CFOs thinking about firing their companies’ independent auditors for legitimate reasons, like dissatisfaction with the firm’s price or quality, might want to cut the cord before the end of their fiscal second quarter, an author of a new study of auditor dismissals advises.
If a company announces the dismissal of its auditor after the second quarter, it risks being “lumped in with the bad apples,” that want to end the relationship to cover up “nefarious” doings, according to Jeff Burks, an associate professor of accountancy at Notre Dame’s Mendoza College of Business.
In contrast, dismissals of auditors earlier in the year, when auditor contracts are typically up for renewal, signal to investors that the company’s action “was a planned process” and not just a “sudden change of heart,” he says. “Investors have a good idea that firms tend to sign up their auditors early in the year. So if you’re changing auditors later in the year, that’s a pretty good sign you’ve changed your mind.”
And such a sign is bound to trigger questions in the capital markets about your company. “What prompted you to change your mind? You knew what the auditors fee was going to be, so what’s likely is that you were prompted by some kind of conflict with the auditor,” Burks adds.
In that case, the assumption might end up being that the problem is with the company’s financial reporting rather than the work of the auditor. That’s because auditors, who are interested in protecting their reputation for confidentiality, typically stay closed-lipped about a problem with a client’s reporting — even a client that had fired the audit firm.
In any event, Burks and his co-author, Jennifer Stevens, an assistant professor at Ohio University’s College of Business, offer evidence in their paper of what investors have long suspected: when a company waits more than a quarter or two to fire its auditor, it’s more likely that the markets might soon get some negative news about the company than if it had taken action earlier.
“Firms that dismiss auditors after the second fiscal quarter have markedly higher rates of future restatements, material weaknesses, and delistings compared with firms that dismiss auditors shortly after filing the prior year’s 10-K,” according to the unpublished paper, “Auditor Dismissals: Opaque Disclosures and the Light of Timing.”
In fact, auditor firings after that quarter “roughly double the odds of a restatement and more than quadruple the odds of a material weakness over the next two years,” the authors find.
For the study, the authors culled data from Audit Analytics, a research firm, to identify 16,096 auditor dismissals announced between 2000 and 2013. They kept dismissals falling within fiscal years 2001-2012 that matched data from Compustat, the Center for Research in Security Prices, and the Securities and Exchange Commission’s Edgar database, leaving 3,976 dismissals.
The mandatory, often boilerplate corporate disclosures about auditor firings “have little incremental predictive power,” the authors write. “Stock price drifts following the mandatory disclosures indicate that the market tends to underreact to them.”
But the timing of when the disclosure is made matters a great deal, they contend. “The end of the second fiscal quarter sharply separates innocuous from suspicious dismissals,” according to the paper.
The most common time to dismiss an auditor, on the other hand, is in the 30 days after a company files its 10-K. That’s the time when an auditor’s contract typically comes up for renewal.
Further, a company must make the hire-or-fire decision shortly after filing its annual report to give auditors time to review its first-quarter 10-Q and let shareholders vote on the auditor at the company’s annual meeting.
Since engagement contracts typically cover the entire reporting year, “dismissals that occur after the early-year engagement renewal period are typically cases in which the client is reversing its original choice of auditor for the year,” according to Burks and Stevens.
“Such a reversal could occur as management grows in awareness of accounting problems or as conflicts with the auditor sharpen,” they add.
Dismissals occurring once the third quarter starts “entail a level of future restatement risk approaching that of auditor resignations,” which are much less common than company firings of auditors, according to the study.
Citing earlier studies by other researchers, the authors note that when it’s the auditors that quit, it’s a clear sign of accounting woes or elevated audit risk at the company. The reason? Auditors “typically have little incentive to drop healthy, low-risk clients.”
Other research has found that “resignations are often followed by revelations of internal control problems, class-action lawsuits, and delistings,” according to Burks and Stevens.
Thus, if corporate dismissals of auditors after the third quarter represent nearly as big a restatement risk as auditor resignations, that’s quite a leap in the probability that trouble’s afoot. And the markets are likely to begin taking note.