Final Version Thesis

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Auditor dismissals with going-concern report under SOX1

The impact of Sarbanes-Oxley Act on auditors dismissals following going-concern opinion

issuance.

Jing Bao

ACCT 597 Capstone

Dr. Myungsoo Son

December 15th

, 2011


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ABSTRACT

After the Enron Scandal, the congress passed Sarbanes-Oxley Act to require auditors and

managers to increase disclosures and expand responsibilities. The purpose of SOX is to create

stronger corporate governance within the listed companies and Section 301 specifically requires

all members of the audit committee to be independent. Prior to SOX, the management typically

have a major influence on external auditors selection and dismissal process. The passage of

Sarbanes-Oxley Act is intended to take away management teams responsibility and power, and

shift it to the audit committee. This shift of power could have direct impact on the correlation

between auditors dismissal and issuance of going-concern reports. Prior studies have shown

that there is a direct correlation between auditors dismissals after the issuance of going-concern

report. In this study we further expand on prior studies by researching the post-SOX era with

regards to auditors dismissal following going-concern reports issuance. Our results confirm the

findings from prior studies, which indicate that auditors are more likely to be dismissed in the

year after the issuance of going-concern report. In addition, our data also indicate that in the

post-SOX era, auditors are less likely to be dismissed after the issuance of going-concern reports.

Both results concurs with our prediction; therefore we believe that SOX has had a huge impact

on improving the corporate governance for the listed companies, especially in establishing and

maintaining the independence of the audit committees.


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INTRODUCTION

In 2001, when the Enron scandal first broke out, the general public was shocked and

shattered by the magnitude of the fraud. Investors confidence level had reached a new low and

stock markets reacted violently to the incident. Moreover, Arthur Andersen, whom was one of

the largest public accounting firms at the time, was completely dissolved as the result of this

scandal. In the following year, the SEC and the U.S. Congress took some drastic measures

hoping to boost investors confidence, stabilize the financial markets and to further regulate the

financial reporting process and the corporate governance of the U.S. companies. (Pitt, 2001;

Ruder, 2002) Sarbanes-Oxley Act (also known as SOX) therefore was passed in the effort to

increase disclosures of financial statements and to expand responsibilities of both auditors and

managers in order to strengthen the corporate governance. (Pitt, 2001; Ruder, 2002)

This paper is going to focus on the relationship between auditors dismissals after their

issuance of going-concern reports and the effect of Sarbanes Oxley Act on that relationship. The

first part of this paper will examine and retest the topic thats been already researched from prior

researches, which is namely the correlation between auditor changes following the issuance of

going-concern reports. Prior researches conducted by Chow and Rice (1982); Mutchler (1984)

and Geiger et al. (1998) have found that there is a positive correlation between client firing or

changing the auditors after auditors issue an unfavorable report, which in this case will be the

going-concern reports. For the purpose of our research, our main focus is to test the effect of

SOX on this relationship, but we will retest the correlation between auditor changes following

going-concern reports with a more accurate and comprehensive data set.

The second part of this paper deals with the Sarbanes-Oxley Act, which is the main focus

of our study. Prior to the passing of SOX, researchers have found that auditors who issue a new


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going-concern report are more likely to be dismissed in the following year. (Chow & Rice, 1982;

Mutchler, 1984 & Geiger et al., 1998) Additional researches also have shown the dissatisfaction

experienced from auditors toward the audit committees before the passage of SOX. (Cohen,

Krishnamoorthy & Wright, 2002) According to an interview study done by Cohen,

Krishnamoorthy and Wright (2010), before SOX, auditors by and large found audit committees

to be unsuccessful when it comes to the process of monitoring and supervising the financial

reporting. (Cohen, Krishnamoorthy & Wright, 2010) The introduction of SOX has delivered a

whole new perspective. Studies done by previous researchers have shown that there is a

significant change to the auditors as far as the environment they work in and the people they deal

with before and after SOX. (Cohen, Krishnamoorthy & Wright, 2010) Therefore it is

worthwhile to explore the same relationship or correlation between auditors dismissal and the

issuance of a new going-concern report in the post-SOX era. This research will determine

whether the independence of the audit committee has any effect on auditors dismissal following

a new going-concern report. For the purpose of this paper, the definition of a going-concern

report throughout the paper will be issuing a brand new going-concern report after a clean or

unmodified report in the previous fiscal year.

Corporate governance has been attracting a lot more attention after disastrous scandals

such as Enron and WorldCom; simply because corporate governance is an essential element in

the business operation when it comes to accountability of the management team. (Parker, Peters

& Turetsky, 2005) Consequently, the strength of corporate governance has been recognized and

becoming increasing important in the global stage. Companies with strong corporate governance

tend to ensure investors confidence and interest within the company and improve both internal

and external auditor experiences, through the influence exercised over the financial reporting and


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audit processes. (Cohen, Krishnamoorthy & Wright, 2010) Corporate governance also plays an

important role in preventing fraud and financial scandals. (European Corporate Governance

Institute, 2011) Audit Committee has been widely used by firms as a corporate governance

mechanism. SOX have had a huge impact on corporate governance practiced by all public firms.

Researches throughout the board agreed that corporate governance has been improved

significantly for all public firms following the passage of SOX. (Cohen, Krishnamoorthy &

Wright, 2010) Therefore, this paper is also looking at how strong corporate governance could

impact auditors dismissal after the issuance of a going-concern report by examining the post-

SOX era and the impact of SOX on those public companies. This aspect of the research has

never been done before and it will be an interesting and important contribution to the Accounting

Literature and Accounting field in general due to the significance of practicing good and strong

corporate governance in all companies worldwide.

Prior to the passage of SOX, the power to appoint, retain and dismiss the external

auditors typically lies in the hands of managers or top executives, even if there is an audit

committee in the house. (Cohen, Krishnamoorthy & Wright, 2010) These people hold the

golden ticket to a continuation of employment opportunity for the external auditors. Therefore, it

is common to see auditors doing all they can to avoid disputes or conflicts with the management.

However, things changed after the passage of SOX in 2002. SOX 301 required all public firms to

have independent audit committees and these audit committees now have the power to hire and

fire the external auditors. In addition, members of the audit committee are responsible and

expected to impact the financial audit progress and the quality of the audits. One of the theory

for having an independent committee is that by keeping all the members of the audit committee

separate, or independent from any other division of the company, will ensure professionalism


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and unbiased financial audit reports. (BRC, 1999) Financial statements and reports could be

vague or unclear at times, therefore it is critical for auditors, especially external auditors to use

their utmost professional and yet impartial judgments to audit financial statements. (Levitt, 2000)

Furthermore, it is expressly true when the company is facing problems that are reflected on their

financial statements. Carcello and Neal (2000) found that when an external auditor is facing an

ambiguous reporting situation, he or she is less likely to follow through with the going-concern

report if the company does not have an independent audit committee. The logic behind this

finding is that external auditors might be threatened of dismissal by the management team if they

go ahead and issue the new going-concern report. (Carcello & Neal, 2003) A going-concern

report is usually a bad news for the investors because it signals a red flag that represents the

financial troubles of a company. Managers will try to prevent that from happening as much as

possible. One way of preventing a going-concern report is by threatening the external auditors.

Hence, if anyone in the audit committee is not independent, he or she is more likely to side with

managements decision. Therefore, auditors are less likely to issue the going-concern report due

to the fear of dismissal in the following year.

Audit Committee was not the only mechanism used by public companies to ensure

corporate governance, but it is definitely one of the most widely used and probably among one of

the most effective measure to ensure corporate governance. In addition to audit committee,

corporate governance can also be strengthened through other measures, such as stock options,

management compensation package and implementing a high quality board within the company.

In recent years, it is very common to see many big firms making efforts into constructing a high

quality board. A well-established high quality of board was among one of the common

mechanisms introduced as a mean and a method to strengthen the corporate governance. (Turley


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& Zaman, 2004) Prior researchers have also found that a board which includes independent

members with a fewer number of members and with frequent meetings tends to show stronger

and strengthened governance. (Hoitash & Hoitash, 2009)

The purpose of this paper is to examine the association between going-concern reports

and auditor dismissal during the post-SOX era. During the post-SOX era, all members of the

audit-committee were required to be independent and were responsible for appointment,

compensation and dismissal of outside auditors. (BRC, 1999) The findings of this paper will help

to determine the actual results of SOX and whether an independent audit-committee is helpful or

demanded. In theory, independent audit committees should contribute to greater auditor

independence and objectivity and therefore auditors who issued going-concern opinions should

be less likely to be dismissed. (Hoitash & Hoitash, 2009)

BACKGROUND

The importance of having an independent audit committee was recognized back in the

1940s. (Bronson, Carcello, Hollingsworth, & Neal, 2009) Regulatory agencies, such as SEC

did not require, but encouraged public companies to achieve audit committee independence.

(Bronson, et al., 2009) However, there was a lack of concrete and detailed regulation; therefore

information regarding audit committee independence was rather unclear. (Bronson, et al., 2009)

Finally, in 1999, The Blue Ribbon Committee on Improving the Effectiveness of Corporate

Audit Committee (BRC) issued a report providing recommendations regarding increasing the

efficiency of corporate audit committees. The report indicated that public companies should keep

their audit committees entirely and completely independent. At the same time, audit committees

should take over the power from management to supervise and evaluate all activities done by

external auditors. (BRC, 1999) Following the issuance of BRCs report, other agencies such as


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the NYSE and NASD followed report by changing their listing requirements to require listing

firms to have independent audit committees. (SEC, 1999a,b).

However, there are some loopholes with NYSE and NASDs listing requirements. First

of all, this requirement only applies to large size companies, which means not everyone is under

the same scrutiny, some smaller scaled companies could get away with it. (SEC, 1999a,b)

Secondly, listing firms had options and exceptions to have non-independent members sit in the

committee. (SEC, 1999a,b) Finally, the rules and the definition are not consistent for the stock

exchange and the securities dealers association. (Bronson, et al., 2009)

Two years after the BRCs report, tragedies such as Enron and WorldCom came

crumbling down the Wall Street like a snowball. Congress had to react to these devastating

events, and thus SOX was born. (Pitt, 2001; Ruder, 2002) Section 301 of SOX specifically

requires all public firms to maintain a completely independent audit committee. (SEC 2003a)

That means, everyone that sits in the committee has to be 100 percent independent from

management. The passage of this section was not embraced by the listing companies.

Opponents of this regulation argue that the definition of independence is too strict, and that in

order to comply with this regulation, the availability of board members has gone down

significantly. (Lamb, 2005) Opponents also believe that the benefits does not outweigh the costs,

they believe that such costs, which include but are not limited to board member searching cost

and other increased cost related with expanding the board with independent members. They

also argue that by replacing certain knowledgeable but dependent board members with

independent members who might not have the specific knowledge about the company is

definitely a loss. (Bronson, et al., 2009) Despite the oppositions, SOX was passed with Section

301 targeting at the independence of audit committee. In this paper, we will further examine


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whether the passage of SOX, especially SOX 301, has had any actual impact on the auditors

dismissal after the issuance of going concern reports.

When looking at the history of audit committee, it will be helpful and important to also

look at the history and background of corporate governance, since audit committee is a part of

the corporate governance mechanism. Corporate governance has a long history which dates back

to 1980s. (AICPA, 1988) Corporate governance was mainly established as a mechanism to

counter the principle-agency theory. An agency theory exists when the agent, in most cases are

CEOs, do not act on behalf of the principle, which in most cases are the stockholders. It is

critical for the management executives to have their personal interest in line with the interest of

the mass stockholders, because that will insure the agent to act on behalf of the principle to make

the most profit for the stockholders. (Fama & Jensen, 1983a and 1983b) Corporate governance is

a broad umbrella that incorporates many specific mechanisms under it. Prior studies have found

that some effective measures towards agency problems include: establish an effective and

independent in house audit committee, establish a high quality and effective board, offer stock as

an incentive to the executive managers, etc. (Wallace & Cravens, 1997)

In 1991, The Committee on the Financial Aspects of Corporate Governance, also known

as the Cadbury Committee, was officially formed. (Boyd, 1994) The purpose of this committee

was to issue and establish a response and reaction towards the growing number of accounting

fraud and management manipulation which led to a decline of confidence from investors. (Boyd,

1994) The main idea of Cadburys report was to establish recommendation in the effort of

increasing corporate governance, such as launch a high quality, effective and independent audit

committee that will eventually bring back investors confidence. (Boyd, 1994)


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PRIOR STUDIES AND HYPOTHESIS FORMATION

According on Cohen, Krishnamoorthy and Wright (2002)s researched paper, which was

conducted through interviews and surveys with auditors before SOX, most of the participants

thought the audit committees were not efficient, and did not show signs of expertise and

authority. (Cohen, Krishnamoorthy & Wright, 2002) The auditors that were interviewed also

believed that the audit committee members were not taking their roles actively or aggressively,

rather they felt that the audit committee members were passive and had a ceremonial role.

(Cohen, Krishnamoorthy & Wright, 2002) The findings from Cohen, Krishnamoorthy and

Wrights study is critical to this study, because it is important to gather both information from

before and after SOX to determine the impact or influence of SOX on the auditors experience,

and particularly on auditors dismissal following the issuance of going-concern opinions. As

indicated earlier, previous researches also established a correlation between auditors dismissal

and issuance of going-concern reports. (Chow & Rice, 1982; Mutchler, 1984; Geiger et al., 1998)

The action of dismissing the auditors could be made under the logic that by firing the current

auditor, the firm might have a chance of finding someone more capable, flexible and compliant

to work with. The dismissal could also be seen as a penalty to those auditors who issued going-

concern reports. (Craswell, 1988). According to Carcello and Neal (2003), audit committee

independence and stronger governance are among the major factors that prevent the auditors

from being dismissed after issuing a going-concern report. (Carcello & Neal, 2003) Other

researches also found that in the post-SOX era, members of the audit committee took more

initiative to monitor the process of financial reporting. (Cohen, Krishnamoorthy & Wright, 2010)

In this research paper, we specifically look at the post SOX era to see whether Section

301 of the SOX has had any effect on the relationship between auditor dismissal and issuance of


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going-concern reports. Based on previous researches, an independent audit committee is one of

the top measures that will decrease the probability of an auditor getting punished or fired after

issuing the going-concern report. (Carcello& Neal, 2003) To further explain their reasoning,

Carcello & Neal categorized members of audit committee into two groups: independent and

dependent. Dependent members are also defined as affiliated directors, which mean they are

attached to the company either on a financial level or a personal level. Members of these

categories include current or ex- executives, staffs, directors that also sit in other boards that are

interlocked with the company, suppliers and professionals that are of help to the company, such

as attorneys, accountants and consultants. (Vicknair, Hickman & Carnes, 1993; Beasley, 1996;

Carcello& Neal 2000). The problem with the affiliated directors is their attachments with the

company. Due to the fact that these people are too closely related and tied to the company on

multiple levels (financial or personal), their ultimate goal is to make company successful, so they

could also benefit from the success. However, the issuance of going-concern report is definitely

not a good sign for the company, in fact, many analysts and investors take going-concern reports

as a red alarming sign to stop the investment. Consequently going concern reports will most

likely cast a shadow on companys earnings and share prices. Previous researches shown that

before the passages of SOX, when management has disagreement with the external auditors, the

dependent members, or the affiliated directors from the audit committee, are more likely to align

with the management. (Baysinge r& Butler, 1985) To the contrast, when it comes to the

independent members of the audit committee, it is widely believed and expected that these

people will make more impartial and objective decisions, due to their independence from the

management and the company and their knowledge in that specific field. (Braiotta, 1999) A 100

percent independent audit committee whom oversees the selection, appointment and dismissal of


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external auditors should result in less auditors dismissal after issuing going-concern reports,

according to prior findings. (Carcello & Neal, 2003) Since SOX is intended to improve the

corporate governance for all public companies and that Section 301 specifically requires an

entirely independent audit committee, we expect to see less auditor dismissal due to going-

concern reports during the post-SOX era. Although we believe that audit committee is not the

only factor that led to less auditors dismissals following the issuance of going-concern reports in

the post-SOX era, we do believe it is one of the main factors that have contributed to the results.

Furthermore, researchers have also studied the importance of having strong corporate

governance in the company. Cohen, Krishnamoorthy and Wright (2010)s research found that

corporate governance tends to improve both internal and external auditor experiences, through

the influence exercised over the financial reporting and audit processes. Cohen and Hannos

(2000) research paper also found auditors preparation and decisions are inevitably related with

managements beliefs and the corporate governance mechanism in place. Moreover, Bedard and

Johnstone (2004) study also found that theres a correlation between earning management risk on

audit work preparation, and this is especially true when the company does not have a strong

corporate governance structure within the company. Other related researches in regards to

corporate governance and audit committee includes Ryan and Wigginss (2004) research paper

that showed directors salary package is closely related to the control of other independent

directors versus the executives. (Ryan & Wiggins, 2004) All of these researches have contributed

great information to the literature of accounting in regards to corporate governance. An

independent audit committee is by all means related to corporate governance. As we all know,

the passage of SOX literally revolutionized the treatment of corporate governance in almost all

public companies. Therefore studies and findings about corporate governance in regards to audit


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risks and other financial reporting and auditing processes are definitely important to this study as

well as studies done directly on audit committees.

Based on prior studies and our theories, we have formulated the following hypotheses:

H1: Auditors dismissals are more frequent following issuing going concern opinions. H2: In the post SOX era, auditors who issue going concern opinions are less likely to be

dismissed.

MOTIVATION

Going-concern reports have become one of the hottest topics in recent years. Due to the

recent economic recession, many financial companies have been forced to seek government

bailouts or simply go out of business. However, almost all of those companies that have gone

bankrupt did not receive a going-concern report from their auditors. These unfortunate and

unforeseen phenomena received a lot of attention from both the regulating agencies and the mass

investors. People cant stop asking why these companies were given clean audit reports, when

something was definitely going wrong with companies financial situations. In fact, the issue

with going-concern report was also brought up during the 10 th Annual SEC Reporting

Conference.

The contribution of this research paper is mainly focused within the accounting literature

by establishing and validating the impact of SOX on auditors dismissal after issuance of going-

concern reports. The passage of SOX has considerably increased and magnified the

responsibilities for both auditors and the managers. Such act is focused to improve the quality of

financial reporting process and procedure within the companies. Auditors, both internal and

external play vital roles in this process. In this study, we focus primarily on external auditors

experience after their issuance of going-concern opinions. We believe that this research will


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further probe and analyze different factors that either have a positive or negative relationship on

auditors dismissal. In addition, our findings may also contribute to all stakeholders, companies

and regulators who may find this paper helpful and useful. Furthermore, our study is also useful

to regulators because if H2 holds true, then it wouldve proven that SOX has had a very positive

and effective influence and impact on the financial reporting process for all U.S. companies.

The rest of the paper is structured with data collection and empirical results; data analysis

and finally conclusion with discussions and implications.

METHODOLOGY

We will be using regression model in this research to:

First examine and analyze the relationship and the correlation between the likelihoodsof auditor dismissals following the issuance of going-concern opinion

Secondly, we will examine and analysis the relationship and correlation between thelikelihoods of auditors dismissals following the issuance of going-concern opinion

during a post-SOX era

Regression Model: ACt = b0 + b1GCt-1 + Others t-1 +E

ACt = b0 + b1GC t-1 + b2PostSOX t-1 + b3GC x PostSOX t-1 + Others t-1 +E

When performing the t-test, except for AC, where the data is collected for that year, all other

variables were collected one year before the auditor changes, which is t-1.

Variables Definition:

AC = this variable identifies whether the auditor has been dismissed from the client in

the following year after issued a going-concern report (for this variable, 1 =

auditors dismissed, 0 = no auditor dismissal) For the purpose of this paper, were

only looking at auditor dismissals and not auditors who resigned from the


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company. Because the purpose of this paper is to find out how SOX has changed

managements behavior and therefore it is appropriate to study auditor dismissals

as a result of management retaliation or punishment. In contrast, auditors who

resign from their clients are not a focus of this study and therefore should not be

included.

POSTSOX = this variable classifies the year of research into either pre-SOX era or post-SOX

era (1= Post SOX, 0 = Before SOX)

GC= this variable identifies whether a going-concern opinion was issued (1 = going

concern opinion issued, 0 = clean).

In this research, we will be using control variables along with our test variables. By

controlling certain variables, the results should be relatively accurate and therefore reflect better

data for analysis purposes.

When performing the regression, we expect to see b1, the going-concern opinion indicator

to be statistically significant and positive, for both models. Secondly, we expect b3 to be

statistically significant and negative, meaning during post-SOX era, the likelihood between

auditors dismissed after issuing a going-concern report will be decreased. Finally, we will have

to run the regression to determine whether b2 is positive or negative.

The control or other variables for this research are: the size of the company, auditors

market share, auditor tenure, financial status of the company and changes incurred in the

executive management level.

SIZE: When it comes to the size of the firms, larger firms tends to retain their external

auditors. (Francis &Wilson, 1988; Krishnan, 1994) First of all, larger companies tend to have

more power because they pay more audit fees compare to smaller sized companies. (McKeown


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et al., 1991), therefore we can assume that larger firms will tend to have fewer disputes between

auditors and the management. Secondly, large firms are constantly under strict inspection from

business analysts, the media and sometimes even the government; therefore it is to their best

interest to not make any moves that will bring in scrutiny from all stakeholders.

INDSHARE: Previous researches have found that companies are less likely to dismiss

auditors who have expertise in their own industry. (Haskins &Williams, 1990; Williams, 1988)

The findings from these researches suggested that companies typically believe that auditors with

a higher market share in that companys industry will be more efficient and effective and

therefore companies would want to retain those auditors. As prior studies indicated, we expect

to see that higher market share for auditors will result in a fewer auditors dismissals following

their issuance of going-concern opinions.

TENURE: According to Williams (1988) paper, he suggested that a long term

relationship between auditors and their clients will result in fewer auditors dismissals. The

longer the tenure, the less likely auditors will be dismissed. The logic behind this variable is

pretty intuitive; obviously the bonds between auditors and their clients get stronger throughout

the years. In addition, auditors commonly develop a specific set of knowledge and skills that

pertain to those clients only. We expect to see the same result from prior studies which believe

that longer auditors tenure will result in lower probability of auditors getting dismissed.

Auditors tenure will be measured as number of continuing years that the auditors worked for

same client.

FIN: Other things aside, the financial situation of the clients will definitely affect the

chances of auditors getting dismissed. (Krishnan & Stephens, 1995) To measure this variable,

we will be using the Zmijewski financial condition score to determine whether a company is


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financially healthy. When using the ZFC score system, a lower score usually shows a healthy or

free from financial troubles or distress. We expect to see less auditors dismissals in a company

with lower ZFC score.

MGMT: This variable indicates whenever there is a change to the top executive positions

in the company, such as CEOs or CFOs. Prior researches have shown that changes in managerial

positions are related to auditors dismissals. (Williams, 1988) There many reasons and

explanations for that relationship. First of all, when a new CEO comes on board, he or she will

probably want to present a whole new viewpoint for the company, and therefore he or she might

want to change out the auditors just to start fresh. (Carcello & Neal, 2003) In addition, CFOs

might also want to change auditors due to their own preferences. Many CFOs have an public

accounting background, which means that they might want to hire someone that they worked

with before or even a previous employer (Iyer, 1998). When measuring this variable 1 = changes

in CEO or CFO, 0 = no change in the year when going concern report was issued or in the next

year. We expect to see higher auditor dismissals as a result of managerial changes in the client

firms.

SAMPLE AND RESULTS

When collecting our data samples as indicated in Table 1, we first started with active

firms from the database Compustat. In order to compare the results of post-SOX era, we

collected our sample firms from 2001-2009. 2001 and 2002 are considered to be the pre-SOX

era, and 2003-2009 are considered to be the post-SOX era. While there is a consideration as far

as whether 2003 and 2004 should be considered transaction period and therefore be omitted, we

tried gathering data omitting those periods of years and the result came back to be the same.

Therefore we decided to use all the years from 2001-2009. We then merged all the sample firms


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data found from Compustat to Audit Analytics, where firms had their auditors dismissed in the

year following the issuance of going-concern opinions. Next, we narrow our samples to firms

with our control variables only. Finally, our actual sample firms are firms without auditor

resignations. Although when looking for firms with auditor changes; we would encounter both

auditors dismissed from the companies and auditors who resign themselves due to any reasons.

However, since this study is focused on the impact of independent audit committee on auditors

dismissals, we are assuming that independent audit committee will replace managers who

typically use dismissal of auditors as a form of retaliation or punishment for issuing an

unfavorable report against them; therefore our data will include firms with auditor dismissals,

and not auditor resignations. In addition, the fact that due to the Enron scandal, one of the

largest accounting firms, Arthur Andersen was dismantled as a punishment to the firm from SEC.

When preparing our sample firms, we decided to ignore those companies who had auditor

changes due to the dismissal of Arthur Andersen. We felt that was a special circumstance and it

was a one-time only extraordinary event, and therefore data related to this event, should be

excluded.

The numbers of sample firms used by prior studies are relatively smaller and outdated. In

Chow and Rices 1982 study, they only used 418 firms with auditor changes. Carcello and

Neals 2003 research paper also only used 174 firms as their sample firms. In our study, the total

number of firms that met our criteria is 49,143, which is significantly larger sample pool. Table

1 shows our preliminary results and our final data set of actual samples. The purpose of

repeating this part of the research is to confirm the results from prior studies.


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Table 1: Sample Firms

Active Firms inCompustat

Merged with AuditAnalytics

Firms with controlvariables

Firms without auditorresignations

2001

10,729 8,501 6,124 6,0642002

10,460 8,845 6,272 5,229

2003

10,189 8,786 6,011 5,873

2004

9,914 8,710 5,888 5,686

2005

9,700 8,624 5,807 5,624

2006

9,404 8,410 5,676 5,530

20079,020 8,101 5,405 5,281

2008

8,552 7,594 5,059 4,998

2009

8,146 7,209 4,949 4,858

Total:

86,114 74,780 51,191 49,143

We then use a separate Table 2 (Descriptive Statistics) to show the descriptive statistics

for our control variables and auditor changes. The focus here is on the relationship between

auditor changes and the issuance of going-concern reports. Thus, in Table 2, we compare the

main differences between two groups using t-test. We used t-1 for GC, and t for AC, because the

going-concern reports happens one year prior to auditor changes. Group one is for firms

receiving going-concern reports and another group is for firms receiving non-going concern

reports. The results are very similar to our prediction and it also concurred with prior studies

findings. The percentage of auditors getting changed or dismissed in the year following their

issuance of going-concern reports are 14%, compare to 5% auditor changes when there is no


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going concern reports issued. Both statistics are also significant at the 1% level, meaning the p-

value is less than 0.01

When it comes to the control variables, the results of all control variables were tested to

be statistically significant with p value < 0.01. For the control variable FIN, firms with higher

ZFC scores are more likely to receive going-concern report with descriptive data of 3.9327

compare to a 2.1686 descriptive data under non-going concern reports (p


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here, managerial changes does not necessarily result in more going-concern opinions, the

statistics between both groups are 0.0631 for going-concern opinions and 0.0375 for non-going

concern opinions. Although the resulting data are statistically significant, but we cannot make

any inference in regards to the relationship or impact on going-concern opinion when there has

been a management position changes within the company in the year when audit was done and

going-concern report was issued, as well as the year following the going-concern report issuance.

Table 2: Descriptive Statistics

Going Concern Opinion Non-Going Concern Opinion Mean

Mean Median Std Mean Median Std Difference

AC 0.1398 0.0000 0.3468 0.0558 0.0000 0.2295 21.22***

FIN1 3.9627 1.8077 6.6329 2.1686 2.2893 2.5254 120.15***

INDSHARE2 0.0896 0.0125 0.1365 0.1945 0.1975 0.1537 41.93***

TENURE3

5.4167 4.0000 5.1281 7.9848 5.0000 7.8237 20.48***

MGMT4

0.0631 0.0000 0.2432 0.0375 0.0000 0.1900 7.99***

SIZE5 2.5685 2.0560 2.0083 5.5763 5.5314 2.2887 80.80***

***: significant at the 1% level (p value


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Note 1: The financial conditions of the firms are calculated by using the Zmijewski financial condition

score (ZFC score), the lower score meaning a healthier company financially. The data are collected from

Compustat database.

Note 2: the industry share of the auditors are calculated by adding the revenue from each auditor and then

take individual auditors sales total to divide by the total sales amount to determine the industry share.

The data for this variable is also gathered from Compustat database.

Note 3: the tenure of the auditors is manually calculated to determine the years that each auditor stayed

with the firm. So for an example, if a firm hired KPMG to do their auditing work for year of 2007, and

then switched to Ernst & Young for 2008, 2009 and 2010, then the tenure for Ernest & Young would be

three years. Data also from Compustat.

Note 4: The management change variable is simply collected through audit analytics.

Note 5: for size of the company, we calculate it by taking the log of the total assets of the firms to

determine its size. Data from Compustat database.

Our Table 3 is the Pearson Correlation Matrix, where we examine the correlations and

the relationships between the independent variables and the control variables. The correlations

are all below the absolute value of 0.13, with the highest being -0.12101 (


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change in presence within the company, meaning when there is a new CEO or CFO, or any top

executive in the company, in that case, the auditors are more likely to get dismissed. In addition,

some other control variables received a negative rho number which indicates an inverse

relationship with auditor changes. For example, TENURE variable received a negative rho

number (rho = -0.02307, p< 0.0001), which indicates that auditors that have longer and

consecutive period of serving the clients are less likely to be dismissed. Also, auditor are less

likely to get dismissed when their industry share is high (rho = -0.05307, p < 0.0001), which is

also an expected result. Finally, the size of the firm are inversely correlated with auditor changes,

meaning bigger size firm will lead to less auditor dismissals following the going-concern reports.

All variables tested are statistically significant at the 1% level (p < 0.001)

Table 3: Pearson Correlation Matrix

GC FIN INDSHARE TENURE MGMT SIZE

AC 0.0953

(


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Logistic Regression Models Analysis

Auditor Dismissals and Post-SOX era

The results from Table 4, shows that our tests for both hypotheses are statistically

significant with Model 1 significant at p 0, p < .0001),

which indicates that auditors who issued going-concern reports are more likely to get dismissed

in the following year. Secondly, the coefficient for GC*SOX came out to be negative (b3 < 0, p-

value = 0.0240, significant at 5% level), which agrees with our predication that in the post-SOX

era, auditors who issued going-concern reports are less likely to get dismissed. In addition, since

both models data are statistically significant and also concurs with our predication, we find that

there is a huge difference between auditors dismissals after the issuance of a clean report

compare to the issuance of a going-concern report. Furthermore, SOX also had a big impact on

auditors dismissals after issuing the going-concern reports by strengthened and improved the

corporate governance within the companies.

As far as the control variables, the coefficients and the signs under both models are very

similar. Variables MGMT and SIZE are both statistically significant at 1% level (p < .0001),

which indicates that managerial changes within the companies are more likely to result in

auditors dismissals and that large size companies are less likely to switch auditors.


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Table 4: Logistic Regression Models

ACt = b0 + b1GCt-1 + Others t-1 +E

ACt = b0 + b1GC t-1 + b2PostSOX t-1 + b3GC x PostSOX t-1 + Others t-1 +E

*, **, and *** indicate significance at p < 0.10, p < 0.05, and p < 0.01.

Variable Definitions:

AC = 1 if firm changed its auditor following the issuance of going-concern report from previous year

GC = 1 if there is a going-concern report issued, 0 if there is none

SIZE = log of total asset of the company

INDSHARE = the market share in the specific industry for each auditor, determined by using auditors

total sales divide by all auditors added total sale in that industryTENURE = number of consecutive years the firms has employed the auditors

FIN = the ZFC score, which is an index that identifies firms financial healthiness.

MGMT = 1 if there has been a change of CEO or CFO during the year of going-concern report or in the

next year, 0 for none.

VariableExpected

Sign

Model 1 Model 2

Coefficient P-value Coefficient P-value

INTERCEPT +/ - -1.9493


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SUMMARY AND IMPLICATIONS

This paper studies and gives evidence on:

1. The relationship between auditors dismissals after the issuance of going-concern reports.

2. Whether there have been any changes to that relationship in the post-SOX era.

Our results confirm the findings from previous studies that the issuances of going-

concern reports are definitely related to auditors dismissals in the following year. Furthermore,

in this paper, we conducted a new research to examine the effect of SOX to auditors dismissals

following going-concern report issuance by comparing pre-SOX group and post-SOX group.

The results are as expected, which shows that auditors dismissals in the post-SOX era have been

decreasing. Prior to the passage of SOX, management team has always had a huge impact on

auditors selection and dismissals processes. In many cases, even if there is an audit committee

established in the company, management can still influence the audit committee significantly and

have the audit committee to side with managements decisions in some cases. Nonetheless, audit

committee still pertains as one of the most commonly used corporate governance mechanism in

many corporations, especially in all public companies, since theyre required to establish one

within the company. However, during pre-SOX era, many audit committees are not entirely

independent, affiliated directors and other members of the audit committee are many times

dependent. The passage of SOX 301 tried to solve this problem, by requiring all companies to

have 100% independent committee, in hopes that independent members will make more

informed and more objective decisions when it comes to external auditors hiring and firing. The

results of our regression model clearly showed that auditors dismissals have been decreasing in

the post-SOX era, which meets our expectation and further concurs with our theory that SOX

had proved audit committees independence issue, and it further led to less auditors dismissals


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following an unfavorable going-concern reports. Our results also confirms prior studies done by

Carcello and Neal in 2003 which indicated that a more independent audit committee is more

effective in managing and defending external auditors from managers retaliation or punishment

that leads into dismissals after the issuance of going-concern reports. (Carcello & Neal, 2003)

In addition, Cohen, Krishnamoorthy, and Wrights (2010) research paper also indicated that

auditors have seen noticeable improvements on the board and that the audit committee is taking a

more proactive, more diligent and more attentive role when it comes to disputes between the

management and the external auditors in post-SOX era. (Cohen, J., Krishnamoorthy, G., &

Wright, A., 2010) Results like these further proves that independent audit committee is definitely

necessary in order to provide a high quality and impartial audit reports from external auditors.

(Millstein, 2002; Teslik, 2002; Turner, 2002) It is critical to provide a safe and friendly

environment for the external auditors to do their job, where they dont have to worry about

getting retaliated and punished by the managers after issuing an unfavorable report. SOX

provided a great initiative to require companies to establish and maintain the independence of the

audit committees. By following SOX lawfully, we have already seen a decrease in auditor

dismissals, and therefore we can assume that SOX has strengthened corporate governance for all

public listed companies. However, SOX only applies to listed companies, which means small to

medium sized companies might not be affected by SOX, hence we propose that small and

medium sized companies should try to keep their audit committees as independent as possible

and to maintain a strong corporate governance in order to achieve the best results for both

auditors and the companies.

This research has some limitations to it. First of all, our data period for pre-SOX era was

considerably shorter compare to post-SOX era, which could create an obscured result due to


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unbalanced data. We were unable to find data before 2001, as it was not in the database,

therefore future studies can expand on a longer data period, preferably dated back to before 2000

to retrieve a more balanced data set. Secondly, when researching the relationship between

auditors dismissals due to their issuance of going-concern reports, we were only able to

determine the relationship and association between these two, but not the actual causation.

Finally, we could have missed some variables that have correlation with both of our models. We

tried to solve this problem by controlling some of the variables (company size, companys

financial healthiness, auditor tenure, auditor industry market share and managerial changes) that

have impact on our dependent and independent variables, but there could possibly be more

variables that need to be controlled.

This study was conducted using a regression model. We believe that the same scope of

research can be done through other alternative methodologies, such as interviews and surveys or

other logistic models to further test the accuracy of the results. Moreover, we originally

established a model that will test the impact of a high quality board on auditors dismissals

following the going-concern reports; however, due to difficulties in the data collection process,

we had to forfeit that model. This research here mainly focus on the impact of stronger corporate

governance created by SOX on auditors dismissals, audit committee is only one of the measures

used to strengthen corporate governance. Future studies can be done using other mechanism (i.e.

high quality board) of the corporate governance to test the correlations.

Moreover, when examining the relationship between auditors dismissals after the

issuance of going-concern reports, we do need to take into consideration that there are other

external factors influencing auditor changes. First of all, the recent economic crisis has created a

world-wide recession for almost all businesses. Consequently, firms are more inclined to reduce


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their costs by switching to more affordable auditing firms, such as local and regional firms.

(Cohen, J., Krishnamoorthy, G., & Wright, A. 2010) Furthermore, opinion shopping is definitely

another important factor here. Many firms try to shop for different auditor opinions in order to

prevent an unfavorable report against the company. We propose that future studies should

include and control these two variables if possible; studies can also be done under better

economic times to determine whether there are differences between good economic times and

bad economic times.

The study of auditors dismissals and going-concern reports issuance has been a

relatively popular topic in the field accounting. Many studies have been done that are related or

simply built on this topic. The implications of this study are not only critical to the accounting

field scholars and academia but also important to the general public. The economic crisis has

caused many firms in recent years to go down and under. Going-concern is undoubtedly one of

the most effective measures to warn the public about the financial conditions of the firms.

Therefore it is extremely important to ensure and to protect external auditors when they issue the

going-concern reports that could result in hostility from the management. By conducting a study

like this, we probe the problem and make recommendations and suggestions to the issue of

auditors dismissals after issuance of going-concern reports in the post-SOX era. First of all,

investors and other stakeholders are entitled to know the financial situation of the companies.

Based on this study, we find that investors should pay more attention and beware of those firms

that changes auditors after the issuance of going-concern reports; because by changing the

auditors, the firms are trying to get a better opinion other than the going-concern report, and that

usually signals the firm is going through some financial difficulties, and that theyre not willing

to disclose it. Secondly, through findings of this paper, we find that corporate governance is


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definitely very important to all firms, companies with higher governance tends to gain investors

confidence and trust, and could result in better company performances. Moreover, this study

indicated that corporate governance has definitely been strengthened and improved during the

post-SOX era, thus companies should establish and maintain higher corporate governance

standards in order to produce high quality financial statements for the investors and other

stakeholders. Lastly, this research is also especially useful not only to investors, but also

regulators and standard setters. The evidences presented through this paper is a good indication

that SOX had done its job, and that it effectively improved corporate governance and the

independence of audit committee, which lead to less auditors dismissal following the issuance

of going-concern reports.


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