Enforcement Actions And Auditor Changes

Marcus Brocard

University of Mannheim – Department of Business Administration and Accounting

Benedikt Franke

University of Mannheim – Department of Business Administration and Accounting

Dennis Voeller

University of Mannheim

June 15, 2015

Abstract:

In this paper, we examine the relation between erroneous financial statements uncovered by enforcement actions and auditor changes. We argue that enforcement actions provide new information about the auditor or the client. Therefore, the relation between a firm and its external auditor should be affected during the ongoing enforcement process. In line with this argument, our empirical findings indicate that firms with erroneous financial statements are more likely to subsequently change the auditor. Further, our results show that firms are significantly more likely to change from a Non-Big4 auditor to a Big4 auditor. This suggests that firms not only want to blame accounting errors on the incumbent auditor, but also commit to improved audit oversight in the future. These effects are even more pronounced if an uncovered error is more severe. Moreover, additional tests suggest that auditor changes take place even before the public announcement of an error.

Enforcement Actions And Auditor Changes – Introduction

This paper examines the effects of erroneous financial statements uncovered by the German enforcement system on the auditor-client relation.1 With the enactment of EC Regulation No. 1606/2002, the European Union (EU) required member states to establish appropriate enforcement measures to ensure compliance with the International Financial Reporting Standards (IFRS). Since 2005, Germany has a two-tier enforcement system in place. The government-appointed, privately organized Financial Reporting Enforcement Panel (FREP) is responsible for regular reviews of financial reports of firms that have securities outstanding on the regulated market. In addition, the Federal Financial Supervisory Authority (BaFin) is in charge of unsettled cases and of enforcing the disclosure of error findings to the public.

Enforcement in general and EU accounting regulation in particular received increasing attention in recent years (e.g., Holthausen, 2009; Ernstberger et al., 2012; Hitz et al., 2012; Christensen et al., 2013). Since 2013, all EU member states have introduced enforcement mechanisms that cover regulated markets in their jurisdiction (ESMA, 2014). These mechanisms typically require a public announcement if an erroneous financial statement has been identified by an enforcement agency. Such enforcement actions arguably raise concerns about management’s reporting behavior, internal control systems, and the external auditor. In line with this notion, Hitz et al. (2012) document negative abnormal returns around the public announcement of error findings under the newly established German enforcement system.

The objective of this paper is to investigate the effects of enforcement actions on the auditor-client relation. By examining subsequent auditor changes, we analyze whether an investigation affects the auditor-client relation substantially. Changes in the economic situation of the client as well as new information about client risk and audit quality increase the probability of auditor changes (Johnson and Lys, 1990; Bockus and Gigler, 1998). Thereby, auditor changes may be driven by the external auditor or the client. On the one hand, auditors are more likely to resign from a client if the client is perceived as more risky (Krishnan and Krishnan, 1997; Shu, 2000; Johnstone and Bedard, 2004). On the other hand, client-induced auditor changes aim at blaming accounting errors on the incumbent auditor (Mande and Son, 2013). In this case, an auditor change can be interpreted as a positive signal to outside parties promising better accounting conduct in the future (Hennes et al., 2014). We make use of enforcement actions by the German enforcement system which serve as an event that provides new information to the auditor or the client. Auditors, for example, might learn that clients carry a different business risk than previously expected. Further, enforcement actions increase the probability of negative consequences such as legal prosecution or reputation losses for auditors and clients. Therefore, the auditor-client relation is likely to be affected by enforcement actions as soon as mutual expectations of auditors or clients change.

Germany provides a suitable setting to investigate the effects of enforcement on auditing in Europe. For example, audit-related information is available since the introduction of the enforcement system in 2005. Moreover, the German enforcement system offers some particularities that we exploit in our analysis. Specifically, virtually all reporting errors are announced publicly, the enforcement process might last more than two years, and the sampling procedure is to a large extent based on stratified random sampling.2 Our dataset is based on all firms that were supervised by the responsible enforcement agencies between 2005 and 2012. After requiring availability of firms’ financial information and of hand-collected data on the external auditor, our sample consists of 417 firms which represent around 80% of the German Composite Index (CDAX).

Enforcement Actions

Enforcement Actions

Enforcement Actions

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