichols and Smith 1983; Francis and Wilson 1988; Shu 2002 and Landsman et al. 2005). 2 After AA’s criminal indictment on June 15, 2002 and subsequent agreement to stop practicing in front of the SEC, all of their public clients were forced to select a new auditor. 3 Therefore, our sample of former AA clients is homogeneous in the decision to dismiss their auditors, enabling us to create more direct tests of the costs involved in the selection of a new auditor than has been possible in past studies. We hypothesize the selection of a new auditor involves three primary concerns: 1) switching costs, 2) agency costs, and 3) implicit insurance provided by the auditor. We hold the latter constant by considering only switches to one of the remaining Big4 audit firms (Deloitte, PriceWaterhouseCoopers, KPMG, or Ernst & Young). 4 We characterize the selection of a new auditor as being either: 1) completely independent of any existing relationships with AA’s audit personnel or 2) based on the prospective employment of the AA audit team. For example, in Casella Waste Systems’ Form 8-K filing on June 13, 2002, the firm reports: As recommended by the audit committee, the Board of Directors on May 20, 2002, decided to no longer engage its independent accountants, Arthur Andersen LLP, and engaged KPMG LLP (“KPMG”) to serve as the Company’s independent accountants for the fiscal year ending April 30, 2003 and to audit the Company’s financial statements for the fiscal year ended April 30, 2002. The Audit Committee’s recommendation to engage KPMG was based on the assumption that certain individuals from Arthur Andersen’s Boston, Mass. office, including the team auditing the Company, would join KPMG. That event did not occur. As a result, the Audit Committee subsequently reconsidered its recommendation and, as recommended by the Audit Committee, the Board of Directors on June 13, 2002 decided to no longer engage KPMG, and engaged PricewaterhouseCoopers LLP (“PWC”) to serve as the Company’s independent accountant for the 2 Schwartz and Menon (1985) is a notable exception that examines factors associated with 35 firms that changed auditors because of bankruptcy related issues. 3 Arguably, the demise of Andersen occurred on March 14, 2002, the date of Andersen’s indictment, while the criminal conviction simply represented the ceremonial nail in the coffin. Supporting this position, the Wall Street Journal stated “In the 212-year history of the U.S. financial markets, no major financial-services firm has ever survived a criminal indictment.” “Called to Account: Indictment of Andersen In Shredding Case Puts Its Future in Question,” Wall Street Journal, March 15, 2002 (page A1). 4 This assumes that the relative implicit insurance provided by the remaining Big4 auditors is in fact reasonably equal. This is consistent with prior literature that examined implicit insurance (i.e. Menon and Williams 1994), which utilizes a BigN/non-BigN designation to test for differences in insurance values. 3 fiscal year ending April 30, 2003 and to audit the Company’s financial statement for the fiscal year ended April 30, 2002. As it turned out, AA’s Boston office actually became part of PWC rather than KPMG. We argue that firms like Casella Waste Systems did not switch audit teams, but instead simply transferred their existing audit relationship to a new firm. Since other firms clearly severed ties with their former AA audit team, we have identified an interesting quasi-experimental setting to study the cost/benefit relationship underlying the selection of a new auditor under a mandatory rotation regime. We find firms with greater agency issues and/or monitoring concerns, as measured by earnings transparency, geographic diversity and the presence of an outside blockholder, were more likely to severe ties with Andersen completely and select an entirely new auditor. At the same time, using an indicator whether AA was the industry expert and performance adjusted discretionary accruals as proxies for switching costs, we find firms with greater switching costs were more likely to follow their former AA audit team to the new auditor. The unique research design allows us to simultaneously determine if switching and agency costs played a role in the selection of a new auditor in a setting incrementally more powerful than previous studies using measures such as abnormal returns and duration. The final set of tests provide direct evidence concerning the hypothesis posed and tested in Myers et al. (2003) on the quality of earnings before and after mandatory auditor rotation. As discussed above, we find that firms that followed AA had more aggressive performance matched discretionary accruals relative to the non-follow firms in the final year audited by AA. Utilizing this discretionary accrual measure as an indicator of earnings quality, results are consistent with more aggressive firms attempting to follow AA in an effort to minimize the costs associated with said behavior. However, when we model the discretionary accruals using the framework 4 outlined in Myers et al. (2003), we find firms in the lowest quintile of accruals (i.e. the most conservative) in the final year of AA continue to have lower discretionary accruals on average in the following year regardless of the follow decision. This finding suggests the mandatory rotation did nothing to improve the reporting for firms in this particular tail. Further, the follow firms in the highest quintile of discretionary accruals in their final year with AA exhibit reversion in the following year under a new auditor whereas the corresponding not-follow firms do not. Given followers did not fully switch firms per se, we expect the not-follow group to exhibit the greatest degree of reversion in aggressive behavior if mandatory rotation is effective in improving financial reporting. This is not the case and therefore casts some doubt that reporting quality would be greatly influenced under a mandatory rotation regime. However, these results need to be interpreted with caution since this is not the typical mandatory rotation regime entertained by the literature and rule making bodies. We discuss these limitations in section 4 below. The rest of the paper is organized as follows. Section 2 reviews the related literature on mandatory auditor rotation and develops hypotheses. Sample selection and research design are outlined in section 3. Section 4 provides results and robustness checks. Section 5 concludes. II. H YPOTHESIS DEVELOPMENT The GAO’s November 2003 report on mandatory auditor rotation states that the majority of Tier 1 public accounting firms and Fortune 1000 public companies “believe that the costs of mandatory audit firm rotation are likely to exceed the benefits.” Costs identified by the GAO include the risk of audit failure in the early years of an audit engagement, audit firm competition issues, increased initial year audit costs, auditor selection costs and support costs. The report 5 goes on to explain that the “benefits of mandatory audit firm rotation are harder to predict and quantify …” (GAO 2003, 8). The prior literature on auditor changes has not addressed this issue because of the general lack of mandatory auditor rotation regimes. 5 Instead, research has focused on auditor changes that result from the dismissal or resignation of the incumbent auditor, which is obviously quite different than mandatory rotation. However, the collapse of Arthur Andersen creates the opportunity to study the costs and benefits related to mandatory auditor rotation. We acknowledge that the collapse of Andersen is not the standard mandatory auditor rotation setting. Nevertheless, it is arguably the closest setting available to date with enough data to properly address this important issue. The unexpected and rapid collapse of Arthur Andersen provides us an opportunity to examine a group of firms that switched auditors for the same reason: their former audit firm was forced to stop practicing. We use this mandatory rotation to examine a firm’s choice of new auditor. Specifically, we examine which costs explain a client’s decision to follow their former AA audit team or to choose an entirely new audit firm. Given the decision to change auditors has been uniformly mandated, prior research on auditor change and the debate on auditor rotation suggest three potential costs involved in the selection of a new auditor - switching, agency, and implicit insurance. We hold the latter constant by only examining switches to the remaining Big4 auditors, allowing us to focus on switching and agency costs. 6 We also utilize the setting to test the implications of a mandatory auditor rotation on the financial reporting characteristics of firms. Specifically, we analyze firms’ performance adjusted discretionary accrual behavior surrounding the collapse of AA. Myers et al. (2003) document 5 Exceptions include Austia, Brazil, Italy and Singapore which currently have mandatory rotation policies. Also, Spain and Canada had mandatory policies that were ended in 1995 and 1991 respectively (GAO 2003). 6 See footnote 4 above. 6 more aggressive accrual behavior for firms with shorter auditor tenure. They interpret their findings as being inconsistent with mandatory auditor rotation improving financial reporting. However, the authors recognize that they are not analyzing mandatory auditor rotation and that their results are simply suggestive. On the contrary, the current setting is a more direct form of mandatory auditor rotation and therefore has the potential to be informative for this debate. S WITCHING COSTS We define switching costs as the start-up costs incurred by both the client and auditor for a new audit engagement. These include the (1) costs incurred by the auditor to learn about the company’s operations, systems, financial reporting practices, and accounting issues, (2) costs incurred by the client to aid the auditor in understanding its operations, and (3) costs incurred by a client in selecting a new auditor (GAO 2003). Further, there is an increased risk of audit failure. AICPA (1978), Palmrose (1986, 1991), Geiger and Raghunandan (2002) and Myers et al. (2003) all find evidence consistent with a greater likelihood of audit failure in early years of an audit engagement. Standard value maximizing behavior suggests that firms will seek to minimize switching costs, ceteris paribus. We hypothesize that companies may try to minimize the cost of switching auditors by following their AA audit team who already possess client and industry specific knowledge or more succinctly: H 1 : The greater the switching costs, the more likely a former AA client will follow its AA audit team to a new auditor, ceteris paribus. 7 7 The maintained assumption throughout is that, ceteris paribus, following AA has lower switching costs than not- following. Education of the audit team about the operations of the firm along with obtaining comfort with the reported results is an expensive and time consuming proposition. Following AA would almost certainly reduce these costs even if the audit team is not maintained because at minimum they would be available for consultation. 7 AGENCY COSTS Consistent with Jensen and Meckling (1976), we define agency costs as monitoring expenditures by the principal, bonding expenditures by the agent, and loss in welfare experienced by the principal due to the agent not acting in the principal’s best interest. Auditing is widely believed to be a means of reducing agency costs through the monitoring of the agent by an independent third party auditor (Jensen and Meckling 1976 and Watts and Zimmerman 1983, among others). Further the greater the agency costs, the greater is the demand for high quality audits (DeAngelo 1981; Dopuch and Simunic 1982). 8 The decision to change auditors is frequently cast in terms of mitigating agency costs and/or changes in audit quality (Nichols and Smith 1983; Francis and Wilson 1988; Johnson and Lys 1990; DeFond 1992). In our setting, it may be that agency conflicts at the firm are unchanged, while the perceived quality of the AA audit has suddenly declined. The results in Chaney and Philipich (2002) and Krishnamurthy et al. (2003), which document negative market reactions for Andersen clients after negative news concerning their auditor, suggest that investors may have perceived audit quality issues to be systematic at AA. Further, duration analyses examining cross sectional differences in former AA clients support the notion that firms were concerned about the perceived quality of AA’s audits by illustrating clients with greater agency conflicts dismissed AA sooner (Chang et al. 2003, Barton 2004). If firm management perceived audit quality issues and/or is concerned with investors’ perceptions of audit quality, then we hypothesize that: Consistent with this notion, the GAO found that Tier 1 public accounting firms (firms with 10 or more public company clients that were members of the AICPA’s self-regulatory program for audit quality) “generally saw more potential value in having access to the previous audit team and its audit documentation than in performing additional audit procedures and verification of the public company’s data during the initial years of the auditor’s tenure” (GAO 2003, 2133). 8 Consistent with DeAngelo (1981) and DeFond (1992), we define audit quality as the probability that an audit firm will detect and report “material breaches in the accounting system.” 8 H 2 : The greater the agency conflicts, the more likely a former AA client will not follow its AA audit team to a new auditor, ceteris paribus. It is important to note that a firm may have conflicting costs (i.e. high agency and switching costs), which biases against finding any systematic relation between the decision to follow and our measures of the underlying costs. III. RESEARCH DESIGN AND SAMPLE SELECTION We model the decision to follow AA personnel as a function of variables aimed at capturing the degree of switching and agency costs, along with industry fixed effects to allow for differences in mean follow rates across industries: εγγγ γγγγ γγγγγα ++++ ++++ +++++= ∑ RETURNLOSSROA INSIDERBLOCKLEVERAGEACCRUAL COMPLEXCYTRANSPARENSIZETENUREEXPERTFOLLOW II 121110 9876 54321 where all variables are measured as of the final year audited by AA and are defined as follows (Compustat data items in parentheses): FOLLOW = 1 if the client followed AA, and 0 otherwise; EXPERT = 1 if AA had at least 5% more clients in a particular industry and state than the next closest competitor, and 0 otherwise; TENURE = number of years audited by AA per Compustat; SIZE = natural logarithm of total assets (#6); TRANSPARENCY = decile rank of absolute value of residual from regression of annual returns on annual earnings (#18), changes in annual earnings, both scaled by total assets (#6) and SIZE. COMPLEX = ∑ =                         N i i i TotalSales Segment Segment TotalSales LN 1 where TotalSales is company sales revenue for 2001 and Segment i represents the sales for a specific geographic segment of the business per Compustat (Bushman et al. 2002). ACCRUAL = performance adjusted discretionary total accruals following Kothari et al. (2004); LEVERAGE = ratio of debt (#9 + #34) to total assets (#6); BLOCK = 1 if an outside blockholder per Spectrum holds at least 5% of the 9 outstanding shares, and 0 otherwise; INSIDER = 1 if an insider per Spectrum holds at least 5% of the outstanding shares, and 0 otherwise; ROA = return on assets, defined as net income before extraordinary items (#18) divided by ending total assets (#6); LOSS = 1 if ROA < 0, and 0 otherwise; RETURN = abnormal market model return for the ±1 days surrounding AA’s indictment date, using CRSP’s value weighted index as a proxy for the market. I denotes industry as defined in Barth et al. (1998). We utilize logistic regression to isolate the determinants of auditor choice. The empirical specification of the dependent variable, FOLLOW, is a 1 when firms are categorized as following AA, and 0 otherwise. In constructing our sample, we identified firms that were audited as of fiscal year 2000 or 2001 by AA and changed auditors after November 8, 2001. 9 Next, we hand collected information concerning the acquisition of AA offices by other auditors from a variety of sources including audit firm press releases, AA client Form 8-Ks relating to the choice of a new auditor, and representatives from two of the remaining Big4 audit firms. Through this process we were able to classify 561 former AA clients as either following AA personnel to a new auditor or completely severing ties with their AA audit team. 10 Of these firms, 425 have the necessary financial statement information to perform our baseline tests concerning the decision 9 AA received a subpoena from the SEC as Enron’s auditor on November 8, 2001. The following highlights other key dates in Arthur Andersen’s collapse. On March 15, 2002, the grand jury indictment of AA was unsealed. AA signed and announced a Memorandum of Understanding with Deloitte and Touche for the sale of its tax practice on April 4, 2002, following through on plans to reduce its business to just the core audit practice. The criminal trial of AA began on May 6, 2002, the same day that AA agreed to settle a lawsuit with the Baptist Foundation of Arizona for $217 million. The first of many office sale announcements, was also made on May 6, 2002 – Ernst & Young acquired the Detroit, Toledo, Ann Arbor and Grand Rapids offices of AA. Finally, AA was convicted of one count of obstructing justice on June 15, 2002. As a result of the conviction, AA agreed to cease practicing before the SEC by August 31, 2002. 10 For example, KPMG acquired AA’s Philadelphia office. If an AA client whose audit opinion was signed Philadelphia chose KPMG as their new auditor, we assume they followed their AA audit team. If that same client chose Ernst & Young, we assume that they did not follow their AA audit team. 10 [...]... maximum of 10 SIZE is the natural logarithm of total assets (data6) TRANSPARENCY is the descending rank of the absolute value of the residual from a cross sectional regression of annual returns on ROA, changes in earnings, SIZE, and industry fixed effects COMPLEX is the geographic sales diversity of a company and is defined mathematically on page 9 ACCRUAL is performance matched discretionary accruals... following their former AA audit team to a new auditor, 0 otherwise EXPERT is equal to 1 if AA had at least 5% more clients in a particular industry and state than the closest competitor, and 0 otherwise TENURE equals the number of years audited by AA with a maximum of 10 SIZE is the natural logarithm of total assets (data6) TRANSPARENCY is the descending rank of the absolute value of the residual from... 0.03 0.06 -0 .12** Variablea ACCRUAL LEVERAGE BLOCK INSIDER 0.15** 0.06 -0 .06 0.01 FOLLOW 0.11** 0.23** 0.04 -0 .03 EXPERT 0.08* 0.10** -0 .12** -0 .07 TENURE -0 .09* 0.45** -0 .15** -0 .11** SIZE 0.01 0.08* -0 .12** -0 .10** TRANSP -0 .18** -0 .14** -0 .06 -0 .04 COMPLEX 0.09* 0.06 -0 .07 ACCRUAL 0.12** -0 .03 -0 .03 LEVERAGE 0.08 -0 .07 0.02 BLOCK -0 .07 -0 .04 0.02 INSIDER -0 .07 0.06 -0 .13** 0.03 ROA 0.03 -0 .12** 0.11**... Exploring the Term of the Auditor- Client Relationship and the Quality of Earnings: A Case for Mandatory Auditor Rotation? The Accounting Review 78 (July): 77 9-7 99 Nichols, Donald R and David B Smith 1983 Auditor Credibility and Auditor Changes Journal of Accounting Research 21 (Autumn): 53 4-5 44 Sankaraguruswamy, Srinivasan and Scott Whisenant 2003 An Empirical Analysis of Voluntarily Supplied Client -Auditor. .. that many of AA’s international offices transferred their businesses to other Big4 firms immediately, rather than waiting to determine whether AA would be convicted 20 selecting a new auditor The findings indicate if AA was the designated expert then clients were more likely to follow Further, the greater the performance adjusted discretionary accruals the more likely firms were to follow their former. .. is equal to 1 if AA had at least 5% more clients in a particular industry and state than the closest competitor, and 0 otherwise TENURE equals the number of years audited by AA with a maximum of 10 SIZE is the natural logarithm of total assets TRANSPARENCY is the descending rank of the absolute value of the residual from a cross sectional regression of annual returns on ROA, changes in earnings, SIZE,... equal to 1 if ACCRUAL in year t is in the highest quintile, 0 otherwise FOLLOW*AGGRESSIVE is the interaction of FOLLOW and AGGRESSIVE TENURE equals the number of years audited by AA with a maximum of 10 AGE is the number of years the firm reported total assets on Compustat since 1980 SIZE is the natural logarithm of total assets INDUSTRY GROWTH total industry sales in the current year divided by total... least 5% more clients in a particular industry and state than the closest competitor, and 0 otherwise SIZE is the natural logarithm of total assets (data6) TRANSPARENCY is the descending rank of the absolute value of the residual from a cross sectional regression of annual returns on ROA, changes in earnings, SIZE, and industry fixed effects COMPLEX is the geographic sales diversity of a company and... mathematically on page 9 ACCRUAL is performance matched discretionary accruals per the modified Jones [1991] model scaled by ending total assets LEVERAGE equals total debt divided by total assets BLOCK is equal to one if an outside blockholder has 5% or more of the stock per Spectrum, 0 otherwise INSIDER is equal to one if an insider has 5% or more of the stock per Spectrum, 0 otherwise ROA is net... 0.15** 0.15** 0.09* -0 .05 RETURN ROA 0.07 0.13** 0.21** 0.16** 0.07 -0 .05 0.14** 0.11** -0 .06 -0 .05 -0 .86** 0.08 LOSS -0 .03 -0 .15** -0 .26** -0 .25** -0 .17** 0.03 0.03 -0 .09* 0.11** 0.01 -0 .41** -0 .09* RET 0.06 0.04 0.04 -0 .03 0.10** 0.00 0.01 0.02 0.03 -0 .06 -0 .04 -0 .01 - * indicates significance at the 10% level ** indicates significance at or below the 5% level a FOLLOW is equal to 1 if a client is . The Ultimate Form of Mandatory Auditor Rotation: The Case of Former Arthur Andersen Clients Jennifer Blouin University of Pennsylvania Barbara Grein Drexel. represented the ceremonial nail in the coffin. Supporting this position, the Wall Street Journal stated “In the 212-year history of the U.S. financial markets, no major financial-services firm. Tyco) as part of the national debate on mandatory auditor rotation and the quality of financial statements. 1 The primary tradeoff involved in the debate on mandatory auditor rotation involves