Introduction
There have been cases of corporate scandals in the recent past including the Enron, Tyco, WorldCom, and Global Crossing to name a few. These scandals fueled concerns regarding the financial reporting standards not only in the USA but also in economies where the financial markets tumbled as a consequence of the news of such scandals becoming public. These scandals arose because of weaknesses in internal controls and lack of independence by external auditors. For instance in the Enron, case, the external audit firm known as Arthur Andersen was criticized for lack of independence both in fact and appearance. The external auditors offered both external audit and non-audit services to Enron. A number of the members of audit committee at Enron previously worked for Arthur Andersen creating a close affinity with external auditors. Consequently, the Sarbanes-Oxley Act was enacted in 2002 to remedy some of the underlying factors that facilitated the corporate scandals. The major provisions of the Act include:
Executive officers should certify every Form 10-K as well as Form 10-Q that are filed with Securities and Exchange Commission (SEC)
The CFO and CEO must make a formal written statement as an accompaniment to the financial statement explicitly indicating theta the financial statements are a true and fair reflection of the financial position and performance of the corporation.
The CFO and CEO must also make a formal written statement to the effect that they have reviewed the effectiveness of the corporation’s internal controls and that any material weaknesses or deficiencies have been reported.
The internal controls must be assessed and reviewed by the external auditors and the finding included in the audit report.
Prohibition of external auditors from providing certain non-audit services that mat create a conflict of interest.
Establishment of the Public Company Accounting Oversight Board (PCAOB) that is mandated to promulgate audit standards for public corporations and inspect external auditors.
Imposed harsher fines and penalties for corporate fraud.
The Sarbanes-Oxley Act raised the bar for external audit standards due to the increased scrutiny of the internal controls. There was an increase in the number of corporations that receive adverse audit opinions on the basis of the weaknesses in the internal controls which adversely impacted the relationship between external auditors and their clients. Consequently, corporations that feel victimized felt the urge to scout for new external auditors who will give the corporation an unqualified audit report. There was a spike in audit opinion shopping or auditor switching which intuitively can be predicted to dent external auditors’ independence. External auditors may feel pressured to give an unqualified opinion even in situations that warrant a qualified opinion for the fear of being dropped as the external auditors to the affected firm. External auditors report add credibility and reliability to financial statements because they conduct independent audits. However, if the audit opinion is shaped by the client expectation and demand then the quality of the audit is put to question. There was concern that the Sarbanes Oxley Act remedied one problem but created a new one. Subsequently, there has been extensive research on the impact of opinion shopping or auditor switching. This paper explores the concept of audit opinion shopping or auditor switching. It further highlights the findings of existing empirical literature on various aspects. Specifically, it will explore the impact of audit opinion shopping on the quality of audit report, the factors that influence auditor switch after an adverse audit opinion is issued and the effect of auditor switch on shareholders’ wealth in the pre and post Sarbanes Oxley Act.
Audit Opinion Shopping/Auditor Switching
In this section, a detailed explanation of what audit opinion shopping entails will be made. Audit opinion shopping is defined by the Securities and Exchange Commission as the practice of looking for external auditors who are willing to support of given accounting treatment that allows the corporation to achieve certain preconceived objectives even though such adoption may impair the true and fair representation of the financial statement. Corporations have a legal right to switch auditors when they deem fit. However, switching auditors for the sole of enforcing certain positions that are contrary to the applicable accounting standards may compromise the quality of the audit.
An external audit is a legal requirement for publicly listed corporations under the Sarbanes Oxley Act, Corporations Act and the various accounting regulatory frameworks that government the preparation and presentation of financial statements. Auditors are required to give an audit opinion as to whether the company has strong internal controls, the financial statements are free from material error and fraud and whether the financial statements are a true and fair reflection of the financial position and financial performance of the corporation. The external audit opinion maybe qualified or unqualified. An unqualified opinions is issued if the corporation financial statements are presented fairly in all material respect and in accordance with the applicable accounting framework. Otherwise, an adverse opinion is issued. Corporations that suspect that they are likely to receive a qualified opinion based on their engagement with external auditors may engage in opinion shopping to find external auditors who will ignore any inadequacies on the internal controls or the preparation of the financial statements and issue an unqualified opinion.
Empirical Evidence
Alali & Rubina (2013) explored opinion shopping behavior during the financial crisis and economic downturn. Their study period was 2008-2011. Alali & Rubina (2013) argue that during a financial crisis or economic downturn many corporations experience financial difficulties creating the pressure to engage in creative accounting to report favorable results that may deviate from the actual performance. Besides, the risks to the going concern assumption are higher during such periods. Therefore, that corporations are increasingly motivated to switch auditors in order to obtain a favorable opinion. Alali & Rubina (2013) use a sample of 9.942 firm-year observations derived between the periods of interest to test the hypothesis by investigating whether corporations that received and those that did not receive a going concern audit opinion are more likely to receive a favorable audit opinion if they switch auditors.
Alali & Rubina (2013) hypothesize that corporations that have received a going concern report in the past are more likely to receive a going concern audit report in the subsequent financial period. Besides, they are more likely to switch auditors to increase the likelihood of obtaining a going concern audit report in the subsequent period. Alali & Rubina (2013) also predict that corporations that are undergoing financial difficulties are more likely to participate in opinion shopping.
The study findings reveal that both a switch of auditors and receipt of a going concern opinion in a given period reduces the likelihood of receipt of a clean audit opinion in the year during which the change is implemented. However, the study does not find any significant empirical evidence that to support the hypothesis that corporations that received a favorable audit opinion in the past are more likely to receive a going concern opinion after changing auditors. The results hold even when robustness tests are conducted.
The study provides insights on the relationship between opinion shopping behavior and receipt of a favorable audit opinion specifically during period of financial and economic difficulties. The study shows that in fact opinion shopping has no impact on the audit report that a corporation receives. The findings can be interpreted as plus for the effectiveness of the Sarbanes Oxley Act in upholding integrating and mitigating corporate scandals. The increased scrutiny created by the Act counter the potential risks of comprises in audit quality created by audit opinion shopping.
Thevenot and Hall (2011) study the factors that influence a firm’s decision to switch auditors or stick with their existing external auditors when they get an adverse audit opinion on the basis of weaknesses in the internal controls. Internal controls weaknesses can be classified into two: account-specific or entity-level. Account-specific are those weaknesses that relate to specific financial statement entries such as receivables or inventory. They are regarded as less severe. On the other hand, entity-level affect a broader dimensions impacting of several accounts. Examples include segregation of duties or revenue recognition. Thevenot and Hall (2011) hypothesize that a report both internal control weaknesses heightened levels is likely to influence a firm decision to switch auditors after the receipt of an adverse audit opinion.
Thevenot and Hall (2011) argue that there is empirical evidence that audit fees charged to firms with internal control deficiencies is higher than those that have strong internal controls because of the effort required to conduct the external audit. Audit fees are also likely to be lower after an auditors switch because the firm can bargain for lower fees. Therefore, Thevenot and Hall (2011) hypothesize that there is a positive relationship between audit fees and the likelihood of an auditor switch after an adverse audit report. Thevenot and Hall (2011) suggest that the decision to switch is likely to be influenced by the strength of the relationship between the firm and the auditor. If they have a strong, bond, the firm is less likely to switch auditors even after an adverse opinion has been issued by the auditors. The strength of the relationship between the auditor and the client is proxied by the length of the relationship in years. They hypothesize that there is a positive relationship between the length of the relationship and the likelihood to switch auditors after an adverse audit report. Thevenot and Hall (2011) also point to empirical evidence that high risk clients, including those with internal control deficiencies, are more likely to hire small audit firms as opposed to the Big 4. Therefore, they hypothesize that a firm is likely to change auditors after receipt of an adverse opinion if the incumbent auditor was one of the Big 4.
The study uses a sample of 765 firms that received an adverse audit opinion in 2004 of which 116 changed their auditors and 649 retained their existing auditors in the subsequent year. Thevenot and Hall (2011) use a logistic regression with the probability to switch auditors being the dependent variable. The independent variables are the number of internal weaknesses reported, total fees, length of the auditor’s tenure and a dummy for a Big 4 auditor. In addition, the regression controls for market capitalization and industry characteristics.
The study finds no significant evidence to support the hypothesis that there is a positive relationship between the number of account specific deficiencies and the likelihood to switch auditors. The study also finds limited significant evidence to support the hypothesis that there is a positive relationship between the number of entity-level deficiencies and the likelihood to switch auditors.
Thevenot and Hall (2011) find significant evidence to support the hypothesis that there is a positive relationship between audit fee and the likelihood to switch auditors. Thevenot and Hall (2011) find significant evidence that is contrary to their expectation on the relationship between the length of audit tenure and the likelihood to switch auditors. The relationship is negative and significant at 5 percent. Thevenot and Hall (2011) also find significant evidence to support the hypothesis that a firm is likely to change auditors after receipt of an adverse opinion if the incumbent auditor was one of the Big 4.
Stunda & Pacini (2013) examine the effects of audit opinion and switching auditors on shareholders wealth in the pre-Sarbanes Oxley Act and in the post-Sarbanes Oxley Act. An auditor switch may result in negative or positive stock price reaction depending on the circumstances surrounding the switch. Similarly, it may affect trade volumes. Stunda & Pacini (2013) argue that the Sarbanes Oxley Act introduced stringent scrutiny of the internal controls of firms. Consequently, it lead to rise in the number of auditor switches, increase in audit fees, rise in litigation risks and auditors conservatism in issuing clean audit reports. All these factors are likely to influence shareholders wealth.
Stunda & Pacini (2013) point out that empirical evidence on the relationship between auditors switch and share price reaction in the post-Sarbanes Oxley Act period is mixed. Therefore, they hypothesize that there is no difference in the share price reactions to unexpected income earning in the pre and post-Sarbanes Oxley Act environments for a clean audit report with or without a change of auditors. Similarly, there is no difference in the share price reactions to unexpected income earning in the pre and post-Sarbanes Oxley Act environments for an adverse audit report with or without a change of auditors.
Pre Sarbanes-Oxley Act period was taken as the period between 1998 and 2003 while the post-Sarbanes Oxley Act was taken as the period between 2005 and 2010. A sample of 31,900 firms was taken for the pre-Sarbanes Oxley Act period and a sample of 29,400 firms was taken for the post-Sarbanes Oxley Act period.
Stunda & Pacini (2013) use an OLS regression model to test the hypotheses. The finding reveal that there are no differences in investor reactions in both periods. The study provides insight on the impact of audit switches in the pre and post-Sarbanes Oxley Act periods on investor reactions for qualified and unqualified audit reports. We can deduce that there is no empirical evidence that the act influenced shareholder’s wealth.
Conclusion
This paper sought to explore audit opinion shopping. A detailed explanation of what audit opinion shopping entails is given. The intuitive expectation is that audit opinion shopping will compromise the quality of audit reports. However, empirical evidence shows that the Sarbanes-Oxley Act has adequate provisions that prevent such an eventuality. The Act made external auditors more conservative in issuing clean report because of the heightened litigation risks. Therefore, they will only give unqualified opinion to a firm if the internal controls are sound and the financial statements are true and fair. The literature review also dispels fear that the Sarbanes-Oxley Act adversely affected shareholder wealth by increasing various risks and the like hood of auditor switch. There is no evidence to support the assertion. Empirical evidence shows that there is no difference in investors’ reaction as a result of auditors switch for both qualified and unqualified audit reports in the pre and post Sarbanes-Oxley Act. Lastly, the paper explored the factors that are likely to influence a firm to switch auditors after receiving an adverse audit report. There is empirical evidence to support the length of the audit tenure, a Big 4 firm, and audit fee. There is a significant positive relationship for audit fee and Big 4 firm and a significant negative relationship for length of audit tenure. There is no evidence that the number of internal control deficiencies influences the decision to switch auditors after an adverse audit opinion.
Bibliography
Alali , Fatima, and Maryna Rubina. 2013. "Opinion Shopping Revisited: Evidence From the Financial Crisis and the Great Recession Period." Internal Auditing 1-13.
Stunda, Ron, and Carl Pacini. 2011. "The Shareholder Wealth Effects of Auditor Changes and Auditor Opinion: Does A Difference Exist in Pre-SOX and post-SOX Enviroments." Academy of Accounting and Financial Studies Journal 29-40.
Thevenot, Maya, and LInda Hall. 2011. "Adverse Internal Control Over Financial Reporting Opinion and Auditors Dismisal/Resignation." Academy of Accounting and Financial Studies Journal 41-60.
