Auditor Changes Increase the Heat

Corporate America’s spasm of hiring new audit firms since Sarbanes-Oxley finally seems to be easing. That doesn’t mean things will be getting any easier for the Big 4.

According to data from research firm Glass, Lewis & Co., 1,193 public companies dismissed and hired a new audit firm in 2007, representing 10.1 percent of all listed registrants. The number reflects a steady decline from an 11 percent turnover rate in 2006, 11.8 percent in 2005, and 12.1 percent in 2004.

Ueltschy

“But that’s still a pretty high number,” says Rick Ueltschy, head of the financial services audit practice for Crowe Chizek. Changes in audit firms are slowing, but not yet returning to pre-SOX levels, says Susan Scholz, a professor at the University of Kansas who has studied auditor turnover. “I always thought things would settle back down into a more steady state of being,” she says. “It’s been an open question as to what that equilibrium would be.”

Sarbanes-Oxley overturned long-standing traditions around retaining a Big 4 audit firm. It imposed new requirements for companies to assess their independence from auditors and gave them new reasons to evaluate service, quality, and cost. At the same time, audit firms faced resource strains and fears of liability that led them to re-evaluate riskier clients. The resulting stir led to an unprecedented period of changes in audit-client relationships in the last few years—not only among Big 4 firms, but also to second-tier and smaller audit firms who were all too happy to scoop up the surplus work.

Tyranski

The recent churn in auditor relationships may have also shaken the notion that only audits from Big 4 firms can be taken seriously in capital markets. Glenn Tyranski, senior vice president at NYSE Regulation, told the Treasury Department’s Advisory Committee on the Auditing Profession last week that 94 percent of its listed companies are audited by the Big 4, compared with 98 percent a few years ago.

“The NYSE has never required that a listed company have a Big 4 auditor,” he says. “It is purely a matter of perception … We do think that this expectation that a company must use a ‘Big’ auditing firm is beginning to erode.”

Data from Glass Lewis support that idea. In 2007, the Big 4 as a whole lost 85 clients. (KPMG led the way by losing 41; the only Big 4 firm to gain clients was Ernst & Young, which added a whopping one.) In contrast, the second-tier firms—Grant Thornton, BDO Seidman, McGladrey & Pullen, and Crow Chizek—gained 66 clients last year.

Trent Gazzaway, head of corporate governance for Grant Thornton, says the firm’s research on its own clients suggests that dumping a Big 4 audit firm won’t hurt a company’s stock price, as market perceptions would typically expect. Still, he says, the investment banking community clings to the tradition. “It’s just easier to tell investees to go with one of the four firms,” he says.

AUDITOR TURNOVER

Glass, Lewis reports on the number of companies that experienced auditor turnover in the past four years.

Year

No. of Cos. With Auditor Change

Percent of Cos. With Auditor Change

2004

1, 452

12.1%

2005

1,430

11.8%

2006

1,327

11.0%

2007

1,193

10.1%

Source

Glass Lewis & Co. (2008).

Audit experts do agree that plenty of companies are looking for auditors these days based on more than just market perception. “A lot of auditor changes now are more for what I’d call commercial purposes,” Ueltschy says. “We talk with many companies that are truly evaluating auditor relationships for business reasons: looking for better service style, better pricing, or an expertise in a particular industry. They’re looking for answers to operational issues.”

What Others Think

Markets still wonder, however, whether a change in auditor might signal an accounting or financial reporting problem, Glass Lewis says in its recent trend report. The firm notes that within a year of a change in audit firms, companies are three times more likely to restate financials or disclose material weaknesses.

Glass Lewis has called for more disclosure around auditor changes, contending that the current lack of disclosure leaves investors in the dark about whether a change in auditing might result from a disagreement over accounting. The Council of Institutional Investors recently penned a letter to the Securities and Exchange Commission calling for new rules compelling more disclosure.

“The obscurity surrounding the reason for the switch encourages speculation and precludes investors from differentiating between legitimate reasons for the change and those that raise a red flag,” CCI General Counsel Jeff Mahoney wrote.

Scholz says she’s spent a lot of time studying Form 8-K filings with the SEC, which companies file to disclose major changes or events, such as an auditor change. She’s not so convinced auditor changes are indicative of accounting problems. “I’ve read a lot of 8-Ks, and when there’s a dispute, it gets in there,” she says. “Usually they’ve just decided this isn’t working for us, and that’s all there is to it.”

Gazzaway

Gazzaway says he doesn’t see a great deal of “opinion shopping”— where companies look for a new auditor simply to get acceptance of a particular accounting approach—among companies in the market for auditors today. “I don’t think it’s an issue any more than before,” he says. “I don’t think it happens as often as people think it happens. We’ve had situations where the prior auditor’s opinion was just flat out wrong, but that’s different. One is a quality issue and the other is an integrity issue.”

Mark Grothe, a research analyst at Glass Lewis, says he finds a strong preference for a Big 4 audit still endures. “It looks a little better on the surface,” he says. But he acknowledges that the trend toward auditor churn has opened the door for smaller firms to get a piece of the action.

AUDITOR SCORECARD

Glass, Lewis examines auditor turnover for the Big Four and Tier Two firms.

Audit Firm

Resigned/Dismissed

Replacement

Net Gain/Loss

Big Four

208/16.5%

123/10.1%

-85

Tier Two

68/5.4%

134/11.0%

66

Source

Glass Lewis & Co. (2008).

And now that capacity is catching up with demand, competition is returning. Grothe says he wonders if the Big 4 will begin cutting their hourly rates for audit work to regain some of the clients they lost or resigned when audit capacity was constrained. “They want to be at or near 100 percent capacity,” he says. “If they can get back smaller companies, they’ll do what they need to do.”

Gazzaway says fee pressure is an increasing reality. “Competition is heating up. All the firms are finding themselves with resources to spare, so they’re redeploying and bidding on new work,” he says. “There were a lot of situations where larger firms wouldn’t even propose for an audit that was out for bid. That’s not the case today. Now we’re seeing when a company goes out for bid, there’s more than enough competition out there.”

Ueltschy says the recent shakeup has given markets some exposure to audit services available from mid-tier and smaller firms, and he’s not convinced the Big 4 will so easily snatch back lost clients. “The migration toward mid-tier firms has been based on a long-term evaluation process,” he says. “CFO and audit committees have learned a lot more about those firms and have learned they’ve raised their sophistication and strengthened their international networks. The underlying factors still exist, and I expect that trend to continue.”