MANDATORY AUDIT FIRM ROTATION AND AUDIT

QUALITY †

Andrew B. Jackson∗
School of Accounting
The University of New South Wales
Sydney, NSW 2052, Australia
a.b.jackson@unsw.edu.au

Michael Moldrich
Independent
michaelmoldrich@yahoo.com.au

Peter Roebuck
School of Accounting
The University of New South Wales
Sydney, NSW 2052, Australia
p.roebuck@unsw.edu.au

First Draft: May 2006

Current Draft: July 2007

∗
Contact author.
†
Financial assistance for this study was kindly provided by the Capital Markets and Co-operative Research
Centre (CMCRC) and the Australian School of Business, UNSW. We would also appreciate the helpful
comments of participants at the 2005 Faculty of Commerce and Economics UNSW National Honours
Colloquium, Liz Carson, Jeff Coulton, Asher Curtis, Rob Czernkowski, Andrew Ferguson, Gerry Gallery,
Caitlin Ruddock, Roger Simnett and Stephen Taylor. All errors remain our responsibility.

Electronic copy available at: http://ssrn.com/abstract=1000076

 MANDATORY AUDIT FIRM ROTATION AND AUDIT

QUALITY

Abstract

This study investigates the effect a regime of mandatory audit firm rotation would have

on audit quality in an Australian setting. Using two measures of audit quality, being the

propensity to issue a going-concern report and the level of discretionary accruals, the

study examines the switching patterns of clients in their current voluntary switching

capacity, and the levels of audit quality. We find that audit quality increases with audit

firm tenure, when proxied by the propensity to issue a going concern opinion, and is

unaffected when proxied by the level of discretionary accruals. We conclude that given

the additional costs associated with switching auditors there are minimal, if any, benefits

of mandatory audit firm rotation. Other initiatives to address concerns about auditor

independence and audit quality therefore need be considered before imposing mandatory

audit firm rotation.

JEL classification: M40

Key words: Audit Quality, Audit Firm Rotation, Audit Opinion, Discretionary Accruals

Electronic copy available at: http://ssrn.com/abstract=1000076

Introduction

Considerable research has examined the effect that the length of the auditor-client tenure

has had on audit quality, but commonly fails to consider the financial characteristics of

clients in the years preceding a switch. This study examines the financial attributes of

clients in the years preceding and succeeding an audit firm switch, as well as voluntary

auditor switching behaviour to determine whether such auditor movements would be

favourable under a scheme of mandatory rotation. The ability of the top-tier audit firms

and industry-specialists to provide consistently high levels of audit quality is also studied.

Following recent legislative changes imposed on the auditing profession through the

introduction of the Sarbanes-Oxley Act (SOX) and the Corporate Law Economic Reform

Program (Audit Reform & Corporate Disclosure) Act 1999 (CLERP 9), there is a need to

determine whether the current regulations are enough to restore public confidence in the

profession, or whether further regulatory changes, such as a system of mandatory audit

firm rotation, are desirable. There has also been a call for further research on this topic

by both the international standard setters and academics (see, for example, GAO, 2003;

Nagy, 2005). This study is further motivated by a lack of research examining

characteristics of the client in the years prior to the audit firm switch, which may have an

impact on subsequent audit quality.

The aim of this study is to understand whether the client’s financial characteristics under

the predecessor auditor have an impact on audit quality under the incumbent auditor. An

additional aim is to determine whether current voluntary switching patterns would be

conducive to a system of forced rotation, and whether the top-tier audit firms and industry

specialists are able to provide higher levels of audit quality over a period of time.
2

Electronic copy available at: http://ssrn.com/abstract=1000076

We find that audit quality increases with audit firm tenure, when proxied by the

propensity to issue a going concern opinion, and is unaffected when proxied by the level

of discretionary accruals. Given our results, we conclude that mandatory audit firm

rotation will not improve audit quality. Considering the costs involved during the early

stages of an auditor-client relationship, requiring firms to rotate their auditors will place

unnecessary costs on both the auditor and the client with minimal benefits. In order to

address concerns that have arisen surrounding auditor independence issues, we conclude

that other initiatives are more likely to have a greater impact than mandatory audit firm

rotation.

Background and Empirical Predictions

Audit Firm Rotation

A system of mandatory audit firm rotation would require companies to rotate their

independent auditor periodically. Currently, listed companies in Italy and Brazil are

required to rotate their independent auditor every nine and five years respectively. In

Australia, there is currently no legislative requirement for reporting entities to rotate their

independent audit firm, although periodic rotation of lead audit partners is now obligatory

under s324DA of the Corporations Act 2001 (Cth).

Advocates of audit firm rotation believe a scheme of compulsory rotation would prevent

auditors from becoming too aligned with managers, impacting on their independence. A

client may be a significant source of revenue for an auditor, and the auditor may be

reluctant to jeopardise this revenue stream (Hoyle, 1978). Firm rotation may also help to

prevent large-scale corporate collapses. Morgan Stanley estimates the market

3
capitalisation loss of the collapses of WorldCom, Tyco, Quest, Enron and Computer

Associates to be $US460billion. Firm rotation can help restore confidence in the

regulatory system, which was found to be the case in Italy (Healey and Kim, 2003).

Further, if a client seeks a new auditor, auditors will compete with other audit firms to

win the tender and differentiate themselves in terms of service, improving audit quality

(Hoyle, 1978).

On the contrary, mandating firm rotation would lead to a loss of client knowledge when

the auditor is forced to resign. Auditors experience a significant learning curve with new

clients (Knapp, 1991), and much of the knowledge acquired during an audit is client-

specific (Kinney and McDaniel, 1996). Audit failures are generally higher in the first

years of the auditor-client relationship as the new auditor becomes familiar with the

client’s operations (Arel et al., 2005). Audit costs would also rise due to the additional

work needed by the new audit firm. The Government Accountability Office (GAO)

estimated that companies would incur additional auditor selection costs equal to 17% of

their first year audit fees (GAO, 2003). Opportunity costs would also arise because of a

mismatch between the client’s needs and those which the auditor can offer (Arruñada and

Paz-Ares, 1997). Auditor resignations provide valuable signals to the market (Wells and

Loudder, 1997). Under mandatory rotation, if a client is experiencing conflicts with its

auditor over accounting treatments and the auditor is forced to rotate, the market misses

out on valuable signals that would have taken place under voluntary rotation. The largest

accounting firms may also increase their market share under mandatory rotation, as has

been the case in Italy (Buck and Michaels, 2005), leading to a less competitive

environment.

4
Related Literature and Empirical Predictions

It has been argued that companies switch auditors to avoid receiving qualified audit

reports. This argument assumes that managers dislike qualified reports and that

manager’s influence the appointment decision.

The first assumption is relatively uncontroversial. A qualified report may signal to

investors that managers are poor stewards of the company’s affairs, or that managers

have attempted to present an over-favourable view of the company’s performance and/or

position. In addition, qualified reports cause share prices to fall, reducing managerial

utility if managers own shares or if their compensation is directly related to market value

(Firth, 1978; Banks and Kinney, 1982; Fleak and Wilson, 1994; Chen and Church, 1996;

Jones, 1996).

The second assumption is more controversial. By law in Australia, auditors are appointed

by shareholders. However, in fact, managers exert considerable influence over auditor

appointments. Incumbent auditors are often dismissed by managers without consulting

shareholders, with the shareholders merely voting on whether to accept their

recommendation regarding the appointment of a new auditor or the re-appointment of the

incumbent. Secondly, managers have some influence over the appointment of a new

auditor or the re-appointment of the incumbent auditor. Managers set meeting agendas

when auditor appointments are proposed, and they typically have the proxy votes of a

large number of shareholders. Thus, managers have considerable influence over auditor

hiring and firing.

5
If managers dislike qualified reports and have some influence over auditor appointment,

they may try to use auditor switching to avoid receiving qualified reports. Teoh (1992)

usefully identifies two ways in which this could occur. First, a manager may actively use

the auditor switch decision to avoid receiving a qualified report. If a new auditor is less

likely to give a qualified report compared to the incumbent auditor, the manager may

choose to switch. Similarly, if a new auditor is more likely to give a qualified report

compared to the incumbent, the manager may choose not to switch. Second, if auditors

earn client-specific rents, a manager may obtain a more favourable report from an

incumbent auditor by threatening to switch to a new auditor.

Geiger and Raghunandan (2002) find that auditors are more likely to issue an unqualified

audit opinion prior to a client filing for bankruptcy in the early years of the auditor-client

relationship. Myers et al. (2003) on the other hand find that as auditor tenure increases,

auditors place greater constraints on the degree of discretionary and current accruals

allowed by management. These results suggest that mandatory audit firm rotation may

have adverse effects on audit quality, as audit quality is lower in the earlier years of the

auditor-client relationship.

A number of other reasons have been proffered as to why clients decide to change

auditors. Chow and Rice (1982) find that the incidence of a qualified report was a

significant reason for clients to switch auditors. Schwartz and Menon (1985) find that

failing clients had a greater propensity to switch auditors, while Williams (1988) argues

that financially-distressed clients have greater incentives to change auditors than healthy

clients in order for managers to portray a good image of the company. Hence, there is

some evidence that a large proportion of switching clients may be financially distressed.
6
However, a change in auditor is not always initiated by the client, but rather may be

initiated by the audit firm. Prior research indicates that audit firms by virtue of their own

internal quality procedures have a tendency to shed risky clients. An audit firm with a

risky client may decide to drop the client from its portfolio in order to reduce their

engagement risk (Johnstone and Bedard, 2004). Auditors generally resign from clients

with high financial distress and in receipt of a modified (particularly going-concern)

opinion (Krishnan and Krishnan, 1997). Shu (2000) also finds that an auditor resignation

is positively related to client legal exposure. The preceding arguments suggest that as a

result of risky clients deciding to change auditors, or auditors deciding to resign from

risky clients, a large proportion of clients that do switch will be financially unsound.

A large body of research underscores the higher levels of audit quality that the top-tier

audit firms can provide to their clients. DeAngelo (1981) argues that audit firms with

more clients have greater incentives to supply higher quality audits. Teoh and Wong

(1993) find that clients of Big N audit firms generally have higher earnings response

coefficients to audited earnings announcements, while Francis et al. (1999) find that Big

N audit firms were able to reduce the level of discretionary accruals reported by their

clients, indicating a more effective assertion of independence. The prior literature

suggests that firms with higher levels of discretionary accruals are able to manage

earnings which lead to lower audit quality.

Some audit firms differentiate themselves from their competitors by specialising in

auditing clients in particular industries. Craswell et al. (1995) find that industry-

specialists command a fee premium of around 16% over non-industry specialists,

7
indicating that clients are willing to pay more for the services of such an auditor. Schauer

(2002) finds that clients of industry specialists had lower bid-ask spreads, signifying

lower levels of information asymmetry associated, and Krishnan (2003) observes that

clients of industry-specialists reported lower levels of accruals.

From the prior research, it appears that audit quality as measured by the propensity to

issue a going concern opinion and the level of discretionary accruals is impacted by a

change in auditor. Therefore, we propose the following hypothesis, stated in the null:

H0: Audit firm rotation does not affect audit quality.

Sample Selection and Research Design

Sample Selection

This study examines auditor switches occurring between 1995 and 2003 for Australian

listed entities. It was decided to study the period from 1995, as data were readily

available for the year, and follows many of the Big N audit firm mergers. The period

1995 – 1999 also offers a comparable time period with 2000 – 2003. The period from

2000 has been marked by a number of considerable changes and events. The Ramsay

Report, issued in 2001, highlighted a number of threats to auditor independence,

including the provision of non-audit services. The passage of SOX in the US, which

mandated partner rotation and prohibited the provision of a number of non-audit services

provided simultaneously with an audit, took place. In addition, high profile corporate

collapses, including Enron, WorldCom, and HIH, brought auditor-client relationships

under even greater examination.

8
The initial sample consisted of 772 auditor switches for listed ASX entities between 1995

and 2003. Financial sector firms were excluded due to the inherent differences in their

reporting nature. After excluding clients where discretionary accruals data was not

available, those with insufficient data, those reporting in a foreign currency, and for

clients where a matched entity could not be found, a total of 205 auditor switches

resulted. The total sample was used to measure changes in the level of discretionary

accruals with auditor tenure. Both switching client firm-year observations and non-

switching client firm-year observations were included, yielding a total of 1750 firm-year

observations.

Each listed entity’s independent auditor was identified from Craswell’s Who Audits

Australia database from 1994 to 2003. The age of clients was obtained from the ASX

website and Aspect Huntley’s DatAnalysis. Financial statement balances were also

obtained from Aspect Huntley’s DatAnalysis. Takeover announcements were collected

from Connect 4, while debt and equity issues data were collected from Thompson's SDC

Platinum New Issues Database. Market capitalisation data was collected from CRIF.

Any missing data was hand collected from relevant sources. Variables were winsorised

at the 5th and 95th percentiles to remove the effect of significant outliers.

Research Design

Audit quality has been defined in numerous ways, ranging from the relative degree to

which the audit conforms to applicable auditing standards (Krishnan and Schauer, 2001;

Tie, 1999; McConnell and Banks, 1998; Cook, 1987), the market-assessed probability

that the financial statements contain material errors and that the auditor will discover and

report them (DeAngelo, 1981), the accuracy of the information reported on by auditors
9
(Titman and Trueman, 1986; Beatty, 1989; Krinsky and Rotenberg, 1989), and a measure

of the audit’s ability to reduce noise and bias and improve fineness in accounting data

(Wallace, 1980). Any metric used to measure audit quality, however, are not perfect.

Proxies for audit quality can only be devised in most cases using publicly available

information, and not private information known to the auditor. The true audit quality is

when the audit does not result in a type I or type II error – a failing company being given

an unqualified report or a non-failing company being given a qualified report.

In order to test our hypothesis that a change in audit firm has no effect on audit quality

we estimate the following model:

AQ = α + β 1TENURE + β 2 FRISK + β 3 SIZE + β 4 LEV + β 5 CLEV

+ β 6 RETURN + β 7 LDISTRESS + β 8 INVEST + β 9 FEERATIO + β 10 SCFO (1)
+ β 11 PRIOR + β 12 BIG _ N + β 13 LEADER + β14 INDUSTRY + ε

where AQ is audit quality, TENURE is the number of continuous years the incumbent

auditor has been with the client; FRISK is the client financial risk as measured by the

Zmijewski (1984) financial distress score1; SIZE is measured as the natural log of total

assets, LEV is the ratio of liabilities to assets, CLEV is the percentage change in LEV

during the year, RETURN is the percentage change in the book value of net assets over

the year, LDISTRESS is a dummy variable indicating if the client was financially

distressed2 in the previous year, INVEST is investment securities measured by current

assets less current debtors and inventory scaled by total assets, FEERATIO is fee

dependence as measured by non-audit fees divided by non-audit and audit fees paid to the

1
Calculated as per Carcello et al. (1995): FRISK = -4.803 – 3.6(net profit/total assets) + 5.4(total
liabilities/total assets) – 0.1(current assets/current liabilities).
2
The measure of financial distress employed is negative cash flows from operations and/or a loss after
abnormal items.

10
incumbent auditor, SCFO is the net cash flows from operations scaled by lagged total

assets, PRIOR is a dummy variable indicating if the client received a going-concern

opinion in the prior year, BIG_N is a dummy variable indicating if the firm was audited

by a Big N auditor, LEADER is a dummy variable indicating if the audit firm is a leader

in the firm’s industry, and INDUSTRY is a dummy variable indicating if a firm is in the

mining sector.

Two measures of audit quality are employed within this study. First, audit quality is

measured as the propensity of the auditor to issue a going concern opinion (GCO) after

controlling for other factors that might affect this decision. A finding that auditors have a

lower (higher) propensity to issue going concern opinions with increased tenure would

provide convincing evidence in favour of (in opposition to) mandatory rotation, i.e. if

there is lower propensity to issue GCO with increased tenure, then independence

becomes impaired. As the dependent variable in this measurement of audit quality is a

dichotomous variable, being the propensity to issue a going concern opinion, a logistic

regression is run.

Second, the level of discretionary accruals (DA) is used. Discretionary accruals are

accruals that do not relate to normal operating activities, and so a higher level of these

accruals may indicate that management has been able to exert its power over the auditor

by being able to report on terms favourable to management. As this second measurement

of audit quality is a continuous variable, an OLS regression is sufficient.

To measure discretionary accruals, a performance-matched modified-Jones (1991)

discretionary accruals model was used. Dechow et al. (1995) find that the modified Jones
11
model had the highest statistical power in detecting earnings management, while Kothari

et al. (2005) suggest matching for performance helps to control for changes in accruals

models associated with client performance levels. Performance matched firms are

matched by year and industry. Discretionary accruals are estimated by:

TACC = α 1 + α 2 (ΔSales − Δ Re c ) + α 3 PPE + α 4 LTACC + α 5 Growth + ε (2)

where is TACC is total accruals (operating net profit after tax – cash flows from

operations), ΔSales is the change in sales for the year scaled by lagged total assets, ΔRec

is the change in accounts receivable during the year scaled by lagged total assets, PPE is

the gross property, plant and equipment scaled by lagged total assets, Growth is the ratio

of next year’s sales to this years, and the residual from the regression, ε, is the measure of

discretionary accruals. The higher the level of the residual indicates a lower level of

accrual quality.

The model employed in this study is based closely on that used by DeFond et al. (2002)

and Carey and Simnett (2006). The Zmijewski (1984) probability of bankruptcy score

(FRISK) is included because clients closer to bankruptcy should have a higher chance of

receiving a going-concern report. SIZE is included because larger clients will have more

assets to sell in the event of financial difficulty, and should be less prone to receiving a

going-concern report. LEV and CLEV are employed because higher levels of debt

relative to total assets indicate higher risk, and greater changes in leverage may suggest

that the client is close to violating a debt covenant. RETURN is included, because clients

with higher levels of growth should be less likely to fail.

12
Results

Descriptive Statistics

Descriptive statistics are presented in Table 1. Panel A provides the results for the full

sample, with Panels B and C providing the results for the switching and non-switching

firms respectively. Means of the variables are consistent with prior research. Of the total

sample, 4.06% of firm-year observations result in a going concern opinion being issued,

which increases to 5.37% for switching firms (3.88% for non-switching firms).

- - - INSERT TABLE 1 ABOUT HERE - - -

Table 2 outlines the correlation coefficients between the variables, using both Pearson

and Spearman rank correlations. Firms that were financially distressed in the prior year

have a high negative correlation with both RETURN and SCFO.

- - - INSERT TABLE 2 ABOUT HERE - - -

Going Concern Opinion

Table 3 presents the results of the logistic regression using the propensity to issue a

going-concern audit opinion as a proxy for audit quality. Panel A provides the results for

the full sample, with Panels B and C providing the results for the switching and non-

switching firms respectively.

- - - INSERT TABLE 3 ABOUT HERE - - -

Results from Table 3 indicate that audit-client tenure increases the likelihood of the

auditor issuing a going concern audit opinion. This result is inconsistent with the results

of Geiger and Raghunandan (2002) who found no statistically significant relationship,

13
and with those of Choi and Doogar (2005) who found a significantly negative

relationship between audit quality and tenure.

As expected, FRISK was positively associated with the propensity to issue a going

concern opinion, indicating that firms with higher probabilities of bankruptcy are more

likely to receive a going concern opinion. SIZE was found to have a significant negative

coefficient, consistent with the expectation that larger firms will have more opportunities

to get out of financial difficulties, and thus be less likely to receive a going concern

opinion. LDISTRESS and PRIOR both have positively significant coefficients as per

expectations, consistent with prior findings (see, for example, DeFond et al., 2002; Choi

and Doogar, 2005). Additionally, firms in the mining sector are also found to have a

higher propensity to receive a going concern opinion, consistent with many firms in this

sector being speculative or loss making firms.

Firms with larger investments (INVEST) and strong cash flows from operations (SCFO)

are less likely to receive a going concern opinion, as per expectations, as indicated with

statistically significant negative coefficients. Firms audited by an industry leader are

found to have a lower propensity to receive a going concern audit opinion, however, the

coefficient estimates are not significant at any meaningful level.

Discretionary Accruals

Table 4 presents the results of the model using discretionary accruals as the proxy of

audit quality. Again, Panel A provides the results for the full sample, with Panels B and

C providing the results for the switching and non-switching firms respectively.

- - - INSERT TABLE 4 ABOUT HERE - - -

14
The main variable of interest in this study, TENURE, is both economically small and

statistically insignificant. This suggests that there is no significant change in audit quality

over time, leading to our conclusion that there may be no need to rotate auditors. Results

show that larger clients have higher levels of performance-matched discretionary

accruals. Consistent with Johnson et al. (2002) and Ferguson et al. (2004), leverage is

positively related to the level of discretionary accruals. There was a significant negative

coefficient for cash flow from operations and for firms operating in the mining sector.

Companies that experience higher growth in net assets were found to report lower levels

of discretionary accruals, although statistically insignificant. This may be similar to

industry growth, although Myers et al. (2003) and Blouin et al. (2005) did not find any

significant relationship between industry growth and discretionary accruals. Firms

audited by an industry leader are found to have higher levels of discretionary accruals but

not at any meaningful level of significance.

Sensitivity Analysis

The TENURE variable was replaced by two dummy variables indicating length of tenure

greater than 5 and 6 years. Untabulated results are consistent with the earlier results,

using both the propensity to issue a going concern opinion and discretionary accruals as

proxies for audit quality. The implication of these results suggest that contrary to an

argument for mandatory audit firm rotation, the length of audit tenure does not have an

economically or statistically significant effect on audit quality, as measured by the level

of discretionary accruals, and the propensity to issue a going concern audit opinion

increases with the length of audit firm tenure.

15
Carson et al. (2006) report that since 2001 there has been an increase in the percentage of

firms that receive a going concern opinion. To test our results to the sensitivity of

changes in audit behaviour, we included a dummy variable for firm years from 2001 to

the end of our sample period. Including this variable does not alter our results.

Conclusions and Limitations

Using two proxies for audit quality, being the propensity to issue a going concern audit

opinion and the level of discretionary accruals, we find that audit quality is not negatively

affected by audit firm tenure. Using the propensity to issue a going concern opinion, the

length of audit tenure actually increases audit quality. However, when using the level of

discretionary accruals to measure audit quality there is neither an increase nor a decrease

in audit quality conditional on the length of auditor tenure. Given this result, there are

minimal, if any, benefits of imposing mandatory audit firm rotation onto Australian firms.

Further, given the costs involved in switching auditor, it does not appear that mandatory

audit firm rotation would be beneficial to the market. In order to address the concerns

that have arisen recently around auditor independence and audit quality, other initiatives

are more likely to have a greater impact than imposing mandatory audit firm rotation.

The proxies used in this study to measure audit quality, however, are not perfect. Proxies

for audit quality can only be devised in most cases using publicly available information,

and not information known to the auditor. Audit quality can be divided into perceived

audit quality and actual audit quality (Taylor, 2005). This study only examines levels of

actual audit quality.

16
Additionally, the signal that an audit firm switch sends to the market may be of interest to

investors, and send a valuable signal which mandatory audit firm rotation would remove.

To fully understand the signal, information about the reasons for the switch, and who

instigated the switch, be it the client or the audit firm, would need to be known. In the

Australian environment, however, this information is not publicly available.

17
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20
Table 1: Sample descriptive statistics

Panel A: Full-sample descriptive statistics (n=1750)

Variable Mean Std Min Quartile1 Median Quartile3 Max
GCO 0.0406 0.1974 0.0000 0.0000 0.0000 0.0000 1.0000
DA -0.0239 0.1396 -1.0476 -0.0758 -0.0168 0.0342 0.8606
TENURE 7.2954 5.4532 1.0000 3.0000 6.0000 10.0000 32.0000
FRISK -2.3819 1.6920 -8.1190 -3.3102 -2.4805 -1.6405 4.1519
SIZE 17.9659 1.8758 11.4616 16.6620 17.7435 19.1076 24.4907
LEV 5.8128 15.0874 0.0000 0.0086 0.1596 1.9684 63.0075
CLEV 0.3075 0.8741 -0.6120 -0.1122 0.0553 0.3602 3.5736
RETURN 0.1170 0.4600 -0.6797 -0.0869 0.0559 0.2149 1.5453
LDISTRESS 0.5754 0.4944 0.0000 0.0000 1.0000 1.0000 1.0000
INVEST 0.1389 0.1748 -0.5415 0.0311 0.0713 0.1740 1.0000
FEERATIO 0.3238 0.2389 0.0000 0.1316 0.3078 0.4902 0.9779
SCFO 0.0376 0.2022 -0.9795 -0.0246 0.0647 0.1260 0.6041
PRIOR 0.0063 0.0791 0.0000 0.0000 0.0000 0.0000 1.0000
BIG_N 0.6983 0.4591 0.0000 0.0000 1.0000 1.0000 1.0000
LEADER 0.1977 0.3984 0.0000 0.0000 0.0000 0.0000 1.0000
INDUSTRY 0.5394 0.4986 0.0000 0.0000 1.0000 1.0000 1.0000

Panel B: Switching clients descriptive statistics (n=205)

GCO 0.0537 0.2259 0.0000 0.0000 0.0000 0.0000 1.0000
DA -0.0168 0.1549 -0.9269 -0.0710 -0.0069 0.0427 0.6390
TENURE 2.1951 3.1593 1.0000 1.0000 1.0000 1.0000 18.0000
FRISK -2.2218 1.7884 -5.4695 -3.4345 -2.5547 -1.4187 4.1262
SIZE 17.6379 1.9665 11.4616 16.3290 17.4886 18.8584 24.4907
LEV 10.2942 19.0199 0.0000 0.0211 0.8149 7.7183 63.0075
CLEV 0.3610 0.9785 -0.6120 -0.1527 0.0789 0.4448 3.5736
RETURN 0.1534 0.5569 -0.6797 -0.1617 0.0555 0.3164 1.5453
LDISTRESS 0.6439 0.4800 0.0000 0.0000 1.0000 1.0000 1.0000
INVEST 0.1542 0.1871 0.0002 0.0371 0.0848 0.1964 1.0000
FEERATIO 0.2819 0.2548 0.0000 0.0228 0.2365 0.4762 0.9077
SCFO -0.0123 0.2277 -0.9795 -0.0815 0.0406 0.1154 0.6041
PRIOR 0.0537 0.2259 0.0000 0.0000 0.0000 0.0000 1.0000
BIG_N 0.6195 0.4867 0.0000 0.0000 1.0000 1.0000 1.0000
LEADER 0.1951 0.3973 0.0000 0.0000 0.0000 0.0000 1.0000
INDUSTRY 0.4634 0.4999 0.0000 0.0000 0.0000 1.0000 1.0000

21
Table 1 continued: Sample descriptive statistics

Panel C: Matched non-switching clients descriptive statistics (n=1545)

GCO 0.0388 0.1933 0.0000 0.0000 0.0000 0.0000 1.0000
DA -0.0249 0.1375 -1.0476 -0.0767 -0.0175 0.0332 0.8606
TENURE 7.9722 5.3343 1.0000 4.0000 7.0000 11.0000 32.0000
FRISK -2.4031 1.6783 -8.1190 -3.3043 -2.4742 -1.6757 4.1519
SIZE 18.0094 1.8598 11.9939 16.7108 17.7731 19.1437 23.5549
LEV 5.2182 14.3888 0.0000 0.0074 0.1427 1.5702 63.0075
CLEV 0.3004 0.8594 -0.6120 -0.1088 0.0521 0.3528 3.5736
RETURN 0.1121 0.4455 -0.6797 -0.0774 0.0560 0.2087 1.5453
LDISTRESS 0.5663 0.4957 0.0000 0.0000 1.0000 1.0000 1.0000
INVEST 0.1369 0.1731 -0.5415 0.0309 0.0698 0.1722 0.9721
FEERATIO 0.3294 0.2363 0.0000 0.1440 0.3140 0.4940 0.9779
SCFO 0.0443 0.1977 -0.9795 -0.0163 0.0681 0.1274 0.6041
PRIOR 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
BIG_N 0.7087 0.4545 0.0000 0.0000 1.0000 1.0000 1.0000
LEADER 0.1981 0.3987 0.0000 0.0000 0.0000 0.0000 1.0000
INDUSTRY 0.5495 0.4977 0.0000 0.0000 1.0000 1.0000 1.0000

GCO is a dummy variable indicating if a firm received a going concern opinion, DA is a measure of the level of
discretionary accruals, TENURE is the number of continuous years the incumbent auditor has been with the
client; FRISK is the client financial risk as measured by the Zmijewski (1984) financial distress score; SIZE
is measured as the natural log of total assets, LEV is the ratio of liabilities to assets, CLEV is the percentage
change in LEV during the year, RETURN is the percentage change in the book value of net assets over the
year, LDISTRESS is a dummy variable indicating if the client was financially distressed in the previous
year, INVEST is investment securities measured by current assets less current debtors and inventory scaled
by total assets, FEERATIO is fee dependence as measured by non-audit fees divided by non-audit and audit
fees paid to the incumbent auditor, SCFO is the net cash flows from operations scaled by lagged total
assets, PRIOR is a dummy variable indicating if the client received a going-concern opinion in the prior
year, BIG_N is a dummy variable indicating if the firm was audited by a Big N auditor, LEADER is a
dummy variable indicating if the audit firm is a leader in the firm’s industry, and INDUSTRY is a dummy
variable for firms in the mining sector.

22
Table 2: Pearson and Spearman correlations

GCO DA TENURE SIZE FRISK LEV CLEV RETURN LDISTRESS INVEST FEERATIO SCFO PRIOR
0.0537 -0.0156 -0.2043 0.2327 0.1130 0.0320 -0.1016 0.1298 0.0062 -0.0485 -0.1984 0.0911
GCO
(0.0245) (0.5147) (<.0001) (<.0001) (<.0001) (0.1806) (<.0001) (<.0001) (0.7947) (0.0426) (<.0001) (0.0001)
0.0627 -0.0068 0.0365 0.0227 -0.0154 0.0576 -0.0105 0.0553 -0.1240 0.0303 -0.5203 0.0501
DA
(0.0087) (0.7763) (0.1267) (0.3435) (0.5193) (0.0160) (0.6612) (0.0207) (<.0001) (0.2052) (<.0001) (0.0360)
-0.0121 -0.0194 0.2193 -0.0247 -0.1415 -0.0751 -0.0167 -0.0869 -0.0962 0.0405 0.0998 -0.0880
TENURE
(0.6145) (0.4180) (<.0001) (0.3026) (<.0001) (0.0017) (0.4839) (0.0003) (<.0001) (0.0905) (<.0001) (0.0002)
-0.2112 0.0201 0.1976 0.0022 -0.3326 -0.0713 0.0933 -0.2714 -0.3188 0.2694 0.3476 -0.0507
SIZE
(<.0001) (0.4015) (<.0001) (0.9260) (<.0001) (0.0028) (<.0001) (<.0001) (<.0001) (<.0001) (<.0001) (0.0338)
0.1552 0.0369 0.0232 0.1146 0.1094 0.0295 -0.3190 0.1584 -0.1993 -0.0283 -0.1827 0.0808
FRISK
(<.0001) (0.1229) (0.3323) (<.0001) (<.0001) (0.2172) (<.0001) (<.0001) (<.0001) (0.2360) (<.0001) (0.0007)
0.1157 -0.0005 -0.1671 -0.4679 0.0184 0.0028 -0.0694 0.0409 0.1075 -0.0977 -0.1722 0.0310
LEV
(<.0001) (0.9822) (<.0001) (<.0001) (0.4415) (0.9085) (0.0037) (0.0874) (<.0001) (<.0001) (<.0001) (0.1950)
-0.0124 0.0331 -0.0949 0.0357 0.0987 -0.0225 0.2598 0.1015 0.0417 0.0162 -0.1065 0.0177
CLEV
(0.6028) (0.1665) (<.0001) (0.1349) (<.0001) (0.3467) (<.0001) (<.0001) (0.0814) (0.4996) (<.0001) (0.4583)
-0.1151 0.0366 0.0071 0.1639 -0.2973 -0.0950 0.1467 -0.1847 0.0595 0.0805 0.0920 0.0474
RETURN
(<.0001) (0.1255) (0.7652) (<.0001) (<.0001) (<.0001) (<.0001) (<.0001) (0.0127) (0.0007) (0.0001) (0.0475)
0.1298 0.0342 -0.0801 -0.2768 0.1173 -0.0146 0.0040 -0.2910 0.1426 -0.0974 -0.3505 0.0248
LDISTRESS
(<.0001) (0.1529) (0.0008) (<.0001) (<.0001) (0.5410) (0.8665) (<.0001) (<.0001) (<.0001) (<.0001) (0.2991)
-0.0134 -0.1622 -0.0778 -0.2634 -0.1938 0.1393 -0.0310 0.0219 0.1109 0.0307 -0.1734 -0.0149
INVEST
(0.5762) (<.0001) (0.0011) (<.0001) (<.0001) (<.0001) (0.1949) (0.3608) (<.0001) (0.1992) (<.0001) (0.5322)
-0.0522 0.0191 0.0506 0.2686 0.0020 -0.0924 0.0597 0.0655 -0.0979 0.0299 0.0496 -0.0328
FEERATIO
(0.0291) (0.4251) (0.0344) (<.0001) (0.9329) (0.0001) (0.0125) (0.0061) (<.0001) (0.2112) (0.0381) (0.1707)
-0.2252 -0.5004 0.1082 0.3684 -0.1216 -0.1744 0.0329 0.2997 -0.3901 -0.0473 0.0861 -0.0558
SCFO
(<.0001) (<.0001) (<.0001) (<.0001) (<.0001) (<.0001) (0.1689) (<.0001) (<.0001) (0.0479) (0.0003) (0.0195)
0.0911 0.0513 -0.1159 -0.0511 0.0528 0.0187 -0.0238 0.0238 0.0248 -0.0013 -0.0362 -0.0601
PRIOR
(0.0001) (0.0320) (<.0001) (0.0325) (0.0270) (0.4339) (0.3191) (0.3189) (0.2991) (0.9557) (0.1301) (0.0120)

Pearson (Spearman rank) correlation above (below) the diagonal; the two-tailed p-value is provided in parentheses below the correlation. GCO is a dummy variable
indicating if a firm received a going concern opinion, DA is a measure of the level of discretionary accruals, TENURE is the number of continuous years the incumbent auditor has
been with the client; FRISK is the client financial risk as measured by the Zmijewski (1984) financial distress score; SIZE is measured as the natural log of total assets,
LEV is the ratio of liabilities to assets, CLEV is the percentage change in LEV during the year, RETURN is the percentage change in the book value of net assets over the
year, LDISTRESS is a dummy variable indicating if the client was financially distressed in the previous year, INVEST is investment securities measured by current assets
less current debtors and inventory scaled by total assets, FEERATIO is fee dependence as measured by non-audit fees divided by non-audit and audit fees paid to the
incumbent auditor, SCFO is the net cash flows from operations scaled by lagged total assets, and PRIOR is a dummy variable indicating if the client received a going-
concern opinion in the prior year.

23
Table 3: Logistic Regression – Going Concern Opinion
GCO = α + β1TENURE + β2FRISK + β3 SIZE + β4LEV + β5 CLEV + β6 RETURN +
β7LDISTRESS + β8 INVEST + β9 FEERATIO + β10SCFO + β11PRIOR + β12BIG_N +
β13LEADER + β14INDUSTRY

Panel A: Full-sample (n=1750)

Variable Coefficient Estimate Std Error Wald Chi-Square
Intercept 4.3094** 2.0190 4.56
TENURE 0.0570** 0.0267 4.55
FRISK 0.3071*** 0.0692 19.67
SIZE -0.4710*** 0.1163 16.41
LEV 0.0038 0.0068 0.31
CLEV -0.0189 0.1391 0.02
RETURN -0.1800 0.2737 0.43
LDISTRESS 0.6623* 0.4024 2.71
INVEST -1.2595 0.8223 2.35
FEERATIO 0.8203 0.5938 1.91
SCFO -1.2163* 0.6272 3.76
PRIOR 1.8439** 0.7959 5.37
BIG_N -0.6020** 0.2984 4.07
LEADER -0.1912 0.4567 0.18
INDUSTRY 0.6559** 0.3007 4.76
Log Likelihood 594.416

Panel B: Switching clients (n=205)

Intercept 10.7286 7.7614 1.91
TENURE -0.1666 0.4192 0.16
FRISK 0.4614** 0.2031 5.16
SIZE -0.7299* 0.4305 2.87
LEV -0.0205 0.0200 1.05
CLEV 0.1401 0.3529 0.16
RETURN -0.8198 0.7122 1.33
LDISTRESS 0.1693 1.3866 0.01
INVEST 1.0830 2.1641 0.25
FEERATIO -3.2259 2.2570 2.04
SCFO 3.2308 2.7457 1.38
PRIOR 2.1499** 1.0357 4.31
BIG_N -1.6093 1.0410 2.39
LEADER -9.4295 293.4000 0.00
INDUSTRY 0.6150 0.8476 0.53
Log Likelihood 85.751

24
Table 3 continued: Logistic Regression – Going Concern Opinion

Panel C: Matched non-switching clients (n=1545)

Intercept 3.8100* 2.1499 3.14
TENURE 0.0570* 0.0295 3.74
FRISK 0.2864*** 0.0782 13.42
SIZE -0.4556*** 0.1247 13.34
LEV 0.0099 0.00741 1.78
CLEV -0.1288 0.1627 0.63
RETURN -0.1550 0.3196 0.24
LDISTRESS 0.7063* 0.428 2.72
INVEST -1.7941* 0.9389 3.65
FEERATIO 1.353** 0.6602 4.20
SCFO -1.9129*** 0.7395 6.69
BIG_N -0.6204* 0.3303 3.53
LEADER -0.1675 0.4693 0.13
INDUSTRY 0.7044** 0.3304 4.55
Log Likelihood 507.451

*, **, *** significant at the 10%, 5% and 1% levels respectively. GCO is a dummy variable indicating if the firm
received a going concern opinion, TENURE is the number of continuous years the incumbent auditor has been
with the client; FRISK is the client financial risk as measured by the Zmijewski (1984) financial distress
score; SIZE is measured as the natural log of total assets, LEV is the ratio of liabilities to assets, CLEV is the
percentage change in LEV during the year, RETURN is the percentage change in the book value of net
assets over the year, LDISTRESS is a dummy variable indicating if the client was financially distressed in
the previous year, INVEST is investment securities measured by current assets less current debtors and
inventory scaled by total assets, FEERATIO is fee dependence as measured by non-audit fees divided by
non-audit and audit fees paid to the incumbent auditor, SCFO is the net cash flows from operations scaled
by lagged total assets, PRIOR is a dummy variable indicating if the client received a going-concern opinion
in the prior year, BIG_N is a dummy variable indicating if the firm was audited by a Big N auditor,
LEADER is a dummy variable indicating if the audit firm is a leader in the firm’s industry, and INDUSTRY
is a dummy variable for firms in the mining sector.

25
Table 4: OLS Regression – Discretionary Accruals
DA = α + β1TENURE + β2FRISK + β3 SIZE + β4LEV + β5 CLEV + β6 RETURN +
β7LDISTRESS + β8 INVEST + β9 FEERATIO + β10SCFO + β11PRIOR+ β12BIG_N+
β13LEADER + β14INDUSTRY

Panel A: Full-sample (n=1750)

Variable Coefficient Estimate Std Error t-stat
Intercept -0.2259*** 0.0334 -6.77
TENURE 0.0000 0.0005 -0.05
FRISK -0.0114*** 0.0018 -6.52
SIZE 0.0134*** 0.0018 7.36
LEV -0.0004* 0.0002 -1.88
CLEV 0.0038 0.0032 1.20
RETURN -0.0070 0.0065 -1.08
LDISTRESS -0.0238*** 0.0059 -4.02
INVEST -0.1559*** 0.0167 -9.32
FEERATIO 0.0075 0.0116 0.64
SCFO -0.4625*** 0.0149 -31.15
PRIOR 0.0572* 0.0337 1.70
BIG_N -0.0117* 0.0065 -1.81
LEADER 0.0053 0.0070 0.75
INDUSTRY -0.0131** 0.0054 -2.41
Adjusted R2 0.3796

Panel B: Switching clients (n=205)

Intercept -0.3674*** 0.1267 -2.90
TENURE 0.0036 0.0030 1.21
FRISK -0.0298*** 0.0059 -5.05
SIZE 0.0199*** 0.0069 2.90
LEV 0.0003 0.0006 0.56
CLEV 0.0140 0.0096 1.46
RETURN -0.0167 0.0180 -0.93
LDISTRESS -0.0495*** 0.0211 -2.35
INVEST -0.1736*** 0.0537 -3.23
FEERATIO -0.0254 0.0371 -0.68
SCFO -0.4301*** 0.0463 -9.28
PRIOR 0.1063** 0.0409 2.60
BIG_N -0.0289 0.0216 -1.34
LEADER 0.0079 0.0247 0.32
INDUSTRY -0.0201 0.0181 -1.11
Adjusted R2 0.3472

26
Table 4 continued: OLS Regression – Discretionary Accruals

Panel C: Matched non-switching clients (n=1545)

Intercept -0.2102*** 0.0342 -6.14
TENURE -0.0003 0.0005 -0.65
FRISK -0.0093*** 0.0018 -5.11
SIZE 0.0129*** 0.0019 6.86
LEV -0.0004* 0.0002 -1.82
CLEV 0.0023 0.0034 0.67
RETURN -0.0061 0.0069 -0.87
LDISTRESS -0.0203*** 0.0061 -3.33
INVEST -0.1535*** 0.0175 -8.77
FEERATIO 0.0099 0.0123 0.80
SCFO -0.4711*** 0.0157 -30.02
BIG_N -0.0117* 0.0067 -1.74
LEADER 0.0031 0.0073 0.43
INDUSTRY -0.0111* 0.0057 -1.95
Adjusted R2 0.3912

*, **, *** significant at the 10%, 5% and 1% levels respectively. DA is a measure of discretionary accruals,
TENURE is the number of continuous years the incumbent auditor has been with the client; FRISK is the
client financial risk as measured by the Zmijewski (1984) financial distress score; SIZE is measured as the
natural log of total assets, LEV is the ratio of liabilities to assets, CLEV is the percentage change in LEV
during the year, RETURN is the percentage change in the book value of net assets over the year,
LDISTRESS is a dummy variable indicating if the client was financially distressed in the previous year,
INVEST is investment securities measured by current assets less current debtors and inventory scaled by
total assets, FEERATIO is fee dependence as measured by non-audit fees divided by non-audit and audit
fees paid to the incumbent auditor, SCFO is the net cash flows from operations scaled by lagged total
assets, PRIOR is a dummy variable indicating if the client received a going-concern opinion in the prior
year, BIG_N is a dummy variable indicating if the firm was audited by a Big N auditor, LEADER is a
dummy variable indicating if the audit firm is a leader in the firm’s industry, and INDUSTRY is a dummy
variable for firms in the mining sector.

27