Auditor Switches in a Post-Sox Environment, Does the Change in Auditor Mean a Change in Stock Price?

ABSTRACT :Extant studies regarding the impact that auditor switches have had on firms' security prices have been mixed. Some indicate an increase in stock prices follow auditor switches while others show negligible or negative stock price changes. The vast majority of these studies take place prior to the Sarbanes-Oxley Act (SOX) of 2002. One of the requirements of SOX is that public companies must change external auditors every five years, thus making the number of auditor switches more plentiful, and the assessment more rich. This study evaluates auditor switches that occurred in a post-SOX environment (2005-2010). Study samples were broken down into two groups: 1. Client firms currently engaging Big 4 auditors that switch to either another Big 4 auditor or a non-Big 4 auditor. 2. Client firms currently engaging non-Big 4 auditors that switch to either another non-Big 4 auditor or a Big 4 auditor. Findings suggest that when client firms engaging a Big 4 auditor switch to another Big 4 auditor, there are minimal stock price increases. When, however, these client firms switch to a non-Big 4 auditor, there are significant price declines. With respect to client firms engaging non-Big 4 auditors, when a change is made to either another non-Big 4 auditor or a Big 4 auditor, minimal stock price increases are noted. The implication is that public companies currently engaging Big 4 auditors should consider switching to another Big 4 auditor when required change, as set forth by SOX, is imminent, thus precluding any potential negative stock price effects.INTRODUCTIONClient firms switch auditors for many different reasons. One reason is that a firm may change to a better quality auditor to supply more credible information to creditors, investors, and regulators (Schwartz and Menon 1985). Another reason is that a client firm may be engaged in opinion shopping. A firm may seek a new auditor to conceal or downplay "bad news" or to avoid a qualified or going concern opinion (Fried and Schiff 1981; Chow and Rice 1982a). A third reason for an auditor change is a disagreement between the auditor and client (Davidson et al. 2006). Prior research shows that a reduction in audit fees also motivates auditor changes (Johnson and Lys 1990; Ettredge et al. 2007). Lower audit fees may improve company financial performance through lower costs but may also diminish audit quality. Auditor changes may also be related to higher auditor litigation risk (Krishnan and Krishnan 1997), auditor industry specialization (Carcello and Neal 2003), management desire to manage or manipulate earnings (Davidson et al. 2006), and better service provided by auditors (Johnson and Lys 1990; Chang et al. 2010). Finally, auditor change may be triggered by new regulations, such as the Sarbanes-Oxley Act (SOX). In July 2002, Congress enacted the Sarbanes-Oxley Act in response to various corporate scandals including Enron, WorldCom, Tyco, and Global Crossing. A major provision of SOX is that the public company change its auditors every five years so that too close of a relationship does not develop between the audit firm and client.Between 2003 and 2006, 5,325 auditor switches occurred among U.S. publicly traded firms. This number represents over 40 percent of U.S. public companies during that time period (Grothe and Weirich 2007). The trend among U.S. firms has been to switch away from the Big Four toward smaller audit firms (OwensJackson et al. 2008). The majority of firms that have switched away from Big Four auditors were smaller companies (with less than $75 million in market capitalization)(Grothe and Weirich 2007; Owens-Jackson et al. 2008). In any event, auditor switches can have serious consequences for clients, audit firms, client firm shareholders, regulators, and others. For example, auditor switches can result in negative share price reactions, which adversely affect various parties and are a factor associated with whether a specific audit is selected by the PCAOB for inspection (Stefaniak et al. …