the impact of management influence on auditor independence: post-sox … · 2019-08-10 · 1 the...

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The Impact of Management Influence on Auditor

Independence: Post-Sox Evidence

Dan S. Dhaliwal, Phillip T. Lamoreaux* Landon M. Mauler*

University of Arizona

Latest Draft as of: October 11th, 2010

Preliminary and Incomplete Draft – Please Do Not Cite Suggestions Welcome

ABSTRACT: In an attempt to promote auditor independence, Section 301 of the Sarbanes-Oxley Act requires the audit committee to have “direct responsibility” for the auditor appointment decision. This study examines the post-SOX impact of management influence on both the auditor selection decision and auditor independence. Using a sample of auditor switches from 2004-2009 we find that manager-auditor affiliations, our proxy for management influence, have a significant influence on which firm is selected in an auditor switch. These results appear to be contrary to Section 301 of the Sarbanes-Oxley Act. During this period, we also find that management influence is negatively associated with our proxies for auditor independence. Specifically, we find management influence is associated with an increased propensity to meet/beat analyst forecasts, a decreased propensity to receive a going concern opinion, and a decreased earnings response coefficient. This study provides empirical evidence on the effectiveness of audit committees with respect to auditor appointments and the negative impact of management influence on auditor independence post-SOX. Keywords: Auditor Independence, Auditor appointments, Sarbanes-Oxley, Management influence, Affiliations *Corresponding authors. Please contact at [email protected] or [email protected].

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1. INTRODUCTION

To enhance auditor independence, the Sarbanes-Oxley Act (2002) placed responsibility

for a firms’ relationship with the external audit firm directly on the audit committee. This shift

of responsibility represents a regulatory attempt to eliminate management influence on the

external auditor by inserting an independent audit committee between management and the

external auditor. The Sarbanes-Oxley Act (hereafter SOX) states that the audit committee

“…shall be directly responsible for the appointment, compensation, and oversight of the work

of any registered public accounting firm …” (Section 301, SOX). This regulation represents a

new statutory requirement for independent audit committees. However, the effectiveness of

the regulation in enhancing auditor independence remains uncertain. To evaluate this new

requirement, we examine if management influence impacts audit firm selection decisions in the

post-SOX era and whether management influence impacts auditor independence. We find

evidence of management influence on audit firm selection and we also find evidence of

impaired auditor independence associated with management influence.

In a survey of Big4 partners and managers, Cohen et al. (2010) find external auditors

perceive management as ’key drivers in determining auditor appointments and terminations’

post-SOX. In a survey of audit committee members, however, Beasley et al. (2009) find audit

committee members perceive themselves as fulfilling the responsibilities outlined by SOX,

including the appointment and termination of the external auditor. These studies provide

conflicting evidence on the effectiveness of regulation requiring audit committee responsibility

for audit firm selection. Our study provides the first large-sample empirical evidence evaluating

the effectiveness of this provision of the Sarbanes-Oxley Act.

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To empirically examine the impact of management influence on the audit firm selection

decision, we use management affiliations as a proxy for management influence. ‘Management

affiliation’ is defined as a prior working relationship of a management member with a Big4

auditing firm. Lennox and Park (2007) find management affiliations have a significant impact on

audit firm selection during 1995-2000; a period of time when the audit committee was not

directly responsible for audit firm selection. We find, during the period 2004-2009,

management influence still has a significant impact on which of the Big4 firms is selected in an

auditor appointment decision. For example, in our sample, PricewaterhouseCoopers (PWC) is

appointed 21 percent of the time when there is no management affiliation with PWC; however,

PWC is appointed almost 47 percent of the time when there is a management affiliation with

PWC. Our findings are consistent with the results of Cohen et al. (2010) and the results of

Fiolleau et al. (2010). These results cast doubt on the effectiveness of this regulation in its’

attempt to eliminate management influence on audit firm selection.

Due to management influence on audit firm selection, we evaluate the impact of

management influence on auditor independence, proxied by measures of audit quality.

Management affiliation may have positive or negative consequences regardless of regulator

perception and regulatory statutes. Management affiliation may lead to enhanced audit quality

as a result of audit firm familiarity and improved auditor relationships. Geiger, Lennox and

North (2008) find positive market reactions to the hiring of auditor affiliated employees. In

addition, recent evidence suggests SOX increased the effectiveness of audit committees and the

integrity of management (e.g., Cohen et al. (2010) and DeZoort et al. (2008)). Finally, Naiker

and Sharma (2009) find evidence that auditor-audit committee affiliations are associated with

http://www.pwc.com/

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higher financial reporting quality immediately following SOX. However, prior research has

documented affiliated firms have increased propensities to meet/beat analyst forecasts

(Menon and Williams 2004), report cleaner audit opinions (Lennox 2005), and report higher

discretionary accruals ((Menon and Williams (2004) and Krishnan and Dowdell (2004)), all of

which indicate that management affiliations lead to impaired audit quality in the pre-SOX

regime. Consequently, the impact of management affiliations on auditor independence in the

post-SOX period remains uncertain.

We find firms with an affiliated auditor are more likely to meet/beat analyst forecasts

and are less likely to receive a going concern opinion. We also proxy for perceived auditor

independence through earnings response coefficients (ERCs). We find earnings response

coefficients decrease when an affiliated auditor is appointed, consistent with a perception of

impaired auditor independence. Taken as a whole, our results provide evidence that

management influence on the auditor-client relationship results in an impairment of auditor

independence in the post-SOX regime.

Our study makes two main contributions to the existing auditing and corporate

governance literature. First, we provide evidence that management influence impacts the

selection of the external audit firm during a period in which independent audit committee

members are charged with ‘direct’ responsibility for auditor appointment. This result casts

doubt on whether “independent” audit committees truly act independent of management

influence. This finding also calls into question the effectiveness of recent regulation pertaining

to increased audit committee responsibility. Second, in determining whether management

influence has positive or negative effects, we document that management influence remains

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inversely related to auditor independence. We utilize multiple audit quality proxies and our

results consistently indicate a negative association between management affiliations and audit

quality. Our results provide evidence that, although regulation attempted to enhance auditor

independence, the negative impact of management influence on audit quality exists in the

post-SOX period.

The remainder of our paper is organized as follows. Section 2 discusses additional

background information and our hypotheses. Section 3 outlines our research design and

results. Section 4 concludes with a summary of our findings and limitations.

2. BACKGROUND AND HYPOTHESES

2.1 Auditor appointment and the regulatory environment

As a result of the significant number of financial statement frauds in the late 1990’s and

early 2000’s, auditor independence became a widely debated topic in the popular press and by

the Securities and Exchange Commission (SEC 2000). The Sarbanes-Oxley Act of 2002 (SOX) was

the culminating regulatory change brought about as a result of the accounting scandals.

Included in SOX are multiple attempts to enhance auditor independence. One specific

provision of SOX directed at increasing auditor independence is the enhancement of audit

committee’s responsibilities to eliminate management influence on the external auditor.1

Included among the audit committee’s new responsibilities is the responsibility for auditor

1 Also included in SOX are limitations on the ability to hire employees of the current auditor (“cooling-off” period)

(SOX Section 206), limitations on non-audit services that audit firms can provide (SOX Section 201), mandated audit committee independence, and the creation of the PCAOB, a new regulatory body of the external audit firms. All of these provisions represent attempts to enhance auditor independence.

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appointment. To date, we are unaware of any large sample, empirical evidence documenting

the effectiveness of SOX on auditor appointment decisions.

Section 301 of SOX states:

“The audit committee of each issuer, in its capacity as a committee of the board of directors, shall be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer… for the purpose of preparing or issuing an audit report or related work, and each such registered public accounting firm shall report directly to the audit committee.” (bold and italics added)

While recommendations existed for auditor appointment to be a responsibility of the

audit committee prior to the Sarbanes-Oxley Act2, no statutory requirement existed until the

enactment of SOX.

Prior research has documented negative consequences on auditor independence

resulting from management influence on the external auditor. For example, Carcello and Neal

(2000, 2003) find that in the event of adverse auditor negotiations (e.g., determination of

whether to issue a going concern opinion), the threat of dismissal by management and audit

committee independence affects auditor decisions. As such, by eliminating management threat

of dismissal through audit committee responsibility for appointment and termination, overall

auditor independence is expected to be enhanced.

Management influence on the audit committee, and consequently the external auditor,

can take many forms and is therefore difficult to empirically observe. Managers’ prior

employment experience with external audit firms provides an empirically observable proxy for

2 The Blue Ribbon Committee Report on Improving the Effectiveness of Corporate Audit Committees (1999)

provides an outline of recommendations to improve corporate audit committees, many of which were considered and implemented in the Sarbanes Oxley Act of 2002 including 100% independent audit committees, adequate financial expertise of audit committee members and audit committee responsibility for the relationship with the external auditor including auditor appointment and termination

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management influence.3 This employment experience (affiliation) has been shown to have a

significant influence on audit firm selection. Lennox and Park (2007) find management

affiliations have a significant impact on which firm is selected in an auditor switch prior to SOX.

However, during the sample period of Lennox and Park (2007), audit committee responsibility

for auditor selection was not mandated. If management affiliations impact the audit firm

selection decision in the post-SOX period we would interpret this as management influence on

the selection decision and thus would provide evidence on the effectiveness (or lack thereof) of

recent regulation.

In a recent study using survey data of Big4 audit firm partners and managers, Cohen et

al. (2010) find management (not the audit committee) is perceived as the key driver in the

auditor appointment in the post-SOX regime. Consistent with Cohen et al. (2010), Fiolleau et al.

(2010) find in a case study that management heavily influenced the auditor appointment which

was also interpreted as contrary to the intent of SOX. Using survey data of audit committee

members, Beasley et al. (2009) find contradictory results in that audit committee members

perceive themselves as having properly assumed the responsibilities levied by SOX, including

the appointment and termination of the external auditor. These mixed results indicate

uncertainty about how independently of management the audit committee acts and provide

motivation for additional empirical evidence. Consistent with the recent results of Cohen et al.

(2010) and Fiolleau (2010), we state our first hypothesis as follows:

3 We acknowledge there are several ways in which management could influence the selection of the external

auditor. However, in our study, the existence of management influence is more important than the form of management influence. For a more detailed discussion of the ways management may influence the audit committee, see Fiolleau et al. (2010) and Cohen et al. (2010). Prior research has also documented that audit firm alumni have a propensity to provide economic benefits to their former firm, (Iyer 1998). This finding provides additional support for our use of management affiliation as a proxy for management influence on the audit firm selection decision.

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H1: Management influence (measured by management affiliation) has a significant impact on the audit firm selection post-SOX.

2.2 Affiliations and auditor independence

While managers may influence auditor appointment decisions, the effect of this

influence on subsequent auditor independence remains uncertain. Management affiliations

may result in improved working relationships between firm employees and the external

auditor. This possibility represents one positive outcome which may be associated with the

affiliation. However, if the threat of dismissal is a primary consequence of management

influence, management affiliations may bear on the independence of the external auditor

(Carcello and Neal 2000, DeAngelo 1981).

The second general standard of auditing states that the auditor must maintain

independence in mental attitude in all matters relating to the audit and the auditor should

avoid circumstances in which the general public would believe an independent attitude has

been or could be impaired. (AICPA AU 220). Auditor independence cannot be empirically

observed; as such measures of audit quality and public perceptions are examined ex post and

inferences are drawn regarding impaired auditor independence. If independence or perceived

independence is impaired, a negative audit quality measure, or an altered judgment by market

participants, should be observable ex post.

Prior research has examined the impact of management affiliations on auditor

independence in the pre-SOX regime. Using the propensity to meet analysts’ targets as a proxy

for audit quality, Menon and Williams (2004) find that “FP firms” (an “affiliated firm” in our

study) are more (less) likely to meet/beat (miss) analyst forecasts as compared to unaffiliated

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firms. Using an alternative proxy, the propensity to receive a going concern opinion, Lennox

(2005) finds that affiliated firms have a lower propensity to receive a going concern qualified

audit opinion. The results of both studies indicate impaired independence associated with the

affiliation (management influence). Our final proxy for auditor independence, earnings

response coefficients (ERCs), is based on the perceptions of market participants. While this

proxy has not been used directly in connection with management affiliations, this proxy has

been used in prior studies examining auditor independence (Francis and Ke (2006)).

It is important to note that whether or not the association between management

affiliations and auditor appointment decisions persists post-SOX, it remains unclear whether

management affiliations would continue to be associated with impaired auditor independence

in the post-SOX period. While one provision of SOX may not be completely effective (the audit

committee taking direct responsibility for auditor appointment decisions) we cannot infer

whether other provisions of SOX (such as the cooling off period, the creation of the PCAOB,

mandated audit committee independence, management certifications, and mandatory audit

partner rotation) increased the effectiveness of audit committees or the integrity of

management.

Recent evidence indicates other provisions of SOX did result in an improved corporate

governance environment. Using data from 2004-2005, Naiker and Sharma (2009) examine how

auditor-audit committee affiliations are associated with internal control deficiencies and they

find auditor-audit committee affiliations are associated with higher levels of financial reporting

quality. In addition, Cohen et al. (2010) document that while auditors perceive management

heavily influences the auditor appointment decision post-SOX, the same auditors also indicate

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that many aspects of auditor independence have improved. For example, the survey results of

Cohen et al. (2010) report ’96 percent of the respondents in the current study indicated that

audit committees have become more effective in monitoring the financial reporting process’ (p.

769). Other studies, such as DeZoort et al. (2008) find similar findings in reporting ‘audit

committee support for an auditor-proposed adjustment is significantly higher in the post-SOX

period’.

Other aspects of SOX, such as the certification of financial statements by the CEO and

CFO, also seem to have impacted the aggressiveness of management. The survey results of

Cohen et al. (2010) state ’68 percent of the respondents indicated that the requirement for

management certification had a positive impact on the integrity of the financial reports’

(p.771). Thus, while management may still be involved in the appointment decision in the post-

SOX regime, the impact of management influence on audit quality remains unclear due to the

results of Naiker and Sharma (2009), along with the multiple other changes resulting from SOX.

While some evidence suggests improved corporate governance environments post-SOX

(e.g., Naiker and Sharma (2009), Cohen et al. (2010) and DeZoort et al. (2008)), prior literature

documents an association between management affiliations and diminished audit quality.

Therefore, we state our second hypothesis, stated separately for each of our proxies, as

follows:

H2a: Post-SOX, management affiliations are associated with impaired independence as measured by an increased propensity to meet/beat analyst earnings forecasts. H2b: Post-SOX, management affiliations are associated with impaired independence as measured by a decreased propensity to receive a going concern opinion.

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H2c: Post-SOX, investors perceive information (earnings surprises) to be of lower quality for affiliated firms as compared to unaffiliated firms as measured by the earnings response coefficient.

3. RESULTS

3.1 Data Collection and Sample Selection

Our initial sample consists of 10,764 auditor switches between 2004-2009 from Audit

Analytics.4 We then exclude switches resulting from mergers and acquisitions because the

factors influencing the auditor appointment decision are likely unique. We also exclude non-

Big4 appointments and focus solely on Big4 appointments for two main reasons. First, while we

hand-collect affiliation data for management members who had prior accounting experience at

any accounting firm, the large majority of individuals who have previous accounting experience

are alumni of the Big5.5 Second, we wish to be consistent with prior research examining

auditor affiliations in the pre-SOX regime which also focus on Big5 alumni and appointments

(e.g., Lennox and Park (2007).6 Finally, after eliminating financial firms, foreign firms, and firms

without necessary financial data, we begin our analysis with a sample of 473 auditor switches.

Panel A of Table 1 outlines our sample selection procedure.

Panel B of Table 1 provides a breakdown of our initial sample of 473 auditor

appointments and dismissals by Big4 auditor. We find that each of the Big4 audit firms was

4 While 2003 is technically post-SOX, many auditor switches in 2003 could be resulting from unique events, such as

the collapse of Arthur Andersen and subsequent reshuffling of Andersen clients. As a result, the generalizability of results based on 2003 is questionable). 5 In our final sample of 473 firms, 372 is the total number of individuals with prior experience and 17 are from non-

Big5 firms. 6 Lennox and Park (2007) track the Big5 while we only follow the Big4 because we did not track Arthur Andersen

alumni. While this may lead to additional measurement error, we do not feel the exclusion of Andersen alumni should bias our results significantly.

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appointed between 18.6-30.9% of our sample. This is fairly consistent with Lennox and Park

(2007) who document appointment rates of 18.1-23% for the Big5 audit firms between 1995-

2000. In addition, 27.5% of our sample switches are from a non-Big4 audit firm to a Big4 audit

firm.

[INSERT TABLE 1]

To identify Big4 alumni, as well as management affiliations, we supplement our dataset

from Audit Analytics with hand-collected affiliation information from a firm’s proxy statement

(def 14A) and/or form 10-K.7 If the biographical information mentions former employment

with any of the Big4 audit firms, the individual is labeled as alumni of the respective Big4 firm.

When the appointed audit firm is the same firm for which that individual had worked, we code

1 for the existence of a management affiliation with the respective Big4 firm and 0 otherwise.8

The descriptive statistics relating to our classification of Big4 alumni and auditor affiliations are

provided in Table 2. As seen in Panel A, 146 firms from our sample (30.87%) have at least one

Big4 alumni in management. Of those 146 firms which have Big4 alumni, and therefore have

the potential to create an ‘affiliation,’ we find that 52 companies (35.6%) appoint an auditor

which is the former employer of at least one management member. In Panel B, we examine

7 To identify Big4 alumni, we examine the proxy statement and 10-K of each firm immediately preceding the date

of the auditor switch to identify individuals who were employed at the time of the auditor switch. We also examine the def 14A and form 10-K filed immediately after the switch to ensure the individuals examined did in fact stay in place through the auditor switch. If there were changes in employees, we then examined whether the changes occurred before or after the auditor switch. We then read the disclosed biographical information of each management member and board members. For our analyses, we focus primarily on management alumni and management affiliations. 8 Our data collection process is subject to measurement error due to potentially incomplete disclosure of prior

positions of employment. The results of our data collection process understate the true number of Big4 alumni as well as the number of affiliates due to some companies only disclosing the mandated five-year employment history. This potential measurement error will bias against our results and we cannot identify any reason why this error could drive our findings.

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whether some firms have multiple Big4 alumni. We find the large majority of firms have only 1

management member who is a Big4 alumni.

[INSERT TABLE 2 HERE]

In Panel C, we breakdown the specific job titles of the Big4 alumni using the job titles

provided in the company’s proxy statement.9 We find that of management members with Big4

experience, almost half (49.4%) are employed as the chief financial officer. Because a large

majority of the Big4 alumni are either CFOs or controllers, both positions which interact with

the external auditors regularly, we examine whether these affiliations impact the auditor

appointment decision.

In Table 3, we provide descriptive statistics to compare firms who do, and don’t, appoint

affiliated, audit firms. We examine these statistics to see how our ‘affiliated’ firms compare to

our total population of switch firms. Mean and median comparisons indicate that firms which

appoint an affiliate are slightly smaller and less profitable but basic t-tests indicate these

differences are insignificant.


3.2 APPOINTMENT DECISION

To test our first hypothesis, whether management affiliations impact auditor

appointment decisions, we employ a logistic regression modeling the probability of appointing

9 We include the breakdown of job titles purely for descriptive purposes. We recognize there may be variation in

the titles and responsibilities between firms. However, our results are unaffected by variation in classification as we only run our regressions at the aggregate level.

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an affiliate auditor. More specifically, we utilize a similar logistic model (Equation 1) to that of

Lennox and Park (2007). Our dependent variable (Appt_xx) is a dichotomous variables equal to

1 if the appointed auditor is the former employer of at least one member of the client’s

management and 0 otherwise. We use Equation 1 to examine how management affiliations

impact the appointment decision.

Our variable of interest is Mgmt_xx, a dummy variable =1 if at least one member of

management is affiliated with firm ‘xx;’ 0 otherwise. If Mgmt_xx is a valid proxy for

management influence on the audit committee, we expect to be positive and significant.

While the auditor appointment decision is not completely understood, we attempt to control

for certain factors which may impact a client’s decision of which firm to appoint. Prior studies

have examined how audit quality and fee premiums can be affected by an auditor’s

classification as an industry specialist. Because it is feasible to expect firms to appoint an

industry specialist, in addition to prior findings that industry specialists are associated with

increased audit quality (Reichelt and Wang, 2010), we control for industry specialization

(Industry Spec). While many industry specialization classifications exist, the results reported in

Table 4 use a national specialist definition employed by Reichelt and Wang (2010).10 We also

control for firm size and for whether the company’s former auditor was a Big4 auditor. While

these controls may be sufficient, the possibility exists that each Big4 auditor has a unique type

10 To ensure our results were not sensitive to our definition of industry specialist, we tested multiple other measures of industry specialists. In untabulated results, we utilized four additional measures of national specialization and our results did not change. In addition, we included ten different classifications of both local and joint industry specialization and our results continued to be consistent across these alternative classifications.

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of clientele and a firm switching auditors may choose an auditor simply because the company

most closely matches the clientele of a single Big4 audit firm. To attempt to control for this

possibility, we utilize the Match_xx variable used in Lennox and Park (2007). The Match_xx

variable is generated based on the size, financial health, and two-digit industry code of the

clientele of each Big4 auditor and represents the probability of appointing a specific Big4 audit

firm based on a match between the client’s characteristics and the characteristics of the audit

firm’s clientele. Using all clients of Big4 auditors from 2004-2009, we generate the likelihood a

company matches the clientele of each of the Big4. Match_xx is coded as a 1 for the audit firm

which is most likely to be appointed and 0 otherwise.

We evaluate Equation 1 at the audit firm level; that is, we run the probability of

appointing PWC in column 1, the probability of appointing Ernst & Young in column 2, the

probability of appointing KPMG in column 3, and the probability of appointing Deloitte in

column 4. Because it is impossible for the outgoing auditor to be appointed in an auditor

switch decision, we exclude all switches for which the auditor of interest is the outgoing

auditor.


The results in Table 4 suggest, for three of the Big4 auditors, management affiliations

have a significant impact in auditor appointment decisions. Management affiliations only fail to

have a significant impact on the appointment decisions when Deloitte is appointed.11 This

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The primary cause of an insignificant relation between affiliations with Deloitte and the propensity to appoint Deloitte appears to be driven by the relation between ‘Former Big 4’ and the appointment of Deloitte. Deloitte is appointed more often by firms which had a Big4 auditor prior to the switch. Through additional inspection, we found a much larger proportion of Deloitte appointments had other, non-Deloitte, Big4 alumni, many of which were affiliated with the previous auditor.

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evidence indicates that management still has a significant influence on the auditor appointment

decision in the post-SOX regime.

While we are unable to conclusively state whether this association is in violation of the

letter of Sarbanes-Oxley, the results seem inconsistent with the intent of Sarbanes-Oxley. In

2003, William H. Donaldson, SEC Chairman, stated “The audit committee must be directly

responsible for the appointment, compensation, retention and oversight of a company's

outside auditors.”

Our evidence suggests management affiliations significantly impact appointment

decisions, which calls into question whether audit committees act independently of

management in the appointment of the external auditors. While other studies (i.e., Cohen et

al. (2010) and Filleau (2009)) suggest management may still be involved in the appointment

decision post-SOX, our results provide, to our knowledge, the first large-sample empirical

evidence of management influence on auditor appointment decisions post-SOX.

While our results do suggest management is involved in auditor appointment decisions,

the results from Table 4 do not address how management influenced the appointment decision

nor do they point to whether this management involvement has negative consequences. We

attempt to provide additional evidence on the impact of management affiliations by examining

how proxies of audit quality are impacted by management affiliations. Because the proxies of

audit quality are imperfect, we examine multiple proxies in an attempt to find corroborating

evidence as to the impact of management affiliations.

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3.3 AUDITOR INDEPENDENCE

Propensity to Meet/Beat Analyst Forecasts:

The first proxy of audit quality we utilize to examine the impact of management

influence on auditor independence is the propensity for a firm to meet/beat analyst forecasts.

Prior literature has shown the importance of meeting forecast targets to managers (e.g., Barth

et al. 2002, Kasznik and McNichols 2002). In an earlier study examining the impact of

affiliations pre-SOX, Menon and Williams (2004) document that affiliations are associated with

an increased (decreased) propensity to meet/beat (miss) analyst forecasts. We run two logistic

regressions to examine the impact of affiliations on a firm’s ability to meet/beat analyst

forecast targets (equation 2).

(equation 2)

Our variable of interest (Affiliation_xx) is the affiliation between management and the

external auditor. We expect that firms with a management affiliation, our proxy for

management influence on the audit committee, will be positively (negatively) associated with

the ability to meet/beat (miss) analyst forecasts. We also include the natural log of the market

value of equity (LMVE) in our regression. Prior studies have found the market value of equity to

be positively associated with the likelihood of meeting or beating the analyst forecast (Barton

and Simko (2002)). Prior studies have also found firms with ‘bloated’ balance sheets are less

likely to manage earnings to meet forecasts (Barton and Simko (2002)). Therefore, we predict a

negative coefficient on net operating assets (NOA). We control for downward revisions

(Down_Rev) in the final month of the fiscal year because firms’ ability to meet analysts’

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forecasts may be reflective of its ability to manage analysts’ expectations. Lastly, similar to

Menon and Williams (2004), we include firm age (Firm_Age), capped at nine. Prior studies have

found young firms to be more likely to make small profits (Dechow et al. (2003)) and so we

expect a negative coefficient on firm age.

We use two different classifications in these regressions. First, due to our small sample,

we use two broad classifications to analyze if management affiliations affect whether a firm

misses or meets/beats its’ target. We code miss = 1 if (actual-forecast) < 0 and miss = 0

otherwise. We code meet/beat = 1 if (actual – forecast) >= 0 and meet/beat = 0 otherwise.

While the results using meet/beat and those using miss are symmetric, we show both for

completeness. Table 5 suggests that affiliations have a significant positive (negative) impact on

the propensity to meet/beat (miss) analyst forecast targets.


In addition, we used the same classifications as Menon and Williams (2004) where three

different classifications were used. ‘Just miss’ is defined as -.02 <= (actual – forecast) < 0, ‘just

meet’ is defined as 0 <= (actual-forecast) <= .01, and ‘beat’ is defined as 0 <= (actual-forecast),

similar to our meet/beat classification in our previous classification. We report these results

(see Table 6) to be consistent with Menon and Williams (2004); however, due to our small

sample size, very few firms are classified as ‘just meet’ and ‘just miss,’ reducing the power of

our results. The results from this classification are consistent with the earlier results in that

affiliations have a positive impact on a firm’s ability to ‘just meet’ and ‘beat’ analyst forecasts.

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However, while this ‘just miss’ classification has the expected sign, it is insignificant. We believe

this insignificant result is primarily due to the fact that less than 16% of the firm-years in our

sample meet this narrow definition of ‘just miss.’


Propensity to receive a going concern opinion:

Our second proxy of audit quality is the propensity to issue a going concern opinion.

Going concern opinions have been used in prior studies as an alternative measure of audit

quality and auditor independence (e.g., Lennox (2005), DeFond et al. (2002), Francis and Yu

(2009)). Using our sample of ‘switch’ firms, we examine audit opinions from 2004-2009 and

identify which opinions were provided by an ‘affiliated’ auditor. We then examine a logistic

regression with the presence or absence of a going concern opinion as the dependent variable

(equation 3).

(equation 3)

We utilize a similar model as used by DeFond et al. (2002). Our variable of interest,

Affiliation, represents the influence of management on the audit committee and we expect

<0. Our control variables, defined in Table 7, have been used in other studies examining the

propensity to receive going concern opinions and we have similar predictions to those of

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DeFond et al. (2002).12 The results in Table 7 indicate that firms with an affiliated auditor have

a lower propensity to receive a going concern opinion. The evidence based on the going

concern opinion proxy is consistent with the meet/beat results; that is, affiliations seem to be

associated with lower levels of audit quality proxies.13 In summary, our results from Tables 5, 6

and 7 suggest that auditor affiliations have a significant impact on audit quality.


Lastly, we attempt to provide evidence on the impact of affiliations on perceived

independence by examining how earnings response coefficients (ERCs) are affected by

affiliations. We are unaware of any prior studies which examine investors’ reactions to

management affiliations. However, earnings response coefficients have been examined in

other settings, such as Francis and Ke (2006) who examine how earnings response coefficients

are affected by the presence and magnitude of non-audit fees. Using a similar model as Francis

and Ke (2006), we find (see equation 4) that, subsequent to the formation of an affiliation,

earnings response coefficients decrease significantly.

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Our predictions are consistent with DeFond et al. (2002). For brevity, the control variables are defined in Table 7. 13

We are aware that many other proxies could be used. For example, the propensity to issue a restatement could be utilized. However, because our sample includes very recent auditor switches, we would be unable to fully capture restatements which may not be identified until a later date. We did use abnormal accruals but the results were marginal and extremely sensitive to specification. However, prior research finds mixed results for the impact of affiliations on abnormal accruals (Menon and Williams (2004), Krishnan and Dowdell (2008), and Geiger et al. (2008)) and so the expected results are unclear.

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(equation 4)

Using a 3-day cumulative abnormal return as our dependent variable, our variable of

interest is PostAffFERR, which captures investors’ reaction to earnings surprises, after an

auditor switch, with an affiliation (see Table 8). Our control variables are all defined in Table 8.

Because prior research has identified four ERC determinants (growth opportunities, risk,

earnings persistence, and the risk-free rate), we control for these determinants along with

other factors which have been show to impact earnings response coefficients.14 The coefficient

on PostAffFERR is negative and significant, providing evidence that ERCs decrease after the

creation of a management affiliation. Our control variables are defined in Table 8. The

decrease in ERCs in the presence of affiliations is consistent with an impairment of

independence in appearance due to auditor affiliations.


4. CONCLUSION:

In summary, our results indicate management influence, proxied by management

affiliations, impacts auditor appointment decisions. In addition, we provide evidence

management influence is associated with impaired independence. SOX was aimed, in part, at

removing the influence of management on auditor appointment decisions to improve auditor

14

For a full discussion of these variables, see Francis and Ke (2006).

22

independence. Our initial results call into question whether Section 301 of SOX has eliminated

the influence of management on auditor appointment decisions. Given the impact of

management influence on auditor appointements, we examine the impact of this influence on

auditor independence, as measured by the propensity to meet/beat analyst forecasts, the

propensity to receive a going concern, and earnings response coefficients. We document that

management affiliations are associated with increases in the propensity to meet/beat analyst

forecasts and decreases in the propensity to receive a going concern. In addition, investors

seem to react negatively to these affiliations, indicating a perceived lack of independence due

to management affiliations. These results suggest that, while other mechanisms to enhance

audit quality were put in place by SOX, the presence of management influence continues to

negatively impact audit quality. Collectively, our results indicate affiliations impact not only the

appointment decision but also subsequent auditor independence. As a result of these negative

implications, we encourage additional research pertaining to other consequences, and possible

mitigating factors, of management-auditor affiliations.

23

5. REFERENCES

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Going-Concern Reports. The Accounting Review 78, No. 1: 95-117. Cohen, J., G. Krishnamoorthy, and A. Wright. 2010. Corporate Governance in the Post Sarbanes-Oxley

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Advances in quantitative analysis of finance and accounting, 3(Part A), 85–110. DeAngelo, Linda. 1981. Auditor Size & Audit Quality. Journal of Accounting and Economics 3, No. 3:

183-199. Dechow, P., S. A. Richardson, and I. Tuna. 2003. Why are earnings kinky? An examination of the

earnings management explanation. Review of Accounting Studies 8 (June-September): 355-384. DeFond, M. and Francis, J. 2005. Audit Research after Sarbanes-Oxley. Auditing: A Journal of Practice

and Theory 24 (supplement): 5-30. Defond, M. Raghunandan, K. and K.R. Subramanyam. 2002. Do Non-audit Service Fees Impair Auditor

Independence? Evidence from Going Concern Audit Opinions, Journal of Accounting Research 40, No. 4 (Sep 2002): 1247-1274.

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Donaldson, William H. “Testimony Concerning Implementation of the Sarbanes-Oxley Act of 2002.”

September 9, 2003. Dopuch, N., King, R., Schwartz, R., and P Zhang. 2003. Independence in Appearance and in Fact: An

Experimental Investigation, Contemporary Accounting Research 20, No. 1: 79-119. Fiolleau, K., K. Hoang, K. Jamal, and S. Sunder. 2010. Engaging Auditors: Field Investigation of a

Courtship. Working paper. Francis, J., and B. Ke. 2006. Disclosure of Fees Paid to Auditors and the Market Valuation of Earnings

Surprises. Review of Accounting Studies 11, No. 4: 495-523. Francis, J. and M. Yu. 2009. Big 4 Office Size and Audit Quality. The Accounting Review 84, Issue 5:

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Geiger, M., C. Lennox, and D. North. 2008. The hiring of accounting and finance officers from audit firms: how did the market react? Review of Accounting Studies 13, No. 1: 55-86.

Iyer,V. 1998. Characteristics of Accounting Firm Alumni Who Benefit Their Former Firm. Accounting

Horizons 13, No. 1: 18-30. Kasznik, R., and M. McNichols. 2002. Does meeting expectations matter: Evidence from analyst

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management pressure, The Accounting Review 60 (April): 202-211. Krishnan, J. and T. Dowdell Jr. 2004. Former Audit Firm Personnel as CFO’s: Effect on Earnings

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and Economics 39, No. 2: 201-231. Lennox, C. Geiger, North. 2008. The Hiring of Accounting and Finance Officers from Audit Firms: How

did the market react? Review of Accounting Studies, forthcoming Lennox, C. and C. Park. 2007. Audit Firm Appointments, Audit Firm Alumni, and Audit Committee

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25

Menon, K. and D. Williams. 2004. Former Audit Partners and Abnormal Accruals. The Accounting Review 79, No. 4: 1095-1118.

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U.S. Congress. 2002. Sarbanes-Oxley Act Section 301.

26

TABLE 1:

Sample Construction and Auditor Switch Descriptive Statistics

Panel A: Sample Construction

Auditor Switches from Audit Analytics (2004-2009) 10,764

Less:

Switches resulting in a non-Big 4 appointments (8,852)

M&A-related switches and non-financial audits (150)

Foreign Firms or Observations without necessary data (1,147)

Financial Firms (SIC 6029-6999) (142)

Auditor Switches in Final Sample 473

Panel B: Incoming/Outgoing Audit Firms

Audit Firm N % N %

Deloitte & Touche 124 26.2% 74 15.6%

Ernst & Young 146 30.9% 90 19.0%

KPMG 115 24.3% 80 16.9%

PWC 88 18.6% 99 20.9%

Non-Big4 Firm - - 130 27.5%

TOTAL 473 100% 473 100%

Incoming Auditor Predecessor Auditor

27

TABLE 2:

Auditor Affiliation Descriptive Statistics

Panel A: Auditor alumni and the formation of affiliations

Management Affiliations

Appointment

of Unaffiliated

Auditor

Appointment

of Affiliated

Auditor Totals

Firms with no Big4 Alumni in Management 327 0 327

Firms with at least 1 Big4 Alumni in Management 94 52 146

Totals 421 52 473

Panel B: Dispersion of Management Members with Big 4 Experience

# of management per company with Big 4 Experience # of Companies

1 125

2 20

3 1

Total 146

Panel C: Positions of Management Members with Big 4 Experience

Management: # of Mgmt

CFO 83

Controller 26

Other 19

CAO 16

VP of Finance 8

Treasurer 8

CEO 8

TOTAL 168

28

TABLE 3: Financial Descriptive Statistics

Panel A: Firms With No Affiliation

Mean Standard

Deviation

Lower

Quartile

Median Upper

QuartileLong-Term Debt - Total 827.45 2248.49 0.36 59.92 527.48

Assets - Total 4769.63 21422.90 174.50 593.57 2641.06

Income Before Extraordinary

Items

79.18 756.09 -17.04 11.89 66.43

Market Value of Equity 2851.38 11447.60 180.94 525.97 1842.12

Current Ratio 3.08 3.89 1.27 2.13 3.27

Total Equity 1025.52 3515.39 64.66 235.38 704.10

Special Items -57.11 479.79 -10.89 0.00 0.00

NationalLeader1 0.13 0.33 0.00 0.00 0.00

FormerBig4 0.72 0.45 0.00 1.00 1.00

Panel B: Firms With An Affiliation

Mean Standard

Deviation

Lower

Quartile

Median Upper

QuartileLong-Term Debt - Total 541.37 1040.18 2.18 180.10 484.18

Assets - Total 1631.45 3036.29 252.50 611.35 1452.27

Income Before Extraordinary

Items

-1.28 331.76 -19.39 7.25 49.62

Market Value of Equity 1354.93 2432.68 234.46 441.31 1423.00

Current Ratio 2.66 2.70 1.33 1.65 2.63

Total Equity 501.81 888.08 67.91 242.72 549.23

Special Items -17.94 95.92 -10.53 -1.83 0.00

NationalLeader1 0.09 0.28 0.00 0.00 0.00

FormerBig4 0.87 0.34 1.00 1.00 1.00

29

TABLE 4: The Impact of Management Affiliations on Auditor

Appointment Decisions

Notes: The sample sizes for each model are different as a result of excluding switches which dismissed the auditor being examined (as the probability of that firm being appointed is, of necessity, 0). For a firm to be in our sample we required an auditor switch and so the dismissed auditor could not be appointed. Due to different dismissal rates for each of the Big4, the resulting sample sizes for each model is unique. MgmtAlum_XX = 1 if the company appoints Firm XX as their new auditor and the company has a member of management which was formerly employed by Firm XX and 0 otherwise. For example, in the model estimating the probability of appointing KPMG, MgmtAlum_KPMG = 1 if a firm appoints KPMG and their CFO is a former KPMG partner. Specialist_XX = 1 if the company appoints Firm XX as their new auditor and the new auditor is classified as a specialist in the company’s industry. The results in this table are generated by using a classification of national industry specialist utilized by Reichelt and Wang (2010). Ln(Assets) = log of total assets in the year of the auditor switch.

Exp.

Sign

Panel A:

EYPanel B:

PWC

Panel C:

KPMG

Panel D:

DeloitteMgmt_xx + 0.6791 0.9022 0.8002 0.0443

1.47* 2.44*** 1.81** 0.11

IndustrySpec + 0.4097 0.0927 -0.8207 -0.17071.21 0.24 -1.92** -0.47

ln(AT) ? 0.1392 0.0496 -0.0613 -0.1106

1.71** 0.5600 -0.76 -1.35*

FormerBig4 ? -0.1063 0.4723 0.0893 1.3614

-0.38 1.53* 0.28 3.98***

Match_xx 0.4538 0.0134 1.2196 0.6322

1.74** 0.0300 2.94*** 1.78**

Intercept -1.66 -1.8481 -0.755 -1.2154

-2.89*** -3.20*** -1.61* -2.49***

Pseudo R2

2.06% 2.80% 4.74% 5.58%

N 314 310 327 329

Coefficients (z-statistics) are reported from our logistic regression, with standard

errors that are robust to heteroscedasticity.

***, **, * significant at one-tailed p<.01, p<.05, p<.10 levels

30

Former Big 4 = 1 if the dismissed auditor was a Big 4 auditor and 0 otherwise. Match_xx = 1 if the client undergoing an auditor switch is more closely aligned with the clientele of the auditor of interest. This variable was utilized in Lennox and Park (2007) and is based on the average client of each of the Big 4 firms. By then examining a specific company’s size, financial health, and two-digit SIC industry code, we compute the probability that the company matches the clientele of each Big 4 auditor. Match_xx = 1 if the company matches the clientele of the audit firm of interest more than the clienteles of the other Big 4 auditors and 0 otherwise.

31

TABLE 5: The Impact of Affiliations on the Propensity to Meet/Beat

Analyst Forecasts

Notes: Affiliation = 1 if an affiliation exists in the firm-year of the observation; 0 otherwise. LMVE = log(market value of equity) NOA = Net operating assets DOWN_REV = 1 if the analyst forecast was revised downward in the final month of the year; 0 otherwise. Firm_Age = the number of years a firm has been listed on Compustat.

Exp.

Sign Meet/Beat

Exp.

Sign Miss

Intercept -0.2531 0.2531

(0.5161) (0.5161)

Affiliation + 0.5622 - -0.5622

(0.2859)** (0.2859)**

LMVE + 0.2790 - -0.2790

(0.0466)*** (0.0466)***

NOA - -0.1502 + 0.1502

(0.0450)*** (0.0450)***

DOWN_REV 1.4877 -1.4877

(0.2221)*** (0.2221)***

Firm_Age - -0.1216 + 0.1216

(0.0488)*** (0.0488)***

Pseudo R2 10.09% 10.09%

N 1484 1484

Year FE YES YES

Ind FE YES YES

Clustered By Firm Firm


Coefficients (standard errors) are reported from our logistic regression,

with standard errors that are robust to heteroscedasticity.

32

TABLE 6: The Impact of Affiliations on the Propensity to Meet/Beat

Analyst Forecasts

Notes: Affiliation = 1 if an affiliation exists in the firm-year of the observation; 0 otherwise. LMVE = log(market value of equity) NOA = Net operating assets DOWN_REV = 1 if the analyst forecast was revised downward in the final month of the year; 0 otherwise. Firm_Age = the number of years a firm has been listed on Compustat.

Exp.

Sign Just Meet Beat

Exp.

Sign Just Miss

Intercept -0.5772 -0.2531 -1.2962

(0.6684) (0.5161) (0.7706)**

Affiliation + 0.3919 0.5622 - -0.0818

(0.0.2853)* (0.2859)** (0.2703)

LMVE + 0.1038 0.2790 - -0.0867

(0.0651)* (0.0466)*** (0.0586)*

NOA - 0.0390 -0.1502 + -0.0058

(0.0567) (0.0450)*** (0.0488)

DOWN_REV -0.2545 1.4877 -0.9547

(0.2148) (0.2221)*** (0.3370)***

Firm_Age - -0.0445 -0.1216 + -0.0010

(0.0587) (0.0488)*** (0.0657)

Pseudo R2 5.12% 10.09% 4.35%

N 1484 1484 1484

Year FE YES YES YES

Ind FE YES YES YES

Clustered By Firm Firm Firm


Coefficients (standard errors) are reported from our logistic

regression, with standard errors that are robust to

33

TABLE 7: The Impact of Affiliations on the Propensity to Receive a Going

Concern Opinion

Notes: Affiliation = 1 if a management affiliation exists in the firm-year of the observation; 0 otherwise. Zscore = probability of bankruptcy score (Zmijewski [1984]) Beta = the firm’s beta over the fiscal year Abnormal Ret = firm’s abnormal stock return over the fiscal year Volatility = the variance of the residual from the market model over the fiscal year Leverage = total liabilities over total assets at the end of the fiscal year Change Lev. = change in leverage during the fiscal year

Coefficient Std. Error Coefficient Std. Error

Intercept 339.4 (44.7590)*** -3.3864 (7.6726)

Affiliation -6.2783 (0.4018)*** -11.2942 (0.4005)***

Zscore -0.0149 (0.0081)** -0.0170 (0.0101)**

Beta 0.0541 (0.0905) 0.0527 (0.0934)

Abnormal Ret 0.0010 (0.0051) 0.0007 (0.0054)

Volatility 1.0405 (1.8188) 0.8798 (1.7946)

Leverage 0.0008 (0.0043) 0.0009 (0.0043)

Change Lev. 0.0027 (0.0025) 0.0028 (0.0024)

Loss(t-1) 1.1063 (0.7020)* 1.0774 (0.7080)*

Op. Cash Flows -1.4701 (1.0484)* -1.5254 (1.0487)*

Reporting Lag -0.0002 (0.0020) -0.0001 (0.0020)

Asset -0.8695 (0.2973)*** -0.8720 (0.2878)***

Investment -0.9739 (1.2018) -0.9875 (1.1719)

Firm Age -5.7483 (0.7515) 0.0638 (0.1299)

Industry Spec. 1.3598 (0.5298)*** 1.3697 (0.5313)***

N 1407 1407

Year FE YES NO

Ind FE YES YES

Clustered By Firm Firm

Propensity to Issue a Going Concern Opinion

Coefficients (standard errors) are reported from our logistic regression, with

standard errors that are robust to heteroscedasticity.


34

Loss(t-1) = 1 if a loss was reported in the previous year, 0 otherwise. Operating Cash Flows = operating cash flows scaled by total assets at fiscal year end Reporting Lag = the number of days between fiscal year-end and earnings announcement date Asset = log of total assets at the end of the fiscal year Investment = short- and long-term investment securities scaled by total assets at the end of fiscal year Firm Age = the number of years a firm has been listed in Compustat Industry Specialist = 1 if the auditor meets the national industry specialist definition used by Reichelt and Wang (2010); 0 otherwise.

35

TABLE 8: The Impact of Affiliations on Earnings Response Coefficients

Notes: Affiliation = 1 if an affiliation exists in the firm-quarter of the observation; 0 otherwise. Post = 1 if the firm-quarter observation is after the auditor switch; 0 otherwise. FERR = the forecast error of the firm-quarter of the observation. GROWTH = analysts’ median 5-year long term earnings growth forecast in the fiscal quarter (in percentage) Stdret = the standard deviation of daily stock returns over a 90-day window ending 7 days prior to the earnings announcement date, with a required minimum of 10 non-missing daily returns

Coefficient Std. Error

Intercept -0.3386 (0.5579)

Affiliation -0.6638 (0.6873)

post -0.2944 (0.6713)

Post*Aff 0.6210 (1.6062)

Post*FERR 11.9622 (2.0454)***

Post*Aff*Ferr -17.0750 (7.1332)***

FERR*GROWTH 0.1545 (0.2846)

FERR*Stdret 18.5877 (68.9968)

FERR*DE -0.0979 (0.0335)***

Post*NLeader 1.5263 (1.4648)

Post*nonbig4 -0.7992 (1.1180)

FERR*LNMV 0.5550 (0.5028)

FERR*ABSFERR -1.5536 (0.7381)**

FERR*LOSS -0.1444 (2.3555)

FERR*FQTR4 2.1407 (0.6132)***

FERR*RESTRUCTURE -3.8738 (3.5188)

R2 0.0835

N 1667

Year FE YES

Ind FE YES

Clustered By Firm

Earnings Response Coefficients

Coefficients (standard errors) are reported from our

regression, with fixed effects and clustering noted above.

***, **, * significant at one-tailed p<.01, p.05, p<.10 levels

36

DE = ratio of total (short and long term) debt to total equity AbsFERR = absolute value of FERR NLeader =national leader as defined by Reichelt and Wang (2010) nonbig4 = if the switch contained a dismissal by a non-big4 auditing firm. LNMV = log(market value of equity) at beginning of the quarter LOSS = 1 if the quarterly earnings are negative; 0 otherwise. FQTR4 = if the firm-quarter observation is fiscal quarter 4; 0 otherwise. RESTRUCTURE = 1 if special items as a percentage of total assets is less than or equal to -5%; 0 otherwise.

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