Clive S. Lennox

Identifying failing companies: a re-evaluation of the logit, probit and DA approaches

This paper examines the causes of bankruptcy for a sample of 949 publicly quoted companies in the UK between 1987-94. The most important determinants of bankruptcy are profitability, leverage, cashflow, company size, industry sector and the economic cycle. In contrast to previous studies, this paper argues that well specified logit and probit models can identify failing companies more accurately than discriminant analysis (DA). Tests for mis specification also reveal that cashflow and leverage have non linear effects on the probability of bankruptcy. Taking account of these non-linear effects significantly improves the explanatory power of the bankruptcy model.

Audit Quality and Auditor Size: An Evaluation of Reputation and Deep Pockets Hypotheses

Empirical studies have shown that large auditors are more accurate than small auditors. The reputation hypothesis states that large auditors have more incentive to be accurate because an inaccurate report may lead to a loss of client-specific rents (DeAngelo, 1981). The deep pockets hypothesis states that large auditors should be more accurate because they have greater wealth at risk from litigation (Dye, 1993). This paper presents evidence on the relationship between auditor size and litigation and on the market shares of criticised and uncriticised auditors - the findings give greater support to the deep pockets hypothesis than the reputation hypothesis. Copyright Blackwell Publishers Ltd 1999.

Do Companies Successfully Engage in Opinion-Shopping? Evidence from the UK

Abstract Since observed audit opinions do not generally become more favourable after companies switch auditors, it has been argued that companies do not successfully engage in opinion-shopping. Rather than comparing observed pre- and post-switch audit reports, this study tests for opinion-shopping by predicting the opinions companies would have received had they made opposite switch decisions. My results indicate that companies would have received unfavourable reports more often under different switch decisions. This suggests that companies do successfully engage in opinion-shopping.

Are large auditors more accurate than small auditors

Theoretical research suggests that large auditors have more incentive to issue accurate reports compared to small auditors (DeAngelo, 1981; Dye, 1993). Controlling for the client characteristics of large and small auditors, this paper shows that large auditors issue reports that are more accurate and more informative signals of financial distress. These findings are consistent with the theoretical prediction of a positive relationship between auditor size and auditor accuracy.

The Large Audit Firm Fee Premium: A Case of Selectivity Bias?

Audit fee studies often find large (Big 5) audit firms earn significantly higher fees than small (non-Big 5) firms, but they treat auditor choice as exogenous. In contrast, this paper takes into account that companies are not randomly assigned to audit firms. We find the effects of auditor selection bias on audit fees are statistically and economically significant. Consistent with the predictions of analytical research, our results suggest large (small) audit firms experience advantageous (adverse) selection in attracting high (low) quality companies. Our results indicate the premium earned by large audit firms is more than twice as large when selectivity effects are taken into account (53.4% compared to 19.2%).

Management Ownership and Audit Firm Size

The finance literature identifies two agency problems between managers and outside shareholders. First, there is a divergence-of-interests problem as management ownership falls. Second, there is an offsetting entrenchment problem when management ownership increases within intermediate regions of ownership. Agency problems are mitigated through contracting, but contracts are often based upon accounting numbers prepared by management. Since accounting numbers must be reliable for contracts to be enforced, agency theory predicts a demand for higher quality auditors when agency problems are more severe. However, extant studies find no significant or robust relation between management ownership and audit firm size (Francis and Wilson, 1988; DeFond, 1992). In contrast to extant research, this study samples unlisted companies rather than listed companies for two reasons. First, the monitoring value of auditing may be greater in unlisted companies because they are less vulnerable to takeover and they are required to disclose much less non-accounting information to shareholders. Second, unlisted companies have much greater variation in management ownership and this permits more powerful tests of the demand for auditing as ownership varies between 0% and 100%. Consistent with a divergence-of-interests effect, the association between management ownership and audit firm size is found to be significantly negative within low and high regions of management ownership. The association is flatter and slightly positive within intermediate regions of management ownership, suggesting the existence of an opposite entrenchment effect. The negative association and the non-linearity is consistent with the finance literature and with the predictions of agency theory.

The Accuracy and Incremental Information Content of Audit Reports in Predicting Bankruptcy

A series of corporate failures in which auditors failed to warn about impending bankruptcy led to widespread criticism of the UK auditing profession during the last recession. For a sample of 976 quoted companies (1987-94), this paper shows that there are two reasons why audit reports were not accurate or informative indicators of bankruptcy. First, audit reports poorly reflected publicly available information about the probability of bankruptcy. Secondly, strong persistence in audit reporting reduced the accuracy of audit reports Copyright Blackwell Publishers Ltd 1999.

The Demand for Audit in Private Firms: Recent Large-Sample Evidence from the UK

Abstract Although theory suggests that companies would rationally select into audit even if it were not a legal requirement, many countries impose mandatory audits. This is arguably due to an audit having elements of a public good, which may result in not enough audits being purchased without regulatory intervention. The mandatory nature of public company audit has created problems for researchers wishing to investigate the demand for voluntary audit. Recent events in the UK, however, have provided such an environment. In the UK, private companies must publicly file financial statements and, until recently, they had also to be audited. However, this requirement has now been relaxed for many private companies. We are therefore able to examine the determinants of voluntary audit in a large sample of companies for which we have financial statement data. We analyse a sample of 6274 recently exempt companies, following them for three years post-exemption. We use agency theory and prior evidence to generate our hypotheses and examine them using a more comprehensive set of explanatory variables than has previously been available in the literature. Our results indicate that companies are more likely to purchase voluntary audits if they have greater agency costs, are riskier, wish to raise capital, purchase non-audit services from their auditor, and exhibited greater demand for audit assurance in the mandatory audit regime. We also document a trend away from audit over time. Overall, our results strongly support the idea that companies choose to be audited when it is in their interests to do so.

Management Influence on Auditor Selection and Subsequent Impairments of Auditor Independence During the Post-SOX Period

This study investigates the influence of management over auditor selection decisions during a period in which audit committees have “direct responsibility” for auditor selection. We find that contrary to the intent of SOX, management continues to have significant influence over auditor selection and this is not mitigated by the presence of an apparently higher quality audit committee. As SOX presumes that management influence over auditor selection leads to negative outcomes, we also examine the impact that management influence has on proxies for subsequent auditor independence during the post-SOX period. We find that companies whose managers influence auditor selection are significantly less likely to receive going concern opinions, but no evidence of an impact on earnings management. We also find mixed evidence as to whether the relationship between management influence over auditor selection and subsequent audit quality is influenced by audit committee quality.

The Changing Regulatory Landscape: Editorial

This editorial first summarizes the changes to the regulatory landscape that have primarily affected the auditing profession. I then discuss the content of the four papers contained in this special issue. Finally, I put these papers into context by outlining the major findings in the empirical literature regarding the consequences of the changed regulatory environment.