UBC Theses and Dissertations

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UBC Theses and Dissertations

Stock market reaction to auditor changes by OTC firms Kinnear, Valerie Ann 1986

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STOCK MARKET REACTION TO AUDITOR CHANGES BY OTC FIRMS by VALERIE ANN KINNEAR B.S.W., The U n i v e r s i t y of Calgary, 1978 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE IN BUSINESS ADMINISTRATION i n THE FACULTY OF GRADUATE STUDIES The F a c u l t y of Commerce and Business A d m i n i s t r a t i o n We accept t h i s t h e s i s as conforming to the r e q u i r e d standard THE UNIVERSITY OF A p r i l © VALERIE ANN BRITISH COLUMBIA 1986 KINNEAR, 1986 In p r e s e n t i n g t h i s t h e s i s i n p a r t i a l f u l f i l m e n t of the requirements f o r an advanced degree at the The U n i v e r s i t y of B r i t i s h Columbia, I agree that the L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e f o r r e f e r e n c e and study. I f u r t h e r agree t h a t p e r m i s s i o n f o r e x t e n s i v e copying of t h i s t h e s i s f o r s c h o l a r l y purposes may be granted by the Head of my Department or by h i s or her r e p r e s e n t a t i v e s . I t i s understood that copying or p u b l i c a t i o n of t h i s t h e s i s f o r f i n a n c i a l gain s h a l l not be allowed without my w r i t t e n p e r m i s s i o n . The F a c u l t y of Commerce and Business A d m i n i s t r a t i o n The U n i v e r s i t y of B r i t i s h Columbia 2075 Wesbrook Pl a c e Vancouver, Canada V6T 1W5 Date: A p r i l 1986 ABSTRACT T h i s t h e s i s examines the stock market r e a c t i o n to a u d i t o r change announcement by OTC f i r m s . The g e n e r a l m o t i v a t i o n stemmed from p r e v i o u s research on t h i s t o p i c that 1) f a i l e d to adequately motivate the e m p i r i c a l i n v e s t i g a t i o n and 2) found i n s i g n i f i c a n t r e s u l t s . The t h e o r e t i c a l j u s t i f i c a t i o n f o r expecting a market r e a c t i o n i s based on the e x i s t e n c e of product d i f f e r e n t i a t i o n i n the market for a u d i t s e r v i c e s i n terms of the l e v e l of c r e d i b i l i t y an a u d i t o r c a n ' o f f e r . I t i s c o n j e c t u r e d that c l i e n t f i r m s w i l l demand more c r e d i b i l i t y as the p r o p o r t i o n of e x t e r n a l ownership i n the f i r m i n c r e a s e s . Management's r e - e v a l u a t i o n of t h e i r optimal r e s i d u a l f i r m value and p e r q u i s i t e consumption combination a f t e r a change in the ownership s t r u c t u r e i s suggested as a p o s s i b l e reason fo r an a u d i t o r change. The a u d i t o r change s i g n a l s i n f o r m a t i o n about the manager and causes a market r e a c t i o n . A sample of 44 non-Big E i g h t to Big E i g h t and 15 Big E i g h t to non-Big E i g h t a u d i t o r changes are examined. The standard event study method of abnormal r e s i d u a l a n a l y s i s i s r e p l a c e d with a new method in which c r o s s - s e c t i o n a l market model r e g r e s s i o n s i n the announcement and a c o n t r o l p e r i o d on the same firms are compared. R e s u l t s provide strong evidence that the i n c r e a s e i n f i r m value from an a u d i t o r change announcement i s g r e a t e r f o r non-Big E i g h t to Big E i g h t changes than Big E i g h t to non-Big E i g h t changes. Evidence i s a l s o found that firms i i changing a u d i t o r s experience g r e a t e r v a r i a b i l i t y i n r e t u r n s d u r i n g an announcment p e r i o d than d u r i n g a c o n t r o l p e r i o d p r i o r to the change. Table of Contents ABSTRACT i i LIST OF TABLES v LIST OF FIGURES vi. ACKNOWLEDGEMENTS v i i I . INTRODUCTION . . . 1 A. Background 1 B. Purpose 2 C. O u t l i n e of T h e s i s 3 I I . PRODUCT DIFFERENTIATION IN THE MARKET FOR AUDIT SERVICES 5 I I I . THE AUDITOR CHOICE ISSUE 14 A. I n i t i a l A u d i t o r S e l e c t i o n 14 B. A u d i t o r Changes 18 1. L i t e r a t u r e Review of Research on A u d i t o r Changes 18 2. T h e o r e t i c a l Framework and P r e d i c t i o n s on A u d i t o r Changes 25 IV. SAMPLE SELECTION AND DATA COLLECTION 32 V. EMPIRICAL TEST METHOD AND HYPOTHESES 38 VI. RESULTS 45 A. T e s t s of Hypotheses 1 and 2: • 45 B. T e s t s of Hypothesis 3 47 C. T e s t s of Hypotheses 4, 5 and 6 48 VI I . SUMMARY AND CONCLUSIONS 51 BIBLIOGRAPHY 64 LV LIST OF TABLES Number  Sample Firms and Event Dates T e s t s of Hypothesis 1: Event E i g h t to Big E i g h t Sample Tes t s of Hypothesis 2: Event to non-Big E i g h t Sample Page 55 E f f e c t i n the Non-Big 57 E f f e c t i n the Big Eig h t 58 T e s t s of Hypothesis 3: J o i n t T e s t s on the D i f f e r e n c e Between the Market Reaction to an A u d i t o r Change on N-B Sample vs. B-N Sample 59 Var i a n c e of Stock Returns i n Announcement vs. Non-Announcement Period s 60 LIST OF FIGURES Number Page 1. Costs and B e n e f i t s of A u d i t i n g i n Firms with Low and High E x t e r n a l Ownership 61 2. Impact of an Increase i n the E x t e r n a l Ownership of a Firm 62 3. Impact of a Decrease in the E x t e r n a l Ownership of a Firm 63 v t ACKNOWLEDGEMENTS I am g r a t e f u l to the members of my t h e s i s committee, P a t r i c a Hughes, Dan Simunic and Rex Thompson who a l l pr o v i d e d v a l u a b l e feedback and encouragement. In p a r t i c u l a r I am indebted to Dan Simunic, who ac t e d as chairman and s u p p l i e d the m o t i v a t i o n f o r t h i s t h e s i s , and Rex Thompson, who pr o v i d e d the i n s i g h t r e q u i r e d f o r the e m p i r i c a l a n a l y s e s . F i n a n c i a l support from D e l o i t t e Haskins & S e l l s i s a l s o acknowledged. F i n a l l y , s p e c i a l thanks go to W i l f r e d Zerbe and h i s d r a f t i n g s k i l l s f o r the p r e p a r a t i o n of F i g u r e s 1 , 2 and 3. vi I I. INTRODUCTION A. BACKGROUND The F i n a n c i a l Accounting Standards Board (FASB) [1978] has d e f i n e d the f u n c t i o n of f i n a n c i a l r e p o r t i n g by business e n t e r p r i s e s to be the p r o v i s i o n of i n f o r m a t i o n that i s u s e f u l to those making economic d e c i s i o n s about business e n t e r p r i s e s , such as i n v e s t o r s and c r e d i t o r s . The FASB f u r t h e r notes that both those who provide the i n f o r m a t i o n and those who use i t o f t e n view an independent a u d i t o r ' s o p i n i o n as enhancing the c r e d i b i l i t y and r e l i a b i l i t y of the i n f o r m a t i o n . T r a d i t i o n a l l y , the i d e n t i t y of the f i r m performing the a u d i t has been c o n s i d e r e d i r r e l e v a n t . For example, i n the Cohen Report [1978], i t i s s t a t e d t h a t : there i s l i t t l e e f f e c t i v e product d i f f e r e n t i a t i o n from the view p o i n t of the present buyer of the ( a u d i t ) s e r v i c e , . . . A "clean o p i n i o n " obtained from one r e p u t a b l e f i r m i s about as v a l u a b l e to the competent, honest f i n a n c i a l manager as one from another f i r m . (AICPA [1978], p.111) Since a u d i t s must be conducted a c c o r d i n g to g e n e r a l l y accepted a u d i t i n g standards (GAAS) and a u d i t o r s must be p r o f e s s i o n a l l y q u a l i f i e d , c o r p o r a t e f i n a n c i a l statement a u d i t s may be c o n s i d e r e d homogeneous. S e v e r a l recent s t u d i e s (Simunic [1980]; DeAngelo [1981(a)] and [1981(b)]; Dopuch and Simunic [1982]; Simunic and S t e i n [1986]) have taken a view c o n t r a r y to that of the Cohen Commission. They have suggested that a u d i t s e r v i c e s are l i k e l y to be d i f f e r e n t i a t e d a c r o s s a u d i t o r s . B a s i c a l l y , 1 2 i t i s argued that Big E i g h t a u d i t o r s 1 supply higher q u a l i t y a u d i t s than medium s i z e d or l o c a l a u d i t i n g f i r m s . There have a l s o been attempts ( f o r example see Simunic [1980]; N i c h o l s & Smith [1983]; Shockley & H o l t [1983]) to e m p i r i c a l l y t e s t the v a l i d i t y of the hypothesized a u d i t s e r v i c e d i f f e r e n t i a t i o n . Although l a r g e l y i n c o n c l u s i v e , the r e s u l t s of these s t u d i e s are not i n c o n s i s t e n t with the e x i s t e n c e of product d i f f e r e n t i a t i o n i n the market f o r a u d i t s e r v i c e s . B. PURPOSE An i m p l i c a t i o n of a u d i t s e r v i c e s product d i f f e r e n t i a t i o n i s that an a u d i t o r change may impact on an i n v e s t o r s ' v a l u a t i o n of a f i r m . T h i s t h e s i s extends e a r l i e r r e s e a r c h by N i c h o l s & Smith [1983] and F r i e d & S c h i f f [1981] on stock market r e a c t i o n s to a u d i t o r changes i n three ways. F i r s t , based on the work of DeAngelo, Dopuch and Simunic, and Simunic and S t e i n on a u d i t s e r v i c e s product d i f f e r e n t i a t i o n , reasons f o r and i m p l i c a t i o n s of an a u d i t o r change are developed. Second, understanding the market impact of a u d i t o r changes i s i n v e s t i g a t e d by using a sample of Over The Counter (OTC) f i r m s , which have not been p r e v i o u s l y examined. The N i c h o l s & Smith and F r i e d & S c h i f f s t u d i e s used New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) firms and found s t a t i s i c a l l y 1The Big E i g h t a u d i t i n g firms are Arthur Anderson, Arthur Young, Coopers & Lybrand, D e l o i t t e Haskins & S e l l s , E r n s t & Whinney, Peat Marwick M i t c h e l l , P r i c e Waterhouse and Touche Ross. 3 i n s i g n i f i c a n t r e s u l t s . However, recent s t u d i e s of market r e a c t i o n to earnings announcements ( A t i a s e [1980] and Grant [1980]) have found that smaller firms experience a l a r g e r r e a c t i o n to the i n f o r m a t i o n . Hence i t i s c o n j e c t u r e d that i n f o r m a t i o n about a change i n a u d i t o r w i l l have a gr e a t e r impact on OTC firms than i t has on the l a r g e r NYSE and AMEX f i r m s . T h i r d , t h i s t h e s i s employs a new method f o r event s t u d i e s . Research on OTC companies r e q u i r e s manual c o l l e c t i o n of stock p r i c e s as these f i r m s are not i n c l u d e d i n the CRSP tapes. E s s e n t i a l l y , our a n a l y s i s c o n s i s t s of comparing a c r o s s - s e c t i o n a l r e g r e s s i o n of f i r m r e t u r n s in an a u d i t o r change announcement p e r i o d to a s i m i l a r r e g r e s s i o n on "the same fi r m s i n a c o n t r o l p e r i o d . The method used p r o v i d e s a t e s t of p o s i t i v e or negative stock p r i c e r e a c t i o n to a u d i t o r changes while minimizing data c o l l e c t i o n . C. OUTLINE OF THESIS In order to i d e n t i f y the i s s u e s i n v o l v e d i n t h i s study, we begin by examining the is s u e of product d i f f e r e n t i a t i o n i n the market f o r a u d i t s e r v i c e s i n Chapter I I . In Chapter III f a c t o r s i n v o l v e d i n the s e l e c t i o n of a u d i t s e r v i c e s , reasons f o r a u d i t o r changes, and market r e a c t i o n s to these changes are d i s c u s s e d . A d e s c r i p t i o n of the sample s e l e c t i o n and data c o l l e c t i o n procedures are i n Chapter IV. The t e s t method and hypotheses are developed i n Chapter V. Chapter VI presen t s and d i s c u s s e s the r e s u l t s of the s t a t i s i c a l 4 a n a l y s e s , and Chapter VII summarizes and concludes. I I . PRODUCT DIFFERENTIATION IN THE MARKET FOR AUDIT SERVICES If a u d i t i n g i s a homogeneous product ac r o s s s u p p l i e r s , the a u d i t o r c h o i c e problem i s l a r g e l y i r r e l e v a n t . Since the q u a l i t y of the product r e c e i v e d from a l l a u d i t o r s would be i d e n t i c a l , a l l firms would engage the a u d i t o r quoting the lowest f e e s , and a u d i t o r c h o i c e would be p u r e l y a f u n c t i o n of p r o d u c t i o n f u n c t i o n / c o s t d i f f e r e n c e s a c r o s s a u d i t o r s . However, as mentioned i n the i n t r o d u c t i o n , s e v e r a l r e s e a r c h e r s b e l i e v e that the market f o r a u d i t s e r v i c e s i s c h a r a c t e r i z e d by product d i f f e r e n t i a t i o n , and hence the a u d i t o r c h o i c e problem i s not i r r e l e v a n t . T h e r e f o r e i n order to understand the a u d i t o r c h o i c e problem i t i s necessary to examine how a u d i t s e r v i c e s can be d i f f e r e n t i a t e d and what f a c t o r s w i l l motivate c l i e n t f i r m s i n t h e i r s e l e c t i o n of a u d i t o r s . In t h i s chapter we review some of the arguments fo r and evidence on product d i f f e r e n t i a t i o n i n the market f o r a u d i t s e r v i c e s . DeAngelo [1981(a), 1981(b)] argues f o r the e x i s t e n c e of product d i f f e r e n t i a t i o n i n the f o l l o w i n g sense. She proposes an a u d i t technology i n which a u d i t o r s earn c l i e n t - s p e c i f i c q u a s i - r e n t s . She assumes i f a u d i t o r malfeasance i n order to r e t a i n a s p e c i f i c c l i e n t i s subsequently d i s c o v e r e d , the a u d i t o r i s l e s s l i k e l y to be r e t a i n e d by i t s set of e x i s t i n g c l i e n t s . A l a r g e a u d i t f i r m earns l a r g e aggregate c l i e n t - s p e c i f i c q u a s i - r e n t s and t h e r e f o r e faces a higher p o t e n t i a l o p p o r t u n i t y l o s s from " c h e a t i n g " than a small a u d i t f i r m . Hence, she argues a u d i t q u a l i t y w i l l be 5 6 p o s i t i v e l y c o r r e l a t e d with a u d i t f i r m s i z e . DeAngelo's arguments focus on the supply s i d e of the market f o r a u d i t s e r v i c e s . She ignores the demand f o r d i f f e r e n t i a t e d a u d i t s e r v i c e s , except i n the narrow sense that a c l i e n t i s not w i l l i n g to pay the c o s t of an independent a u d i t to an a u d i t o r who i s not p e r c e i v e d as su p p l y i n g such an a u d i t . Although she demonstrates how a u d i t s e r v i c e s can be d i f f e r e n t i a t e d , she does not attempt to e x p l a i n or j u s t i f y why c l i e n t firms w i l l s e l e c t d i f f e r e n t l e v e l s of a u d i t q u a l i t y . Dopuch and Simunic [1980; 1982] propose a demand based model of product d i f f e r e n t i a t i o n . They c o n j e c t u r e that a u d i t s e r v i c e s have two c h a r a c t e r i s t i c s valued by top management-a c o n t r i b u t i o n to o r g a n i z a t i o n a l c o n t r o l and c r e d i b i l i t y with f i n a n c i a l statement u s e r s . 2 The demand f o r o r g a n i z a t i o n a l c o n t r o l depends on the degree to which top managers can p e r s o n a l l y monitor the v a r i o u s a c t i v i t i e s of t h e i r s u b o r d i n a t e s . The l e s s p e r s o n a l c o n t r o l management has over the f i r m the more l i k e l y an o u t s i d e a u d i t w i l l be v a l u a b l e to management. As Simunic and S t e i n [1986] l a t e r note, the demand f o r o r g a n i z a t i o n a l c o n t r o l can e x i s t i n fir m s of s u f f i c i e n t s i z e or complexity even i f they do not have o u t s i d e debt or e q u i t y . 2 I t has been suggested i n the economics l i t e r a t u r e (Lancaster [1966,1971]) that products are not d e s i r a b l e i n and of themselves, but r a t h e r f o r the bundle of u t i l i t y b e a r i n g c h a r a c t e r i s t i c s they c o n t a i n . T h i s i m p l i e s products can be d i f f e r e n t i a t e d a c c o r d i n g to both the types and q u a n t i t i e s of the c h a r a c t e r i s t i c s they possess. 7 When o u t s i d e debt and/or e q u i t y are in t r o d u c e d i n t o the c a p i t a l s t r u c t u r e the demand f o r c r e d i b i l i t y a r i s e s because of the agency r e l a t i o n s h i p between management and ou t s i d e s h a r e h o l d e r s and c r e d i t o r s . 3 There i s now an asymmetry of i n f o r m a t i o n , or moral hazard problem, between top management and o u t s i d e r s about the a c t i o n s of top management. A c r e d i b l e a u d i t can both reduce agency c o s t s by l i m i t i n g management's a b i l i t y to co n c e a l improper a c t i o n s ( s h i r k i n g ) i n the f i n a n c i a l statements and a l s o s i g n a l management's honesty to i n v e s t o r s . Since managements' u t i l i t y f u n c t i o n s and o p p o r t u n i t y sets f o r s h i r k i n g w i l l vary a c r o s s managers, the l e v e l of c r e d i b i l i t y demanded w i l l vary a c r o s s f i r m s . In t h e i r l a t e r study Simunic and S t e i n [1986] add the scope of the product o f f e r e d by an au d i t f i r m as a t h i r d c h a r a c t e r i s t i c demanded by top management. T h i s c h a r a c t e r i s t i c r e f e r s to the a v a i l a b i l i t y of v a r i o u s management c o n s u l t i n g type s e r v i c e s from the a u d i t s u p p l i e r . I t i s o f t e n claimed that a knowledge e x t e r n a l i t y i s c r e a t e d d u r i n g the a u d i t i n g process which reduces the co s t of c o n s u l t i n g s e r v i c e s s u p p l i e d by the a u d i t o r . T h e r e f o r e , Simunic and S t e i n s t a t e that the a u d i t s e r v i c e purchased by a p a r t i c u l a r c l i e n t from a given a u d i t f i r m can be d e s c r i b e d by s p e c i f i c a t i o n of a ve c t o r of q u a n t i t i e s of the three s e r v i c e c h a r a c t e r i s t i c s : { c o n t r o l , c r e d i b i l i t y , product 3Jensen and Meckling [1976] d e f i n e an agency r e l a t i o n s h i p as "a c o n t r a c t under which one or more persons (the p r i n c i p a l ) engage another person (the agent) to perform some s e r v i c e on t h e i r behalf which i n v o l v e s d e l e g a t i n g some d e c i s i o n making a u t h o r i t y to the agent" (p.308). 8 l i n e ] . Simunic and S t e i n a l s o p o i n t out that the demand f o r a u d i t s e r v i c e s i s d e r i v e d from the o b j e c t i v e f u n c t i o n of the top management of the a u d i t e d company. Th e r e f o r e they q u e s t i o n i f these d e c i s i o n s w i l l a l s o s a t i s f y i n v e s t o r s ' demands. They argue that the demand f o r c o n t r o l and product l i n e scope w i l l be the same f o r management and i n v e s t o r s . But the demand f o r c r e d i b i l i t y c o u l d p o t e n t i a l l y d i f f e r i f the s o l e purpose of c r e d i b i l i t y i s to a m e l i o r a t e the agency problem between management and i n v e s t o r s . The e x i s t e n c e of an agency r e l a t i o n s h i p i m p l i e s that the purpose of e r r o r s or omissions i n the f i n a n c i a l statements caused by management w i l l be to induce f i n a n c i a l statement users to overestimate cash flows. R a t i o n a l c r e d i t o r s and shareholders are aware of t h i s p o s s i b i l i t y and w i l l t h e r e f o r e a p p r o p r i a t e l y a d j u s t the terms of t r a n s a c t i o n s with management. Simunic and S t e i n r e f e r to t h i s as " p r i c e p r o t e c t i o n " and note that i n the extreme, i n v e s t o r s and c r e d i t o r s may even re f u s e to t r a n s a c t with the f i r m . Thus Simunic and S t e i n argue t h a t , under the r a t i o n a l user assumption, i t i s the i n t e r e s t s of top management to demand c r e d i b l e a u d i t i n g . L a t e r , i n Chapter I I I , we d i s c u s s f a c t o r s i n v o l v e d i n management's s e l e c t i o n of a p a r t i c u l a r l e v e l of c r e d i b i l i t y . Simunic and S t e i n a l s o d i s c u s s what a u d i t s e r v i c e designs w i l l be o f f e r e d f o r s a l e , and whether a given a u d i t f i r m w i l l supply a s i n g l e s e r v i c e v e c t o r or simultaneously 9 supply a v a r i e t y of c h a r a c t e r i s t i c v e c t o r s . Audit firms d e s i r i n g to maximize economic r e n t s w i l l choose v e c t o r s i n response to demand from c l i e n t f i r m s and ve c t o r c h o i c e s of other a u d i t o r s . However, an a u d i t o r ' s a b i l i t y to simultaneously supply a v a r i e t y of c h a r a c t e r i s t i c v e c t o r s w i l l be l i m i t e d by t h e i r a b i l i t y to d i f f e r e n t i a l l y "package" these v e c t o r s . R a t i o n a l purchasers of a u d i t s e r v i c e s w i l l not be w i l l i n g to s e l e c t higher and more c o s t l y l e v e l s of a c h a r a c t e r i s t i c unless they can observe the c h a r a c t e r i s t i c s . Since the d e t a i l s of an a u d i t cannot be observed by i n v e s t o r s (and only i m p e r f e c t l y by management) an asymmetric i n f o r m a t i o n problem a r i s e s . T h i s problem presumably has l i t t l e impact on the a u d i t o r ' s a b i l i t y to simultaneously p r o v i d e d i f f e r e n t l e v e l s of i n t e r n a l c o n t r o l or product l i n e . Since management w i l l be ab l e to observe the a u d i t o r s , there w i l l be no problem f o r management to ensure that the a u d i t o r has c o r r e c t l y f u l f i l l e d t h e i r c o n t r a c t u a l r e s p o n s i b i l i t i e s . I n v e s t o r s w i l l a l s o be s a t i s f i e d because management and i n v e s t o r s agree on the l e v e l of i n t e r n a l c o n t r o l and product l i n e to be purchased. However, an a u d i t o r ' s a b i l i t y to simultaneously provide d i f f e r e n t l e v e l s of c r e d i b i l i t y w i l l be l i m i t e d due to i t s u n o b s e r v a b i l i t y . We argued e a r l i e r that i n v e s t o r s and c r e d i t o r s can ensure management w i l l demand c r e d i b i l i t y i n managements' own i n t e r e s t because i n v e s t o r s and c r e d i t o r s can " p r i c e p r o t e c t " themselves. Furthermore, as argued i n Chapter I I I , i n v e s t o r s r e q u i r e a c l e a r i n d i c a t i o n of the 10 l e v e l of c r e d i b i l i t y management has purchased i n order to value t h e i r investment. Dopuch and Simunic [1982] t h e r e f o r e argue that a u d i t o r c r e d i b i l i t y must be a s s o c i a t e d with an observable c h a r a c t e r i s t i c , such as the brand name of the a u d i t o r . Since a u d i t o r s cannot d i r e c t l y communicate in any meaningful way the power of t h e i r t e s t s , each a u d i t f i r m i s r e s t r i c t e d to a s i n g l e brand. Hence, Simunic and S t e i n [1986] argue that a u d i t o r s w i l l s p e c i a l i z e i n the d e l i v e r y of a u d i t c r e d i b i l i t y l e v e l s as opposed to simultaneously o f f e r i n g a v a r i e t y of l e v e l s . An i m p l i c a t i o n of the above i s that i f c o n d i t i o n s i n a c l i e n t f i r m change so they r e q u i r e more or l e s s i n t e r n a l c o n t r o l or product l i n e , they w i l l not n e c e s s a r i l y have to change a u d i t o r s . However, i f c o n d i t i o n s change so more or l e s s c r e d i b i l i t y i s now o p t i m a l , an a u d i t o r change will be necessary. These f a c t s are s i g n i f i c a n t i n our a n a l y s i s of a u d i t o r changes in the next c h a p t e r . If d i f f e r e n t l e v e l s of c r e d i b i l i t y are demanded, which a u d i t f i r m s supply more c r e d i b i l i t y ? DeAngelo's [1981(a),1981(b)] argument t h a t l a r g e a u d i t f i r m s w i l l s u f f e r more from "cheating" i s c o n s i s t e n t with the i m p l i c a t i o n that l a r g e a u d i t o r s are more c r e d i b l e . A d d i t i o n a l l y , given the dominance of the Big E i g h t a u d i t i n g f i r m s i n the market f o r a u d i t s of p u b l i c l y h e l d companies, Dopuch and Simunic [1982] a l s o i n f e r that an a u d i t by a Big E i g h t f i r m i s more c r e d i b l e than an a u d i t by a s m a l l e r f i r m . But, i f Big E i g h t firms d e l i v e r a higher q u a l i t y of s e r v i c e 11 than non-Big E i g h t f i r m s , then other t h i n g s h e l d constant, a u d i t p r i c e s should l i k e w i s e vary between the two groups. Present e m p i r i c a l evidence on t h i s p o i n t i s mixed. Simunic [1980] examined a c r o s s s e c t i o n of a u d i t s of U.S. companies ranging i n s i z e from $500,000 to about $10 b i l l i o n i n a s s e t s . He found that p r i c e s charged by the B i g E i g h t f i r m s were not s i g n i f i c a n t l y d i f f e r e n t and p o s s i b l y somewhat lower than non-Big E i g h t f i r m s . Conversely, F r a n c i s [1984] using a pooled c r o s s s e c t i o n of A u s t r a l i a n companies found that p r i c e s charged by Big E i g h t f i r m s were s i g n i f i c a n t l y higher than p r i c e s charged by non-Big E i g h t f i r m s . T o f f l e r and Ramalinggam [1982], using U n i t e d Kingdom data, report r e s u l t s c o n s i s t e n t with F r a n c i s . However, l a t e r F r a n c i s and Stokes [1985] r e p o r t that the d i f f e r e n c e between Big E i g h t and non-Big E i g h t f i r m p r i c e s appears l a r g e l y c o n f i n e d to the very s m a l l e s t companies i n t h e i r sample. Simunic and S t e i n [1986] argue that the i n c o n s i s t e n c i e s in t h i s evidence may be p a r t l y due to the d i f f i c u l t i e s of i n f e r r i n g a u d i t p r i c e s from the observed a u d i t fee data. They suggest an a u d i t fee can be thought of as the product of the p r i c e times the q u a n t i t y of the a u d i t c h a r a c t e r i s t i c s purchased. A d d i t i o n a l l y , F r a n c i s & Stokes [1985] and Simunic & S t e i n [1986] s p e c u l a t e that i n Big E i g h t a u d i t s of l a r g e companies, s c a l e economies e x i s t . T h i s a l l o w s Big E i g h t f i r m s to o f f s e t the p r i c e e f f e c t s of product d i f f e r e n t i a t i o n with lower p r o d u c t i o n c o s t s . In the a u d i t s of smaller companies i t i s s p e c u l a t e d that s c a l e economies are l e s s 12 l i k e l y to e x i s t and t h e r e f o r e Big E i g h t a u d i t f i r m s would not have a p r o d u c t i o n advantage over non-Big E i g h t f i r m s . T h i s e x p l a n a t i o n i s c o n s i s t e n t with the above s t u d i e s s i n c e Simunic, who found no d i f f e r e n t i a l , was l o o k i n g at firms approximately 10 times l a r g e r than the o t h e r s , who d i d f i n d a d i f f e r e n t i a l . Thus i t i s q u i t e p o s s i b l e there are systematic d i f f e r e n c e s i n a u d i t p r i c e s r e l a t i n g to d i f f e r e n c e s i n s e r v i c e when other f a c t o r s are h e l d c o n s t a n t . To summarize, the e x i s t e n c e of product d i f f e r e n t i a t i o n i n the market f o r a u d i t s e r v i c e s appears h i g h l y p l a u s i b l e . We have proposed that c l i e n t f i r m s may demand d i f f e r e n t l e v e l s of a u d i t s e r v i c e c h a r a c t e r i s t i c s . The most i n t e r e s t i n g a u d i t s e r v i c e c h a r a c t e r i s t i c i s c r e d i b i l i t y because a u d i t o r s must s p e c i a l i z e i n the amount of c r e d i b i l i t y they o f f e r due to the asymmetric i n f o r m a t i o n problem i n observing a u d i t s e r v i c e p r o d u c t i o n . We hypothesize that Big E i g h t f i r m s are more c r e d i b l e or supply higher q u a l i t y a u d i t s than non-Big E i g h t f i r m s . " As s t a t e d e a r l i e r i t i s important that d i f f e r e n t i a t i o n e x i s t s , e l s e the a u d i t o r c h o i c e problem i s p u r e l y cost d r i v e n and l a r g e l y an empty i s s u e . Furthermore, we would not expect to observe a stock market r e a c t i o n to an a u d i t o r change i f a u d i t s e r v i c e s were homogeneous. In the next chapter we examine in "Simunic [1986] notes that any grouping of s u p p l i e r s i n broad c l a s s e s such as Big E i g h t vs. non-Big E i g h t i s n e c e s s a r i l y a r b i t r a r y and should be t e s t e d f o r w i t h i n group homogeneity. Although we have not performed such a t e s t , f o l l o w i n g Dopuch & Simunic [1982], N i c h o l s & Smith [1983], we simply d i s t i n g u i s h between Big E i g h t and non-Big E i g h t a u d i t o r s f o r purposes of t h i s study. 13 more d e t a i l how management s e l e c t s an i n i t i a l l e v e l of a u d i t c r e d i b i l i t y ( q u a l i t y ) . We then suggest a reason why management would change the l e v e l of a u d i t c r e d i b i l i t y and how t h i s w i l l a f f e c t f i r m v a l u e . I I I . THE AUDITOR CHOICE ISSUE A. INITIAL AUDITOR SELECTION In the preceding chapter we suggested that although an a u d i t o r may simultaneously o f f e r s e v e r a l l e v e l s of i n t e r n a l c o n t r o l or product l i n e , they must s p e c i a l i z e i n the l e v e l of c r e d i b i l i t y o f f e r e d , s i n c e the l e v e l of c r e d i b i l i t y must be i n f e r r e d from a brand name. T h i s i m p l i e s that the s e l e c t i o n of an a u d i t o r depends p r i m a r i l y on the l e v e l of c r e d i b i l i t y demanded. To f u r t h e r our understanding of the p o t e n t i a l e f f e c t of a c r e d i b l e a u d i t , and thus the amount of c r e d i b i l i t y demanded, i t i s u s e f u l to examine how users of f i n a n c i a l statements determine t h e i r expected wealth a f t e r an a u d i t . 5 Simunic and S t e i n [1986] suggest a model where given no a u d i t , u s ers w i l l c a l c u l a t e f o r each f i r m the p r i o r p r o b a b i l i t y the f i n a n c i a l statements w i l l be m a t e r i a l l y i n e r r o r , and the l o s s from such f i n a n c i a l statement e r r o r s . An a u d i t of a given l e v e l of c r e d i b i l i t y w i l l cause users to rea s s e s s t h e i r b e l i e f s and c a l c u l a t e the p o s t e r i o r p r o b a b i l i t y of m a t e r i a l e r r o r s and the new expected l o s s from the e r r o r s . As Simunic and S t e i n f u r t h e r e x p l a i n , the p r o b a b i l i t y of e r r o r i s reassessed because an a u d i t may reduce the moral hazard problem between management and users of f i n a n c i a l statements. In a d d i t i o n , the p e r c e i v e d l o s s from e r r o r s w i l l be reduced because users know that a 5 P o s i t i n g an e f f e c t on expected wealth w i l l be r e l e v a n t f o r both r i s k adverse and r i s k n e u t r a l i n v e s t o r s . 1 4 15 c r e d i b l e a u d i t w i l l reduce managements a b i l i t y to conceal a c t i o n s and thus management w i l l be l e s s l i k e l y to s h i r k . 6 Users can c a l c u l a t e t h e i r expected wealth as the p o s t e r i o r p r o b a b i l i t y of no e r r o r s times the wealth of the user i f there are no e r r o r s p l u s the p o s t e r i o r p r o b a b i l i t y of e r r o r s times wealth of the user i f e r r o r s are present l e s s the cost of the a u d i t . We can expect f o r a given f i r m , the g r e a t e r the c r e d i b i l i t y l e v e l of the a u d i t , the l a r g e r the d i f f e r e n c e s between the p r i o r and p o s t e r i o r p r o b a b i l i t y of e r r o r s and a l s o the g r e a t e r the decrease i n the p e r c e i v e d l o s s from e r r o r s . Thus f o r a given f i r m , the greater the c r e d i b i l i t y l e v e l , the gr e a t e r the i n c r e a s e i n i n v e s t o r s ' expected wealth. However, s i n c e i n v e s t o r s can p r i c e p r o t e c t themselves they w i l l be i n d i f f e r e n t to the l e v e l of c r e d i b i l i t y i n i t i a l l y s e l e c t e d . Management w i l l not be i n d i f f e r e n t to the l e v e l of c r e d i b i l i t y s e l e c t e d . We assume that management enjoys two types of b e n e f i t s from t h e i r p o s i t i o n i n the f i r m -p e r q u i s i t e s and the value of t h e i r r e s i d u a l ownership i n the f i r m . Management w i l l s e l e c t the a u d i t o r , and hence the c r e d i b i l i t y l e v e l , t h a t maximizes management's u t i l i t y over 6 F o r t h i s to be true we must have reasonable assurance management i s unable to subvert the a u d i t o r . We assume that a u d i t o r s earn re n t s and/or q u a s i - r e n t s at t h e i r chosen c r e d i b i l i t y l e v e l . Then, as DeAngelo [1981(a),1981(b)] argued, a u d i t o r s w i l l s u f f e r o p p o r t u n i t y c o s t s i f they f a i l to, d e l i v e r the amount of c r e d i b i l i t y a s s o c i a t e d with t h e i r "brand" name. Thus a manager c o u l d subvert an a u d i t o r i f the manager o f f e r e d a s u f f i c i e n t l y l a r g e b r i b e . However, the rent streams w i l l reduce the p r o b a b i l i t y of t h i s o c c u r r i n g . 16 these two b e n e f i t s . There are s e v e r a l p o s s i b l e reasons why the manager of a given f i r m would p r e f e r a p a r t i c u l a r l e v e l of c r e d i b i l i t y . We b e l i e v e the c a p i t a l s t r u c t u r e of the f i r m i s one f a c t o r that can s t r o n g l y i n f l u e n c e the a u d i t o r s e l e c t i o n . As e x t e r n a l ownership i n c r e a s e s i n v e s t o r s w i l l expect management's consumption of p e r q u i s i t e s to i n c r e a s e . T h e r e f o r e , management i s motivated to s h i r k more and use the f i n a n c i a l statements to conceal t h e i r a c t i o n s . As s t a t e d e a r l i e r , r a t i o n a l i n v e s t o r s r e a l i z e t h i s and p r i c e t h e i r investment a c c o r d i n g l y . However, management may p r e f e r to consume l e s s p e r q u i s i t e s and i n c r e a s e the value of the f i r m . T h e r e f o r e , management w i l l s e l e c t the p a r t i c u l a r l e v e l of c r e d i b i l i t y that causes them to reduce t h e i r consumption and r e s u l t s i n the f i r m v a l u e - p e r q u i s i t e combination that maximizes management's u t i l i t y . The g r e a t e r the e x t e r n a l ownership the g r e a t e r the c r e d i b i l i t y i n v e s t o r s w i l l r e q u i r e to be assured that management's a b i l i t y to both s h i r k and conceal t h e i r a c t i o n s i n the f i n a n c i a l statements have been reduced. Given these i n c e n t i v e s , we expect managers of fi r m s with more e x t e r n a l ownership to s e l e c t higher q u a l i t y a u d i t o r s and managers of firms with l e s s e x t e r n a l ownership to s e l e c t lower q u a l i t y a u d i t o r s . Thus based on our a n a l y s i s i n Chapter I I , we expect that i n g e n e r a l , firms with a gr e a t e r p r o p o r t i o n of e x t e r n a l ownership w i l l u t i l i z e the s e r v i c e s of a Big E i g h t a u d i t o r and fi r m s with l e s s e x t e r n a l 17 ownership w i l l use non-Big E i g h t f i r m s . T h i s i m p l i e s the a u d i t s e l e c t e d w i l l c o s t more i n firms with a l a r g e r percentage of e x t e r n a l ownership. To demonstrate that management i n f i r m s with l a r g e r e x t e r n a l ownership w i l l s e l e c t a higher c r e d i b i l i t y (and t h e r e f o r e more c o s t l y ) a u d i t o r than f i r m s with smaller e x t e r n a l ownership, c o n s i d e r F i g u r e 1, adapted from Jensen and Meckling [1976]. L i n e EF i s the manager's budget c o n s t r a i n t i n a 100 percent owner managed f i r m . Since one d o l l a r of p e r q u i s i t e s withdrawn from the f i r m by the manager reduces the value of the f i r m by one d o l l a r , the slope of EF i s -1. I f the manager s e l l s p art of the f i r m the slope of the budget c o n s t r a i n t w i l l become -a, where a r e p r e s e n t s the percentage of the f i r m r e t a i n e d by the manager. F i g u r e 1 .shows p o s s i b l e budget c o n s t r a i n t s and f i r m v a l u e s f o r two otherwise i d e n t i c a l f i r m s whose managers e l e c t e d i n the past to s e l e c t low or high p r o p o r t i o n s of e x t e r n a l ownership. Without a u d i t i n g , f i r m value i n a market where i n v e s t o r s h o l d r a t i o n a l e x p e c t a t i o n s , would be OC f o r f i r m s with low e x t e r n a l ownership and OA f o r firms with h i g h e x t e r n a l ownership. F o l l o w i n g Jensen and Meckling, the purchase of c o s t l y a u d i t i n g t o monitor management's behavior a l l o w s the manager in a f i r m with low e x t e r n a l ownership to make t r a d e - o f f s between f i r m value and p e r q u i s i t e s along the concave l i n e segment emanating from p o i n t H. 7 By i n c u r r i n g a u d i t i n g c o s t s 7An assumption of d i m i n i s h i n g r e t u r n s to more i n t e n s i v e a u d i t i n g w i l l ensure the c o n c a v i t y of t h i s l i n e segment. 18 M, the manager can i n c r e a s e f i r m value to an optimum l e v e l OD. S i m i l a r i l y , the manager i n a f i r m with high e x t e r n a l ownership can i n c r e a s e f i r m value to OB by purchasing a u d i t i n g s e r v i c e s c o s t i n g N. The net b e n e f i t s of a u d i t i n g to management are CD and AB, r e s p e c t i v e l y , in the two cases. Since N i s g r e a t e r than M i t can be seen that f i r m s with a higher e x t e r n a l ownership c a p i t a l s t r u c t u r e w i l l pay more f o r a u d i t i n g than f i r m s with lower e x t e r n a l ownership. In summary, we assume the e x i s t e n c e of an e q u i l i b r i u m where d i f f e r e n t a u d i t firms w i l l o f f e r d i f f e r e n t l e v e l s of c r e d i b i l i t y i n response to c l i e n t s ' demands. A d i s t r i b u t i o n of a u d i t o r / c l i e n t p a i r s can be determined by the ownership s t r u c t u r e of the c l i e n t f i r m s , where managers of f i r m s with low e x t e r n a l ownership s e l e c t low q u a l i t y or non-Big E i g h t a u d i t o r s and managers of firms with h i g h e x t e r n a l ownership s e l e c t h i g h q u a l i t y or Big E i g h t a u d i t o r s . B. AUDITOR CHANGES 1. LITERATURE REVIEW OF RESEARCH ON AUDITOR CHANGES Given the above framework on i n i t i a l a u d i t o r s e l e c t i o n , we can a l s o s p e c u l a t e on the f a c t o r s that w i l l induce management to change a u d i t o r s . However, before doing so i t i s u s e f u l to review other s t u d i e s on a u d i t o r changes. The e a r l i e s t r e s e a r c h on a u d i t o r changes was produced by Burton & Roberts [1967].'Their o b j e c t i v e was to see i f any evidence c o u l d be found that f i r m s were seeking to 19 e x p l o i t the economic r e l a t i o n s h i p with t h e i r a u d i t o r s i n such a way as to t h r e a t e n the independence of the a u d i t o r ' s a t t e s t a t i o n . T h e i r sample c o n s i s t e d of the 83 c o m p a n y - i n i t i a t e d a u d i t o r changes they found in the Fortune 500 i n d u s t r i a l f i r m s between 1952 and 1965. Through i n q u i r i e s to both the c o r p o r a t i o n s and t h e i r a u d i t o r s , Burton & Roberts determined the most common reasons f o r a u d i t o r changes were, r e s p e c t i v e l y , changes i n management and the need f o r a d d i t i o n a l s e r v i c e s . They concluded that t h e i r examination o f f e r e d no evidence that any t h r e a t to the proper e x e r c i s e of the a t t e s t f u n c t i o n e x i s t e d . Carpenter & Strawser [1971] examined the extent of displacement of smaller a u d i t i n g firms with n a t i o n a l firms by c o r p o r a t i o n s ' that are going p u b l i c . They sent q u e s t i o n n a i r e s to c o r p o r a t i o n s which went p u b l i c i n e i t h e r the f i n a l q u a r t e r of 1969 or the f i r s t q u a r t e r of 1970. From t h i s data Carpenter & Strawser concluded that s m a l l e r a u d i t i n g f i r m s were l i k e l y to be r e p l a c e d when a c o r p o r a t i o n goes p u b l i c . The t h i r d study on a u d i t o r changes by B e d i n g f i e l d & Loeb [1974] used the newly mandated a u d i t o r change i n f o r m a t i o n r e p o r t e d on the S e c u r i t i e s and Exchange Commission (SEC) Form 8-K.8 T h e i r sample c o n s i s t e d of 250 " E f f e c t i v e October 31,1971 the SEC Release #34-9344 r e q u i r e d the r e p o r t i n g of changes i n the r e g i s t r a n t ' s a u d i t o r on a Form 8-K w i t h i n 10 days of the month of change. T h i s r e l e a s e r e q u i r e d the r e g i s t r a n t to d i s c l o s e whether i n the eighteen months pre c e d i n g the change there were any disagreements with t h e i r former a u d i t o r on any s i g n i f i c a n t accounting or a u d i t i n g matters, which i f not r e s o l v e d would have caused the former a u d i t o r to note t h i s i n the a u d i t o p i n i o n . 20 a u d i t o r changes between November 1 1971 and February 1973. To o b t a i n a d d i t i o n a l i n f o r m a t i o n on reasons f o r the changes they a l s o sent q u e s t i o n n a i r e s to the f i r m s . In c o n t r a s t to the work of Burton & Roberts and Carpenter & Strawser, B e d i n g f i e l d & Loeb d i d not f i n d an overwhelming tendency f o r companies to s e l e c t a n a t i o n a l f i r m as the new a u d i t o r . Furthermore, whereas Burton & Roberts concluded that fee c o m p e t i t i o n seldom motivated a u d i t o r changes, B e d i n g f i e l d & Loeb r e p o r t e d 47 percent of t h e i r respondents i n d i c a t e d fee c o m p e t i t i o n as c o n t r i b u t i n g to the a u d i t o r change d e c i s i o n . B e d i n g f i e l d & Loeb conclude that the d i f f e r e n c e s are l i k e l y caused by examining d i f f e r e n t p o p u l a t i o n s ; Burton & Roberts' study i n c l u d e d only l a r g e f i r m s , Carpenter and Strawser s t u d i e d only firms that had i s s u e d s e c u r i t i e s f o r the f i r s t time, whereas B e d i n g f i e l d & Loeb i n c l u d e d a l l companies r e g i s t e r e d with the SEC t h a t changed a u d i t o r s . F r i e d & S c h i f f [1981] performed the f i r s t study on the e x i s t e n c e and degree of market r e a c t i o n to a u d i t o r changes. They analyzed stock p r i c e s f o r both a sample of 48 p u b l i c l y l i s t e d companies that switched a u d i t o r s between 1972 and 1975 and a matched set of c o n t r o l companies that d i d not change a u d i t o r s . T h e i r a n a l y s i s was r e s t r i c t e d to f irms that had p r i c e i n f o r m a t i o n a v a i l a b l e on the CRSP tapes. F r i e d & S c h i f f assumed that the g e n e r a l m o t i v a t i o n f o r a change i n 8 ( c o n t ' d ) Subsequent amendments to t h i s requirement i n c l u d e d an e x t e n s i o n of the disagreement p e r i o d to twenty-four months, the mandatory d i s c l o s u r e as to whether the a u d i t o r change was recommended or approved by the f i r m ' s board of d i r e c t o r s , and a recommendation that firms v o l u n t a r i l y d i s c l o s e reasons for the a u d i t o r change. 21 a u d i t o r s was to secure a more f l e x i b l e i n t e r p r e t a t i o n and a p p l i c a t i o n of accounting standards and t h e r e f o r e hypothesized the e f f e c t of a u d i t o r changes on market values would be n e g a t i v e . F r i e d & S c h i f f ' s only exception to t h i s was i f the f i r m changed from a non-Big E i g h t to a Big E i g h t a u d i t o r and there was no r e p o r t e d a u d i t o r - f i r m disagreement. They argued that t h i s type of change c o u l d r e s u l t i n a p o s i t i v e market r e a c t i o n as the market would p e r c e i v e the change as r e s u l t i n g i n improved a u d i t i n g s e r v i c e . They found some evidence of a negative market r e a c t i o n at time of announcement f o r a l l a u d i t o r changes. However, p a r t l y as a r e s u l t of i n s u f f i c i e n t sample s i z e s , there were no s i g n i f i c a n t r e s u l t s . In the next study on a u d i t o r changes, Chow & Rice [1982] focused on the i n f l u e n c e 'of q u a l i f i e d a u d i t o p i n i o n s on a u d i t o r changes. A l l companies that had a q u a l i f i e d o p i n i o n ( e x c l u d i n g c o n s i s t e n c y exceptions) i n 1973 and a l l companies that changed a u d i t o r s between the 1973 and 1974 f i s c a l year ends were examined. T h e i r r e s u l t s support the c o n t e n t i o n that f i r m s switch a u d i t o r s more f r e q u e n t l y a f t e r r e c e i v i n g q u a l i f i e d o p i n i o n s . However, i t was not found that f i r m s t h a t have r e c e i v e d q u a l i f i e d o p i n i o n s switch s y s t e m a t i c a l l y to a u d i t firms with a h i s t o r y of r e n d e r i n g p r o p o r t i o n a l l y fewer q u a l i f i e d o p i n i o n s . 9 F i n a l l y Chow & Rice found no evidence that a company i s more l i k e l y to 9 U s i n g l o g i t a n a l y s i s Chow & Rice i d e n t i f i e d Arthur Young, Coopers & Lybrand and Touche Ross as having a g r e a t e r tendency to q u a l i f y o p i n i o n s . 22 r e c e i v e an u n q u a l i f i e d o p i n i o n a f t e r an a u d i t o r change. Danos & Eichenseher [1982] attempt to e x p l a i n s h i f t s i n market shares of a u d i t firms w i t h i n the context of g e n e r a l i z e d economies of s c a l e . They examine changes i n a u d i t f i r m market shares i n 33 c l i e n t i n d u s t r i e s over a seven year p e r i o d (1972-1979). They p o s i t that the e x i s t e n c e of c o m p e t i t i o n , equal o p e r a t i n g e f f i c i e n c i e s and s c a l e economies w i l l c r e a t e an environment i n which s u r v i v a l of a u d i t s e r v i c e s u p p l i e r s i s p r i m a r i l y a f u n c t i o n of a u d i t f i r m s i z e . T h e i r f i n d i n g s i n d i c a t e l a r g e r a u d i t f i r m s appeared to gain market shares o v e r a l l ; but i n "non-regulated" i n d u s t r i e s , l a r g e i n d u s t r y s p e c i f i c market shares tended to erode. Danos & Eichenseher's r e s u l t s c o u l d imply, given that b e n e f i t s of s c a l e economies accrue only to the l a r g e s t f i r m s , that any p o s i t i v e market share h e l d by non-Big E i g h t f i r m s r e p r e s e n t s a c o n t i n u a l d i s e q u i l i b r i u m i n the market f o r a u d i t s e r v i c e s . However, we argue that product d i f f e r e n t i a t i o n e x i s t s and t h i s w i l l confound the r e l a t i o n s h i p between cost advantages and changes i n market shares. Danos & Eichenseher admit t h i s i s a p o s s i b i l i t y , but d i d not know how to i n c l u d e d i r e c t c o n t r o l s f o r t h i s c o n d i t i o n i n t h e i r t e s t s . A second examination of market r e a c t i o n to a u d i t o r changes was performed by N i c h o l s & Smith [1983]. T h e i r sample c o n s i s t e d of NYSE & AMEX firms changing a u d i t o r s d u r i n g 1973 to 1979; 22 from B i g E i g h t to non-Big E i g h t a u d i t o r s and 29 from non-Big E i g h t to Big E i g h t a u d i t o r s . 23 Using the Dopuch and Simunic [1982] framework d i s c u s s e d e a r l i e r , they hypothesized that a change from non-Big E i g h t to B i g E i g h t a u d i t o r should impact p o s i t i v e l y on share p r i c e and a change from a Big E i g h t to non-Big E i g h t a u d i t o r should produce a negative market r e a c t i o n . T h e i r r e s u l t s are c o n s i s t e n t with t h e i r p r e d i c t i o n s , however, they are not s t a t i s t i c a l l y s i g n i f i c a n t . A d d i t i o n a l l y , t h e i r r e s u l t s f a i l to support the general F r i e d & S c h i f f [1981] argument, s i n c e a p e r v a s i v e s i g n i f i c a n t negative r e a c t i o n was not observed. The most e x t e n s i v e work on a u d i t o r changes was performed by McConnell [ 1983, 1984(a), 1984(b).]. He examined a l a r g e set of a u d i t o r changes f o r NYSE, AMEX and OTC f i r m s o c c u r i n g between January 1 1974, and December 31 1978, which was l a t e r extended to i n c l u d e the four years ending December 31. 1982. McConnell's primary i n t e r e s t was i n e x p l o r i n g the r e l a t i o n s h i p between a u d i t o r changes and c l i e n t - a u d i t o r disagreements, and market shares of Big E i g h t and non-Big E i g h t f i r m s . He examined these i s s u e s f o r NYSE, AMEX and OTC firms s e p a r a t e l y and then compared the r e s u l t s . Of p a r t i c u l a r i n t e r e s t to t h i s study, McConnell's r e s u l t s i n d i c a t e s t a t i s t i c a l l y s i g n i f i c a n t Big E i g h t a u d i t c l i e n t gains from non-Big E i g h t f i r m s i n NYSE and AMEX a u d i t markets, but not in the OTC a u d i t market. These r e s u l t s add f u r t h e r evidence that more f a c t o r s are i n v o l v e d ( p o s s i b l y product d i f f e r e n t i a t i o n ) i n a u d i t o r s e l e c t i o n f o r OTC fi r m s than economies of s c a l e , as the above Danos & Eishenseher [1982] a r t i c l e p o s i t e d . 24 The most recent study on a u d i t o r turnover, by Schwartz & Menon [1985], examined a u d i t o r changes by f a i l i n g f i r m s . T h e i r sample c o n s i s t e d of 132 NYSE and AMEX companies that d e c l a r e d bankruptcy d u r i n g the years 1974 to 1982. They a l s o examined a set of non-bankrupt firms matched on i n d u s t r y and s i z e . T h e i r r e s u l t s i n d i c a t e d that f a i l i n g f i r m s had a g r e a t e r tendency to switch a u d i t o r s than d i d h e a l t h i e r f i r m s . They a l s o found that f a i l i n g f i r m s d i d d i s p l a y a pre f e r e n c e to move to a d i f f e r e n t c l a s s of a u d i t f i r m s . Schwartz & Menon f i n d a s u b s t a n t i a l l y g r e a t e r p r o p o r t i o n of formerly B i g E i g h t a u d i t e d companies s e l e c t i n g non-Big E i g h t a u d i t o r s (48 percent) than e x i s t e d i n McConnell's study (17 p e r c e n t ) . The preceding review of major r e s e a r c h on a u d i t changes i n d i c a t e s there has been c o n s i d e r a b l e i n t e r e s t i n t h i s t o p i c . The work has been p r i m a r i l y e m p i r i c a l with l i t t l e a t t e n t i o n d i r e c t e d towards the development of u n d e r l y i n g t h e o r e t i c a l models. A d d i t i o n a l l y , we note that many of the r e s u l t s appear to be a f f e c t e d by the p a r t i c u l a r sample s e l e c t e d . The SEC's requirement that companies must re p o r t a u d i t o r changes on Form 8-K has brought a d d i t i o n a l i n f o r m a t i o n on these changes i n t o the p u b l i c domain. However, a complete and t r u t h f u l r e p o r t i n g of management's r a t i o n a l e i n a u d i t o r changes i s u n a v a i l a b l e (and would continue to be even i f the SEC mandates that f i r m s must r e p o r t reasons f o r the change). Thus, based on our a n a l y s i s of i n i t i a l a u d i t o r c h o i c e , we develop a t h e o r e t i c a l framework which can p o t e n t i a l l y e x p l a i n a u d i t o r changes. 2. THEORETICAL FRAMEWORK AND PREDICTIONS ON AUDITOR CHANGES Over our p a r t i t i o n of a u d i t o r s there are four types of a u d i t o r changes that can occur. Firms using a Big E i g h t a u d i t o r can switch to another Big E i g h t f i r m or to a non-Big E i g h t f i r m . S i m i l a r i l y , firms u s i n g a non-Big E i g h t a u d i t o r can switch to another non-Big E i g h t a u d i t o r or to a Big E i g h t a u d i t o r . We assume a l l a u d i t o r changes are executed due to a d e s i r e by management to maximize t h e i r u t i l i t y . Changes w i t h i n groups (Big E i g h t to Big E i g h t and non-Big E i g h t to non-Big E i g h t ) , may impact on the s h a r e h o l d e r s ' expected wealth i f the c r e d i b i l i t y of the a u d i t changes. However, s i n c e i t would be impossible to determine an exact d i s t r i b u t i o n of a l l a u d i t o r s from most c r e d i b l e to l e a s t c r e d i b l e , we are unable to p r e d i c t how a given w i t h i n group change would impact on s h a r e h o l d e r s ' expected wealth. We assume t h a t only i n i n t e r g r o u p changes i s i t p o s s i b l e to observe the d i r e c t i o n of the change i n c r e d i b i l i t y and thus p r e d i c t a p o t e n t i a l impact on f i r m v a l u e . Furthermore, i t i s l i k e l y t h a t an w i t h i n group change w i l l r e s u l t i n a only a marginal change in c r e d i b i l i t y , and thus a marginal change i n expected wealth. Other reasons f o r such changes c o u l d i n c l u d e p e r s o n a l i t y c o n f l i c t s between a u d i t o r s and management or new management may p r e f e r to engage the a u d i t o r s they u t i l i z e d i n a p r e v i o u s job. As noted e a r l i e r , 26 Burton & Roberts [1967] found one of the most common reasons f o r a u d i t o r changes was a change in management. Changing a u d i t o r s f o r these reasons should not impact on i n v e s t o r s ' expected wealth. Consequently, we have not performed t e s t s on these two i n t r a - g r o u p a u d i t o r changes. However, we do argue that when management changes a u d i t o r s from a Big E i g h t to a non-Big E i g h t f i r m or v i c e v e r s a , t h i s change should produce an observable impact on stock market p r i c e s . As noted e a r l i e r , N i c h o l s and Smith [1983] have hypothesized that a change from a non-Big E i g h t to a Big E i g h t a u d i t o r should impact p o s i t i v e l y on share p r i c e s and a change from a Big E i g h t to a non-Big E i g h t a u d i t o r should produce a negative market r e a c t i o n . They argue that "a more c r e d i b l e a u d i t should i n c r e a s e the market value of the f i r m (net of a u d i t c o s t s ) " (p.535). Although we agree with t h e i r p r e d i c t i o n s we don't b e l i e v e t h e i r r a t i o n a l e i s adequate. We b e l i e v e that merely an i n c r e a s e i n c r e d i b i l i t y should not be s u f f i c i e n t to cause a p o s i t i v e market r e a c t i o n . If we assume that management had p r e v i o u s l y s e l e c t e d the a u d i t o r with the optimal l e v e l of c r e d i b i l i t y , given the s t r u c t u r e of the f i r m , then an i n c r e a s e i n c r e d i b i l i t y w i l l r e s u l t i n a d d i t i o n a l c o s t s with no o f f s e t t i n g b e n e f i t s . T h i s would r e s u l t i n a negative stock market r e a c t i o n . T h e r e f o r e , we must assume that an exogenous event has occured which caused management to change a u d i t o r s . Since we have argued that management's s e l e c t i o n 27 of the optimum c r e d i b i l i t y of an a u d i t can depend on the f i r m ' s c a p i t a l s t r u c t u r e , we f u r t h e r argue that a change i n c a p i t a l s t r u c t u r e may cause a change i n a u d i t o r c l a s s . To demonstrate the impact of an i n c r e a s e i n e x t e r n a l ownership on a u d i t o r c h o i c e , c o n s i d e r F i g u r e 2, an e x t e n s i o n of F i g u r e 1. We assume that the f i r m i n i t i a l l y has low e x t e r n a l ownership and thus engages a low q u a l i t y (non-Big E i g h t ) a u d i t o r . As s t a t e d e a r l i e r the manager's o p t i m i z a t i o n , process w i l l r e s u l t i n a f i r m of value OD with a u d i t c o s t s of M. A s a l e of stock e x t e r n a l l y w i l l cause a drop i n f i r m value as management w i l l now make t r a d e - o f f s between f i r m value and p e r q u i s i t e s along the concave l i n e segment emanating from p o i n t G. 1 0 A f t e r the change management w i l l s e l e c t the q u a n t i t y of a u d i t c r e d i b i l i t y that maximizes management's u t i l i t y given the new ownership s t r u c t u r e . The more c o s t l y and c r e d i b l e the a u d i t o r whom management s e l e c t s , the g r e a t e r the i n c r e a s e i n f i r m value a f t e r the i n i t i a l drop caused by the ownership change. Management r e a l i z e s that the i n c r e a s e i n e x t e r n a l ownership, other t h i n g s remaining equal, i n c r e a s e s the value of t h e i r p e r q u i s i t e s and decreases the value of t h e i r r e s i d u a l ownership i n the f i r m . We c a t e g o r i z e managers i n t o two b a s i c types- those who o b t a i n g r e a t e r u t i l i t y from p e r q u i s i t e s and those who o b t a i n g r e a t e r u t i l i t y from f i r m v a l u e . Furthermore, we assume that management alone knows 1 0 0 t h e r r e s e a r c h e r s , i n c l u d i n g Myers and Majluf [1984], have demonstrated than an i n c r e a s e i n e x t e r n a l ownership w i l l cause a decrease i n f i r m v a l u e . 28 whether they o b t a i n g r e a t e r u t i l i t y from p e r q u i s i t e s or t h e i r r e s i d u a l ownership. In terms of F i g u r e 2, t h i s means the manager may have a u t i l i t y f u n c t i o n which can be represented by the FV i n d i f f e r e n c e curve l a b e l e d U or by the i n d i f f e r e n c e curve P P l a b e l e d U . I f they are of type U they p r e f e r p e r q u i s i t e s , and hence w i l l maintain a low c r e d i b i l i t y a u d i t o r with a u d i t c o s t s of P. A u d i t i n g c o s t s of P with a low q u a l i t y a u d i t o r may be g r e a t e r than the o r i g i n a l M i f the p r o p o r t i o n of e x t e r n a l ownerhip change was s u f f i c i e n t to cause management to s e l e c t a marginal i n c r e a s e i n c r e d i b i l i t y . But i f they FV are type U and p r e f e r f i r m v a l u e , they w i l l i n c r e a s e f i r m value to OB by i n c u r r i n g a u d i t i n g c o s t s of N. Hence, i f the d e s i r e d i n c r e a s e i n c r e d i b i l i t y i s s u f f i c i e n t , t h i s w i l l r e q u i r e management to change from a non-Big E i g h t a u d i t o r to a B i g E i g h t a u d i t o r . Thus an i n c r e a s e i n e x t e r n a l ownership may or may not cause an a u d i t o r c l a s s change. C e r t a i n l y , there i s evidence that an i n c r e a s e i n e x t e r n a l ownership can cause an a u d i t o r change. Often when firms f i r s t go p u b l i c they switch from a non-Big E i g h t to a Big E i g h t a u d i t o r (see Carpenter & Strawser [1971]). In order f o r a market r e a c t i o n to occur on the day an a u d i t o r change i s announced i t i s c r i t i c a l t h a t i n v e s t o r s cannot p r e d i c t i n advance management's type and p r e f e r e n c e s . We argue that management's pr e v i o u s s e l e c t i o n of a non-Big E i g h t a u d i t o r d i d not n e c e s s a r i l y s i g n a l that management i s the type who p r e f e r p e r q u i s i t e s . I t merely meant that given 29 management's u t i l i t y f u n c t i o n , the firms p r e v i o u s c a p i t a l s t r u c t u r e , and the c o s t s and b e n e f i t s of v a r i o u s l e v e l s of a u d i t o r c r e d i b i l i t y , that a non-Big Eig h t a u d i t o r was the o p t i m a l c h o i c e . Thus, a switch to a Big E i g h t a u d i t o r cannot be a n t i c i p a t e d by i n v e s t o r s even a f t e r they observe an i n c r e a s e in e x t e r n a l ownership. Therefore, i f management announces a switch from a non-Big E i g h t to a B i g E i g h t a u d i t o r , we p r e d i c t a p o s i t i v e stock market r e a c t i o n i n the announcement p e r i o d . Now we examine the impact of a decrease i n e x t e r n a l ownership of the f i r m . F i g u r e 3 demonstrates the e f f e c t of the ownership change on management's a u d i t o r s e l e c t i o n . We now assume the f i r m i n i t i a l l y has high e x t e r n a l ownership and thus engages a high q u a l i t y a u d i t o r . The i n i t i a l f i r m value i s OB with a u d i t c o s t s of N. A repurchase of e x t e r n a l l y h e l d stock w i l l cause an i n c r e a s e i n f i r m v a l u e , as management w i l l now make t r a d e - o f f s between f i r m value and p e r q u i s i t e s along the concave l i n e segment emanating from p o i n t H. Furthermore, the p o t e n t i a l of a c r e d i b l e a u d i t to i n c r e a s e f i r m value w i l l be reduced s i n c e agency c o s t s are reduced. Management r e a l i z e that the decrease i n e x t e r n a l ownership has the e f f e c t of i n c r e a s i n g the value of management's r e s i d u a l ownership r e l a t i v e to the value of t h e i r p e r q u i s i t e s . Since a l l shareholders ( i n c l u d i n g management) are harmed, i n the sense that f i r m value decreases by management's consumption of p e r q u i s i t e s , the manager w i l l be motivated to consume l e s s p e r q u i s i t e s as 30 t h e i r ownership i n the f i r m i n c r e a s e s . N e v e r t h e l e s s , as p r e v i o u s l y argued there are two types P FV of managers, type U , who p r e f e r p e r q u i s i t e s , and type U , who p r e f e r f i r m v a l u e . In F i g u r e 3 i t can be seen that type FV U manager w i l l p r e f e r to maintain a Big E i g h t (high c o s t ) P a u d i t o r d e s p i t e the ownership s t r u c t u r e change. But type U managers w i l l maximize t h e i r u t i l i t y by sw i t c h i n g to a non-Big E i g h t a u d i t o r and paying a u d i t i n g c o s t s of M. The change i n a u d i t o r c l a s s w i l l reduce f i r m value from OD' to OD. Furthermore, c o n s i s t e n t with i n c r e a s e s i n e x t e r n a l ownership, we argue that i n v e s t o r s w i l l be unable to p r e d i c t management's a c t i o n s and p r e f e r e n c e s p r i o r to the announcement of the a u d i t o r change. Thus we p r e d i c t a negative market r e a c t i o n w i l l occur when a Big E i g h t to non-Big E i g h t a u d i t o r change i s announced. From above arguments i t can be seen that not every change i n c a p i t a l s t r u c t u r e w i l l be accompanied by an change i n a u d i t o r c l a s s . Management w i l l have to eva l u a t e the f o l l o w i n g : 1) the c o s t s and b e n e f i t s to the f i r m of engaging an a u d i t o r with a d i f f e r e n t c r e d i b i l i t y l e v e l than the one p r e s e n t l y employed; 2) the impact the change i n c a p i t a l s t r u c t u r e w i l l have on managements a b i l i t y to consume p e r q u i s i t e s and co n c e a l t h i s f a c t i n the f i n a n c i a l statements; 3) the impact the change i n c a p i t a l s t r u c t u r e w i l l have on managements r e s i d u a l ownership i n the f i r m ; and 4) the impact of an a u d i t o r change on the managers u t i l i t y f u n c t i o n given the e f f e c t s of 1), 2), and 3) above. 31 Management e v a l u a t e s each of these f a c t o r s then makes the a u d i t o r c l a s s change d e c i s i o n . Thus the announcement of a change i n a u d i t o r c l a s s p r o v i d e s a s i g n a l to the market about the manager type. But, given that firms have d i f f e r e n t streams of agency c o s t s we expect f o r a change from Big E i g h t to non-Big E i g h t or v i c e v e r s a , that some firms w i l l r e a c t more p o s i t i v e l y ( n e g a t i v e l y ) that o t h e r s . Thus we expect a g r e a t e r v a r i a n c e i n the r e t u r n s d u r i n g the p e r i o d of change than would e x i s t i n a c o n t r o l p e r i o d p r i o r to the change. Given the above t h e o r e t i c a l s t r u c t u r e of the impact of a u d i t o r changes on the stock market we now e m p i r i c a l l y t e s t our p r e d i c t i o n s on non-Big E i g h t to Big E i g h t and Big E i g h t to non-Big E i g h t a u d i t o r changes. IV. SAMPLE SELECTION AND DATA COLLECTION In order to s e l e c t a sample of a u d i t o r changes a number of a l t e r n a t i v e i n f o r m a t i o n sources were c o n s i d e r e d . A f t e r a review of p r e v i o u s e m p i r i c a l l i t e r a t u r e on a u d i t o r changes and d i s c u s s i o n s with Donald M c C o n n e l l 1 1 i t was determined that the SEC Daily News Digest p r o v i d e s the most complete and a c c u r a t e r e c o r d of a u d i t o r changes by p u b l i c l y traded f i rms. As noted e a r l i e r , S e c u r i t i e s and Exchange Commission (SEC) r e g u l a t i o n s r e q u i r e p u b l i c companies to r e p o r t a u d i t o r changes on Form 8-K w i t h i n 10 days a f t e r the month of a c t i o n . The SEC Daily News Digest p u b l i s h e s weekly a l i s t of a l l such 8-K f i l i n g s made with the Commission. The Digest was reviewed from January 1 1984 to December 31 1984, and a l l f i r m s f i l i n g an 8-K f o r a change in t h e i r c e r t i f y i n g accountant ( a u d i t o r ) were noted. Standard and Poors' Daily Stock Price Records were then examined to determine which companies were both traded Over The Counter (OTC) and had a v a i l a b l e s e c u r i t y p r i c e i n f o r m a t i o n . OTC f i r m s were s e l e c t e d f o r s e v e r a l reasons. F i r s t , data from OTC firms a l l o w s us to e x p l o i t recent f i n d i n g s on size-dependent d i f f e r e n t i a l p r i c e r e a c t i o n s to i n f o r m a t i o n r e l e a s e s . A t i a s e [1980] shows that p r i c e r e a c t i o n to annual earnings r e p o r t s i s , on average, gr e a t e r f o r s m a l l e r stocks than f o r l a r g e r s t o c k s . Grant [1980] a l s o 1 1 M c C o n n e l l [1983, 1984(a), 1984(b)], an a s s o c i a t e p r o f e s s o r of a c c o u n t i n g at the U n i v e r s i t y of Texas at A r l i n g t o n , has developed the most e x t e n s i v e data base of a u d i t o r changes, as d i s c u s s e d i n the p r e v i o u s chapter. 32 33 shows that p r i c e r e a c t i o n to annual earnings r e p o r t s i s , on average, g r e a t e r f o r OTC s t o c k s than f o r l i s t e d s t o c k s . A t i a s e ' s and Grant's r e s u l t s are c o n s i s t e n t s i n c e OTC stocks tend to be smaller than l i s t e d s t o c k s . Richardson [1985] argues that a p o s s i b l e e x p l a n a t i o n f o r t h i s phenomenon i s that s i n c e small firms are l e s s l i k e l y to be as c l o s e l y followed by f i n a n c i a l a n a l y s t s as l a r g e r f i r m s , the number of sources of i n f o r m a t i o n r e l e v a n t to the v a l u a t i o n of small companies i s l i m i t e d . We b e l i e v e that the r e l e a s e of i n f o r m a t i o n other than annual earnings may a l s o evoke a size-dependent d i f f e r e n t i a l p r i c e r e a c t i o n . S p e c i f i c a l l y , we argue that the announcement of a change i n a u d i t o r c l a s s may have a g r e a t e r impact on the v a l u a t i o n of a small company than on a l a r g e company. C o n s i s t e n t with t h i s reasoning, N i c h o l s & Smith [1983] a l s o suggest i t i s p o s s i b l e that a u d i t o r c r e d i b i l i t y may be more important f o r s m a l l e r c l i e n t f i r m s . Thus we a n t i c i p a t e the use of OTC firms w i l l p r o v i d e s t a t i s t i c a l l y s i g n i f i c a n t r e s u l t s . Second, OTC companies t y p i c a l l y are not of s u f f i c i e n t s i z e that a l a r g e m u l t i - o f f i c e a u d i t f i r m i s t e c h n o l o g i c a l l y necessary. As d i s c u s s e d e a r l i e r , s c a l e economies are t h e r e f o r e l e s s l i k e l y to e x i s t i n the a u d i t s of small companies. Thus, the market f o r a u d i t s e r v i c e s f o r OTC companies should i n c l u d e both Big E i g h t and non-Big E i g h t a u d i t o r s as e f f i c i e n t s u p p l i e r s . T h i r d , OTC firms have l a r g e l y been ignored by r e s e a r c h e r s because s e c u r i t y r e t u r n i n f o r m a t i o n i s not 34 a v a i l a b l e on computer readable tapes. We b e l i e v e that an examination of OTC firms may enhance the o v e r a l l understanding of s e c u r i t y p r i c e s . The above reasons suggest the p o s s i b i l i t y of i n t e r e s t i n g r e s u l t s from an examination of OTC f i r m s . It i s l i k e l y that the requirement that f i r m s be i n c l u d e d i n Standard and Poors' OTC Daily Stock Price Records has removed some of the s m a l l e s t f i r m s from the sample. However, s i n c e no a l t e r n a t i v e p r i c e i n f o r m a t i o n source was a v a i l a b l e these firms were, of n e c e s s i t y , e l i m i n a t e d . For each remaining f i r m , Who Audits America was c o n s u l t e d to determine the i d e n t i t y of both the o l d and the new a u d i t o r s . A l l firms s w i t c h i n g from a Big E i g h t to another B i g E i g h t a u d i t o r or from a non-Big E i g h t to another non-Big E i g h t a u d i t o r were e l i m i n a t e d from the sample. The 8-K's f o r the remaining f i r m s were obtained from e i t h e r the firms or the SEC. The 8-K's were s c r u t i n i z e d to determine the e a r l i e s t date on which i n f o r m a t i o n about the a u d i t o r change became p u b l i c l y a v a i l a b l e . T h i s date was t y p i c a l l y the day that the new a u d i t o r was h i r e d , the date of a board of d i r e c t o r s ' meeting or the day the a u d i t o r change was announced at the s h a r e h o l d e r s ' meeting. Our c h o i c e of event date i s c o n s i s t e n t with N i c h o l s & Smith [1983]. F r i e d & S c h i f f [1981] used the date of the 8-K f i l i n g as t h e i r announcement date. From our review of the a c t u a l 8-K's we determined that 35 the 8-K f i l i n g date and the date the change became p u b l i c l y a v a i l a b l e are not always i d e n t i c a l . Often the announcement date precedes the 8-K f i l i n g date. T h i s c o u l d p a r t i a l l y account f o r the d i f f e r e n c e between F r i e d & S c h i f f ' s and N i c h o l s & Smith's r e s u l t s . N i c h o l s and Smith a l s o searched the Wall Street Journal (WSJ) Index f o r a p e r i o d of s i x months p r i o r to the date i d e n t i f i e d i n the Form 8-K to determine i f the i n f o r m a t i o n was p u b l i c l y r e p o r t e d at some pr e v i o u s time. They found that i n no case was there a news r e p o r t of the change that was r e p o r t e d e a r l i e r than the date in the Form 8-K. T h e r e f o r e , a search of the WSJ Index f o r t h i s study's sample was not c o n s i d e r e d necessary. In c e r t a i n cases there were two p o s s i b l e announcement dat e s . F i v e f i r ms terminated w i t h t h e i r p r e v i o u s a u d i t o r p r i o r to engaging a new a u d i t o r . In these cases, we s e l e c t e d the day the new a u d i t o r was appointed as our announcement date. P r i o r to t h i s day i t was impossible to determine i f the f i r m planned to h i r e the same c l a s s of a u d i t o r or i f they planned to move to a d i f f e r e n t c l a s s of a u d i t o r . Thus we expect any p o t e n t i a l market r e a c t i o n to occur when i n f o r m a t i o n about the new c l a s s of a u d i t o r i s r e l e a s e d . I f i n f o r m a t i o n about the date the new a u d i t o r was h i r e d was u n a v a i l a b l e the f i r m was removed from the sample. A l s o , the board of d i r e c t o r s at two f i r m s approved an a u d i t o r change on a h o l i d a y or a Saturday. In these two cases the f i r s t t r a d i n g day f o l l o w i n g the meeting was s e l e c t e d as the event date. 36 A f t e r the firms and event dates were i d e n t i f i e d , stock p r i c e s were c o l l e c t e d from the Daily Stock Price Records OTC. The Daily Stock Price Records OTC l i s t two d i f f e r e n t types of p r i c e i n f o r m a t i o n ; h i g h , low and c l o s i n g p r i c e s f o r NASDAQ N a t i o n a l Market Issues and b i d and asked p r i c e s f o r the remaining f i r m s . We u t i l i z e d c l o s i n g p r i c e s when a v a i l a b l e to c a l c u l a t e f i r m r e t u r n s . The average between the b i d and asked p r i c e s was used when c l o s i n g p r i c e s were not a v a i l a b l e . P r i c e i n f o r m a t i o n was c o l l e c t e d f o r each f i r m f o r the two days before, the day of, and the day a f t e r the event date. From the p r i c e i n f o r m a t i o n , r e t u r n s were c a l c u l a t e d f o r the day before, the day of, and the day f o l l o w i n g the announcement. T h i s three day p e r i o d i s the announcement p e r i o d i n the a n a l y s i s d e s c r i b e d i n the next chapter. Returns were a l s o c a l c u l a t e d i n a non-announcement or c o n t r o l p e r i o d e x a c t l y four weeks p r i o r to the three day announcement p e r i o d . The c o n t r o l p e r i o d was chosen t o ensure the d i f f e r e n c e between r e t u r n s i n announcement and non-announcement p e r i o d s was not i n f l u e n c e d by the "weekend e f f e c t " (French [1980]). A d d i t i o n a l l y , four weeks p r i o r to the announcement p e r i o d was c o n s i d e r e d long enough that p o s s i b l e i n f o r m a t i o n leakage about the a u d i t o r change i s u n l i k e l y , but short enough to allow us to make s t a t i o n a r i t y assumptions about the f i r m s a c r o s s the non-announcement and announcement p e r i o d s . 1 2 1 2One of the firms changing from a non-Big E i g h t a u d i t o r to a B ig E i g h t a u d i t o r was added to the Daily Stock Price Record a day a f t e r the c o n t r o l p e r i o d f o r t h i s f i r m s t a r t e d . Consequently, the c o n t r o l p e r i o d f o r t h i s f i r m s t a r t s t h r e e 37 The f i n a l sample c o n t a i n s 44 f i r m s changing from a non-Big E i g h t a u d i t o r to a Big E i g h t a u d i t o r (N-B) and 15 firms changing from a Big E i g h t a u d i t o r to a non-Big E i g h t a u d i t o r (B-N). T h e r e f o r e , there are 132 (44 x 3) r e t u r n o b s e r v a t i o n s i n both the announcement and non-announcement p e r i o d s f o r the N-B sample and 45 (15 x 3) i n both p e r i o d s f o r the B-N sample. A l i s t of f i rms and event dates i n the samples i s p r o v i d e d i n Table 1. The d a i l y r e t u r n s were a l s o used to c a l c u l a t e a three-day r e t u r n f o r each f i r m i n both the announcement and non-announcement p e r i o d s . Thus, there are 44 3-day r e t u r n o b s e r v a t i o n s i n the N-B sample and 15 3-day r e t u r n o b s e r v a t i o n s i n the B-N sample. Market r e t u r n s c o r r e s p o n d i n g to the f i r m s ' announcement and c o n t r o l p e r i o d s were c o l l e c t e d from the CRSP (Centre f o r Research i n S e c u r i t y P r i c e s ) d a i l y r e t u r n s tape. D a i l y r e t u r n s on the e q u a l l y weighted market index were used in the a n a l y s i s . These r e t u r n s were a l s o used to c a l c u l a t e a three-day market r e t u r n . In the f o l l o w i n g chapter our method and hypotheses are d e s c r i b e d . — 1 2 ( c o n t ' d ) weeks and s i x days, as opposed to four weeks, p r i o r to the s t a r t of the announcement p e r i o d . V. EMPIRICAL TEST METHOD AND HYPOTHESES The major concern of event s t u d i e s has been to assess the extent to which s e c u r i t y p r i c e performance around the time of a f i r m - s p e c i f i c event has been abnormal. The t r a d i t i o n a l method of measuring abnormal performance has been to compare observed s e c u r i t y r e t u r n s to those which would have been a p p r o p r i a t e given a model of ex ante expected r e t u r n s . T y p i c a l l y the parameters of the ex ante r e t u r n g e n e r a t i n g process are estimated f o r each f i r m from a time s e r i e s of the f i r m ' s r e t u r n s . For example, N i c h o l s & Smith [1983] use a market and r i s k a d j u s t e d model of the r e t u r n g e n e r a t i n g p r o c e s s . The r e t u r n s f o r each sample s e c u r i t y i n weeks -57 through -5 p r i o r to the announcement of the a u d i t o r change date were regr e s s e d a g a i n s t the r e t u r n s on the market p o r t f o l i o (the E q u a l l y Weighted CRSP Market Index) d u r i n g the corres p o n d i n g calender weeks. T h i s procedure p r o v i d e d r e g r e s s i o n c o e f f i c i e n t s used to estimate the expected s e c u r i t y r e t u r n i n each event r e l a t e d week t beginning with week -4. The expected r e t u r n was s u b t r a c t e d from the a c t u a l s e c u r i t y r e t u r n i n week t, and the r e s u l t i n g r e s i d u a l p r o v i d e d a measure of the s e c u r i t y ' s abnormal performance i n that week. The r e s i d u a l s were normalized, aggregated a c r o s s f i r m s and then analyzed. By examining abnormal r e t u r n s f o r the p e r i o d 4 weeks before the announcement, N i c h o l s & Smith c o u l d t e s t i f the a u d i t o r i change i n f o r m a t i o n appeared to have been a n t i c i p a t e d by 38 39 i n v e s t o r s p r i o r to the date i t became p u b l i c i n f o r m a t i o n . Examining abnormal r e t u r n s a f t e r the* announcement p r o v i d e s a t e s t of market e f f i c i e n c y . While other event s t u d i e s d i f f e r on such t h i n g s as the p e r i o d over which the parameters are estimated, the exact s p e c i f i c a t i o n of the r e t u r n g e n e r a t i n g p r o c e s s , the use of d a i l y , weekly or monthly r e t u r n s , e t c . , the b a s i c procedures remain the same. In t h i s study we u t i l i z e a d i f f e r e n t method to determine abnormal r e t u r n s . E s s e n t i a l l y , our a n a l y s i s c o n s i s t s of comparing a c r o s s - s e c t i o n a l r e g r e s s i o n of f i r m r e t u r n s on the market r e t u r n i n an a u d i t o r change announcement p e r i o d to a s i m i l a r r e g r e s s i o n i n a c o n t r o l p e r i o d . P a r a m e t e r i z a t i o n and e s t i m a t i o n procedures are as f o l l o w s . . Define a = E ( r Ina) - 0 E ( r Ina) ( 1 ) na i I na mt a = E ( r . |a) - 0 E ( r la) (2) a it a mt where E ( r |na) = expected r e t u r n on s e c u r i t y ./ f o r p e r i o d t given p e r i o d t i s a non-announcement p e r i o d . E ( r |a) = expected r e t u r n on s e c u r i t y / f o r p e r i o d t given p e r i o d t i s an announcement p e r i o d . E ( r |na) = expected market r e t u r n i n p e r i o d t given mt p e r i o d t i s a non-announcement p e r i o d . E ( r la) = expected market r e t u r n i n p e r i o d t given mt p e r i o d t i s an announcement p e r i o d . |3 = the c r o s s - s e c t i o n a l market beta, i n a na 40 non-announcement p e r i o d . j3 = the c r o s s - s e c t i o n a l market beta, i n an a announcement p e r i o d . a = economic impact on expected f i r m r e t u r n of na d i s t u r b a n c e s not r e l a t e d to market r e t u r n i n a non-announcement p e r i o d . a = economic impact on expected f i r m r e t u r n of a d i s t u r b a n c e s not r e l a t e d to market r e t u r n i n an announcement p e r i o d . It i s t y p i c a l i n event s t u d i e s to assume the s t a t i o n a r i t y of 0 across time f o r one f i r m . The above model holds /3 s t a t i o n a r y across f i r m s , and we assume that /3 i s the same in non-announcement and announcement p e r i o d s (/3 = na a To d e r i v e a r e l a t i o n s h i p between equations (1) and (2) the r e l a t i o n s h i p between a u d i t o r change announcement dates and market r e t u r n s i s examined. Some events, such as stock s p l i t s or d i v i d e n d i n c r e a s e s , c o u l d be more l i k e l y to occur d u r i n g a p o s i t i v e market r e t u r n . C o n s i s t e n t with our conceptual a n a l y s i s of a u d i t o r changes, we argue no r e l a t i o n s h i p i s expected to e x i s t i n theory between the day an a u d i t o r change i s announced and the market r e t u r n . T h e r e f o r e we assume i n equations (1) and (2) that E ( r |na) mt = E ( r |a). mt Given /} = 0 and E ( r Ina) = E ( r l a ) , the f o l l o w i n g na a mt mt r e l a t i o n s h i p between equations (1) and (2) e x i s t s : 41 a - a = E ( r la) - E ( r Ina) = 7 (3) a na it it where 7 i s the event e f f e c t . That i s , 7 r e p r e s e n t s the economic value of the a u d i t o r change as a percentage of i n i t i a l s e c u r i t y v a l u e . To estimate the parameters, a and a , we assume each a na f i r m s ' r e t u r n s are independently and i d e n t i c a l l y d i s t r i b u t e d ( i . i . d . ) i n c r o s s - s e c t i o n . In the f o l l o w i n g we u t i l i z e two d i f f e r e n t models t o estimate the parameters. In the f i r s t method two c r o s s - s e c t i o n a l market model OLS r e g r e s s i o n s are u t i l i z e d to estimate the parameters: r = a + b r + u i =1, 2. . . n (4) it na na mt i r = a + b r + v i=l, 2. . . n (5) it a a mt i where (4) i s i n the non-announcement or c o n t r o l p e r i o d a c r o s s f i r m s and (5) i s i n the announcement p e r i o d , u. i s a mean zero, i n d e p e n t e n t l y and i d e n t i c a l l y d i s t r i b u t e d d i s t u r b a n c e term f o r s e c u r i t y / i n the non-announcement p e r i o d ; v. i s the same i n the announcement p e r i o d . Since we have assumed each f i r m s ' r e t u r n s are i . i . d . , a , b , a na na a and b are the same across a l l f i r m s / . 1 3 a S o l u t i o n s to the l e a s t squares normal equations provide estimates of the parameters i n (4) and (5) . S p e c i f i c a l l y : 1 3 T h e assumption that the betas (b f l and ban) are the same ac r o s s a l l f i r m s i s u n r e a l i s t i c but does not a f f e c t the a n a l y s i s . T h i s i s because the beta i n a c r o s s - s e c t i o n a l r e g r e s s i o n has expected value equal to the average beta of a l l f i r m s . See Clarkson and Thompson [1986] f o r proof . 42 a = r - B r (6) na na na m, na a =7 - B r " (7) a a a m, a Comparison of equation (6) to (1) and of (7) to (2) i n d i c a t e s the OLS estimates of a and a are a and a . na a na a Furthermore, given our assumptions about the e r r o r terms, u and v i n (4) and (5), the Gauss-Markov theorem shows these i estimates are unbiased and have minimum v a r i a n c e when compared to a l l other unbiased e s t i m a t o r s that are l i n e a r combinations of r . In the second e s t i m a t i o n method we aggregate the two models i n t o a pooled model of the f o l l o w i n g form: r = a 5 + a 6 + b r + b r + e (8) it a a an an a m, a an m, an it where a , b , a and b are i d e n t i c a l to equations (4) and na na a a (5) and: r = r e t u r n on s e c u r i t y i i n both announcement and / t non-announcement p e r i o d s . 6 = 1 i n an announcement p e r i o d and 0 i n a a non-announcement p e r i o d . 6 = 1 i n a non-announcement p e r i o d and 0 i n an an announcement p e r i o d . r = corresponding market r e t u r n i f p e r i o d t i s an m, a announcement p e r i o d and 0 otherwise. r = corresponding market r e t u r n i f p e r i o d t i s a m, an non-announcement p e r i o d and 0 otherwise. 43 e = a mean zero, i . i . d . d i s t u r b a n c e term f o r s e c u r i t y it i . Our model p r e d i c t s : 1) a change from a non-Big E i g h t a u d i t o r to a Big Ei g h t a u d i t o r should produce a p o s i t i v e market r e a c t i o n and 2) a change from a Big E i g h t a u d i t o r to a non-Big E i g h t a u d i t o r should produce a negative market r e a c t i o n . Our hypotheses can be couched i n terms of the parameters of equations (4), ( 5 ) , and (8). The a l t e r n a t e form of the hypotheses a r e : H : a - a = 7 > 0 A1 a, N-B na,N-B 'N-B H : a - a = 7 < 0 A2 a, B-N na,B-N 'B-N where N-B r e f e r s to a non-Big E i g h t to Big E i g h t change and B-N r e f e r s to a Big E i g h t to non-Big E i g h t change. The n u l l form of these hypotheses a r e : 01" a,N-B na,N-B 'N-B H : a - a = 7 = 0 02 a, B-N na,B-N 1 B-N A stronger t e s t of our model i s to perform a j o i n t t e s t on the above two p r e d i c t i o n s . T h i s leads to a t h i r d h y p o t hesis of the f o l l o w i n g a l t e r n a t e and n u l l forms: H A 3 : V* " "B-N > ° H : 7 - 7 = 0 03 N-B 'B-N In Chapter III we a l s o p r e d i c t e d there would be a gr e a t e r v a r i a n c e i n stock r e t u r n s d u r i n g the announcement p e r i o d than would e x i s t i n the non-announcement p e r i o d f o r both types of a u d i t o r changes. T h e r e f o r e , we t e s t the n u l l hypotheses: 2 2 H : 0 = a 04 a,N-B na,N-B H : a = a 05 a,B-N na,B-N a g a i n s t the a l t e r n a t i v e s : 2 2 H : o > o A4 a,N-B na,N-B 2 2 H : a > a A5 a,B-N na,B-N We a l s o examine the hyp o t h e s i s of g r e a t e r v a r i a n c e i n stock r e t u r n s d u r i n g the announcement p e r i o d than the non-announcement p e r i o d a c r o s s both samples. The j o i n t n u l l and a l t e r n a t e hypotheses a r e : 2 2 2 2 H : a = o = o = a 06 a,N-B na,N-B a, B-N na,B-N 2 .2 2 2 H : o * a * a ± a A6 a,N-B na,N-B a,B-N na,B~N To perform the t e s t s on market r e t u r n s both the separate model (equations (4) and (5)) and and the pooled model (equation (8)) were run using the d a i l y r e t u r n s and the three-day r e t u r n s d i s c u s s e d i n Chapter IV. The v a r i a n c e t e s t s were run on the separate model only u s i n g both d a i l y and three-day r e t u r n s . The r e s u l t s are presented i n Chapter VI. VI . RESULTS A. TESTS OF HYPOTHESES 1 AND 2: Tables 2 and 3 c o n t a i n the r e s u l t s of t e s t s on H and 1 H^, r e s p e c t i v e l y . The parameter estimates, and the standard e r r o r s and t - v a l u e s of these estimates are presented f o r separate and pooled models and d a i l y and three-day r e t u r n s . The parameter estimates are i d e n t i c a l f o r separate and pooled models. The standard e r r o r s and t - v a l u e s of these estimates are s l i g h t l y d i f f e r e n t i n the separate and pooled ~2 . . . models because a i s i n f l u e n c e d by a l l o b s e r v a t i o n s i n the pooled model. Table 2 c o n t a i n s evidence of a p o s i t i v e market r e a c t i o n to a non-Big E i g h t to Big E i g h t a u d i t o r change. The event e f f e c t 7N_B i s .008121 and .021193 f o r d a i l y and three-day r e t u r n s r e s p e c t i v e l y . The t e s t s t a t i s t i c on y was c a l c u l a t e d as f o l l o w s : a a " ana t= / [ ( S E ( a f l ) ) 2 + ( S E ( a n a ) ) 2 ] 2 2 where (SE(a )) and (SE(a )) are the squares of the a na standard e r r o r of the c o e f f i c i e n t s . .However, the t - v a l u e s f o r each model and r e t u r n s group (ranging from 1.108 to 1.278) are not s i g n i f i c a n t at the .05 l e v e l of confidence assuming a o n e - t a i l e d t e s t and the degrees of freedom as noted on Table 2. The market r e t u r n c o e f f i c i e n t s , b and b , were a na examined to t e s t the reasonableness of our assumption i n 45 46 Chapter V that the c r o s s - s e c t i o n a i beta i n the announcement and non-announcement p e r i o d s are equal. The t - s t a t i s t i c s on b - b , were c a l c u l a t e d using the above t t e s t , and range a na from -.039 to -.5295 as noted i n Table 2. Since we cannot r e j e c t the assumption that the betas are the same i n announcement and non-announcement p e r i o d s the data are c o n s i s t e n t with our model. Table 3 c o n t a i n s evidence of a negative market r e a c t i o n to a Big Eight, to non-Big E i g h t a u d i t o r change. The event e f f e c t JB N i s -.015499 f o r d a i l y r e t u r n s and -.044902 f o r three-day r e t u r n s . However, as i n the non-Big E i g h t to Big E i g h t sample these r e s u l t s are not s i g n i f i c a n t at the .05 l e v e l . The t - v a l u e s range from -1.1697 to -1.266, i n d i c a t i n g only weak support f o r our h y p o t h e s i s . The c r o s s - s e c t i o n a l betas were examined as i n the N-B sample to t e s t the assumption of e q u a l i t y i n announcement and non-announcement p e r i o d s . The t - s t a t i s t i c s on b - b , ranging from -.480 to a na .047, i n d i c a t e the evidence i s c o n s i s t e n t with our assumption i n both samples. These r e s u l t s are c o n s i s t e n t with N i c h o l s and Smith [1983]. T h e i r s t a n d a r d i z e d r e s i d u a l s i n the announcement week are p o s i t i v e f o r the non-Big E i g h t to Big E i g h t group and negative f o r the B i g E i g h t to non-Big E i g h t group. 47 B. TESTS OF HYPOTHESIS 3 The weak support of our p r e d i c t i o n s on the impact of stock r e t u r n s generated by the t e s t i n g of H^  and H^ i n d i c a t e that the j o i n t t e s t , proposed i n H^ w i l l be u s e f u l . In Table 4 r e s u l t s f o r separate and pooled models, and d a i l y and three-day r e t u r n s are presented. The t e s t s t a t i s t i c was a comparative t - t e s t c a l c u l a t e d as f o l l o w s : 1N-B ~ tB-N t = Sp + 1/N5_#] where t i s d i s t r i b u t e d with N + N - 4 degrees of N-B B-N * freedom. N and N are the number of f i r m s i n the N-B and B-N N-B B-N groups r e s p e c t i v e l y . 2 2 S = y/{ [ (N - 2)S + (N - 2)S ]/[N + N - 4]} P N-B N-B B-N B-N ' N-B B-N S = S E ( 7 ) / N N-B 'N-B N-B S = S E ( 7 ) / N B-N B-N B-N S and S are the c r o s s - s e c t i o n a l standard N-B B-N d e v i a t i o n s of 7^ and 7^ ^ r e s p e c t i v e l y , S p i s the pooled c r o s s - s e c t i o n a l standard d e v i a t i o n (Larsen and Marx [ 1 9 8 1 ] ) . 1 " 1"An assumption necessary to use t h i s t - s t a t i s t i c i s that the standard d e v i a t i o n s of both p o p u l a t i o n s , N-B and B-N, are e q u a l . A p r i o r i there i s no evidence c o n t r a r y to t h i s assumption and t h e r e f o r e t h i s t - t e s t i s c o n s i d e r e d a p p r o p r i a t e . 48 The t - v a l u e s of 1.7709 and 1.7661 f o r d a i l y r e t u r n s and 1.7167 and 1.7069 f o r three-day r e t u r n s are a l l s i g n i f i c a n t at a .05 l e v e l assuming a one-sided t e s t . T h e r e f o r e we r e j e c t the n u l l h y p o t h e s i s that the impact on f i r m r e t u r n s f o r a non-Big E i g h t to Big E i g h t a u d i t o r change i s the same as the impact of a B i g E i g h t to non-Big E i g h t a u d i t o r change. The t e s t s p r o v i d e strong evidence that the i n c r e a s e i n f i r m value i s g r e a t e r f o r the N-B sample than the B-N sample. N i c h o l s and Smith [1983] a l s o performed a j o i n t t e s t on the d i f f e r e n c e between the r e s i d u a l s i n both a u d i t o r change groups. C o n s i s t e n t with our a n a l y s i s , they found the i n c r e a s e i n f i r m value was g r e a t e r i n the N-B sample than the B-N sample. However, t h e i r t - v a l u e f o r the d i f f e r e n c e was only 1.133, which i s not s i g n i f i c a n t at the .05 l e v e l of conf idence. C. TESTS OF HYPOTHESES 4, 5 AND 6 Hypotheses 4 and 5 were formed to determine i f r e t u r n s are homoscedastic a c r o s s announcement and non-announcement p e r i o d s w i t h i n each of the N-B and B-N samples. A F - t e s t f o r e q u a l i t y of v a r i a n c e s was c a l c u l a t e d as f o l l o w s : 2 . 2 F = S /S a na 2 2 where S and S are the r e s i d u a l v a r i a n c e s from the a na c r o s s - s e c t i o n a l market model and F i s d i s t r i b u t e d as an F - s t a t i s t i c with N - 2, N - 2 a na 49 degrees of freedom i f the n u l l h ypothesis of equal v a r i a n c e s i s t r u e . T h i s t e s t was performed on the separate model using both d a i l y and three-day r e t u r n s i n the N-B and B-N samples. R e s u l t s are c o n t a i n e d i n Table 5. F values of 3.3505 and 2.7437 f o r d a i l y and three-day r e t u r n s r e s p e c t i v e l y i n the N-B sample are s i g n i f i c a n t at the .01 l e v e l . T h i s allows us to r e j e c t the n u l l of equal v a r i a n c e s i n the N-B sample. The evidence supports the a l t e r n a t e h y p othesis of i n c r e a s e d v a r i a n c e i n the announcement p e r i o d . F v a l u e s of 1.4638 and 1.0119 f o r d a i l y and three-day r e t u r n s r e s p e c t i v e l y i n the B-N sample are not s i g n i f i c a n t at the .01 or the .05 l e v e l . Thus we cannot r e j e c t the n u l l of equal v a r i a n c e s i n announcement and non-announcement p e r i o d s f o r the B-N sample. The v a r i a n c e i s only s l i g h t l y l a r g e r i n the announcement p e r i o d than i t i s i n the non-announcement p e r i o d . T h i s p r o v i d e s very weak support f o r the hypothesis of g r e a t e r v a r i a n c e i n the announcement p e r i o d . Hypothesis 6 was formed to determine i f r e t u r n s are j o i n t l y homoscedastic f o r both samples i n the announcement p e r i o d versus the non-announcement p e r i o d . A j o i n t t e s t 2 under the hypothesis that a l l the v a r i a n c e s (a ) are equal i s : Sa,N-B + Sa,B-N F = - : -2 2 Sna,N-B + Sna,B-N 50 where F i s d i s t r i b u t e d as an F s t a t i s t i c with N + N - 4, N-B B-N N + N - 4 degrees of freedom. N-B B-N * As with Hypotheses 4 and 5, t h i s model was performed on the separate model using both d a i l y and three-day r e t u r n s . The r e s u l t s are i n Table 5. The F value of 1.984 f o r d a i l y r e t u r n s when compared to a c r i t i c a l value of approximately 1.43 f o r 173,173 degrees of freedom i s s i g n i f i c a n t at a .01 l e v e l . However, when compared to a c r i t i c a l value of approximately 1.554 f o r 55,55 degrees of freedom, the F value of 1.547 f o r three-day r e t u r n s i s not s i g n i f i c a n t at a .05 l e v e l . Since d a i l y r e t u r n s p r o v i d e b e t t e r estimates and more degrees of freedom g r e a t e r emphasis should be placed on these r e s u l t s . Thus, the r e s u l t s of t e s t s on hypotheses 4, 5 and 6 generate support f o r the argument t h a t the v a r i a n c e of ret u r n s i s g r e a t e r i n the announcement p e r i o d than i n the non-announcement p e r i o d . V I I . SUMMARY AND CONCLUSIONS T h i s t h e s i s has examined the stock market r e a c t i o n to a u d i t o r change announcements i n OTC f i r m s . The general m o t i v a t i o n stemmed from p r e v i o u s r e s e a r c h on t h i s t o p i c that 1) f a i l e d to adequately motivate the e m p i r i c a l i n v e s t i g a t i o n and 2) found i n s i g n i f i c a n t r e s u l t s . The t h e o r e t i c a l j u s t i f i c a t i o n f o r e x p e c t i n g a market r e a c t i o n i s based on the e x i s t e n c e of product d i f f e r e n t i a t i o n i n the market f o r a u d i t s e r v i c e s . A u d i t o r s are c h a r a c t e r i z e d by the amount of c r e d i b i l i t y they provide f i n a n c i a l statement users i n t h e i r assessment of f i n a n c i a l statements. I t i s c o n j e c t u r e d that c l i e n t f i r m s w i l l demand more c r e d i b i l i t y as the p r o p o r t i o n of e x t e r n a l ownership in the f i r m i n c r e a s e s . Since an a u d i t o r ' s work cannot be observed by f i n a n c i a l statement users, the a u d i t o r must s p e c i a l i z e i n the amount of c r e d i b i l i t y they o f f e r . The Big E i g h t firms are c o n s i d e r e d high c r e d i b i l i t y a u d i t o r s ; the non-Big E i g h t firms are assumed to o f f e r low c r e d i b i l i t y . An e q u i l i b r i u m i s p o s i t e d i n which the management of firms with high percentage e x t e r n a l ownership u t i l i z e Big E i g h t a u d i t o r s and those with low percentage e x t e r n a l ownership s e l e c t non-Big E i g h t a u d i t o r s . An a u d i t o r change i s assumed to be the r e s u l t of management's r e - e v a l u a t i o n of t h e i r optimal r e s i d u a l f i r m value and p e r q u i s i t e consumption combination a f t e r a change i n the ownership s t r u c t u r e . I f the e x t e r n a l ownership i n c r e a s e s , and management p r e f e r p e r q u i s i t e consumption, management w i l l not change a u d i t o r s . 51 52 However, i f management p r e f e r s r e s i d u a l f i r m value they w i l l change t o a high c r e d i b i l i t y a u d i t o r . T h i s wi^Ll r e s u l t i n an in c r e a s e i n f i r m v a l u e . Hence, a p o s i t i v e market r e a c t i o n f o r non-Big E i g h t to B i g E i g h t a u d i t o r changes i s p r e d i c t e d . Since the management "type" cannot be determined i n advance, the market w i l l not be able to a n t i c i p a t e the change p r i o r to the announcement. S i m i l a r reasoning i s u t i l i z e d to p r e d i c t a negative market r e a c t i o n f o r Big E i g h t to non-Big E i g h t a u d i t o r changes. These p r e d i c t i o n s are t e s t e d on a sample of 44 non-Big E i g h t to B i g E i g h t a u d i t o r changes and 15 Big E i g h t to non-Big E i g h t a u d i t o r changes i n OTC f i r m s . The standard event study method of abnormal r e s i d u a l a n a l y s i s i s r e p l a c e d with a new technique i n which c r o s s - s e c t i o n a l market model r e g r e s s i o n s i n the announcement and a c o n t r o l p e r i o d are compared. The event e f f e c t i s c a l c u l a t e d as the d i f f e r e n c e between the i n t e r c e p t i n the announcement p e r i o d c r o s s - s e c t i o n a l market model and the i n t e r c e p t i n the c o n t r o l p e r i o d c r o s s - s e c t i o n a l market model. P a r a m e t e r i z a t i o n and e s t i m a t i o n of the event e f f e c t i s d e s c r i b e d i n d e t a i l . Our e m p i r i c a l analyses on the market r e a c t i o n to a u d i t o r changes are c o n s i s t e n t with the p r e d i c t i o n s of our model. Furthermore, the magnitude of the d i f f e r e n c e i n the r e a c t i o n s was s t a t i s t i c a l l y s i g n i f i c a n t at a .05 l e v e l . T h i s p r o v i d e s s t r o n g support f o r the general h y p othesis of product d i f f e r e n t i a t i o n i n the market f o r a u d i t s e r v i c e s . 53 It was a l s o p r e d i c t e d that r e t u r n s would be more v a r i a b l e i n the announcement p e r i o d than i n the c o n t r o l p e r i o d . In the non-Big E i g h t to Big E i g h t sample there was strong evidence of i n c r e a s e d v a r i a n c e . In the Big E i g h t to non-Big E i g h t sample only weak evidence was found in support of the h y p o t h e s i s . However, j o i n t s t e s t s are c o n s i s t e n t with the p r e d i c t i o n of i n c r e a s e d v a r i a n c e . A p o s s i b l e l i m i t a t i o n of t h i s r e s e a r c h i s that none of the firms i n the sample were examined f o r evidence of a c a p i t a l s t r u c t u r e change p r i o r to the a u d i t o r change. However, the purpose of t h i s paper was to present a p o t e n t i a l d e s c r i p t i v e model suppo r t i n g our p r e d i c t i o n s on the impact of a u d i t o r changes. Furt h e r t e s t s on t h i s p a r t i c u l a r model c o u l d i n c l u d e p a r t i o n i n g a sample of f i r m s changing a u d i t o r s i n t o 1) firms e x p e r i e n c i n g a change i n c a p i t a l s t r u c t u r e and 2 ) firms with no change i n c a p i t a l s t r u c t u r e . The model c o u l d then be f u r t h e r r e f i n e d to a l l o w separate p r e d i c t i o n s about stock market r e a c t i o n f o r each group. A second l i m i t a t i o n of t h i s r e s e a r c h i s that a l t e r n a t e models f o r understanding and p r e d i c t i n g the impact of a u d i t o r changes on f i r m v a l u e s were not examined. For example, a u d i t o r changes may occur i n anticipation of a change i n c a p t i a l s t r u c t u r e , not i n response to an e a r l i e r c a p t i a l s t r u c t u r e change. T h i s and other p o s s i b i l i t i e s c o u l d be modeled to determine i f we would always expect a p o s i t i v e market r e a c t i o n to non-Big E i g h t to Big E i g h t a u d i t o r 54 changes and v i c e v e r s a . I t i s a l s o p o s s i b l e that a t t e n t i o n to these l i m i t a t i o n s c o u l d provide f u r t h e r understanding of why the d i f f e r e n c e i n the v a r i a n c e of r e t u r n s between the announcement and non-announcement p e r i o d s , was stronger i n the non-Big Eig h t to Big E i g h t group than i n the Big E i g h t to non-Big E i g h t group. For example, perhaps the non-Big E i g h t to Big E i g h t group c o n s i s t s of d i f f e r e n t types of firms and p a r t i t i o n i n g the group may allow us to e x p l a i n the i n c r e a s e d v a r i a n c e . In c o n c l u s i o n , we b e l i e v e t h i s t h e s i s p r o v i d e s a c o n t r i b u t i o n to accounting r e s e a r c h . F u r t h e r evidence on market r e a c t i o n s to a u d i t o r changes i s presented. A d d i t i o n a l l y , a new method f o r event s t u d i e s i s i n t r o d u c e d . T h i s method can be d i r e c t l y a p p l i e d to many other s t u d i e s a l l o w i n g an examination of markets p r e v i o u s l y not c o n s i d e r e d because of data c o l l e c t i o n problems. TABLE 1 Sample Firms and Event Dates Panel A: Non-Big E i g h t to Big E i g h t Sample Name Event Date ABM Computer Systems May 01 1 984 American Bloodpressure Centers, Inc. Jan 31 1 984 American S o l a r King C o r p o r a t i o n Mar 16 1 984 A r t E x p l o s i o n , Inc. Mar 12 1 984 AW Computer Systems, Inc. Aug 22 1 984 B i l l i n g s C o r p o r a t i o n Jan 03 1 984 CACI, Inc. Mar 20 1 984 Cadmus Communications C o r p o r a t i o n Sep 25 1 984 Casey's General S t o r e s , Inc. Feb 28 1 984 C i n c i n n a t i Microwave, Inc. Jan 24 1 984 Codercard, Inc. Apr 23 1 984 Cogenic Energy Systems, Inc. Jun 12 1 984 Commonwealth Bancshares C o r p o r a t i o n Jun 27 1 984 Comprehensive Care C o r p o r a t i o n J u l 03 1 984 C r e a t i v e C o n s u l t i n g C o r p o r a t i o n Dec 08 1 983 F l e x i b l e Computer C o r p o r a t i o n Jun 04 1 984 Frey A s s o c i a t e s , Inc. Apr 05 1 984 Genetic Dynamics C o r p o r a t i o n Aug 17 1 984 H o l l y ' s , Inc. Oct 15 1 984 Hydro O p t i c s , Inc. Apr 16 1 984 K r e i s l e r Manufacturing C o r p o r a t i o n Mar 21 1 984 Lesco, Inc. Sep 27 1 984 L i n c o l n Income L i f e Insurance Company Feb 14 1 984 Lucky Chance Mining Company, Inc. Jun 22 1 984 Marquest M e d i c a l Products, Inc. Nov 26 1 984 M i n e r a l s E n g i n e e r i n g Company May 21 1 984 Newport Pharmaceuticals I n t e r n a t i o n a l , Inc. Jan 24 1 984 Osmonics, Inc. Sep 14 1 984 P e n n - P a c i f i c Corp. Oct 07 1 983 P e t t i b o n e C o r p o r a t i o n Nov 08 1 984 P o l y c a s t Technology C o r p o r a t i o n May 21 1 984 Robeson I n d u s t r i e s Corp. Dec 05 1 983 S.A.L. Cable Communications, Inc. Aug 15 1 984 Shoppers World S t o r e s , Inc. Oct 01 1 984 Software S e r v i c e s of America Inc. J u l 30 1 984 Southern A t l a n t i c C o r p o r a t i o n Mar 20 1 984 Spectrum Microwave C o r p o r a t i o n Oct 05 1 984 Union Bancorp Inc. May 07 1 984 U.S. M i n e r a l s E x p l o r a t i o n Company Dec 07 1 984 U n i v e r s a l S e c u r i t y Instruments, Inc. Jan 03 1 984 V Band Systems, Inc. May 07 1 984 V e r d i x C o r p o r a t i o n Jan 13 1 984 V u e b o t i c s C o r p o r a t i o n Jan 05 1 984 Xenerex Corp. Aug 21 1 984 TABLE 1 c o n t i n u e d Sample Firms and Event Dates Panel B: Big E i g h t to Non-Big E i g h t Sample Name Event Date Angstrom Technologies, Inc. Sep 06 1984 Crime C o n t r o l , Inc. Nov 05 1 984 D i g i t a l Products C o r p o r a t i o n Jan 25 1 984 H e r i t a g e F i n a n c i a l C o r p o r a t i o n Jun 21 1 984 Inacomp Computer Centers, Inc. Nov 06 1 984 Isramco, Inc. Dec 16 1983 K r e i s l e r Manufacturing C o r p o r a t i o n Oct 18 1 984 Marquest Me d i c a l Products, Inc. Mar 01 1984 J . M i c h a e l s , Inc. Nov 08 1 984 Space Microwave L a b o r a t o r i e s , Inc. Aug 14 1984 Teleram Communications C o r p o r a t i o n Sep 19 1984 Tesco American, Inc. Dec 30 1983 U i n t a h Energy C o r p o r a t i o n Nov 1 4 1 984 U.S. Energy Search, Inc. Aug 05 1984 V a l l e y Forge C o r p o r a t i o n Apr 1 3 1984 57 TABLE 2 T e s t s of Hypothesis 1 Event E f f e c t i n the Non-Big E i g h t to Big E i g h t Sample Panel A: D a i l y Returns Separate Model Pooled Model Parameter Standard Standard ^ Parameter Estimate E r r o r t - v a l u e E r r o r t - v a l u e na aa~ana=y "na b -b na .006078 -.002043 .008121 .30009 .34802 -.04793 .005561 .003077 .006355 .95574 .64083 1.1507 .093 .6642 .278 .31399 .54308 .04165 .004481 .004538 .006377 .77009 .94512 1.2191 1 .3565 -.45035 1 .274 .38968 .36822 -.039 Panel B: Three-day Returns Separate Model Parameter Standard Pooled Model Parameter Estimate E r r o r S t a n d a r d t - v a l u e T E r r o r t - v a l u e T "na a -a na = 7 na ba~bna .017640 -.003553 .021193 .36337 1.2478 -.88443 016138 010022 018997 ,31 35 ,0317 ,67024 1 .093 -.3545 1.1156 .27664 1.2094 -.5295 .013329 .013712 .019123 1 .0849 1.4116 1.7804 1.3234 -.25909 1 . 108 .33492 .88398 -.497 * 264-4=160 degrees of freedom t 88-4=84 degrees of freedom 58 TABLE 3 T e s t s of Hypothesis 2 Event E f f e c t i n the Big E i g h t to non-Big E i g h t Sample Panel A: D a i l y Returns Separate Model Pooled Model Parameter Standard Standard Parameter Estimate E r r o r t - v a l u e E r r o r t - v a l u e "na aa~ana=1 ba~bna .006281 .009218 .015499 .95860 .83070 .1279 010238 008416 01 325 1384 6644 2.7098 -.6136 1.0954 -1.1697 .44828 .49910 .047 .009392 .009341 .013246 1.9617 1.8473 2.6946 -.6688 .9869 -1.170 .48865 .44968 .047 Panel B: Three-day Returns Separate Model Parameter Standard Pooled Model Parameter Estimate E r r o r Standard t - v a l u e T E r r o r t - v a l u e l "na aa~ana=^ "na ha~bna .017636 .027266 .044902 1 . 1 769 .60398 •1 .78088 025266 ,024892 ,035468 ,3993 ,8234 3.70516 -.698 1.0954 -1 .266 -.49050 .21392 -.48065 .025192 .024965 .035467 2.3923 2.8317 3.707 -.70004 1 .0921 -1.266 -.49195 .21329 -.480 * 90-4=86 degrees of freedom t 30-4=26 degrees of freedom 59 TABLE 4 1 T e s t s of Hypothesis 3 J o i n t T e s t s on the D i f f e r e n c e Between the Market Reaction to an A u d i t o r Change on N-B Sample v. B-N Sample Panel A: D a i l y Returns Separate Model Pooled Model yN-B ~ ^B-N .02362 .02362 S / [ 1 /N + 1 /N ] P N-B B-N .0133468 * .0133788 * t - v a l u e 1 .7709 1.7661 degrees of freedom 1 73 350 Panel B: Three-day Returns Separate Model Pooled Model 7 - 7 N-B B-N .066095 .066095 S / [ 1 /N + 1 /N ] P N-B B-N .038534 .0387357 * t-v a l u e 1.7167 1.7069 degrees of freedom 55 1 1 4 * s i g n i f i c a n t at a .05 l e v e l assuming a one-sided t e s t 60 TABLE 5 Variance of Stock Returns in Announcement vs Non-announcement Period s Panel A: T e s t s of Hypotheses 4 and 5 N-B Sample B-N Sample D a i l y Three-day D a i l y Returns Returns Returns 2 S a .0040568 .011310 .0046520 .0093267 2 S na .0012108 .0041221 .0031781 .0092173 F 3.3505* 2.7437* 1 .4638 1.0119 degrees of 130,130 42,42 43,43 13,13 freedom Panel B: T e s t s of Hypothesis 6 D a i l y Returns Three-day Returns 2 S + a,N-B 2 S na,N-B 2 S a, B-N 2 + S na,B-N .0087088 .0043889 * .0206367 .0133394 F 1 .984 1 .547 degrees of freedom 173,173 55,55 * S i g n i f i c a n t at a .01 l e v e l Three-day Returns 61 FIGURE 1 Costs and B e n e f i t s of A u d i t i n g i n Firms with Low and High E x t e r n a l Ownership TOTAL FIRM VALUE F MARKET VALUE OF PERQUISITES 62 FIGURE 2 Impact of an Increase i n the E x t e r n a l Ownership of a Firm TOTAL FIRM VALUE F MARKET VALUE OF PERQUISITES 6 3 FIGURE 3 Impact of a Decrease i n the E x t e r n a l Ownership of a Firm TOTAL FIRM VALUE F MARKET VALUE OF PERQUISITES BIBLIOGRAPHY A t i a s e , R., 1980, " P r e d i s c l o s u r e I n f o r m a t i o n a l Asymetries, Firm C a p i t a l i z a t i o n , F i n a n c i a l Reports and S e c u r i t y P r i c e Behavior", Unpublished Ph.D. d i s s e r t a t i o n , U n i v e r s i t y of C a l i f o r n i a , B e r k e l y . 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