Does Auditor Industry Specialization Matter? Evidence from Market Reaction to Auditor Switches

Abstract

Numerous capital market studies have investigated the stock market's reaction to firms switching to and from brand name auditors (Big 8/6/5/4 auditors). However, audit firm brand name is only one possible indication of the quality of an auditor. This study contributes to the existing literature on auditor switching, by examining how the market reacts to auditor switches to or from audit firms that are considered to be industry specialists. Consistent with our hypotheses, we find that firms switching between Big 4 auditors experience significant positive abnormal returns when the successor auditor is an industry specialist, and they experience significant negative abnormal returns when the successor auditor is not a specialist. We also find that these market reactions are more likely to be due to changes in perceived audit quality rather than differential costs of using specialist auditors. In supplemental analysis of switches involving non-Big 4 auditors, we find that firms that switch from a specialist Big 4 auditor to a non-Big 4 auditor suffer the largest negative market reaction. Surprisingly, we also observe that the market reacts most positively when a company switches from a non-Big 4 auditor to a Big 4 auditor who is not a specialist. These results suggest that the market does perceive audit quality differences based on industry specialization to be relevant to the valuation of a company's market value.

Comments by the Auditing Standards Committee of the Auditing Section of the American Accounting Association on the PCAOB Rulemaking Docket Matter 029: PCAOB Release No. 2011-007, Improving Transparency Through Disclosure of Engagement Partner and Certain Other Participants in Audits

“…For example, Dunn et al (1999) and Eichenseher et al (1989) find that switching from Big N to non-Big N auditors raises a ''red flag'' to investors. Knechel et al (2007) find that firms switching between Big 4 auditors experience significant positive abnormal returns when the successor auditor is an industry specialist and that they experience significant negative abnormal returns when the successor auditor is not a specialist. We expect that the market would react similarly to audit partner turnover if the audit partner's identity is publicly available.…”

FAKTOR REPRESENTASI STOCK HOLDER DAN DEBT HOLDER BERPENGARUH TERHADAP KEPUTUSAN PEMILIHAN AUDITOR BERKUALITAS1 (Studi Empiris Pada Perusahaan Manufaktur Yang Terdaftar Di Bursa Efek Indonesia)

“…Penelitian lain mengenai perubahan auditor juga dilakukan oleh Sankaraguruswamy dan Whisenant (2004) yang melihat perubahan auditor dipengaruhi oleh reaksi pasar. Tema yang sama dilakukan antara lain oleh Smith (1988), Well dan Loudder (1997), Shu (2000), Whisenantet al, (2003), Beneish et al, (2005), serta Knechel et al, (2007).Scott dan Gist (2013) yang meneliti perubahan auditor berdasarkan fee audit dan spesialisasi industri auditor.…”

Economic consequences of public oversight of the auditing profession

“…It is also well documented empirically in prior literature that auditor reputation is valued in the capital market. For example, Knechel, Naiker and Pacheco (2007) find that firms switching between Big 4 auditors experience significant positive abnormal returns when the successor auditor is an industry specialist, and they experience significant negative abnormal returns when the successor auditor is not a specialist. Krishnamurthy et al (2006) find that the market reacted negatively to Andersen clients after the news about Andersen's indictment was released.…”

“…Klock (1994) argues that the greater the availability of information about a firm, the less likely incremental information is contained in an event. Following Knechel, Naiker and Pacheco (2007) and Defond et al (2005), I include SIZE as a client firm control variable, which is calculated as the natural log of total assets in the year prior to the events. Given that firm size is commonly used as a proxy for information availability (Collins and Kothari 1989), an inverse relationship is expected between firm size and abnormal returns (Freeman 1987).…”