Market Reactions to Auditors Switching from Big Four to Smaller Accounting Firms

Written by Dr. C.S. Agnes Cheng

As you may know, GLO has been registered with the Public Company Accounting Oversight Board (PCAOB) for approximately three years.  Our industry is in a paradigm shift of which we are in the forefront where large and small public companies are switching from the Big Four international firms to other CPA firms.  As a large regional firm with a global footprint supported by Integra International®1, we are able to compete on a regional and global basis.  We are happy to present to you the following Executive Summary from a study performed by Dr. Agnes Cheng and Dr. Ken Reichelt. 

After the demise of Arthur Anderson, the big players in the auditing profession included only four firms (referred to as the Big Four).  This high concentration has put the capital markets at risk.  Regulators have been encouraging public companies to select smaller accounting firms to improve competition.  The solution to the current high level of concentration faces several hurdles.  One hurdle is related to auditor expertise.  Many large firms involve global expansion and small domestic accounting firms will not be able to fulfill their needs.  Moreover, accounting standards are becoming more complicated and specialized; smaller firms may not have the resources to invest in developing their expertise.  Aside from this hurdle, a big problem may be that companies are worried about the market perception of using smaller accounting firms even when there are capable smaller firms.  Academic studies have provided negative evidence on market reaction when a company changes auditors.  Most of these studies use data prior to the enactment of the Sarbanes-Oxley Act of 2002.  A recent study by Grant Thornton2 reports no negative reaction to the auditor change from the Big Four to Grant Thornton.  Our study focuses on the market reaction to auditor changes from the Big Four to firms that are smaller (Small) than Grant Thornton and BDO Seidman (Medium Two). 

We collected auditor change data from Audit Analytics3 and analyzed the trend of auditors switching.  Out of all the switches, we found the ratio of switches from the Big Four to smaller firms has been increasing.  For public companies, the ratio rises from 37.5% (out of 349 switches) in 2003 to 52.4% (out of 418 switches) in 2006.  This trend is encouraging.  It probably reflects the increasing degree of comfort with respect to the perception of switching from the Big Four to smaller accounting firms by the public companies and Wall Street.  However, this conjecture needs empirical evidence of market responses.

To analyze market responses, we collected return data from CRSP4 from February 2002 to December 2006.  We have a total observation of 1,814 auditor changes from return data in our final sample.  After August 23, 2004,5 firms are required to file 8-K within 4 business days after the occurrence of a triggering event; this is a change from the old requirement of 5 business or 15 calendar days.  To accommodate this change of rules, we used two different event windows.  For the period prior to August 23, 2004 (Period One), we accumulated returns starting from 11 days prior to the 8-K filing date,6 expressed as (-11,0).  For the period post August 23, 2004 (Period Two), we used an event window of (-4,0). We found that prior to August 23, 2004, the market rewarded firms switching from the Big Four to the Middle Two accounting firms.  However, this reward is limited to smaller public companies.  This continues to be true for the period after August 23, 2004.  However, different from Period One, we found the market rewarded large public companies switching from the Big Four to Small accounting firms more than the switching to the Medium Two or Big Four firms. 

Our conclusion is based on both univariate statistics and multivariate regression analysis.  Specifically, our univariate analysis reports that a relatively large public company has earned an average of 1% market-adjusted return over a five-day window of (-4,0) when it switched from Big Four to Small during the period after August 2004.   Our multivariate analysis adds control for types and reasons of the switch and our finding confirms with the univariate analysis.  We have conducted robustness checks such as varying the length of event windows and deleting large positive return, and our conclusion remains.  

The result we found most interesting is that the market rewards large companies who switch from the Big Four to Small accounting firms in recent years. The possible reason is that the market perceives the economic benefits from switching, or a more aggressive conclusion is that possibly the market rewards large public companies in performing their social responsibility of investing in smaller accounting firms (assuming no loss of economic benefits). On the other hand, our findings can be due to omitted confounding events. If this is the case, large companies are able to simultaneously engage these events and at the same time switch to smaller accounting firms without being penalized by the market.  At the very least we are finding that the switching does not cancel out the benefits.  The regulators encourage large companies to consider using smaller accounting firms; our findings certainly support this recommendation. 

The above is summarized from a paper titled “Market Reactions to Auditors Switching from Big Four to Smaller Accounting Firms” written by Dr. C.S. Agnes Cheng (Full Professor of Accounting at the University of Houston) and Dr. Ken J Reichelt (Assistant Professor of Accounting at the Louisiana State University).  For the research that supports this summary, please contact the authors directly.  Their email addresses are acheng@uh.edu and reichelt@lsu.edu.

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We are extremely positive about our ability to service companies on a regional or global basis which would be considered large, i.e. registered with the New York Stock Exchange, and other public companies on a high-quality, cost-effective basis.  We would appreciate the opportunity to visit with those that have an interest in obtaining a complimentary consultation for our service. 

About GLO CPAs, LLLP - Established in 1981, GLO CPAs, LLLP is one of Houston’s leading certified public accounting and advisory firms. GLO CPAs has a strong global footprint and provides services including auditing, accounting, financial planning, personal and corporate tax planning and preparation, and investment services.  With team members encompassing a wide variety of skills including fluency in the English, Spanish, Chinese (Mandarin), Vietnamese, Korean, Russian, Hindi and Malayalam languages, GLO CPAs, LLLP helps clients to manage and optimize growth while maintaining the highest quality control standards in the accounting industry.

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