Academic journal article Accounting Historians Journal

Auditor Switching and the Great Depression

Academic journal article Accounting Historians Journal

Auditor Switching and the Great Depression

Article excerpt

Abstract: This paper explores the pattern of auditor switching in Canada before and during the Great Depression based on a sample of 1,344 financial statements. Hierarchical log linear analysis shows that there is a significant change in the pattern of switches. Prior to the Depression, the contemporary pattern of auditor switching is observed; that is, there is a flow of clients from small to large audit firms and from Canadian to international audit firms. During the Depression, however, this flow of clients is reversed with large international firms losing clients through switches, on average, to Canadian and smaller audit firms. The contemporary audit literature suggests possible reasons for the observed patterns in terms of the demand for higher quality audits by clients and audit firms' risk management of potential client bankruptcy.

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This paper explores changes in the pattern of auditor/client switching and continuity in Canada before and during the Great Depression of the 1930s. The Great Depression has been referred to as a "defining moment" in economic history [Bordo et al., 1998]. It provides a setting that allows the market's response to shocks to be assessed. The shock to the audit market was twofold. First, the Depression exposed the securities market manipulations of the late 1920s and made potential and current investors aware of the importance of credible financial information for assessing the liquidity, solvency, and future earnings potential of firms [Previts and Merino, 1979, p. 245]. This shock increased the value of the audit as a signal of the quality and credibility of financial statements and, hence, provided incentives for client firms to switch to higher reputation auditors. (1)

The second impact of the Depression was to increase dramatically the risk of financial distress and bankruptcy faced by client firms and, derivatively, the risk of loss of reputation and litigation for damages faced by auditors. Audit firms must assess the risks posed by their portfolios of clients in order to ensure their profitability and survival. This will involve a pre-engagement assessment of the risk of new clients and the resignation from engagements with existing clients where the risk level has become unacceptable. The Depression dramatically, if temporarily, increased the average risk level of auditors' portfolios of clients. This could result in auditor switches initiated by the auditor in order to maintain an acceptable level of risk in its portfolio of clients.

The Great Depression also coincided with significant changes in the regulation of the audit market in some countries [Edwards, 1989]. In the U.S., the Securities Exchange Acts of 1933 and 1934 increased the disclosure requirements of publicly listed firms and increased the auditor's liability for fraudulent statements. While the effect and intent of such legislation on the stock markets is subject to debate [Benston, 1973; Merino and Neimark, 1982; Cooper and Keim, 1983; Tinker, 1984], its impact on the U.S. auditing profession is less controversial. The audit profession emerged from the Depression with a statutory demand for its services, revised audit objectives (i.e., the change in focus from the balance sheet to the income statement and the greater emphasis on the "fairness" of the financial statements rather than the accuracy of their tracking of transactions), and greater liability for misleading financial statements [Gilman, 1939].

In countries of the British Commonwealth, audited financial statements were required by statute well before the Depression (1844 in the U.K., 1907 in Canada). In these countries, there was no immediate legislative response to the financial reporting issues exposed by the Depression. Nonetheless, the Depression also coincides with changes in the practice of auditing in these countries [Chandler et al., 1993]. In the U.K., the 1931 Royal Mail Steam Packet Case, where secret reserves were used to hide deteriorating performance, is widely credited with increasing the emphasis on the income statement and the quality of earnings, although an audited income statement was not required by law in the U. …

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