Market Reaction to Deteriorating Auditor-Client Relationships

• In Event: Continental Breakfast - Research and Education Forum
  In Roundtable Session: Table 5: Risk Signals and the Market's Response

Abstract

Building upon the two-agent agency model of Antle (1982) and the strategic auditor model of Teoh (1992), I reexamine market reaction to auditor-client splits from a relationship’s perspective. Specifically, I use event study and explore empirically the association between cumulative abnormal returns (CAR) surrounding the event date and signals conveyed by the relationship termination, in addition to other concurrent observables. I first test and find that adverse conditions publicly reported in previous two years, i.e., qualified audit opinions and earnings misstatements, have a differential effect on the subsequent relationship deterioration and ultimate termination. I also predict and find that stock market penalizes issuers whose auditors depart late in their audit year cycles, especially those after the turn of the year and before the 10-K report deadline, or the ‘fifth quarter’ switches, probably due to investors’ concern of increased time pressure on the incoming auditor and uncertainty of the subsequent earnings quality. Meanwhile, investors react positively to a company’s prompt termination of a relationship damaged by previously reported adverse conditions, indicating that market rewards the corrective actions taken by the client to restore public confidence. Nevertheless, the reward soon disappears (after the end of three quarters) as manager’s remedy time takes longer. I contribute to extant accounting literature by disentangling the timing effect of a relationship termination and identifying a heretofore unreported ramification of auditor changes, the ‘fifth quarter’. I also contribute to the capital market research by depicting a bigger picture (both negative and positive dimensions) of market response to a single auditor switch event.

Author

• Dong Li, Louisiana State University