Audit Committee Characteristics and Auditor Changes

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INTRODUCTION

Since 1992 Audit committees have been mandated for all listed companies and registrants on the New York Stock Exchange (NYSE), the American Stock Exchange (ASE), and the National Association of Securities Dealers (NASD). A rash of fraudulent financial reporting cases, earnings misstatements, auditor changes, and questions about external auditor independence have led to calls for more effective audit committees (Blue Ribbon Committee 1999; NYSE 2002; and the Sarbanes-Oxley Act 2002). Research suggests that both the presence of the audit committee and the characteristics of committee members influence the effectiveness and reliability of financial reporting (Wild 1996; McMullen 1996). Section 301 of the Sarbanes-Oxley Act makes the audit committee responsible for the appointment, compensation, and oversight of the external auditor (Sarbanes-Oxley Act 2002). Thus, the audit committee oversees auditor changes. Centering this responsibility in the audit committee is more likely to produce the desired financial reporting quality if, committee members possess key characteristics.

Research suggests that certain committee member characteristics positively influence audit committee effectiveness (Abbott et al. 2004; Abbott and Parker 2000; Carcello and Neal 2000, 2003). For example, the probability of auditor dismissal after a new going-concern report decreases when independent audit committee members have more governance expertise and less stock ownership. (Carcello and Neal 2003). There are, however, many reasons for auditor changes other than a going-concern report. Accounting disagreements, auditor resignations, audit fee disputes, and qualified audit opinions are associated with auditor changes. Prior studies indicate that auditor changes may signal an attempt by management to shop for a new auditor who will agree with financial reporting and or disclosure decisions (Whisenant et al. 2003; Lennox 2002; McMullen 1996). If the current auditors are terminated as a result of accounting disagreements with management, the likelihood of inappropriate financial reporting and disclosure may increase.

In addition, research has shown that audit fees are related to auditor changes. With auditor resignations, fees are higher one year before and after the auditor change indicating that both the incumbent and incoming auditors charge a premium (Owens et al. 2008, Asthana et al. 2004, Griffin and Lont 2005, Simon & Francis 1988, Walker & Casterella 2000). With auditor dismissals, the pattern in fees is the opposite due to the discounting hypothesis (Griffin and Lont 2005). Also, the learning curve of subsequent auditors can result in a temporary reduction in audit quality at a time when management may be shopping for a favorable audit opinion. It is almost universally accepted that the first year or two of an audit engagement is sub-optimal (Latham, Jacobs & Roush 1998). If audit committees with independent and financial expert members can reduce auditor resignations then they may prevent significant increases in auditor fees and reductions in audit quality.

A variety of other member characteristics have the potential to impact audit committee effectiveness. Five vital characteristics identified by the Blue Ribbon Committee (BRC) are independence, financial expertise, commitment to duties and responsibilities, firm specific knowledge, and governance expertise. Evaluating the auditor changes in light of the BRC recommendations provides a more complete picture of the association between auditor changes and audit committee member characteristics.

The current research examines the association between the five audit committee characteristics recommended by the BRC and auditor changes following disagreements, auditor resignations, audit fee disputes, and qualified audit opinions (hereafter auditor changes). The results indicate that three of the characteristics are inversely related to auditor changes. …