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...literature on corporate governance by investigating the relation between audit committee characteristics (independence, governance expertise, financial expertise, and stock ownership (1)) and auditor dismissals following the issuance of new going-concern reports. We define a going-concern report as new if the client received an unmodified (clean) report in the previous year. (2)
One of the primary functions of an audit committee is to safeguard the independence of the external auditor. Auditor independence is essential to audit quality because it minimizes "the possibility that any external factors will influence an auditor's judgments" (SEC 2000, 5). The independence of the auditor is particularly critical in financial accounting and reporting situations that are ambiguous, such as when a client is experiencing financial distress and the "temptation to `see it the way your client does' is subtle, yet real" (Levitt 2000, 5). In their examination of an ambiguous reporting situation, Carcello and Neal (2000) find that audit firms are less likely to issue going-concern reports to financially distressed clients whose audit committees lack independence. Auditors may hesitate to issue a going-concern report if management implicitly or explicitly suggests that the client will dismiss the auditor if the auditor issues a going-concern report.
Prior research finds that clients receiving a going-concern report are more likely to switch auditors (e.g., Chow and Rice 1982; Mutchler 1984; Geiger et al. 1998). We test the hypothesis that management is less likely to terminate the auditor following the issuance of a going-concern report if the audit committee--which reviews all auditor-management disputes--embodies certain characteristics (PricewaterhouseCoopers 2000).
As shareholder representatives, the audit committee plays an important role in the auditor dismissal process. The NYSE-NASDAQ-sponsored Blue Ribbon Committee (BRC) (1999, 14) recognized the audit committee's "ultimate authority and responsibility to select, evaluate, and where appropriate, dismiss the outside auditor." Moreover, Securities and Exchange Commission Chairman Harvey Pitt has recently proposed additional safeguards to prevent management from firing the auditor without audit committee approval (Pitt 2002b).
Audit committee performance should be of high quality when members are independent (Public Oversight Board [POB] 1994; BRC 1999; PricewaterhouseCoopers 2000), when they have more governance expertise (Fama 1980; Fama and Jensen 1983), and more financial expertise (BRC 1999). Since critics have alleged that higher levels of stock ownership motivate corporate directors (and management) to artificially boost reported performance (Millstein 2002; Pitt 2002a), we expect that owning large stockholdings in the company will impair audit committee members' performance. In sum, we expect that audit committees whose members are more independent, have more governance expertise, more financial expertise, and own less of the company's stock, will be more likely to resist managerial attempts to dismiss an auditor following the issuance of a going-concern report.
Our results generally support our expectations. Auditors who issue a going-concern report are more likely to be dismissed if audit committees have a larger percentage of affiliated directors on the audit committee, or if audit committee members: (1) have less governance expertise, or (2) own a larger percentage of the company's stock. We do not find a significant relation between the percentage of audit committee members with financial expertise and auditor dismissals following going-concern reports.
These results, coupled with the evidence reported by Carcello and Neal (2000), indicate potential problems in the interactions among auditors, audit committees, and management of financially distressed companies. Carcello and Neal (2000) suggest that auditors often believe that they are more likely to be dismissed following a going-concern report if there is a greater percentage of affiliated directors on thee audit committee. The current study provides explicit evidence that this concern is valid. Therefore, we conclude that when affiliated directors dominate the audit committee, management often can (1) pressure its auditor to issue an unmodified report despite going-concern issues, and (2) dismiss its auditor if the auditor refuses to issue an unmodified report.
We organize the remainder of this paper as follows. Section II provides further background on the link between audit committee characteristics and auditor dismissals and develops our empirical predictions. We present the research design and sample selection procedure in Section III, and our results in Section IV. Section V contains supplemental analyses, and the last section discusses the study's implications and limitations.
II. BACKGROUND AND EMPIRICAL PREDICTIONS
Previous research suggests that opinion shopping is generally unsuccessful (e.g., Chow and Rice 1982; Smith 1986; Krishnan and Stephens 1995; Geiger et al. 1998). Nonetheless, clients receiving a going-concern report are more likely to switch auditors (e.g., Chow and Rice 1982; Mutchler 1984; Geiger et al. 1998) perhaps because management believes that once an incumbent auditor is dismissed, the company will find a more pliable auditor (Craswell 1988, 26). Alternatively, management might dismiss an auditor solely as punishment for issuing a going-concern report, or due to irreparable damage to its relationship with the auditor as a result of the conflict.
We posit that an audit committee whose members have more independence, governance expertise, financial expertise, and who own less of the company's stock will be more likely to block a managerial attempt to dismiss an auditor who issued a going-concern report. We now consider in more detail why we expect each of these four audit committee characteristics to affect auditor dismissals.
In our view, the independence of the audit committee is the primary mechanism for reducing the likelihood that the company will dismiss its auditor in retaliation for issuing a going-concern report. We classify audit committee members as either independent or affiliated directors. Affiliated directors (who have strong economic or personal ties to the company or its management) include current or former officers or employees of the company or of a related entity, relatives of management, professional advisors to the company (e.g., consultants, bank officers, legal counsel), officers of significant suppliers or customers of the company, and interlocking directors (Vicknair et al. 1993; Beasley 1996; Carcello and Neal 2000).
Given the strong economic or personal ties between affiliated directors and the company or its management, affiliated audit committee members have more incentive to side with management in disputes with the auditor (Baysinger and Butler 1985). Affiliated committee members also typically own more stock in the company than independent members, and stock ownership may increase the likelihood that a director sides with management. Indeed, we expect independent directors to be more objective and to possess greater expertise than affiliated directors, and the legal system appears to hold independent directors to a higher standard (Braiotta 1999, 104).
An audit committee with greater governance expertise should also reduce the likelihood that the company will dismiss its auditor in retaliation for issuing a going-concern report. Fama (1980) and Fama and Jensen (1983) suggest that directors make costly investments to develop reputations as effective monitors of corporate performance. Moreover, prior research concludes that directors of companies experiencing adverse events such as poor performance or financial distress subsequently serve less often as directors for other companies (Gilson 1990; Kaplan and Reishus 1990). We expect a director's reputation to suffer when the company fires its auditor after issuing a going-concern report. Directors who sit on more boards will have more to lose and therefore we expect them to be more likely to oppose the auditor's dismissal.
An audit committee with greater financial expertise should reduce the likelihood that the company will dismiss its auditor for issuing a going-concern report. The BRC (1999, 25) recommends that every audit committee have at least one member who possesses financial expertise, defined as "past employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual's financial sophistication, including being or having been a CEO or other senior officer with financial oversight responsibilities." We expect that a financial expert will understand and support an auditor's decision to issue a going-concern report, and that an audit committee whose members have greater financial expertise will be more effective in preventing management from dismissing its auditor in this event.
An audit committee with a lower level of stock ownership should reduce the likelihood that the company dismisses its auditor after receiving a going-concern report. Audit committee members who own more company stock are likely to suffer losses if the going-concern report triggers a negative stock price response (Jones 1996; Melumad and Ziv 1997), so we expect them to be more willing to accede to auditor dismissals. (3)
III. RESEARCH DESIGN AND SAMPLE
Model
We use the following logistic regression model to test the relation between the likelihood that the client dismisses its auditor and audit committee characteristics:
DISMISSED = [b.sub.0] + [b.sub.1]AFFILIATED + [b.sub.2]AFFILIATED x GC_OPINION + [b.sub.3]GOVEXPERT + [b.sub.4]GOVEXPERT x GC_OPINION + [b.sub.5]FINEXPERT + [b.sub.6]FINEXPERT x GC_OPINION + [b.sub.7]STOCKOWN + [b.sub.8]STOCKOWN x GC_OPINION + [b.sub.9]SIZE + [b.sub.10]INDSHARE + [b.sub.11]TENURE + [b.sub.12]ZFC + [b.sub.13]MGMTCHG + [epsilon].
We define the dependent, test, and control variables as follows:
DISMISSED = identifies whether a client dismissed its auditor before the client's next annual report (1 = client dismissed auditor, = client did not dismiss auditor);
AFFILIATED = the percentage of audit committee members classified as affiliated directors: current or former officers or employees of the company or of a related entity, relatives of management, professional advisors to the company, officers of significant suppliers or customers of the company, and interlocking directors;
GOVEXPERT = a proxy for audit committee members' governance expertise, the average number of directorship positions they hold in other public companies;
FINEXPERT = the percentage of audit committee members possessing financial expertise, per the BRC (1999) recommendations; (4)
STOCKOWN = the percentage of the client's common stock (and stock options) held by its audit committee members; and
GC_OPINION = a going-concern opinion indicator variable (1 = GC, = clean).
Although...
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