Summary Auditor resignations: Clientele effects and legal liability

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Summary - Auditor resignations: Clientele effects and legal liability

  • 1 Introduction

  • This study examines 2 hypotheses of auditor resignation:

    1. Litigation risk
    2. Clientele adjustment

    She finds that resignation is positively related to increased legal exposure, and to occurrence of clientele mismatch.

    She used a summary-measure approach in which she can distinguish clientele mismatch caused by changes in auditor (supply side) charateristics and changes in client (demand side) charateristics. Evidence suggest resignation is likely driven by supply-side changes.

    Furthermore investor react negatively to resignation and the price drop varies cross-sectionally with litigation risk. 

    The tendency of dropped firms to engage small auditors is positively related to increased litigation risk and to mismatch with large auditors.
  • This paper looks at the auditor's incentive to terminate the relationship instead of the clients incentives. 

    There are two possible reasons for auditors to drop their clients:
    1. Litigation-risk hypothesis. The auditor drops certain clients to reduce their legal exposure. 

    2. Clientele-adjustment hypothesis. Recent changes in the audit industry have altered the relative benefits and cost of each client, motivating auditors to change their client mix. In this process auditors will shift away from poorly matched clients. 
  • 2 Hypotheses

  • Auditor resignation can have 2 possible expanations:

    1. Litigation risk hypothesis
    2. Clientele adjustment caused by changes in auditor or client characteristics
  • 2.1 Litigation risk

  • The frequence and costs of auditor litigation increased. Costs are based on the to paying amount, managment time, and reputation damage. An increase in a clients legal exposure could trigger potential auditor resignation.

    H(a) The litigation risk hypothesis: Incumbent auditors are more likely to drop clients who expose the auditors to increased litigation risk.
  • 2.2 Clientele adjustment caused by changes in auditor or client characteristics

  • Market competition causes audit firms to seek competitive advantages and bild brand names through clientele specialization. The composition of an audit firms client portfolio can change over time as changes occur in the economics of auditor-client relationship. 

    Changes can be caused by audit technology and the menu of non-audit sevices. 
  • Audit technology

    Traditionally auditors performs audits during the busy season but due to technology 60% of the audit can be performed during the whole year. 

    The clients which did not have a good match whit the firms but whit a year end in June were sometimes accepted. These clients are stopped thanks to audit technology. 
  • H(b): the clientele-adjustment hypothesis: Auditors are likely to drop clients whose demand for audit and non audit work becomes inconsistent with the auditors targeted clientele. 
  • The clients mismatch with their auditor could be caused by:

    • Client-specific changes (demand shift) 
    • Change in auditors cost structure and opportunity set (supply shift)
  • 2.3 Differentiating between hypotheses

  • Changes in auditor and client characteristics prior to auditor resignations

    to help shed light on the importanceof the lititgation-risk and clientele-adjustment hypothsis. 

    Litigation risk hyp: Increase in clients legal exposure increases auditors costs and could lead to resignation.

    Clientele-adjustment hyp: Occurrence of a client mismatch lowers auditors profitability and therefore can lead to resignation.
  • Investor reaction to auditor resignation

    Auditor resignations potentially convey auditors' private assessment of clients, they are likely to induce a revision in investors' expectations and affect stock prices. 

    Litigation-risk hypothesis:
    Auditor resignation signals the dropped clients higher-than-expected litigation risk, causing the stock price to drop.

    The drop in stock price is expected to vary cross-sectionally with the revision in investors belief: the greater the upward revision in litigation risk, the larger the stock price drop.
  • Clientele-adjustment hypothesis:

    If auditor resignation only conveys information about changes in an auditor production and cost function - Expect no stock reaction ta a dropped client.

    If the resignation conveys incremental information about the dropped client a stock reaction is expected.

    Resignation of big 6 auditor - Client has lower-than-expected growth prospects and causes a mismatch - resulting in negative stock reaction.

    Resignation of small auditor - Client could show unexpected growth - resulting in positive stock reaction.
  • Characteristics of successor auditor (opvolger)

    • Cross-sectional variation in auditors legal exposure and successor auditors

    Successor auditors are predicted be be small auditor under litigation-risk hypothesis - supply-side effects

    Expected litigation cost is smaller for smaller auditors because they have shallow pockets, unlikely to pay a large amount for a damage, and the indirect costs of providing a low quality audit is smaller.

    • Successor auditors under the clientele-adjustment hypothesis

    If a client is dropped as a result of clientele mismatch we should observe a successor auditor to be more cost-efficient in auditing the dropped firm. Small client will engage a small successor auditor vice versa. 
  • See pg 183 of paper for the summary of predictions.
  • 3 Results

  • Proxy litigation risk

    Logit model of auditor litigation from various client characteristics to capture an auditors legal exposure.

    Proxy clientele mismatch

    Measured based on operational scope variables and financing-activity variables.
  • Auditor resignation and changes in auditor or client characteristics

    Regression results support the litigation-risk hypothesis. This suggests that an auditors's decision to resign is positively related to the change in a client's litigation risk. 

    Also the clientele-adjustment hypothesis is supported. Auditors are more likely to drop a client that experiences a mismatch with the auditor's clientele. 

    A mismatch leads more likely to auditor resignation than clientele-initiated change. This mismatch can occur when client charateristics change or when the cost structure of the auditor changes. 
    Because all variable related to client specific changes are not significant changes in the client characteristics can't explain the auditor to resign. 

    Therefore resignation in driven by changes at the auditor.
  • Auditor resignation and market reaction

    Investors react negatively to auditor resignation. 

    When the audit is stopped during the annual period and this is interactected with changes in litigation risk it is highly significant. The greater the increase in litigation risk the larger the drop in stock price. When the auditor resigns during the audit period is this more indicative of litigation concerns. 

    The clientele-mismatch variable is not significant. This is expected under clientele-mismatch hypothesis if the resignation only conveys information about changes in auditor, and not client, characteristics.  
  • Characteristics of successor auditors

    Study of successor auditors of dropped firms. It is less costly for smaller firms to bear litigation risk. 

    Clients with increased litigation risk are more likely to engage small auditors.

    Large auditors are more likely dropping clients that become mismatched with their clienteles.
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