Investigating the reasons for why firms change auditors

The accounting books offers several potential explanations for why organizations change auditors (i. e. auditor switching). These explanations include: changes in company management who may then prefer another auditor with whom they have some previous association or even to remove an incumbent auditor associated with ex - management (Burton and Roberts, 1967), companies receiving qualified audit views indicating a discord in the auditor-client relationship (Chow and Rice, 1982; Levinthal and Fichman, 1988) or disputes over accounting or reporting methods (DeAngelo, 1982), companies in financial problems whose switching of auditors may be correlated with the explanations just mentioned (Schwartz, and Menon, 1985), and companies heading general public who change auditors to be able to retain a larger accounting firm because of the prestige it may enhance the offering (Menon and Williams, 1991). Throughout, the normal factors related to auditor switching, and influencing auditor selection, are audit fees and qualified audit viewpoints; however, in newer studies non-audit services and auditor-client interactions also appear to be important variables, and way more they have both become identified to impact audit quality by creating potential independence issues. It's the association between auditor switches and auditor-client romantic relationships this is the focus of the review.

In conditions of auditor-client romantic relationships as a changing impacting audit quality, audit companies are generally considered to be a major source of experts for accounting positions outside public accounting supplying a huge amount of alumni to the marketplace given their high turnover rates. Subsequently, previous employees of audit firms may become clients through their positions as older management or audit committee users and these relationships have been proposed with an effect on audit independence (and for that reason audit quality). However, regulatory and academic interest has mostly focused on the effect on audit quality of these connections where employees of audit firms (alumni) were chosen straight by their audit clients, a practice that was at onetime not uncommon. The quality issues stemming from the practice of selecting audit organization alumni arise as the customers may be too acquainted with the audit firm's methods and methods and the auditor will be too more comfortable with his/her former acquaintances. In the U. S. , the Sarbanes Oxley Work of 2002 attempted to restrict the practice of selecting audit company alumni (termed the 'revolving door coverage') by imposing a one-year waiting period for audit organization employees who leave their accounting organization to become an exec or mother board (including its committees) member for a former client. Inside the U. K. , the Ethical Standards set forth by the Auditing Methods Plank in December 2004 took similar steps by imposing a two-year waiting around period for audit lovers (engagement, quality control, or key partner) who leave their accounting firm for a director or key management position with an audited entity. However, the effects of these longing periods on questions of audit quality, including auditor switches, stay an empirical question as do questions typically forgotten by regulators focused on those associations where employees of audit organizations (alumni) were chosen in financial oversight positions by businesses who weren't clients of their alma mater company during their departure but and also require become clients sooner or later afterwards.

Also serving to address issues of audit quality, two of the audit committee rules coming out of the U. S. Securities and Exchange Commission rate therefore of the Sarbanes Oxley Act of 2002 needed that (1) all businesses produce an audit committee made up of at least three customers, including at least one financial expert, and made up entirely of associates self-employed from management and this (2) the audit committee have responsibility for appointing the exterior auditor. In the U. K. , since November 2003, the Combined Code on Corporate Governance's guidelines for firms shown on the London STOCK MARKET on the first point are identical to the U. S. rules. However, on the second point, the U. K. code requires merely that audit committees make suggestions with regards to the session of the outside auditor which, and where in fact the board does not recognize the audit committee's recommendation, the reason why for why the board has taken a new position should be disclosed in the twelve-monthly survey. In both settings, the primary role of the audit committee may be seen concerning oversee the financial reporting process with the best objective of guaranteeing high quality financial reporting, which might be achieved, among other things, through effective monitoring of management and a superior quality audit. Which means first rule requiring all audit committee members to be self-employed seems to follow from typical wisdom that unbiased directors are better monitors of management tendencies than non-independent directors. However, the idea of independence has often been fraught with problems not only because of the difficulty in defining what exactly the idea means but in how it could be observed and measured.

While the organization governance regulations arising in the post-Enron environment business lead to a definition of independence that excludes current or previous employees of the organization, members of a business that receives contributions from the organization, material business relationships such as people that have customers, suppliers, or providers of professional services (legal, consulting, financial) to the firm, relatives of older management, or associates interlocked on another board, these rules do not consider less traditional, but perhaps evenly influential, links between members which might lead to impairment of independence at either the individual member or panel/audit committee group level. As a result, the purpose of the next guideline requiring that the audit committee presume responsibility, full or elsewhere, for appointing the exterior auditor, while representing an attempt to put distance between senior management and the external audit process scheduled to potential conflicts appealing, may be jeopardized by firms replacing members lacking traditional independence with users having unregulated relationships to other participants of the mother board and senior management. This create an additional question of independence in conditions of the scope such unregulated associations impact the oversight and monitoring tasks entrusted to the mother board/audit committee either by discouraging directly connected associates from challenging the group or by encouraging members to truly have a voice in a closely linked group. Thus, in accordance with auditor switching, the question becomes if the connections between the audit committee of the table of directors and senior management will have an impact on the audit committee's support for or opposition to the selection of a company with ties to senior financial management

Background and Theory

Theories considering monetary exchange provide an initial framework for assessing the engagement of any external auditor. For example, Williams (1988) developed a theoretical model to explain auditor switches rooted in the stewardship hypothesis as reflected in the company theory literature. The agency literature clarifies the demand for auditing as arising from conflicting interests between managers, shareholders and stakeholders (i. e. other entities contracting with a client). Beneath the stewardship hypothesis, a administrator, assumed to engage an auditor to satisfy his own passions, would do this by seeking an auditor who satisfies the shareholder's needs for guarantee and therefore choose an auditor of high quality (Williams). Professionals would prefer to choose an auditor with whom he or she has an accommodating relationship which can only help ensure the administrator maintains a good image as the good steward of shareholder's assets (Williams). As company theory considers the auditor-client marriage to be always a nexus of deals, new agreements between managers and shareholders are produced whenever the client hires a fresh manager or officer. When there is a change in mature management, they could require an auditor change because the old auditor is associated with the ex - management or because they prefer to work with an auditor with whom they have had favorable dealings before (Williams). However, the audit engagement process is seemingly more technical, and other disciplines provide alternate perspectives which easier allow that decisions are made by both the prospective client and the proposing audit organization. For example, Simunic and Stein (1990) use stock portfolio theory to model the auditor's consumer selection process which helps make clear the auditor-client commitment as a two-way relationship rather than simple buyer-seller romantic relationship for the reason that if businesses have personal information about customer performance, they may be more selective in their choice of client companies and the level of satisfactory audit fees. This notion of the two-way relationship is contacted from a different perspective in the work by Levinthal and Fichman (1988) who view the affiliation between auditor and customer as a dyadic inter-organizational romantic relationship following public exchange theory.

Social exchange theory generally differs from economical exchange theory in the manner the stars are looked at. Where economic exchange views actors as interacting with market, and responding to various market characteristics, cultural exchange theory views the exchange romantic relationship under imperfect market conditions as the connections between specific celebrities whose actions are each contingent on the actions of the other (Emerson, 1987). These human relationships can also be considered in terms of communal capital theory and techniques developed in cultural network evaluation to make clear how an actor's degree of connectedness contributes to usage of information, potential to coordinate activities, and effectiveness as a monitoring agent. The idea of interpersonal capital presumes that the actions of individuals are facilitated and coordinated through communal group, via common trust, norms and networks (Adler and Kwon, 2002). These actions will vary with regards to the relationships an actor has with other stars, the framework of human relationships among celebrities within the network, or both. Social networking analysis and its own techniques for measuring 'connectedness' rely on this idea of shared characteristics and activities to ease communication and facilitate common understanding, foster personal connections and impede objective monitoring of management. This review will apply the principles of public capital and public network evaluation to older management and plank relationships to find out their potential association with auditor switching.

Literature review

Relative to auditor-client relationships, early studies of auditor changes centered on the association between auditor switching and changes in general management without considering the inter-organizational or inter-personal hyperlink between them. These studies reported no significant connection despite the notion that managers, and especially new managers, may like another auditor with whom they experienced some previous relationship in order to regulate their monitors. For example, Chow and Rice (1982) doc a change in management negatively affects the probability of auditor switching but that association is not significant and this certification of the audit article is really the only significant varying in explaining switching. Later, Schwartz and Menon (1985) give attention to motivations for failing firms in particular to change auditors, determining management changes among the factors that may influence auditor switching. They realize that, although failing businesses have a larger tendency to switch auditors than healthier organizations, neither management changes nor audit skills were statistically significant in this connection. Finally, Williams (1988) model of auditor switches supported that auditor changes aren't triggered by senior management 'shopping' for a lenient or accommodating auditor which was reaffirmed by Archambeault and DeZoort (2001) in their research demonstrating audit committee independence and financial expertise decreases the incidence of suspicious auditor switches that sign judgment shopping. Despite these early results provided research refuting that older management seek auditor changes to be able to control the auditors who monitor them, perceptions of this persist and, as noted by Lennox), plans that reduce managerial affect over auditor dismissal and selection decisions remain in the eye of regulators. As a result, their potential impact on audit quality has been attended to through studies of accounting organization alumni in older management and plank of directors or audit committee independence.

Accounting company alumni in mature management

One line of research has looked into how accounting company 'alumni' in senior management positions of audit clients could compromise audit quality through auditor switching. This line of research brings the inter-organizational hyperlink into the picture, as observed in the analysis by Iyer et al. (1997) who find in a survey U. S. accounting firm alumni that alumni tend to provide economic benefits to their previous audit firms. The best way that alumni in senior management positions of audit clients have been seen to gain their former organization is to influence the appointment of this firm as the business's auditor thereby directing business to their former audit companies. Additionally, the concern is usually that the familiarity between accounting firms and their past employees may impair auditor skepticism and objectivity if the auditor is in charge of auditing a company whose mature management once was utilized by the audit organization. Finally, because alumni have a good understanding of their previous accounting firm's audit methodology, there is the potential for them to more easily deceive auditors.

These concerns are supposed to have a job in certain constraints that arrived of the Sarbanes Oxley legislation on the 'revolving door' of accounting organization personnel to clients. Empirical studies of the U. S. market like the one by Lennox (2005) find that auditors are less likely to issue altered audit records for clients with accounting organization alumni in top-level management positions and by Menon and Williams (2004) file that excessive accruals are larger for clients with former accounting firm lovers as employees implying better earnings management. These two studies provide research that audit behavior is more lenient towards clients with highly put alumni. While this gives evidence of lower audit quality, Lennox (2005) studies that only 10% of audits in his sample involve alumni in older management positions in support of 7% of the sample in Menon and Williams (2004) have past audit lovers. Further, Geiger et al. (2005) presents results for U. S. data which signify that earnings management, in the form of increased accounting accruals, is not any better immediately before or after hiring in the firms participating in the practice of hiring their financial reporting executives (CFO, VP-Finance or Controller) immediately from their external audit form in comparison to three split control groups employing people from other options or keeping their incumbent financial reporting executives.

Despite the seemingly low prevalence of alumni in older management positions and mixed results, Geiger et al. (2008) continue on this subject determining the prevalence of the revolving door selecting practice and investigating the market's reaction to companies employing their mature accounting and finance officers straight from their exterior audit businesses. They find, regular with both studies mentioned above, that the percentage of revolving door hires is relatively low at 6% of these sample, but that when they did happen, the market respected the revolving door meetings more positively than other visits. So regardless of the impact of the 'revolving door' happening may be less significant than commonly thought, there may be indicator that auditor-client romantic relationships may have effects for financial reporting and audit quality.

Board and audit committee independence

In the second line of research, involving studies of board of directors or audit committee independence, the matter that audit quality can be impaired if the business is audited by a firm that formerly applied one of the business's senior officers is seen to be mitigated to the extent a company's audit committee is 3rd party, as an independent audit committee might perceive these cable connections as a potential risk to audit quality, thereby preventing the appointment of officers' former organizations. Prior U. S. research linking audit quality with the boards of directors, and the audit committees of boards of directors, shows that audit quality is higher when boards and audit committees tend to be more indie (i. e. having more external directors). For instance, Carcello and Neal (2000) show that in the existence of more indie boards, auditors will issue heading concern studies for fiscally distressed organizations and less inclined to be replaced by the company following their issuance. Abbott and Parker (2000) report evidence that boards who are more independent boards and who are more vigorous (i. e. meet more often) will demand higher audit quality, a demand which is fulfilled through employing industry specialists as their auditors. And, finally, Klein (2002) present a poor relation between panel and audit committee independence and revenue management as strategy by irregular accruals. Yet these studies do not specifically consider auditor alumni factors.

More straight, empirical studies including the one by Lennox and Area (2007) find an audit firm is more likely to be appointed if the company has an official who is an alumni of the company, especially if the officer has recently remaining the audit organization. However, in addition they find that this likelihood to be mitigated by the extent the company's audit committee is self-employed (i. e. a lot more independent the company's audit committee, the not as likely the business is to appoint an officer's previous audit organization). Finally, in a study of alumni audit associates appointed to company audit committees in the U. S. , Naiker and Sharma (2009) analyze the association between inner control deficiencies reported under Section 404 of the Sarbanes Oxley legislation and the presence of past audit lovers on the audit committee who are affiliated and unaffiliated with the business's exterior auditor finding a poor relationship for both affiliated and unaffiliated past partners. Naiker and Sharma (2009) interpret their studies to claim that both affiliated and unaffiliated past lovers on the audit committee are associated with an increase of effective monitoring of internal adjustments and financial reporting and that concerns about 'revolving door' visits are less suitable to the audit committee setting up because audit committee people are very sensitive to the probability of affiliations threatening audit quality.

Board and audit committee ties

Recently, the independence of the mother board and the audit committee has been considered in terms of its inside connectedness, an application of public network examination, which focuses on the professional and social connections within the panel or between the CEO and other plank members. You can find two measurements to consider in calculating internal contacts: 1) the amount and 2) the sort (professional or public). The degree can be identified at two levels of interconnection: a) an initial degree interconnection, i. e. , two people know each other because they sit down or have sat on another table together be it of a general public or private company or of a business (charitable, university, art, sporting, politics, etc. ), have been utilized by the same company at the same time or they have got direct communal ties such as regular membership in the same organizations or attendance at the same university, and b) another degree interconnection where two mother board members share the professional or interpersonal tie with a 3rd person or again they reveal a typical backgrounds (same alma mater, same nationality, same religion, same professional record (e. g. , both are engineers, CA, served in the armed service). The literature in this field can be involved with issues of corporate and business governance such as the board's impact on commercial decision making or interior corporate governance methods. For instance, the Hwang and Kim (2009a) review expands on the work of Klein (2002) to consider the impact of sociable ties between your CEO and audit committee customers showing these ties are associated with higher degrees of earnings management and higher CEO bonuses. They also claim that internally linked audit committee people have been exchanging economically or family connected members since the regulations governing audit committee independence were enacted. Utilizing the same dataset, Hwang and Kim (2009b) claim that CEO compensation is leaner and more hypersensitive to pay performance when boards are handily and socially 3rd party from the CEO. Their way of measuring public ties is quite broad with the traditional definition of independence providing as a direct measure (current worker of the company, former employee of the company, member of a business that receives contributions from the firm, business relations (customer/supplier) with the organization, offers professional services (legal, consulting, financial) to the firm, relative of the CEO, interlocked on another table) as well as what's categorized above as second level characteristics offering as an indirect measure (CEO and member have help in the military services, share the same alma mater, same local origin, studied the same self-control, proved helpful in the same industry, common third party connection).

Measuring these relationships, while possible using biographic information within annual reviews or proxy statements, is quite tedious (refer to Appendix B for more information on dimension). More recently, different data source mangers have begun collecting the data and allowing broader research, one of these being BoardEx. Fracassi and Tate (2009) analyze the exterior network connections between the CEO and his panel participants using BoardEx data for the S&P 1500 companies between 2000 and 2007. They look at the current and previous employment network, the training network as the other activities network which they aggregate into a Social Network Index. They find that better CEOs have a tendency to appoint directors with whom they show cultural ties. Further, companies with higher inside connectedness have lower market valuations and take part in more value destroying acquisitions in the absence of compensating governance mechanisms. Schmidt (2009) examines the cost and benefits of 'friendly boards' during mergers and acquisitions. Using BoardEx data, he defines friendly boards as those where increased numbers of directors are linked to the CEO via golf clubs, fraternities, not-for-profit organizations, qualifications (spiritual organizations, armed service), network organizations, or having done their MBA jointly. He sees that friendly acquiring planks lead to higher abnormal announcement results when advisory needs are higher but the opposite when monitoring needs are greater.

4. Conclusion

Despite a preexisting literature on audit quality in terms of auditor switching and an evergrowing literature on board and audit committee cable connections in the money and economics self-control (refer to Appendix A summarizing the books reviewed above), earlier studies of audit quality and table contacts in the U. S. have been limited by professional (alumni) affiliations of the panel of directors or older management of the business to the incumbent auditor and mother board/audit committee independence issues but have not considered the opportunity of affiliation, and therefore possible impairment of independence of your different mother nature, through non-professional (i. e. interpersonal) means. Furthermore, there are few studies looking at the partnership between auditor transitioning and auditor-client contacts through the closeness of the client's management and audit committee users, in particular in the environment pre- and post-changes to the corporate governance regulations on revolving door hires and audit committee independence in the U. K. Within this study, we propose to examine whether cable connections, in terms of auditor-client affiliations as well as professional and communal ties between older management and audit committee people, impact on auditor moving over not in conditions of leading to the auditor swap a lot as influencing the selection of the new auditor. In particular, this study will answer the questions of (1) whether older financial management (CEO and CFO being the most influential) of the business appoint their former audit firms given a big change in auditors and (2) whether the extent of mature management and audit committee associations facilitates or inhibits such appointments. Both of these questions will be looked at in light of relevant changes in the U. K. corporate governance code designed to encourage audit quality by promoting auditor independence.

In a preliminary stage, we focus on an example of 563 auditor changes in the U. K. between 1997 and 2009 and research the role of auditor-client romantic relationships in the auditor selection decision through the analysis of former audit alumni in financial oversight tasks who choose their alma mater firm as auditors. Later, we may investigate whether the closeness of the mature management and audit committee customers, as assessed by their professional and cultural ties, comes with an impact on this selection. We look at the U. K. setting up since 1) it signifies a marginally different corporate governance and institutional environment than that of the U. S. and 2) we expect greater connections in the united kingdom, at least prior to the enactment of changes to the united kingdom code, because of its smaller size and for that reason smaller network.

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