Recent Auditor Downgrade Activity and Changes in Clients’ Discretionary Accruals

Abstract

This study examines whether recent auditor downgrade activity is associated with subsequent changes in clients’ discretionary accruals. The market for audit services has undergone dramatic change in recent years, resulting in a substantial increase in the number of clients realigning to smaller auditors. This shift in the audit market raises concern about the potential adverse effects of clients moving away from larger, and perhaps more effective, auditors. Consistent with this concern, our analysis of auditor switches occurring between 2003 and 2005 indicates that downgrade clients reported a significant increase in signed discretionary accruals over the two years following the switch. In contrast, we find no significant change in discretionary accruals for a control sample of lateral switches. However, between-sample comparisons fail to provide consistent evidence that the two groups reported accrual changes differently following the auditor switch.

Keywords: Audit Quality, Auditor Switches, Discretionary Accruals, Financial Reporting Quality