Determinants and consequences of auditor switching during fiscal year‐end audit fieldwork

• Published date: 01 April 2023
• Author: Bum‐Joon Kim,Vivek Mande,Myungsoo Son
• Date: 01 April 2023
• DOI: http://doi.org/10.1111/ijau.12303

ORIGINAL ARTICLE

Determinants and consequences of auditor switching during

fiscal year-end audit fieldwork

Bum-Joon Kim

1

| Vivek Mande

2

| Myungsoo Son

2

1

The Catholic University of Korea, Seoul,

South Korea

2

College of Business and Economics, California

State University, Fullerton, California, USA

Correspondence

Myungsoo Son, College of Business and

Economics, California State University,

Fullerton, CA, USA.

Email: mson@fullerton.edu

Funding information

The authors have no specific funding to

declare.

We compare a group of firms switching auditors while their annual audit is underway

(LateSwitches) with two control groups: firms switching their auditors during the

fourth quarter of the fiscal year and firms switching their auditors during the first

three quarters. First, we find that LateSwitches tend to be riskier with regard to litiga-

tion risk, audit risk and business risk. Second, we find that LateSwitches have a higher

chance of announcing restatements and receiving going concern opinions in the first

year of audit with the successor auditor. Despite the higher risks, we fail to find that

LateSwitches disclose more adverse events in Forms 8-K than other groups. We also

document that stock market returns following an auditor change are more negative

for LateSwitches. These results indicate that LateSwitches stand to face significant

negative consequences when the relationship with their auditor is terminated

abruptly in the final phases of an audit.

KEYWORDS

auditor switch timing, dismissal, Form 8-K, going concern opinion, restatement

1|INTRODUCTION

In January 2012, Suffolk Bancorp dismissed its auditor, Grant Thorn-

ton, after the 2011 fiscal year-end but before its audit report was

issued and subsequently hired a new auditor to perform its 2011

audit. The company disclosed that there was a disagreement with the

departing auditor regarding management's methodology for calculat-

ing the contingencies component of the allowance for loans and lease

losses but stated that the auditor was not dismissed because of this

disagreement.

1

This is an example of an auditor switch that took place

while the annual audit was underway (LateSwitches hereafter).

Auditors do not normally resign during the final phases of an audit

unless there exists a level of risk to them that cannot be diversified

away through other available strategies (Elder et al., 2009; Krishnan

et al., 2013). We believe that LateSwitches should be of real concern

to investors and regulators because an auditor change in the final

stretch of an audit is likely due to the presence of serious disagree-

ments over accounting issues and/or the impending audit opinion.

Only a few prior studies have discussed auditor turnover in an

audit's final phase. These studies (Burks & Stevens, 2022; Catanach

et al., 2011; Schwartz & Soo, 1996) defined late-term switches as

auditor changes that occur during the fourth quarter (Q4 Switches) or

during periods that include both Q4 Switches and LateSwitches.

2

No

past study, however, has sought to differentiate between LateS-

witches and Q4 Switches. Our research seeks to fill the gap in the lit-

erature by examining how LateSwitches differ from other auditor

switches.

We identify LateSwitches by reading all Forms 8-K relating to

auditor switches during the period between the fiscal year end and

the audit report date (ARD hereafter).

34

We then compare these firms

with two control groups: (1) firms that switch auditors in the fourth

quarter (Q4 Switches) and (2) all other auditor-switching firms (Q1–

Q3 Switches). Focusing on a sample of auditor switches during the

post-Sarbanes-Oxley Act period (2003–2017), we find that LateS-

witches are about 10% of total auditor switches, an unexpectedly high

number if these events are intended to be rare occurrences.

We document that LateSwitches are riskier firms compared with

Q1–Q3 Switches and even Q4 Switches. Specifically, we find that

LateSwitches are associated with higher levels of audit, business and

litigation risk and are more likely than other switches to receive going

concern opinions and announce restatements in the first year with

their successor auditors. However, despite the elevated risks, results

Received: 25 October 2021 Revised: 8 November 2022 Accepted: 9 January 2023

DOI: 10.1111/ijau.12303

Int J Audit. 2023;27:91–108. wileyonlinelibrary.com/journal/ijau © 2023 John Wiley & Sons Ltd. 91

show that LateSwitches report fewer adverse disclosures than other

auditor switches. Last, we find that the abnormal market returns sur-

rounding the auditor change dates are more negative for LateSwitches

than Q1–Q3 Switches and Q4 Switches.

Our research contributes to the literature in several ways. To our

knowledge, this study is the first to explicitly document differences in

auditors' risk between LateSwitches and all other switches. Compared

with even Q4 Switches, LateSwitches may have the strongest incen-

tives to engage in aggressive earnings management and opinion shop-

ping. Therefore, we believe that auditors, investors and regulators

should be particularly vigilant about these auditor changes.

Second, our findings suggest that regulators need to find ways to

improve compliance and also consider whether the Forms 8-K disclo-

sure requirements for auditor switches should be revised.

5

Against

expectations and casting doubt on the usefulness of the Forms 8-K,

our results show that the frequency of adverse disclosures monotoni-

cally decreases across auditor switching groups ordered by audit risk

(i.e., adverse disclosures by LateSwitches are fewer than those by Q4

Switches, which in turn are fewer than those by Q1–Q3 Switches).

Finally, the findings that LateSwitches are associated with nega-

tive outcomes post-switch (qualified audit opinions, restatements and

unfavourable market returns) should be of interest to audit commit-

tees that are considering changing auditors in the last stages of an

audit because of disagreements with their current auditor.

The remainder of this paper is organized as follows. The next

section reviews the relevant literature and develops our hypotheses.

This is followed by a discussion of the research design and the empiri-

cal results. The last section concludes the study.

2|LITERATURE AND HYPOTHESES

DEVELOPMENT

2.1 |The timing of an auditor switch

Several papers have focused on studying the effects on a firm's audit

quality from engaging an auditor late in the year. Because successor

auditors are provided a relatively short period to learn about their

new clients' businesses, this research examines whether audit quality

suffers as a result (Cassell et al., 2020; Pacheco-Paredes et al., 2017).

In contrast, only a few studies have examined how departing

auditors, especially those terminated in the final phases of an audit

(LateSwitches), influence audit quality. Schwartz and Soo (1996)

defined ‘late switches’as auditor changes in the fourth quarter that

include those after the fiscal year end but before the SEC 10-K filing

dates. They observe that late switches are more likely to be associated

with losses, modified opinions and delayed SEC filings. Catanach et al.

(2011) found that firms whose auditors resign late in the fiscal year

tend to employ non-Big 4 successor auditors. Burks and Stevens

(2022) found that dismissals between the end of the fourth quarter

and the SEC 10-K filing dates are associated with increases in the like-

lihood of delistings in the future.

2.2 |Risk factors related to LateSwitches

We posit that late-term switches occur when disagreements between

auditors and clients about end-of-year accounting treatments are so

severe that the parties are unable to resolve their differences through

other means. As discussed next, these auditor-switching firms may be

associated with very high risks, which should concern successor audi-

tors, regulators and shareholders.

2.2.1 | Audit, business and litigation risk factors

Following previous studies (e.g., Ghosh & Tang, 2015), we measure

auditor risk along three comprehensive dimensions—audit risk, busi-

ness risk and litigation risk.

6

Research (e.g., Zang, 2012) suggests that

accruals-based earnings management by firms largely takes place after

the fourth quarter has concluded and while the annual audit is under-

way. Earnings management along with its potential for future restate-

ments can increase audit risk and also litigation risk (e.g., Palmrose &

Scholz, 2004) for LateSwitches. Also, post-Q4, more than at other

times, disputes with auditors can arise over estimates, assumptions

and other accounting matters and/or the audit opinion itself.

7,8

Often,

the disputes are contentious because of the poor financial condition

of the client firms (Cohen et al., 2008).

9

That is, client firms whose

financial condition is deteriorating or has suddenly deteriorated have

greater incentives to take aggressive positions on reported earnings,

increasing audit risk.

10,11

The impaired financial status of client firms

does not also bode well for their future profitability and survival, in

turn increasing business and litigation risk for the auditors (Houston

et al., 1999; Palmrose & Scholz, 2004; Stice, 1991). We posit that

auditors who do not acquiesce to their clients' accounting positions in

post-Q4 periods will resign or be terminated if the levels of these risks

are unacceptably high. The above arguments suggest, therefore, that

elevated levels of audit, business and litigation risks will be present in

LateSwitches.

12

Alternatively, however, LateSwitches may be informationally

motivated (Dye, 1991), that is, the switches may be unrelated to firm

risk factors. These late-stage replacements may be due to auditors

and auditees having asymmetrical information about the firms' busi-

ness and financial condition, which then can lead to disagreements

about accounting choices and/or the audit opinion. Client firms who

believe that they possess more accurate information may initiate the

separation of the relationship with their auditors and seek to hire

auditors who better understand their accounting judgments.

13

The

motivation for switching auditors under this scenario is not opportu-

nistic. Rather, it is an attempt to better communicate through their

choice of auditor, the firm's financial performance more accurately to

the outside world.

14

The above discussion leads us to the following

non-directional hypothesis:

H1A. LateSwitches are not riskier than other auditor

switches.

92 KIM ET AL.