Managerial Auditing Journal

Do audit delays affect client retention?

Vivek Mande Myungsoo Son

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MAJ
26,1

Do audit delays affect client

retention?
Vivek Mande and Myungsoo Son
California State University, Fullerton, California, USA

32

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Received 7 October 2009

Revised 30 April 2010
Accepted 21 June 2010

Abstract
Purpose The purpose of this study is to examine whether lengthy audit delays lead to auditor
changes in the subsequent year. The paper hypothesizes that a lengthy interaction between clients and
their auditors reflects high audit risk factors relating to management integrity, internal controls, and
the financial reporting process. It argues that auditors are more likely to drop clients with long audit
delays because they would like to avoid these types of audit risks.
Design/methodology/approach Using logistic regressions, the paper first tests whether a
lengthy audit delay leads to an auditor change. It then examines whether as audit delays increase,
auditor changes are more likely to be downward than lateral.
Findings The results support the hypothesis that Big N auditor-client realignments occur following
long audit delays. Further, as the length of the delay increases, the paper finds that there are more
downward changes.
Research limitations/implications An implication of our study is that a long audit delay
represents a publicly observed proxy for the presence of audit risk factors that lead to an auditor change.
Practical implications This study suggests that all else constant, investors should consider a
lengthy audit delay as indicating that there has been deterioration in the quality of the client-auditor
interaction. An audit delay also presents an observable proxy for successor auditors to consider while
evaluating risks associated with a new client.
Originality/value The results of our study increase our understanding of how Big N auditors
manage their client portfolios to mitigate their exposure to risk factors.
Keywords Auditing, Risk assessment, Customer retention
Paper type Research paper

Managerial Auditing Journal

Vol. 26 No. 1, 2011
pp. 32-50
q Emerald Group Publishing Limited
0268-6902
DOI 10.1108/02686901111090826

1. Introduction
Against the backdrop of Sarbanes-Oxley (SOX), this study examines whether lengthy
audit delays, used as a proxy for audit risk, increase the likelihood of Big N auditor
resignations in the subsequent year.
In the years immediately following the passage of the SOX Act, audit firms
experienced sharp increases in the demand for assurance staff (Rama and Read, 2006;
Cenker and Nagy, 2008). Section 404 of SOX, in particular, led to shortages of skilled
auditors (at least in the short run) and increases in audit fees (GAO, 2006). It is
estimated that a typical audit took 40-60 percent more time to complete in the post-SOX
than in the pre-SOX years (Koehn and DelVecchio, 2006).
The paucity of staff resources was more pronounced in the Big N firms because
Section 404 of SOX initially affected only the large (accelerated) filers, whose auditors
were mostly the Big N firms. Facing severe staffing constraints, the Big N auditors
adopted a more conservative stance on client retention by resigning from high risk
engagements (Rama and Read, 2006)[1], and, as a result, Non-Big N audit firms gained
significant market share. Ettredge et al. (2007), for example, find that the majority of

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Big N clients who changed their auditors after SOX hired non-Big N firms as their new
auditors a pattern contrary to pre-SOX trends in auditor changes (Landsman et al.,
2009; Turner et al., 2005; Public Accounting Report, 2004)[2].
Audit firms conduct routine risk reviews of their client portfolios and resign from
clients regarded as high risk (Jones and Raghunandan, 1998; Johnstone and Bedard,
2004; Winograd et al., 2000; Bell et al., 2002; Beneish et al., 2005; Krishnan and
Krishnan, 1997; Shu, 2000). The above cited studies use litigation risk and financial
distress variables to proxy for risk factors considered by auditors in their client
retention decisions. The proxy variables are computed using financial and market data
that are publicly available on research data bases.
An exception to this stream of research is a study by Johnstone and Bedard (2004)
who examine auditor resignations using proprietary auditors assessments of their
clients audit risks[3]. They report that risk factors relating to clients internal controls,
financial reporting quality, and management integrity provide more useful measures
of audit risks than do financial risk factors. Johnstone and Bedard argue that their
proprietary proxies are more comprehensive risk measures than financial risk
measures because they include qualitative risk factors. They find that their risk
measures are more strongly associated with auditors client retention decisions than
are financial and litigation risk variables. Their findings suggest that more research is
needed on how auditors incorporate risks relating to client controls, financial reporting
quality, and management integrity in their client retention decisions.
This paper argues that audit delays, the time between the fiscal year end and the
audit completion date, can be a potential candidate for measuring risk factors relating
to clients internal controls, financial reporting quality, and management integrity.
A lengthy audit delay often occurs due to problems in the audit, disagreements
between the auditor and client on accounting issues, and/or a general deterioration in
the quality of auditor-client interaction. A long delay could also occur when a client
firm has high inherent and/or control risk requiring more work by the auditor (Ireland,
2003). Thus, a lengthy audit delay could represent an observable proxy for the above
non-public audit risk factors that affect client retention decisions.
To investigate whether client risk factors are associated with Big N auditor
resignations, we estimate a logistic regression that models auditor resignations as a
function of audit delays and control variables identified by prior research. We also
consider the direction of auditor switches: lateral (Big N to Big N) or downward (Big N to
non-Big N). Finding another Big N auditor to replace the current auditor might not be a
feasible option for all client firms, in particular for client firms with high audit risks.
As the severity of audit risks increases, these client firms may have no alternative but to
find a non-Big N auditor (i.e. downward change). Therefore, we expect that there will be
an ordered correlation between audit risks (i.e. audit delays) and auditor changes.
We use different proxies for measuring audit delays. Because Section 404 altered
Big N incentives to retain risky clients, we first use the actual delays, proxying for the
existing quality of auditor-client interaction, for predicting auditor changes. However,
we also perform analyses using two alternative proxies: unexpected audit delays and
industry-adjusted audit delays.
Our empirical results are consistent with auditors managing their client portfolios
to reduce their risk exposure. Specifically, we find results consistent with the
hypothesis that auditor resignations occur in the year following lengthy audit delays.

Audit delays

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34

Furthermore, we find that auditor resignations are more likely to result in downward
rather than lateral changes as the length of audit delays increases. Our results also
suggest that more than financial distress, risk factors (proxied by audit delays)
concerning clients internal controls, financial reporting quality, and management
integrity are related to subsequent auditor changes. These findings increase our
understanding of how Big N auditors use audit risk factors generally unobservable
to the investing public in their client management strategy. From an investors
perspective, a lengthy audit delay could suggest that there has been a deterioration in
the quality of the client-auditor interaction, which could translate into a downward
auditor change, and a negative stock price reaction (Krishnamurthy et al., 2006).
While the client-auditor realignments examined in this study reduce Big N auditors
risk, they may not necessarily reflect a socially desirable outcome, since non-Big N
firms must now audit the risky clients dropped by the Big N firms. Because Big N
auditors possibly provide better monitoring of the financial reporting process (Cassell
et al., 2007), following the realignments, there could be a reduction in audit quality and
an increased likelihood of audit failures. This could represent an unintended cost
associated with Section 404 that has not been examined in the literature. It is
noteworthy, however, that the Securities and Exchange Commission (SEC)s view on
this issue is that audit quality is not impaired when dropped Big N clients are picked
up by non-Big N auditors (Taub, 2004). While our focus is limited to the study of
whether audit delays proxy for unobserved audit risks, whether or not overall audit
quality is impaired due to these realignments is a topic that needs to be pursued by
future work.
The remainder of this study comprises five sections. Section 2 reviews the relevant
literature. Section 3 presents the research design, while Sections 4 and 5 discuss results
of main tests and additional analyses, respectively. Section 6 concludes the study.
2. Literature and hypotheses development
Prior research suggests that auditors take actions to mitigate their risk exposure when
managing their client portfolios[4]. Jones and Raghunandan (1998), for example, find
that client portfolios of the Big 6 audit firms shifted towards having fewer
financial-distressed clients and fewer clients in high-tech industries during a period of
increasing litigation. Choi et al. (2004) also report that there is a decrease in the
magnitudes of financial risk measures of Big 6 audit firms clients during a period when
auditors exposure to litigation increased. Schwartz and Menon (1985) find that clients
who are in financial distress are more likely to be dropped by a Big N audit firm when
compared to a matched-pair sample of non-failing firms. Shu (2000) constructs two risk
measures proxying for the likelihood of litigation and the probability of bankruptcy.
Shu finds that there is a positive association between auditor resignations and the
proxies. Finally, Krishnan and Krishnan (1997) find that litigation risk, proxied by
Stices (1991) litigation score, is positively associated with auditor resignations.
The above-mentioned studies use publicly available financial data to construct
empirical proxies for the financial and litigation risk factors.
Following the passage of the Private Securities Litigation Reform Act of 1995, an
auditor cannot be held liable in a class action lawsuit for bankruptcy or mismanagement
by officers of the company, if there is no wrongdoing on the part of the auditor. Thus,
financial distress by itself does not constitute an audit risk factor. Consistent with this

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idea, Johnstone and Bedard (2004) suggest that, more than financial distress, audit risk
factors relating to managements integrity, internal controls, and financial reporting
quality have a greater impact on auditors decisions to retain or dismiss clients.
The authors support their hypothesis with tests using proprietary risk assessments
obtained from auditing firms. However, despite the significance of their findings for
auditing research, there has been little additional work on this issue.
This study argues that audit delays can potentially provide an observable proxy for
the proprietary audit risk factors used by Johnstone and Bedard in their study.
Specifically, we suggest that audit delays often occur when there are concerns about
poor internal controls, low-quality financial reports, lack of management integrity, and
clients lack of attention to the external audit. For example, a lengthy audit delay can
result when an auditor uncovers a problem in the financial statements and needs to do
additional work to give an opinion on the financial statements. A long audit delay
could also occur if a client-firm is attempting to apply aggressive or non-generally
accepted accounting principles accounting treatments that the auditor is unwilling to
accept. These risk factors result in auditors executing additional audit procedures
and/or conducting longer negotiations with their clients.
Consistent with this, a few prior studies have used audit delays as a proxy for risk
factors. Ireland (2003) documents that the longer the audit lag, the more likely a company
is to receive a modified audit report. Ireland argues that a long audit lag occurs when
auditees have a high level of inherent and/or control risk which requires more audit work
often resulting in a modified audit opinion. Furthermore, when auditors wish to modify
their opinion, the result is often longer negotiations between the auditor and the client
over the form of the final accounts and the associated audit report that is the subject of
their disagreement (Ireland, 2003)[5]. Another study is by Schloetzer (2007) who
examines whether a lengthy filing delays lead client firms to switch from a Big N to a
non-Big N auditor. Schloetzer uses the Form 10-K filing delay the time between the
fiscal year end and SEC filing date as a proxy for the quality of client-auditor
interaction[6]. He argues that the longer the filing delay, the lower is the overall quality of
the client-auditor interaction which in turn leads to a change in auditors, from Big N to
Non-Big N[7].
Schwartz and Soo (1996) also find evidence suggesting that a lengthy audit delay
constitutes a risk factor for auditors. Using a sample of auditor changes, they find that
clients who switched auditors late in the fiscal year (late switchers) are associated with
more disagreements with the auditor than early switching firms and, in turn,
experience lengthier audit delays. Knechel and Payne (2001) provide direct evidence
that a lengthy audit delay is due to more audit hours being expended on an
engagement. Using a proprietary database, they document that a lengthy audit delay
occurs because more audit effort and audit hours than normally required are needed to
complete the audit.
Based on the discussion above, we formulate our first hypothesis. H1 predicts that
Big N auditors make client retention decisions based on the quality of the interaction
with their clients during the preceding years audit, suggesting that long audit delays
increase the likelihood of an auditor change in the following year:
H1. There is a positive association between audit delays and auditor resignations
in the following year.

Audit delays

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36

H1 does not distinguish between types of auditor changes: lateral (Big N to another
Big N) or downward (Big N to a non-Big N). Research suggests that once a risky client
leaves a Big N auditor, that firm may have no choice but to seek a non-Big N firm to
serve as its auditor (Bockus and Gigler, 1998). Big N auditors have more to lose from
litigation and suffer a greater loss of reputation from an audit failure than do non-Big N
firms (Jones and Raghunandan, 1998). Big N auditors are also less dependent on any
one clients fees (Watkins et al., 2004). This line of research suggests that Big N
auditors are less likely to accept a client dropped by another Big N auditor because of
the associated client risks that all Big N auditors are anxious to avoid.
However, there is also some prior research which suggests that auditees dropped by a
Big N auditor may be accepted as clients by another Big N auditor (i.e. a lateral auditor
switch). Johnstone and Bedard (2004) suggest that otherwise unacceptable clients are
sometimes accepted into another Big N audit firms portfolio conditional on the
assignment of specialist personnel or the collection of higher engagement fees. Big N
auditors also have a larger client base than non-Big N auditors which allows them
spread a given clients risk over a well-diversified client portfolio ( Johnstone and
Bedard, 2004). Finally, the risks facing the old and new auditors can differ (Landsman
et al., 2009). For example, a Big N auditor who is also an industry expert may be able to
accept a higher level of audit risk than another Big N auditor who has no such industry
expertise.
We empirically investigate whether risky firms dropped by a Big N auditor
find another Big N or a non-Big N auditor. If risky clients are more likely to be excluded
from the Big N audit market, then downward switches will be more highly associated
with client risk characteristics than lateral switches (Landsman et al., 2009). Further,
while another Big N auditor may be willing to accept a risky client dropped by a Big N
auditor, as the level of the audit risk increases, proxied using audit delays, the switch is
more likely to be downward than lateral:
H2. As audit delays increase, auditor changes in the following year are more likely
to be downward than lateral.
3. Research design
3.1 Data
Our initial sample includes all firms for which audit fees and auditor report dates were
available on Audit Analytics for the period 2002-2006 (59,180 firm-years). Following
Sengupta (2004), we delete observations (8,985 firm-years) where the audit report date
was either within seven days of the fiscal year end or more than 90 days after the fiscal
year end, in order to eliminate outliers and/or potential errors in report dates[8].
We require firms to have at least two consecutive years of financial data because we
use lagged independent variables in our tests. This criterion results in the elimination of
30,996 firm-years. We then only consider client firms audited by a Big N auditor in the
previous year. As discussed, this is because resource constraints (e.g. shortage of
assurance staff) were more pronounced for Big N auditors since some of the SOX
provisions applied only to large clients, who make up the majority of the Big N auditors
client base (GAO, 2006). We deleted an additional 2,412 observations consisting of
non-accelerated filers who have a longer period to file their financial statements and can,
therefore, be expected to have a longer audit report lag. Finally, we deleted 665
observations where the auditor change was reported as a dismissal. The final sample

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consists of 11,307 firm-years for the period 2003-2006[9]. It is comprised of three

mutually exclusive groups:
(1) firms continuing with a Big N auditor (no change firms);
(2) firms with lateral auditor changes in the following year; and
(3) firms with downward auditor changes in the following year.
Panel B of Table I exhibits the industry distribution of sample firms where industry
is defined as in Frankel et al. (2002). Sample firms are widely distributed among
industries, with some clustering of firms in the durable manufacturers and computer
industries. Mean audit report lags (ARLs) vary across industries, with longest for
agriculture (64 days) and the shortest for textile and printing (52 days), suggesting a
need to control for industry effects. Panel C of Table I reports the distribution of
sample firms by year. The first column shows the number of firms which switched
their auditors from Big N to non-Big N, while the second column reports the switches
from Big N to another Big N. It is noteworthy that in all years, there are more
downward auditor switches than lateral auditor switches in the post-SOX years.
Consistent with our conjecture that Section 404 triggered Big N resignations, the
panel shows that the largest number of resignations took place in the years 2004 and
2005. The last column represents the number of firms that retained their incumbent
Big N auditors.
3.2 Regression model
We model the likelihood of a Big N auditor resignation using ARLs and a set of
control variables identified by prior studies. The following logistic regression is used
(Table II):
RESIGN t b0 b1 ARLt21 b2 GC t21 b3 MODOP t21 b4 TENURE t21
b5 AUDFEE t21 b6 ROAt21 b7 LOSS t21 b8 LVRGt21
b9 GROWTH t21 b10 DAt21 b11 SIZE t21 year dummies
industry dummies 1

3.3 Control variables used

The control variables used have been identified by prior research as determinants of
auditor resignations.
Companies that do not receive a clean audit opinion are more risky, which increases
the likelihood that there will be an auditor resignation (Krishnan and Krishnan, 1997;
Johnstone and Bedard, 2004). Therefore, we predict positive coefficients on the
variables GC and MODOP. Prior research suggests that client firms with long-tenured
auditors are less risky than those with short-tenured auditors (Stice, 1991; Krishnan
and Krishnan, 1997; Landsman et al., 2009). Therefore, we expect that TENURE will
have a negative relation with the likelihood of an auditor resignation. The nature of the
relationship between audit fees (AUDFEE) and auditor resignations is debatable.
Bockus and Gigler (1998) contend that incumbent auditors might increase audit fees for
riskier clients but once the level of risk crosses a certain threshold, the auditors will
resign. This suggests that there could be a positive association between prior years
audit fees and auditor resignations. On the other hand, it is possible that incumbent

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38

No. of firm-years
Panel A: sample selection procedure
Firm-years with audit fees and ARLs
in Audit Analytics (2002-2006)
Less: ARLs that are less than 7 days
or more than 90 days
Missing lagged ARLs, audit fee data,
and financial data
on Compustat
Firm-years having non-Big N as a
previous auditor
Non-accelerated filers
Auditor dismissals
Final sample (2003-2006)

59,180
8,985
30,996
4,815
2,412
665
11,307

Panel B: distribution of sample by industry

Industry
Agriculture
Mining and construction
Food
Chemicals
Computers
Durable manufacturers
Extractive
Financial
Pharmaceuticals
Retail
Services
Textile and printing/publishing
Transportation
Utilities
Not classified
Total

Total
18
247
263
281
1,731
2,248
423
1,481
765
1,102
993
481
774
462
38
11,307

%
0.00
0.02
0.02
0.02
0.15
0.20
0.04
0.13
0.07
0.10
0.09
0.04
0.07
0.04
0.00
1.00

Auditor
resignation
0
1
2
3
58
33
3
19
11
14
15
8
7
5
1
180

Big N to nonBig N
31
56
42
18

Big N to Big
N
9
12
8
4

No change
2,721
2,956
2,820
2,630

Mean
ARL
64.06
58.07
53.78
55.43
53.25
54.65
61.06
58.44
56.93
54.92
59.51
52.07
60.74
58.62
59.95

Panel C: type of auditor change by year

Year
2003
2004
2005
2006
Total

Table I.
Sample selection and
sample distribution

147

33

11,127

Notes: Agriculture (0100-0999), mining/construction (1000-1999, excluding 1300-1399), food (20002111), chemicals (2800-2824, 2840-2899), computers (7370-7379, 3570-3579, 3670-3679), durable
manufacturers (3000-3999, excluding 3570-3579 and 3670-3679), extractive (2900-2999, 1300-1399),
financial (6000-6999), pharmaceuticals (2830-2836), retail (5000-5999), services (7000-8999, excluding
7370-7379), textiles (2200-2799), transportation (4000-4899), utilities (4900-4999), and not classified
(2112-2199, 2837-2839, 2825-2829); ARL is the number of calendar days from fiscal year end to date of
the auditors report

Variable

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Dependent variable
RESIGN
Test variable
ARL

Expected sign

Audit delays

1 if a Big N auditor resigns and 0 otherwise

Auditor characteristics
GC

MODOP

TENURE

AUDFEE
Firm characteristics
ROA

Definition

/2
2

LOSS

LVRG
GROWTH
DA
SIZE

Number of days between the clients fiscal year end

and the completion date of the audit

39

1 if the audit opinion is a going concern opinion and 0

otherwise
1 if the audit opinion is modified for any reason other
than going concern and 0 if unqualified
Number of years audited by the incumbent (old)
auditor
Natural logarithm of the preceding years audit fee
Return on assets, defined as net income before
extraordinary items divided by total assets
1 if earnings before extraordinary items is ,0 and 0
otherwise
Ratio of long-term debt to total assets
Percentage changes in total assets
Performance-matched discretionary accrualsa
Natural logarithm of the market value of equity

Notes: aWe calculate performance-matched discretionary accruals following Kothari et al. (2005).
First, we obtain discretionary accruals from the Jones model, which requires regressing total accruals
on variables that are expected to vary with normal accruals, such as changes in revenues and capital
intensity; to obtain performance-matched discretionary accruals, we match each firm-year observation
with an observation belonging to a firm from the same two-digit SIC code and year, with the closest
return on assets (net income divided by total assets); then, we define performance-matched
discretionary accruals as each firms discretionary accruals minus its matched counterparts
discretionary accruals

auditors are less likely to resign from clients paying higher audit fees, suggesting a
negative association between the two variables.
We also include controls for clients financial risks. Because less profitable and more
leveraged clients are considered more risky (Schloetzer, 2007), we predict a higher
likelihood of an auditor resignation in these companies. We use the following three
variables, ROA, LOSS, and LVRG, to proxy for financial risks. These variables are
expected to have negative, positive, and positive coefficients, respectively.
Stice (1991) argues that high-growth firms pose additional risks for auditors
because these firms tend to have less-effective internal control systems. Therefore,
we include GROWTH in our regressions and expect this variable to be positively
associated with the likelihood of an auditor resignation. Since positive discretionary
accruals suggest that there is a higher risk of earnings management being present,
we could expect more auditor resignations from client firms with larger positive
discretionary accruals. This predicts that there will be a positive association
between RESIGN and DA. Because large clients are less likely to fail, we predict a
negative coefficient on SIZE. Finally, we include year and industry dummies in the
models[10].

Table II.

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4. Empirical test results

4.1 Descriptive statistics
Table III presents descriptive statistics for the variables used in the regressions
reported separately by the three categories: downward changes (Big N to Non-Big N),
lateral changes (Big N to another Big N), and no changes. We winsorize all
non-indicator variables at the 1 and 99 percent levels to reduce the effects of extreme
values on the test results. Table III presents the means, medians, and SD of the
variables according to each group. There are more downward switches when
compared to lateral switches, which is consistent with Schloetzer (2007) who finds that
auditor changes from a Big N to a non-Big N auditor became more frequent following
the passage of SOX.
The mean value of ARL for the downward switch group is 67.116, which indicates
that it took a Big N auditor, on average, about 67 days to complete the audit of
a client-firm that switched its auditor to a non-Big N auditor in the following year.
The mean value of ARL of downward switch firms (67.116 days) is statistically
significantly longer than that for lateral switch firms (58.969 days). While the mean
ARL of no switch firms (56.205 days) is shorter than that of lateral switch firms (58.969
days), the difference is not statistically significant. The above univariate comparison of
means is consistent with our hypothesis, H2, that firms with longer ARLs are likely to
switch from a Big N to a non-Big N auditor, rather than change from a Big N to another
Big N auditor or stay with incumbent Big N auditor.
Firms that switch auditors downward (compared to other groups) tend to have more
going concern opinions but fewer types of other modified opinions and relatively
smaller audit fees in the year preceding the switch. They are also less profitable and
are smaller in size[11]. With the exception of other modified opinions (MODOP),
these univariate results are consistent with expectations.
Table IV presents correlations for the variables used in the regressions. Consistent
with our prediction, RESIGN is positively correlated with one-year-lagged ARL.
In addition, RESIGN is statistically significantly correlated with all independent
variables except for TENURE and LVRG. Interestingly, contrary to our expectation,
RESIGN is negatively correlated with GROWTH and MODOP (modified opinion).
Also, with the exception of MODOP, ARL is significantly correlated with the following
audit risk factors: going concern opinions, tenure, profitability, leverage, and firm size.
The direction of the correlations supports our argument that audit delays are
significantly related to audit risks. The largest correlation in the table is between firm
size and audit fees (0.70).
Tables III and IV, however, only show results obtained from univariate testing.
Below we present results from estimation of multivariate models which are more
powerful than the univariate tests.
4.2 Regression analyses
Table V presents empirical results of estimations of our logistic regression models.
The table reports results using data pooled over all years and separately using years
before and after Section 404 of SOX went into effect[12]. For the post-Section 404
sample (2005-2006), we include a dummy variable that is coded 1 if a firm reports an
internal control weakness and 0 otherwise. This is due to Ettredge et al. (2007) who

ARL
GC
MODOP
TENURE
AUDFEE
ROA
LOSS
LVRG
GROWTH
DA
SIZE

58.969
0.061
0.576
8.606
13.354
20.101
0.455
0.217
0.132
20.030
5.973

64.000
0.000
1.000
8.000
13.541
0.011
0.000
0.139
0.029
2 0.008
6.087

19.574
0.242
0.502
4.527
0.967
0.259
0.506
0.223
0.502
0.157
1.829

Big N to Big N (B)

(n 33)
Mean
Median
SD
56.205
0.011
0.434
9.779
13.559
0.001
0.250
0.223
0.159
20.011
6.776

59.000
0.000
0.000
7.000
13.474
0.035
0.000
0.183
0.087
2 0.006
6.641

No changes (C)
(n 11,127)
Mean
Median
18.660
0.106
0.496
8.623
1.223
0.169
0.433
0.217
0.339
0.133
1.696

SD

t-test
(B C)
t-statistic
0.85
2.64 * * *
1.64
2 0.78
0.96
2 3.43 * * *
2.71 * *
2 0.14
2 0.47
2 0.85
2 2.71 * * *

t-test
(A B)
t-statistic
2.13 * *
2.03 * *
2 3.26 * * *
1.20
2 3.54 * * *
2 2.09 * *
2.47 * *
2 0.35
2 0.73
1.27
2 5.16 * * *

Notes: Significance at: *10, * *5, and * * *1 percent; variable definitions: RESIGN, 1 if the auditor resigns from its auditor and 0 otherwise; ARL, number
of days between the clients fiscal year end and the audit completion date; GC, 1 if the audit opinion is a going concern and 0 otherwise; MODOP, 1 if the
audit opinion is modified for any reason other than going concern and 0 if unqualified; TENURE, number of years audited by the incumbent (old) auditor;
AUDFEE, natural logarithm of the preceding years audit fee (old auditor); ROA, return on assets, defined as net income before extraordinary items
divided by total assets; LOSS, 1 if earnings before extraordinary items is ,0 and 0 otherwise; LVRG, ratio of debt to total assets; GROWTH, percentage
changes in total assets; DA, performance-matched discretionary accruals; SIZE, natural logarithm of the market value of equity

19.907
0.409
0.453
6.101
1.105
0.361
0.468
0.257
0.515
0.216
1.576

67.116
0.211
0.286
9.959
12.616
20.240
0.680
0.201
0.060
0.020
4.359

Variable
73.000
0.000
0.000
9.000
12.378
20.073
1.000
0.101
20.046
0.011
4.245

Big N to non-Big N (A)

(n 147)
Mean
Median
SD

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Audit delays

41

Table III.
Descriptive statistics

GC

MODOP

TENURE

AUDFEE

ROA

LOSS

Table IV.
Pearson correlation
matrix of variables used
in our tests

Notes: The p-values are in parentheses; see Table III for definitions of the variables; n 11,307

(0.243)
(0.000)
(0.000)
(0.000)
(0.326)
(0.000)
(0.269)
(0.041)

LVRG

2 0.032
0.001
2 0.026
2 0.076
2 0.103
2 0.119
0.036
2 0.081
2 0.077

DA
(0.000)
0.020 (0.031)
(0.946)
0.008 (0.405)
(0.006)
0.019 (0.049)
(0.000)
0.001 (0.896)
(0.000)
0.028 (0.003)
(0.000) 2 0.019 (0.039)
(0.000)
0.021 (0.029)
(0.000) 2 0.026 (0.005)
(0.000)
0.029 (0.002)
0.016 (0.094)

GROWTH

42

RESIGN
0.063 (0.000) 0.182 (0.000) 2 0.024 (0.011) 2 0.001 (0.915) 2 0.082 (0.000) 2 0.153 (0.000)
0.111 (0.000) 2 0.011
ARL
0.088 (0.000) 2 0.070 (0.000) 2 0.088 (0.000)
0.142 (0.000) 2 0.065 (0.000)
0.072 (0.000)
0.092
GC
2 0.105 (0.000) 2 0.030 (0.001) 2 0.031 (0.000) 2 0.237 (0.000)
0.173 (0.000)
0.042
MODOP
0.028 (0.023)
0.122 (0.000)
0.057 (0.000) 2 0.039 (0.000)
0.136
TENURE
0.246 (0.000)
0.108 (0.000) 2 0.121 (0.000)
0.009
AUDFEE
0.186 (0.000) 2 0.176 (0.000)
0.171
ROA
2 0.664 (0.000) 2 0.010
LOSS
0.019
LVRG
GROWTH
DA

ARL

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2 0.155
2 0.129
2 0.164
0.111
0.251
0.703
0.346
2 0.357
0.089
2 0.037
2 0.043

(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)
(0.000)

SIZE

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Variable
Intercept
ARL
GC
MODOP
TENURE
AUDFEE
ROA
LOSS
LVRG
GROWTH
DA
SIZE
MW
Wald x2
Pseudo-R 2
n

Pooled years
Coefficient
p-value
0.9918
0.0170
1.1248
0.0086
0.0485
20.1067
21.1029
0.3091
20.1791
20.3393
0.6114
20.7294

0.4618
, 0.0001
0.0002
0.9630
0.3547
0.3218
0.0026
0.1587
0.6230
0.1074
0.1900
, 0.0001

387.89 * * *
0.2711
11,307

2003-2004
Coefficient
p-value
2 0.7841
0.0134
1.1351
2 0.0901
0.0486
0.0219
2 1.4152
2 0.0368
2 0.2658
2 0.8389
0.5650
2 0.8013

0.6820
0.0199
0.0028
0.7028
0.6824
0.8815
0.0018
0.9013
0.5572
0.0082
0.3583
,0.0001

230.20 * * *
0.2959
5,785

2005-2006
Coefficient
p-value
4.3635
0.0555
0.0249
0.0256
1.0410
0.0516
0.0570
0.8529
0.0545
0.2275
20.3895
0.0286
20.9271
0.1788
0.7212
0.0311
0.2348
0.7099
0.3084
0.3074
0.5042
0.5145
20.6015
0.0001
1.5871
, 0.0001
167.89 * * *
0.3154
5,522

Notes: Significance at: *10, * *5, and * * *1 percent; see Table III for definitions of variables

argue that SOX 404 reports provide a new measure of a clients audit risk[13] that
potentially could lead to a realignment of the auditor-client relationship.
All models are statistically significant, explaining 27.11-31.54 percent of the
variation in the dependent variable. In all models, we find that the variable of interest,
ARL, is positive and statistically significant, which is consistent with H1 that auditor
resignations occur more frequently following lengthy ARLs.
Also, in all models, compared with firms that keep their auditor, audit firms are
more likely to resign from client firms that are smaller in size and have going concern
opinions (significant at least at the 10 percent level of testing). Excepting for the period
2005-2006, auditors are less likely to resign from firms with high return on assets
(ROA). However, a similar result holds for the years 2005-2006 where we find that
auditors are more likely to resign from firms with losses (LOSS). The variable MODOP
(modified opinion) which, contrary to expectations, was significantly and negatively
correlated to audit delays in the univariate tests (Table IV) does not have a significant
association with ARL in the multivariate regressions. The coefficients on AUDFEE
and GROWTH are statistically significant only during 2005-2006 and 2003-2004,
respectively. Importantly, in the post-Section 404 period (2005-2006), we find a
statistically positive coefficient of MW, which is consistent with Ettredge et al. (2007).
It is interesting that our measure of audit risks, ARL, has a significant explanatory
power, over and above MW, for predicting auditor resignations. The coefficients on all
other variables are statistically not significant.
To gauge economic significance, we also estimate the logistic regression using a
dummy variable that takes a value of 1 if the ARL is longer than the median ARL and 0
otherwise (results not reported). In the pooled sample, the coefficient on the dummy is
0.3539 (t-value: 3.56) which suggests that (compared to the control group) there is an
approximately 42 percent greater chance of an auditor resignation taking place for
firms with lengthier ARLs[14].

Audit delays

43

Table V.
Results of logistic
regressions of auditor
resignations

MAJ
26,1

44

Next, we test H2 by ordering our sample into three groups: downward auditor
switches (coded 3), lateral auditor switches (coded 2), and no switches (coded 1). In the
ordered logistic regression analyses in Table VI, we find that the coefficient on ARL is
positive and statistically significant in all regressions which supports H2, namely that
as audit risks increase not only does the likelihood of an auditor change increase but
that clients are more likely to engage a smaller, non-Big N auditor in the subsequent
year. The results on the remaining variables are virtually identical to those presented
in Table V.

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5. Additional analyses
5.1 Unexpected ARL
An advantage of using audit delays in our tests is that they constitute a simple proxy
for the quality of an auditor-client relationship. A more sophisticated proxy that could
be used instead is unexpected audit delay. Unexpected audit delays can be interpreted
as reflecting changes in client-auditor interactions which in turn could result in auditor
switches. (See Appendix for the model used to obtain predicted values of audit delays.)
Unexpected ARLs get at the idea that something has changed for the client firms that
has motivated the auditor change. However, a disadvantage of this proxy from an
investors perspective is its complexity; in addition, measurement error from model
misspecification could affect the test results. While we find positive and statistically
significant coefficients on unexpected audit delays using both logistic and ordered
logistic models (significant at the 1 percent level in both models), it is worth noting that
the simple proxy, audit delay does just as well in predicting auditor changes which is
consistent with our conjecture that Section 404 of SOX altered auditors incentives to
retain risky clients, as proxied by lengthy audit delays (results of these tests are
untabulated).

Variable

Table VI.
Results of ordered logistic
regressions of
auditor resignations

Intercept1
Intercept2
ARL
GC
MODOP
TENURE
AUDFEE
ROA
LOSS
LVRG
GROWTH
DA
SIZE
MW
Wald x2
Pseudo-R 2
n

Pooled sample
Coefficient
p-value
2.7748
2.9886
0.0177
1.1118
20.0895
0.0441
20.1151
21.1438
0.2268
20.1291
20.3737
0.5296
20.8779

0.0037
0.0018
, 0.0000
, 0.0000
0.4774
0.5621
0.1277
, 0.0001
0.1243
0.6042
0.0063
0.0943
, 0.0000

886.49 * * *
0.3694
11,307

2003-2004
Coefficient
p-value
0.6164
0.8402
0.0120
1.1274
20.1587
0.0403
20.0076
21.5429
20.0593
20.0741
20.9264
0.4090
20.9125

0.6534
0.5405
0.0015
,0.0000
0.3129
0.2354
0.9419
,0.0001
0.7621
0.8076
,0.0001
0.3286
,0.0001

522.99 * * *
0.3835
5,785

2005-2006
Coefficient
p-value
7.1352
, 0.0000
7.3600
, 0.0001
0.0317
, 0.0001
1.0932
0.0046
2 0.0318
0.8857
0.0545
0.8326
2 0.4549
0.0004
2 0.9053
0.0741
0.5857
0.0139
0.0304
0.9469
0.3376
0.0992
0.6818
0.2263
2 0.7758
, 0.0000
1.8587
, 0.0000
361.63 * * *
0.4392
5,522

Notes: Significance at: *10, * *5, and * * *1 percent; see Table III for definitions of variables

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5.2 Industry-adjusted ARLs

We also replace ARL with an industry-adjusted ARL. We calculate median values of
ARL for each industry as defined in Frankel et al. (2002) and obtain industry-adjusted
ARLs which are ARLs minus the median of the industry ARLs. We obtain qualitatively
similar results to those documented (results of these tests are untabulated).

Audit delays

5.3 Non-audit service fees

It is possible that auditors will be less likely to resign from clients that provide large
amounts of non-audit service revenue (e.g. fees for tax services). We find (results not
tabulated) that the coefficient on non-audit service fees is negative and statistically
significant, suggesting that auditor changes are less likely to occur for clients requiring
large amounts of non-audit services. The results on the other variables are
qualitatively unchanged.

45

6. Conclusion
This study uses audit delays to proxy for audit risk factors that measure the quality of
auditor-client interactions. Our results are consistent with those of previous work
showing that auditors respond to high audit risk factors by dropping risky clients.
Our results show that more than financial distress, the quality of the auditor-client
interaction determines whether an auditor will stay with a client or resign.
Auditor changes are important events that markets want to know about. However,
companies often do not fully disclose reasons for auditor changes. Our research
suggests that a long audit delay represents a publicly observed proxy for possible
disagreements between auditors and their clients or the presence of audit risk factors
that lead to an auditor change in the following year. This study suggests that all else
constant, investors should regard a lengthy audit report lag as indicating that there has
been a deterioration in the quality of the client-auditor interaction, which could
translate into a downward auditor change in the following year. An audit delay also
presents an observable proxy for successor auditors to consider while evaluating their
risk exposure from the acceptance of a client whose auditor has resigned. As a proxy
for client-auditor disagreement, audit delays are able to predict an auditor change just
as well as our more sophisticated proxy (unexpected audit delays) that controls for
known factors that affect audit delays.
Finally, there is an important concern associated with auditor changes that follow
long audit delays. Our results suggest that the successor auditors are likely to be of
lower quality. Research suggests that capital markets react negatively to downward
auditor changes (Krishnamurthy et al., 2006). This raises an important question for
regulators as to whether the smaller accounting firms will be able to perform quality
audits for these high-risk firms (Turner et al., 2005). An interesting question for future
research would be to examine how non-Big N auditors manage their risk exposure
following the acceptance of risky clients dropped by Big N firms.
Notes
1. There were 2,514 auditor changes during 2003 and 2004 affecting more than one-fourth of all
US publicly traded companies (Taub, 2005).
2. For example, in 2004, BDO Seidman, LLP had a net gain of 71 clients, while Grant Thornton,
LLP gained 17 clients, net (Koehn and DelVecchio, 2006).

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MAJ
26,1

3. Audit risk is the risk that an auditor may unknowingly fail to appropriately modify his/her
opinion on financial statements that are materially misstated (AICPA, 1983, AU 312.02).

46

5. That is, when there is a going concern issue, auditors may delay expressing an audit opinion
or finalizing their report, in the hopes that the problem will be resolved and a modified
opinion will be avoided (Ireland, 2003).

4. Prior studies also suggest that auditors are proactive in managing their client portfolios.
For example, Krishnan and Krishnan (1997) and Shu (2000) document that auditors are more
likely to resign from riskier clients rather than simply wait to be dismissed.

6. There are several differences between this study and Schloetzers (2007) study. First, we
measure the reporting lag as the time between the fiscal year end and the audit completion
date (audit report lag), while Schloetzer (2007) measures delays as the time between the fiscal
year end and the SEC filing date (filing lag). In our sample, the correlation between these two
lags is 0.418, which suggests that the two lags potentially represent different underlying
events. Lee et al. (2009) argue that upon completion of an audit, managers exercise their
discretion by determining the optimal time for announcing earnings or filing their financial
statements by considering the costs and benefits of their timing decisions. For example,
firms with good news are likely to announce earnings or file their financials soon after the
completion of an audit. The filing lag used by Schloetzer, therefore, captures both the nature
of the auditor-client interaction (proxied by the audit report lag) and the client-managers
discretionary timing decision (proxied by the discretionary lag). Second, we focus only on
auditor resignations, while Schloetzers sample includes both resignations and dismissals.
Client firms might dismiss their auditors for lengthy delays because lengthy audit delays
could imply inefficiencies in an audit. Therefore, focusing only on resignations might
provide for a cleaner sample for testing our hypothesis. We thank an anonymous reviewer
for this suggestion. Third, unlike Schloetzer (2007), we control for alternative explanations
for an auditor change, including audit fees, growth opportunity, auditor tenure, and
discretionary accruals (DeFond and Subramanyam, 1998; Johnson and Lys, 1990; Bockus
and Gigler, 1998). Most importantly, we control for internal control weaknesses that have
been shown to significantly increase audit delay (Ettredge et al., 2007). Finally, we provide
an additional new result showing that auditor-client realignments follow an ordered
sequence as audit delays increase.
7. Another proxy for audit risk is a material weakness in internal control which is a required
disclosure under SOX 404. Ettredge et al. (2006) show that the presence of a material
weakness in internal controls over financial reporting is associated with longer audit delays.
This supports our assertion that audit delays proxy for audit risks. In a later section, we
explore this issue in more detail.
8. While we lose a significant number of firms (8,985 observations or 15 percent of the sample)
due to this criterion, we found that a large number of these firms are not covered by
Compustat. For example, we found that approximately half of these firms do not have data
on total assets on Compustat (Krishnan and Yang, 2009). Coverage on Audit Analytics is
much wider than on Compustat whose coverage is restricted to larger firms showing a
survivorship bias. The results are qualitatively the same when we use 180 days for deleting
extreme ARLs.
9. We lose the year 2002 because we use lagged variables in our tests.
10. We also include two more control variables: EXPERT, a dummy variable coded 1 if an
auditor has 30 percent or more market share in an industry and 0 otherwise and MNA, a
dummy variable coded 1 if the client had a merger or acquisition in the two previous years,
and 0 otherwise. The above two variables are used to model auditor changes due to
client-initiated reasons. These variables are included due to Lee et al. (2004) who argue that

sometimes the distinction between resignations and dismissals is blurry. Inclusion of these
variables does not alter our inference.

Audit delays

11. Other than those discussed here, there are no statistically significant differences in the other
variables used in our tests.

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12. The SEC reduced the 10-K filing period for large accelerated filers (i.e. equity public float
$700 M or more) to 60 days for year ends on or after December 15, 2006 (SEC, 2005). To
control for this change, we include a dummy variable for large accelerated filers and an
interaction term with audit delay for the years 2005-2006. Our main results (untabulated)
remain unchanged.
13. The reports reveal auditors judgments about internal controls and accounting-related issues
that are largely independent of a clients financial conditions and provide a strong indicator
(in contrast to bankruptcy or litigation risk metrics) for explaining client retention decisions
(Ettredge et al., 2007).
14. The odds are computed as the exponent of 0.3539, which is 1.42 or a 42 percent larger chance.

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Appendix
Following prior studies (Bamber et al., 1993; Henderson and Kaplan, 2000; Knechel and Payne,
2001), we estimate the following ARL model for obtaining the predicted or expected values of
audit delays. Unexpected ARLs are actual ARLs minus their predicted values:
ARLit a0 b1 TEN it b2 LNNAF it b3 FC it b4 SEGNUM it b5 ABFEE it
b6 EXTRAit b7 LOSS it b8 AUOP it b9 YENDit b10 BIG4it
b11 LNSIZE it b12 NEWS it b13 INSOWNRit industry dummies
year dummies 1it

A1

where (expected sign is shown in parentheses):

ARL

: number of calendar days from fiscal year end to date of the auditors report;

TEN

: number of years working with current auditors (2 );

Audit delays

49

MAJ
26,1

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50

LNNAF

: natural log of non-audit service fees paid to incumbent auditors (2 );

FC

: financial condition measured as Zmijewskis financial condition index ();

SEGNUM

: reportable segments of a client ();

ABFEE

: abnormal audit fees ( );

EXTRA

: 1 if a firm reports extraordinary items and 0 otherwise ();

LOSS

: 1 if a firm reports negative earnings and 0 otherwise ();

AUOP

: 1 if the auditors opinion is modified or qualified and 0 otherwise ();

YEND

: 1 if a firms fiscal year ends in December and 0 otherwise ( );

BIG4

: 1 if an auditor is one of the Big N auditing firms and 0 otherwise (/2);

LNSIZE

: client firm size measured as the natural log of total assets (2 );

NEWS

: clients unexpected earnings defined as the difference between current and

prior years earnings per share (EPS), divided by the absolute value of prior
years EPS (2 ); and

INSOWNR : ranked value of institutional ownership (2).

About the authors

Vivek Mande is a Professor of Accounting at the Mihaylo College of Business and Economics at
the California State University, Fullerton. He is also the Director of the Center for Corporate
Reporting and Governance. His work has been published in Contemporary Accounting Research,
Auditing: A Journal of Practice and Theory, Journal of Accounting and Public Policy, and
numerous other journals.
Myungsoo Son is an Associate Professor of Accounting at the Mihaylo College of Business
and Economics at the California State University, Fullerton. His research interests include audit
quality, auditor fees, and earnings management. Myungsoo Son is the corresponding author and
can be contacted at: mson@fullerton.edu

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