Maj 11 2012 0779

Managerial Auditing Journal
Forced auditor change, industry specialization and audit fees

Winifred D. Scott Willie E. Gist
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Winifred D. Scott Willie E. Gist, (2013),"Forced auditor change, industry specialization and audit fees",
Managerial Auditing Journal, Vol. 28 Iss 8 pp. 708 - 734
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MAJ
28,8
Forced auditor change, industry

specialization and audit fees
708
College of Business, Zayed University, Dubai, United Arab Emirates, and
Winifred D. Scott
Willie E. Gist
School of Accountancy, College of Business, Ohio University,

Athens, Ohio, USA
Abstract
Purpose The purpose of this study is to explore the effect of industry specialization on the
absorption and competitive pricing (or lack thereof) of audits of large Andersen clients (S&P 1500
companies) who switched to the remaining Big 4 international accounting firms in 2002 due to the
demise of Arthur Andersen LLP (Andersen). Did the audit clients pay a premium or discount in audit
fees to their new auditor who specialized in their industry?
Design/methodology/approach Ordinary least squares regression is used to test hypothesis of a
positive association between industry specialization and audit fees charged to former Andersens audit
clients in 2002 following Andersens demise. This study provides more control over size effects by design.
Test variables are constructed based on national market share of audit fees within an industry. Logistic
regression is used to examine the likelihood of choosing new auditor that is an industry specialist.
Findings Results support hypothesis, consistent with auditor differentiation explanation.
Proportion of clients that had engaged an industry specialist in 2001 increased from 38 percent
(84 clients) to 48 percent (105 clients) in 2002. No evidence of price-gouging in 2002 although clients
who aligned with industry specialist paid a 23.2 percent premium in audit fees. Large clients lost
bargaining power to negotiate lower fees. Findings are robust to the inclusion of additional alternative
measures of company size.
Research limitations/implications Results of logistic regression analysis imply that large audit
clients with former auditor of tarnished reputation, long auditor tenure and high leverage are more
likely to switch to an industry specialist to possibly signal audit/financial reporting quality. Large
sample companies may limit the ability to generalize findings to smaller companies.
Practical implications Mandatory audit firm rotation (currently being debated in the profession)
will have costly effect on the pricing of Big 4 audits for companies wanting to signal audit and
financial reporting quality to affect market perception, and large companies would likely lose their
ability to bargain for lower audit fees.
Originality/value The paper focus on the alignment of Andersen clients and impact on audit fees
with Big 4 industry specialists resulting from the sudden increase in audit market concentration. Prior
to Andersens collapse, evidence on the association of audit fees premium and industry specialists was
mixed, and little attention has been given to the influence of auditor industry specialization on both
audit fees and alignment of former Andersen clients with a Big 4 specialist. This paper fills that void.
Keywords Andersen, Industry specialization, Auditor switching, Involuntary auditor change,
Audit fees, Audit market concentration, Price-gouging, Bargaining power, Mandatory auditor rotation,
Auditors, Auditing
Paper type Research paper
Managerial Auditing Journal
Vol. 28 No. 8, 2013
pp. 708-734
q Emerald Group Publishing Limited
0268-6902
DOI 10.1108/MAJ-11-2012-0779
The authors are very thankful for the valuable and constructive comments of anonymous
referees in significantly improving this manuscript.
Data availability. Data are publicly available from the sources identified in the paper.
I. Introduction
Audits play an important role in corporate governance. They provide independent
assurance to investors and other stakeholders that management prepared financial
statements are not materially misstated in accordance with generally accepted accounting
standards. Understanding the clients industry enhances the auditors professional
skepticism about the proper recognition and valuation of transactions and events related
to that industry. Consequently, audit firms differentiate themselves from other competing
audit firms by specializing in certain industries in order to provide better quality service
to their audit clients than a non-industry specialist audit firm (Habib, 2011). The issue of
auditor industry specialization is relevant to the auditing profession as firms organize
their practices along industry lines to increase the effectiveness and quality of their audits
(American Institute of Certified Public Accountants (AICPA, 1998); Owhoso et al., 2002;
Bell et al., 1997; GAO, 2003a; Knechel et al., 2007; Cenker and Nagy, 2008; Cahan et al.,
2008). Industry specialization is often perceived as a proxy for audit quality. In 2001,
Andersen served as an industry specialist auditor to many of its large clients.
When Andersen was barred from conducting and reporting on audits for Securities
and Exchange Commission (SEC) registered companies in 2002, its audit clients had to
find a new auditor in a hurry because they needed to file their annual audited 10-k
statements with the SEC. Although the SEC issued temporary rules on filing
requirements (SEC Release 33-8070, 2002), companies did not want to delay filing of
audited financial statements since investors favor the issuance of timely financial
reports. Filing unaudited financial statements had the potential to hurt investors and
reduce the value of the firm, and was not the preferred course of action. This forced
auditor change (in contrast to a voluntary auditor change) for hundreds of companies at
one time was very unique in the audit market. Since the shredded reputation of
Andersen negatively affected the stock price of its clients (Chaney and Philipich, 2002),
it seems reasonable that many of Andersens former audit clients would have wanted to
signal a positive perception about the expressed opinion on their financial statements
by selecting an industry specialist as their new auditor. A number of studies indicate
that several former Andersen clients selected their new auditor by simply following
their Andersen audit partner to their new auditor (Blouin et al., 2007; Vermeer et al.,
2008; Kohlbeck et al., 2008). Vermeer et al. (2008) report lower fees paid by followers,
whereas Kohlbeck et al. (2008) find no evidence of a premium or discount to followers
compared to audit fees paid by non-follower audit clients. Kealy et al. (2007) find that
clients who were with Andersen for a long time faced greater professional skepticism
about the quality of prior audits and paid larger audit fees than clients with short tenure
with Andersen. Little attention, however, has been given to the influence of auditor
industry specialization on both the audit fees and new auditor selection of the former
Andersen clients. The collapse of Andersen brought about a sudden increase in the
audit market concentration in the large client segment and induced a forced auditor
change environment, in which we examine the auditor specialization and audit fees
relation. In addition to being able to explore specialization effect in this environment,
such a study may have implications for:
.
mandatory auditor rotation;
.
client-auditor alignment; and
.
price-gouging behavior.
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The purpose of this study is to explore the effects of industry specialization on

competitive pricing (or lack thereof) of audits for large Andersen clients that switched to
the remaining Big 4 international accounting firms (hereafter, the Big 4) in 2002. Given
the necessity of the involuntary switching of former Andersen clients, did the audit
clients pay a premium or discount in audit fees to their new auditor who specialized in
their industry? Whether a fee premium or discount is associated with auditor industry
specialization has not been convincingly documented in the literature; the results are
mixed (Mayhew and Wilkins, 2003; Casterella et al., 2004; Hay et al., 2006; Ghosh and
Lustgarten, 2006; Kohlbeck et al., 2008; Habib, 2011). This study contributes to our
understanding of the effect that industry specialization and involuntary auditor
switching had on the audit fees of hundreds of large audit clients who changed auditor
at the same time for the same reason. We believe that given the tarnished reputation of
Andersen, the large former Andersen clients wanted to signal the quality of their
financial reporting, and would likely have done so by engaging a Big 4 industry
specialist. Furthermore, a more likely competitive response by a Big 4 network firm
(discussed below) absorbing these clients would be to increase audit fees (rather than
discount them) to better reflect the value of the audit (whether due to actual or perceived
higher quality) and earn an appropriate return on the additional investment made by
the firm to differentiate its product as a specialist.
This study is restricted to the former Andersen clients who had been part of the
S&P 1500 in 2001 and who chose one of the remaining Big 4 audit firms as their new
auditor. We limit our study to the largest of Arthur Andersens former clients to
provide more control over size effects by design, and to reduce or eliminate possible
confounding effects between any premiums resulting from industry specialization or
from low bargaining power of the smaller audit clients. For example, Casterella et al.
(2004) find that premiums for industry specialization arise when clients have low
bargaining power (in the case of smaller clients). Also, by focusing our study on larger
clients we avoid the size effect issue reported by Francis et al. (2005) and Craswell et al.
(1995) whereby the premiums for industry leadership in their samples are driven by the
upper half of company size. We find that 48 percent of the 221 former Andersen clients
selected an industry specialist auditor in 2002. While 40 former Andersen audit clients
lost the privilege of having an industry specialist auditor in 2002, 61 former Andersen
clients (who did not have Andersen as their industry specialist in 2001) gained the
advantage of having an industry specialist auditor to express an opinion on the
reliability and faithful representation of their 2002 financial statements to investors
and other stakeholders.
Given the size, resources, and national/international presence of the S&P 1500, these
companies are more likely concerned with the firm-wide and international reputation of
their auditors as oppose to the auditors local-office reputation. A Big 4 network firm
refers to the organizational structures and operations of national and international
accounting firm networks that may produce positive synergies which benefit very
large companies to a great degree (Carson, 2009). Therefore, we examine national
industry leadership as opposed to city-specific industry leadership. Francis et al. (2005)
examine both national and city-specific industry expertise and find that they jointly
affect audit fees. City-specific industry expertise may be an appropriate consideration
for the companies in their sample with average total assets of $1.9 billion, however, it is
difficult for us to argue that the average company of $11 billion total assets as in our
sample would fixate on local-office rather than national/international expertise of its

auditors from a Big 4 network firm.
Ordinary least squares (OLS) regression analysis is used to test the association
between the audit fees of Andersens former clients and auditor industry specialization.
As hypothesized we find that the association between audit fees and auditor industry
specialization is positive and significant at 0.05 level or better, consistent with the
Francis et al. (2005) model that considers only national industry leaders. Our finding
supports the product differentiation explanation. OLS results indicate that the former
Andersen clients paid, on average, a fee premium of 23 percent to their new industry
specialist auditor. We also find that these very large companies did not have the
bargaining power to negotiate lower fees, in contrast to Casterella et al. (2004). Since
prior studies (Huang et al., 2007; Kohlbeck et al., 2008) indicate a potential large-client
size effect on pricing audit services, additional tests are conducted to examine whether
the results are driven by client size. We find the inferences of our results unchanged.
Tests also did not indicate that price-gouging or low-balling were pervasive in the
pricing of audits of Andersens former clients. Further, results of logistic regression
analysis indicate that the likelihood of choosing a new industry specialist auditor
increased as the length of the client-auditor tenure with Andersen increased, consistent
with Kealy et al. (2007).
The remainder of the paper is organized into four sections. The next section
provides some background and the hypothesis development. Section III discusses the
methodology and Section IV describes the sample selection. Results of the analyses are
presented in Section V and the conclusion, contribution, and implications are discussed
in Section VI.
II. Background and hypothesis development
Auditor switching and the pricing of audit services
Theoretical models of audit pricing suggest that when a client voluntarily switches
auditors, the client should initially enjoy lower audit fees because non-incumbent
auditors low-ball or discount the initial audit engagement to earn the right to future
quasi-rents of audit fees (DeAngelo, 1981; Beck et al., 1988). Prior to Andersens demise,
empirical studies reported evidence of persistent initial price cutting (Simon and
Francis, 1988; Turpin, 1990; Yardley et al., 1992; Whisenant et al., 2003).
Voluntary auditor switching, in general, focuses on matters such as pressuring
incumbent auditors to issue clean audit opinions, brand name reputation, industry
specialization, market power, and low-balling/price-gouging (DeAngelo, 1981; Chow
and Rice, 1982; Palmrose, 1986a, b; Ettredge and Greenberg, 1990; Yardley et al., 1992;
Craswell et al., 1995; Deis and Giroux, 1996; AICPA, 1998; Owhoso et al., 2002;
Balsam et al., 2003; Krishnan, 2003; Knechel et al., 2007; Kohlbeck et al., 2008). After
Andersens demise, the Herfindahl-Hirschman Index for audit firms increased to 2,566,
well above the score of 1,800 that indicates audit firms have the potential to exercise
market power (Eisenberg and Macey, 2003)[1]. In this unique setting regulators were
concerned about excessive pricing for the hundreds of involuntary auditor switching
companies.
Some studies indicate that several former Andersen audit clients chose to follow
their Andersen audit partner to the new auditor. For example, Blouin et al. (2007) find
that slightly more than half of their sample, 226 out of 407, followed their Andersen
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audit partner to the new auditor. In their follow/non-follow logistic regression model,
they find that audit clients with greater switching costs as well as industries with the
most number of clients in a single industry (CLIENT variable) were more likely to
follow Andersens audit team. However, their CLIENT variable may also be capturing
a lack of competition and less of an indicator of switching costs. While Vermeer et al.
(2008) find that half their sample of 575 former Andersen clients who followed the
Andersen audit partner/team to the new auditor paid lower audit fees, Kohlbeck et al.
(2008) in contrast find that former Andersen clients who were early switchers and
those who followed the audit team did not experience fee discounts or premiums.
Other studies indicate that the larger audit clients of Andersen were more likely to
be early switchers (Kohlbeck et al., 2008; Barton, 2005; Chen and Zhou, 2007). For
example, Chen and Zhou (2007) find that companies with larger audit committees with
greater financial expertise and companies with larger boards were more likely to
dismiss Andersen sooner and choose a Big 4 successor auditor.
In addition, some studies indicate that the perceived riskiness of former Andersen
audit clients influence audit pricing. One measure of client risk of former Andersen
clients is client-auditor tenure. The longer that a company was a client of Andersen, the
greater the skepticism about the quality of prior audits and greater the risk that prior
financial statements of former Andersen clients were not audited independently.
Regulatory limits on client-auditor tenure have not been set by the SEC or PCAOB,
however, a GAO (2003b) report finds that the average client-auditor tenure of
Fortune-1000 companies is 22 years. In our usable sample of large Andersen clients
(S&P 1500 companies), the average client-auditor tenure at the time of Andersens
demise is 15.75 years with 37 percent of sample companies having 17 years or more
tenure with Andersen. Kealy et al. (2007) find a positive and significant association
between audit firm tenure and audit fees paid to the successor auditors by former
Andersen clients. They interpret the results as supporting the perception that long
client-auditor tenure is a factor that increases the risk of a new client. On the other
hand, some view short auditor-tenure as risky. For example, Landsman et al. (2009) use
an multinomial logistic auditor switch model (involving lateral, upward, and
downward moves to/from the Big N auditors) to examine whether company-specific
risk factors and client misalignment are differentially associated with Big N auditor
switch decisions in the pre-Enron period (1993-2001) and post-Enron period
(2002-2005). In their study, short tenure is viewed as a risk proxy that increases the
likelihood of audit failure. Although their evidence is consistent with the Big 4
becoming more sensitive to client risk in the post-Enron period, their post-Enron
sample excludes former Andersen clients from the analysis. Our study controls for the
effect that client-auditor tenure has on the pricing of audit services.
Attention to the influence of auditor industry specialists on both the involuntary
auditor switches by former Andersen clients and audit fees is generally lacking. This
study fills that void. Although Blouin et al. (2007) include an industry specialist variable
in their follow/non-follow model, the association between auditor industry specialist
and audit fees was not examined. Huang et al. (2007) examine the association between
industry specialist, client bargaining power, and audit fees, however, they excluded
former Andersen audit clients from their sample. Huang et al. (2007) fail to find audit fee
premiums charged to small and large audit clients in 2003, but in 2004 evidence
indicates that the smaller audit clients paid an industry specialist fee premium.
Several (Kohlbeck et al., 2008; Huang et al., 2007) of the studies discussed above
indicate a potential size effect on pricing audit services. In this study, the analysis
focuses on very large Andersen clients providing more control over a potential size
effect in our research design. The audit market for the S&P 1500 public corporations is
heavily concentrated because the Big 4/Big 5 firms audit approximately 98 percent of
these companies (GAO, 2008). This study includes only those Andersen clients who
switched to the remaining Big 4 firms, hence, brand name reputation is not a
differentiating factor.
Industry specialization and the pricing of audit services
Auditor industry specialists are perceived to offer a higher level of audit effectiveness
and quality relative to non-industry specialists (Bell et al., 1997; AICPA, 1998;
Owhoso et al., 2002; Balsam et al., 2003; Krishnan, 2003; Carcello and Nagy, 2004;
Knechel et al., 2007). According to a GAO (2003a) survey, 81 percent of the respondents
cited industry specialization or expertise as an important factor in choosing a new
auditor. Habib (2011) states that it is costly to develop specialization in an industry
because a significant amount of resources are required by the audit firm. But once
developed, a specialists knowledge of an industry and its accounting will increase the
auditors ability to detect and curb earnings management and minimize intentional
errors (Balsam et al., 2003). Auditor expertise in an industry is an important factor in
reducing litigation risk, and improving auditor retention and audit quality (Cenker and
Nagy, 2008). Knechel et al. (2007) find that firms who switch from (to) a nonspecialist
Big 4 auditor to (from) a specialist Big 4 auditor experience positive (negative)
abnormal stock returns during 2000-2003, however, their sample excludes auditor
changes that involve former Andersen clients. Their results indicate that industry
specialization matters to investors. Hence, it seems reasonable to assume that former
Andersen audit clients may have wanted to contract with a Big 4 industry specialist to
signal a positive perception about financial reporting and audit quality.
The effect of industry specialization on audit fees is still an open question. The
association of audit fees and industry specialization can have three outcomes positive,
negative, or no association. A positive association indicates a fee premium. A fee
premium from industry specialization would be consistent with auditor differentiation
through the acquisition of industry specialized knowledge and with seeking to recoup
higher audit production costs (Palmrose, 1986a). Craswell et al. (1995) failed to find
consistent support for the presence of an industry specialist audit fee premium in the
post merger years of 1990, 1992, and 1994. A significant and negative relationship
between industry specialization and audit fees indicates a fee discount (Casterella et al.,
2004). A fee discount from auditor industry specialization would be consistent with
auditor production efficiency or production economies where auditors pass on their cost
savings to clients. An insignificant relationship between audit fees and auditor industry
specialization could mean industry specialization has no effect on audit fees. This
neutral position could also mean the presence of both differentiation and production
economies offsetting each other. Furthermore, studies show that the effect of industry
specialization on audit fees is not only mixed, but varies with firm size (Habib, 2011).
The present study explores the effect of industry specialization at the national level
on audit fees from 2001 to 2002 and involuntary auditor change by former Andersen
large audit clients. Prior studies suggest that the effects of the forced auditor change
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may vary between the smaller and larger companies (Kohlbeck et al., 2008; Huang et al.,
2007) or according to whether the firm is a national or city-specific leader (Francis et al.,
2005). The effect of industry specialization on audit fees related to city-specific industry
leaders is not examined. Given the size, resources, and national/international presence
of our sample clients, they would more likely be looking for national level expertise as
opposed to local-office expertise. National and international accounting firm networks
may produce positive synergies that benefit very large companies. As stated by
Reichelt and Wang (2010):
[. . .] at the firm-wide (national) level, positive synergies arise when accounting firms capture
industry expertise through knowledge-sharing practices, such as internal benchmarking of
best practices, the use of standardized industry-tailored audit programs, and extending the
reach of professionals from their primary local-office clientele to other clients through travel
and internal consultative practices.
Thus, while industry knowledge of individual auditors in local offices may play a role
in helping to establish the national reputation of accounting firms, it would be difficult
to argue that very large companies (average total assets of $11 billion) with national
and international operations fixate on local expertise rather than national/international
expertise of their auditors[2]. City-specific industry expertise was more likely an
appropriate consideration for smaller audit clients, such as those in the Francis et al.
sample with an average total assets of $1.9 billion, than for the clients in our sample.
Further, the Big 4 accounting firms are identified as global audit firm networks
(Carson, 2009) which create industry specialist groupings to share knowledge, staff,
and resources with the intention of improving audit quality. Carson (2009) argues that
the industry specialist teams of these large audit firms are supported by knowledge
management databases and common industry-specific work programs and training;
and that given the significant investments in audit technology, global audit firm
networks are efficient mechanisms for developing, retaining, and transferring codified
knowledge. These networks have been developed in part because large companies,
especially multinational operations, demand consistent auditing throughout the world.
Many studies on the determinants of audit fees have shown that audit fees are
higher for larger companies, but very large audit clients may be of economic
importance to the audit firm and may have bargaining power to attain lower audit fees
(Casterella et al., 2004). By limiting our study to the largest of Arthur Andersen former
clients we reduce or eliminate possible confounding effects between any premiums that
result from industry specialization or that may arise from low bargaining power of
smaller audit clients. Casterella et al. (2004) find that premiums for industry
specialization arise when clients have low bargaining power (in the case of smaller
clients). Companies in our sample may not have bargaining power to attain lower audit
fees due to the forced change resulting from the demise of their former auditor.
Therefore, a secondary issue in testing the auditor specialization effect is to control and
test for the bargaining power of former Andersen large clients.
The unique event of involuntary auditor switching by hundreds of firms,
simultaneously, presents an opportunity to draw implications on competitive pricing
(or lack thereof), price-gouging, auditor alignment and mandatory auditor rotation.
While prior research has been mixed with respect to the effect of auditor specialization
on audit fees, we believe (like Carson, 2009) that a more competitive response by a
network firm to a client seeking a specialist to signal its financial reporting quality,
especially given the tarnished reputation of its former auditor, is to increase the audit
fees to better reflect the value of the audit (whether due to actual or perceived higher
quality) and achieve an appropriate return on the additional capital invested by the
firm to differentiate its product. Thus, our hypothesis (in the alternative form) is:
H1. There is a positive association between national industry specialization and
audit fees charged to former Andersens largest clients, ceteris paribus.
This is a one-tailed test. A positive and significant coefficient will indicate that the
former Andersen clients incurred a fee premium for having a national industry
specialist to audit their financial statements, possibly to signal the quality of their
financial reporting.
III. Methodology
To test our hypothesis we construct the national market share specialist variable,
SPECMS, based on prior studies[3]. By accounting firm, industries of specialization
before and after Andersens demise are identified based on the national market share of
audit fees of the S&P 1500 companies. Industry membership of our sample is
determined by SIC codes similar to those of Frankel et al. (2002) and Whisenant et al.
(2003)[4]. The national market share of audit fees per year for each accounting firm,
SPECMS_c, is used to identify the auditor industry specialists for that year.
SPECMS_c is calculated as the sum of audit fees of all companies audited by an
accounting firm in a given industry divided by the sum of all audit fees across all firms
within the same industry, similar to Casterella et al. (2004). Prior studies determining
auditor industry specialization used sales revenues and total assets as proxies for audit
fees (Palmrose, 1986a; Mayhew and Wilkins, 2003; Balsam et al., 2003; Neal and Riley,
2004) since actual audit fee data was not readily available publicly. Francis et al. (2005)
is the first study of industry specialist pricing in the USA to use newly mandated audit
fees disclosures beginning with 2000 fiscal-year data. While we also use mandatory
audit fees disclosures to determine specialization, it is worth noting that Francis et al.
investigate Big 5 industry expertise prior to the demise of Andersen, whereas our
study focuses on the alignment of former Andersen clients with a Big 4 industry
specialist after Andersens demise.
In our analysis we use two measures of specialization:
(1) the calculated percentage of audit fees in an industry is our continuous measure
(SPECMS_c); and
(2) SPECMS is our dichotomous measure based on an audit fee market share
specialist minimum threshold.
Based upon the methodology used by Palmrose (1986a), an audit fee market share
specialist minimum threshold is 24 percent in 2001 among the Big 5, and 30 percent in
2002 among the remaining Big 4[5]. If the audit fee market share for a firm is equal to or
greater than the minimum threshold then SPECMS equals 1, otherwise 0.
To test the hypothesis, OLS regression analysis is used to examine the association
between industry specialization and audit fees. The natural log of audit fees (LnAF) is
regressed on a set of variables that control for auditee size, profitability, complexity,
risk, client bargaining power and industry membership similar to those used in prior
studies. The audit fees OLS model is specified as follows:
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LnAF b0 b1 LnTA b2 LOSS b3 ROA b4 AR b5 NewFIN b6 TENURE

b7 LEV b8 INV b9 MERGER b10 EXDisc b11 FOREIGN
b12 SpecItems b13 AAfee b14 POWER b15 REG
b16 SPECMS or SPECMS_c 1
Variable definitions:
LnAF
Natural log of audit fees, the dependent variable.
LnTA
Natural log of total assets.
LOSS
Indicator variable equals 1 if the client reported a net loss for the year,
and 0 otherwise.
ROA
Return on assets, measured as net income divided by total assets.
AR
Accounts receivable divided by total assets.
NewFIN
Indicator variable equals 1 for clients that issued new equity greater
than $10 million and long-term debt greater than $1 million, and 0
otherwise.
TENURE
The number of years Andersen audited the company.
LEV
Leverage, measured as long-term debt divided by total assets.
INV
Inventory divided by total assets.
MERGER
Indicator variable equals 1 if the client engaged in merger activity, and

0 otherwise.
EXDisc
Indicator variable equals 1 if the client reported extraordinary items or

discontinued operations during the period, and 0 otherwise.
Foreign
Indicator variable equals 1 for foreign operations if the client reported

foreign currency adjustments, and 0 otherwise.
SpecItems
Indicator variable equals 1 if the client recognized special items, and 0

otherwise. Special items are unusual in nature or infrequent in
occurrence, but not both.
AAfee
Indicator variable equals 1 if audit client paid fees to Anderson for

audit work performed on 2002 financial statements prior to being
barred, and 0 otherwise.
POWER
Natural log of company audit fees divided by the sum of industry

audit fees for all companies in the industry audited by the companys
auditor.
REG
Indicator variable equals 1 if client is a member of the financial

services industry or utilities industry, and 0 otherwise.
SPECMS
Industry specialist indicator variable measured based on national

market share of audit fees; equals 1 if minimum threshold for
specialist is met, and 0 otherwise.
SPECMS_c Industry specialist continuous variable measured based on national

market share of audit fees.
Forced auditor
change
Error term.
Control variables expected to influence the level of audit fees (LnAF) are included in the
model for proper specification and to avoid an omitted variable problem. In the
literature, total assets have been found to explain much of the variability in audit fees
(Gist, 1994; Palmrose, 1986a; Simunic, 1980). The proxy for auditee size (LnTA) is
expected to be positively associated with LnAF. A profitable company is considered to
have less business risk and is not expected to be charged an audit risk premium.
Therefore, the reporting of a net loss (LOSS) or a negative return on assets (ROA)
suggests increased business risk and is expected to have a positive coefficient
reflecting an increasing effect on LnAF. Other factors that increase risk such as AR,
INV, and LEV are expected to be positively associated with LnAF. Prior studies tend
not to associate long audit tenure with low audit quality (Nagy, 2005), yet the unique
environment of forced auditor change from an auditor who was barred from
conducting and reporting on audits may lead to the perception of longer tenure posing
greater risk to the new auditor (Kealy et al., 2007). A positive coefficient for TENURE is
consistent with increased skepticism by the new auditor. Obtaining new financing may
lower audit risk because of the additional scrutiny of management by creditors that
occurs during the loan process. A negative coefficient for NewFIN is expected. Factors
that increase audit complexity such as SpecItems, EXDisc, Foreign, and MERGER are
expected to be positively associated with LnAF. A variable (AAfee) to control for fees
paid to Andersen for audit work completed in 2002 prior to its dismissal is included in
the model. AAfee may have a decreasing effect on year 2002 audit fees if it decreases
the amount of audit effort by the new auditor.
POWER is a continuous variable intended to capture the importance of a single
client company in an industry to its auditor. Casterella et al. (2004) argues that the
larger the audit client the greater is its economic importance to the auditor, which leads
to greater bargaining power of the audit client to attain lower audit fees. A negative
coefficient for POWER represents the ability of large audit clients to negotiate and use
their bargaining power to obtain lower fees. On the other hand, one can question how
much bargaining power Andersen clients really had to negotiate lower audit fees. Since
former Andersen clients were operating in a different environment of mandatory
auditor change where hundreds of clients needed to find a new auditor quickly to
replace Andersen, this may have reduced clients bargaining power. Nevertheless,
controlling and testing bargaining power of former Andersen clients will help to isolate
its effect from that of the auditor industry specialization variable. A positive coefficient
for POWER may indicate large audit clients inability to negotiate and use their
bargaining power to obtain lower fees. A positive coefficient for POWER could also
represent a size effect for very large audit clients.
Simunic (1980) and Palmrose (1986a) reports significantly lower audit fees in the
regulated industries of financials and utilities. We therefore use indicator variables to
measure and control the effects of regulated financial services and utilities industries
(REG) in our model. Many studies (Simunic, 1980; Palmrose, 1986a; Davidson and Gist,
1996; Carson, 2009) in the literature have captured and controlled the effects of
regulated industries on audit fees or audit effort using dummy variables.
717
MAJ
28,8
A separate regression model is run using each measure of auditor industry

specialist market share. A positive coefficient would indicate an increase in audit fees
consistent with audit quality differentiation. In contrast, a negative coefficient would
indicate a decrease in audit fees consistent with auditor production efficiency where the
audit firm passes cost savings on to the audit client.
718
IV. Data collection

Auditor identification and company characteristics of the S&P 1500 were collected
from the University of Pennsylvanias Wharton Research Database (WRDS). Of the
S&P 1500 companies, 1,406 public companies audited by the Big 5 international
accounting firms in 2001 were identified. To control for audit quality (or brand name)
only audits by the Big 5 (Big 4) firms were considered in this study (Palmrose, 1988).
We excluded 25 Andersen client companies from the sample that switched to a non-Big
5 auditor in 2002 for a total of 1,381 companies. Of the 1,381 companies, 269 (20 percent)
were audited by Andersen. To be included in the analysis, a former Andersen audit
client had to have auditor fees publicly available for both 2001 and 2002; 48 clients did
not have both years of audit fees data (most often due to mergers or bankruptcy
filings). Thus, the final sample consists of 221 former Andersen audit clients who were
absorbed by the remaining Big 4 firms in 2002. Prior to the felony conviction, Andersen
was still performing services for its audit clients. Hand collected data was obtained
from the proxy statements on audit fees received by Andersen for audit work
performed on the 2002 financial statements (AAfee) prior to being barred from
conducting and reporting on audits for SEC-registered companies. Under the SECs
(2001) proxy disclosure rule S7-13-00, registrants are required to disclose audit fees for
the most recent fiscal year.
V. Analyses and results
Descriptive statistics
Table I shows descriptive data on the distribution of the S&P 1500 in 2001 and 2002
among the international accounting firms before and after the demise of Andersen.
Panel A indicates that PricewaterhouseCoopers (PWC) enjoyed the largest share of the
S&P 1500 audit market with 362 audits or 26.2 percent of the market. Ernst & Young
(E&Y) was second with 335 audits or 24.3 percent. Andersen followed E&Y in third
place with 269 or 19.5 percent of the market. KPMG had the lowest share with 195
audits or 14.1 percent. There are no statistically significant differences in the mean and
median total assets, sales, and net income of clients among auditors.
Panel B of Table I presents descriptive data of the Big 4 after the collapse of
Andersen. While PWC had the most S&P 1500 audit clients in 2001, PWC lost that lead
by a very slight margin to E&Y in 2002. Both E&Y and PWC have 30 percent of the
market. KPMG maintained the lowest share of audit clients (18 percent) among the
S&P 1500. Analysis of variance and median tests indicate that clients average and
median total assets, sales, and net income do not differ significantly among the Big 4
after Andersens demise.
Panel C of Table I shows the distribution of the 221 former Andersen audit clients
across the remaining Big 4 accounting firms in 2002. Deloitte & Touche (D&T) gained
the most former Andersen audit clients (65 clients or 29.4 percent), and PWC gained the
fewest (40 clients or 18.1 percent). PWC gained significantly fewer Andersen clients than
Panel A: distribution of S&P 1500 audit clients in 2001a

AA
D&T
E&Y KPMG PWC
Total
Number of clients
269
220
335
195
362
1,381
Percentage of clients
20
16
24
14
26
100
Total assets ($ in millions)
Mean
7,435 14,603
7,848 16,073 10,862
10,795
Median
1,314
1,283
1,472
1,219
1,645
1,391
Sales ($ in millions)
Mean
3,963
6,750
4,386
4,844
5,888
5,139
Median
1,160
1,282
1,263
1,271
1,294
1,261
Net income ($ in millions)
Mean
153
229
2 31
289
208
154
Median
41
43
37
36
44
41
Panel B: distribution of S&P 1500 audit clients in 2002b
D&T
E&Y KPMG PWC
Total
Number of clients
294
402
249
399
1,344
22
30
18
30
100
Mean
13,831
7,329 14,253 12,520 11,575
Median
1,475
1,552
1,390
1,717
1,523
Mean
5,479
4,589
4,426
5,591
5,051
Median
1,280
1,160
1,179
1,276
1,227
Income ($ in millions)
Mean
156
174
79
182
51
Median
54
41
43
49
45
Panel C: where did they go?c
2002 size and profitability distribution of former Andersen clients
D&T
E&Y KPMG PWC
Total ANOVA F-statistic Significance
Number of clients
65
61
55
40
221
29
28
25
18
100
Mean
8,236
3,615
3,888
7,691
5,780
1.632
0.183
Median
1,887
1,424
1,390
1,031
1,390
Mean
4,504
3,267
3,488
4,392
3,889
0.477
0.698
Median
1,505
1,109
1,207
1,159
1,193
Net income ($ in millions)
Mean
116
47
2 70
392
101
2.909
0.035
Median
54
44
30
45
44
Notes: aThere are no statistically significant differences in the mean and median total assets, sales,
and net income of clients among auditors; banalysis of variance and median tests indicate that clients
average and median total assets, sales, and net income do not differ significantly among the Big 4 after
Andersens demise; cthere are no statistically significant differences in the mean and median total
assets and sales of clients among auditors; the mean net income between KPMG and PWC is
statistically different at the 0.05 level; AA Arthur Andersen, E&Y Ernst & Young, D&T
Deloitte & Touche, PWC PricewaterhouseCoopers
expected based on PWCs (large) 2001 share of the market shown in Panel A ( p 0.00,
x 2-test). In fact, PWC gained significantly less than one-quarter of Andersens clients
( p 0.09, x 2-test). It may be that because PWC had more clients in 2001 than the other
Big 4, it had less opportunity to add new clients. Panel C also shows the total assets, sales
Forced auditor
change
719
Table I.
Distribution of S&P audit
clients
MAJ
28,8
720
and net income of former Andersen audit clients partitioned by their new auditor.
Statistically, client firm size is similarly distributed across auditors. It seems though that
the most profitable audit clients selected PWC as their new auditor.
Table II provides descriptive statistics on audit fees that clients paid to Andersen in
2001 and to their new Big 4 auditors in 2002. In 2001, Andersen charged its clients an
average of $1.07 million in audit services fees (median of $.46 million). In 2002, however,
the former Andersen clients paid their new auditors an average of $582,000 more in audit
fees than was paid to Andersen in 2001. Analysis of variance test indicates that the fee
differences between years 2001 and 2002 are statistically significant at the 0.01 level.
However, the average new audit fees that former Andersen clients paid in 2002 do not
significantly differ among the Big 4 accounting firms ( p . 0.10).
The average change in audit fees for the former Andersen clients increased 54.6
percent and is significantly different from 0 ( p , 0.01). As a benchmark, the average
increase in audit fees for non-Andersen audit clients is 36.1 percent (not shown) and is
also significantly different from 0 ( p , 0.01). The former Andersen clients experienced
larger audit fees increase, on average, relative to audit clients that were not forced to
Audit fees ($ in 000s.)

2001 fees paid to Andersen
2002 fees paid to new auditors

E&Y
D&T
KPMG
PWC
Total
Table II.
Descriptive statistics of
audit fees of former
Andersen clients in 2001
and 2002
Statistical tests
Do fees differ between 2001 and 2002?
F-statistic
Significance
Do fees differ among new auditors in 2002?
F-statistic
Signficance
Mean
Median
n 221
1,065
463
Mean
Median
n 61
Mean
Median
n 65
Mean
Median
n 55
Mean
Median
n 40
Mean
Median
n 221
1,729
622
1,563
757
1,580
478
1,750
594
1,647
613
8.208
0.004
0.076
0.973
Notes: AA Arthur Andersen, E&Y Ernst & Young, D&T Deloitte & Touche, PWC
PricewaterhouseCoopers
change auditors. Further tests are warranted to determine whether the larger audit fees
represents evidence of price-gouging.
Industry specialist by auditor
Auditor market specialist by industry among the S&P 1500 companies shifted slightly
in 2002. In 2002 (2001), an auditor is identified as SPECMS if a companys auditor has
30 percent (24 percent) or more market share based on audit fees. Of the 221 Andersen
clients in 15 industries, four industries made up over half of Andersens audit clients:
46 clients in durable manufacturing, 28 clients in utilities, 20 clients in services, and 20
clients in extractive. E&Y and D&T each gained 16 of the 46 audit clients in the
durable manufacturers industry, while PWC absorbed only five and maintained its
industry specialist position. D&T absorbed 14 of the 28 utilities audit clients and
maintained its leadership position in the industry. Across the 15 industries and the Big
4 auditors, 21 industry specialists (SPECMS) were identified. Further analysis
indicates that of the 84 clients for which Andersen served as SPECMS in 2001, 52
percent were able to obtain a Big 4 industry specialist in 2002. Of the remaining 137
Andersen clients, 45 percent (61 clients) selected a new auditor who specialized in their
industry, possibly to communicate financial reporting quality. Overall, the number of
Andersen clients who had engaged an industry specialist increased from 38 percent (84
clients) in 2001 to 48 percent (105 clients) in 2002, a net increase of 10 percent
attributable to the alignment with a Big 4 industry specialist.
Correlation analysis
Table III shows positive and significant correlations for year 2001 between LnAF and
LnTA (0.80), EXDisc (0.31), TENURE (0.27), and POWER (0.45). As expected, SPECMS
and SPECMS_c are highly correlated at (0.86). In addition, positive and significant
correlations exist between LnTA and NewFIN (0.36), TENURE (0.25), LEV(0.41),
EXDisc (0.33), POWER (0.37), and REG (0.34). Positive and significant correlations for
year 2002 are similar to year 2001. The correlations do not appear to present a problem
with collinearity. This observation is confirmed by the calculated variance inflation
factors (VIFs) reported for the models. Variable definitions are given in Section III.
Regression analysis
OLS regression models for testing the hypothesis are presented in Table IV. Models in
Panel A are based on audit fees paid to Andersen in 2001, while the models in Panel B are
based on audit fees paid by former Andersen clients to new auditors in 2002. For each
year, the audit fees model is run three times. The first model is the base model without
the test variable. The second model includes the SPECMS indicator variable. In the third
model, the SPECMS_c continuous variable is substituted for the SPECMS variable. In
the 2001 OLS regressions (Panel A), the adjusted R 2 of 72.8 percent indicates the power
of the independent variables (excluding the specialist test variable) to explain the
dependent variable, LnAF, the natural log of audit fees. In 2002 (Panel B), the adjusted
R 2 indicates that the independent variables (excluding the specialist test variable)
explain 76.2 percent of audit fees. For both years, the models are significant at the 0.01
level. Also for both years, the F-tests for incremental explanatory power of the industry
specialist variables are significant at the 0.05 level. The OLS assumptions are not
violated. Since all VIFs are below 3.0, multicollinearity does not appear to be a problem.
Forced auditor
change
721
Table III.
Correlation matrix
2 0.174
0.010
0.002
0.973
2 0.079
0.240
0.364
0.000
0.253
0.000
0.411
0.000
2 0.153
0.023
0.145
0.031
0.331
0.000
2 0.010
0.880
0.038
0.576
0.367
0.000
0.343
0.000
0.211
0.002
0.241
0.000
LnTA
**
**
**
**
**
**
**
**
**
2 0.646
0.000
2 0.082
0.223
2 0.080
0.233
0.102
0.129
0.139
0.039
0.053
0.429
0.037
0.587
0.008
0.908
0.048
0.477
0.292
0.000
2 0.107
0.113
2 0.216
0.001
0.001
0.990
2 0.073
0.280
LOSS
**
**
**
0.056
0.407
2 0.047
0.487
2 0.080
0.236
**
2 0.213
0.001
0.047
0.491
2 0.058
0.393
2 0.106
0.118
2 0.060
0.373
**
2 0.271
0.000
0.110
0.104
2 0.003
0.969
2 0.070
0.302
2 0.031
0.647
ROA
2 0.075
0.270
2 0.115
0.087
**
2 0.287
0.000
0.035
0.603
2 0.037
0.589
*
2 0.166
0.013
0.050
0.463
0.013
0.843
0.064
0.343
2 0.128
0.058
0.033
0.621
2 0.037
0.589
AR
0.084
0.215
0.272
0.000
2 0.071
0.293
0.224
0.001
0.132
0.050
0.014
0.841
2 0.022
0.747
0.157
0.019
0.157
0.019
0.141
0.036
0.142
0.035
*
**
**
NewFIN
0.219
0.001
0.156
0.020
0.010
0.877
0.141
0.036
0.060
0.378
0.093
0.166
0.174
0.010
2 0.109
0.105
0.138
0.040
0.136
0.044
*
**
**
TENURE
2 0.180
0.007
0.117
0.083
0.298
0.000
2 0.119
0.078
0.023
0.729
0.039
0.566
0.278
0.000
0.221
0.001
0.241
0.000
LEV
**
**
**
**
**
0.004
0.948
2 0.129
0.055
2 0.003
0.962
0.035
0.609
0.027
0.691
**
2 0.341
0.000
2 0.094
0.166
2 0.084
0.213
INV
0.116
0.085
0.087
0.198
0.010
0.888
0.113
0.094
2 0.060
0.376
0.019
0.783
0.038
0.577
MERGER
2 0.119
0.077
0.058
0.389
*
0.164
0.015
*
0.152
0.024
0.132
0.050
*
0.137
0.042
EXDisc
0.006
0.933
0.022
0.743
**
2 0.205
0.002
2 0.093
0.166
2 0.098
0.145
FOREIGN
0.112
0.098
**
2 0.234
0.000
2 0.057
0.396
2 0.114
0.091
SpecItems
2 0.087
0.198
2 0.049
0.466
*
2 0.140
0.037
POWER
**
0.252
0.000
**
0.265
0.000
REG
722
Panel A: year 2001

LnAF
*
LnTA
0.804
0.000
LOSS
2 0.120
0.076
ROA
2 0.018
0.788
AR
0.095
0.159
*
NewFIN
0.211
0.002
*
TENURE
0.272
0.000
*
LEV
0.187
0.005
INV
2 0.017
0.806
MERGER
0.121
0.071
*
EXDisc
0.313
0.000
FOREIGN
0.102
0.129
SpecItems
0.131
0.051
*
POWER
0.446
0.000
REG
0.105
0.118
*
SPECMS
0.203
0.002
*
SPECMS_c
0.200
0.003
0.864
0.000
**
SPECMS
(continued )
MAJ
28,8
**
**
**
**
**
2 0.662
0.000
0.057
0.398
0.105
0.118
0.098
0.145
0.165
0.014
0.057
0.401
2 0.043
0.521
0.379
0.000
0.129
0.056
0.252
0.000
0.006
0.925
0.137
0.041
2 0.081
0.233
2 0.208
0.002
2 0.178
0.008
2 0.025
0.710
2 0.043
0.529
2 0.106
0.116
0.267
0.000
0.233
0.000
0.441
0.000
2 0.161
0.016
2 0.002
0.980
0.199
0.003
0.016
0.808
0.035
0.607
0.002
0.980
0.507
0.000
0.338
0.000
0.155
0.021
0.134
0.047
**
LOSS
LnTA
**
**
**
**
**
2 0.060
0.377
2 0.133
0.049
2 0.062
0.356
2 0.183
0.006
0.029
0.669
0.008
0.911
2 0.223
0.001
2 0.120
0.075
2 0.194
0.004
2 0.054
0.428
2 0.045
0.509
2 0.002
0.973
0.147
0.029
0.089
0.189
ROA
**
**
**
2 0.035
0.607
2 0.128
0.058
**
2 0.279
0.000
0.050
0.457
0.034
0.615
2 0.121
0.072
0.048
0.482
2 0.045
0.506
2 0.051
0.448
2 0.077
0.253
*
2 0.143
0.034
0.098
0.147
0.004
0.948
AR
0.033
0.629
**
0.329
0.000
*
2 0.136
0.044
2 0.045
0.503
0.105
0.119
2 0.012
0.865
2 0.105
0.119
2 0.079
0.240
*
0.141
0.036
0.129
0.055
2 0.039
0.568
0.016
0.813
NewFIN
**
0.198
0.003
*
0.163
0.016
2 0.118
0.080
0.103
0.126
0.040
0.553
0.105
0.118
2 0.064
0.345
0.111
0.101
2 0.109
0.105
0.002
0.980
0.062
0.363
TENURE
2 0.220
0.001
2 0.050
0.462
0.280
0.000
2 0.138
0.041
0.028
0.683
0.020
0.765
0.246
0.000
0.329
0.000
0.011
0.869
0.062
0.359
LEV
**
**
**
**
0.107
0.114
2 0.074
0.276
0.000
1.000
**
0.192
0.004
*
2 0.146
0.030
2 0.102
0.129
**
2 0.336
0.000
2 0.041
0.544
2 0.011
0.868
INV
2 0.018
0.786
0.108
0.108
*
0.155
0.021
2 0.039
0.566
2 0.057
0.401
2 0.076
0.263
0.102
0.130
0.081
0.229
MERGER
Note: Correlation is significant at: *0.05 and * *0.01 levels (two-tailed), first value is the correlation coefficient and the second value is significance level
Panel B: year 2002

LnAF
*
LnTA
0.823
0.000
*
LOSS
0.144
0.032
ROA
2 0.131
0.051
AR
0.026
0.704
*
NewFIN
0.179
0.008
*
TENURE
0.274
0.000
*
LEV
0.299
0.000
INV
2 0.128
0.058
MERGER
0.067
0.319
*
EXDisc
0.304
0.000
*
FOREIGN
0.145
0.031
*
SpecItems
0.138
0.040
AAfee
2 0.020
0.764
*
POWER
0.550
0.000
*
REG
0.200
0.003
*
SPECMS
0.145
0.032
SPECMS_c
0.106
0.115
2 0.025
0.716
**
0.183
0.006
2 0.015
0.829
*
0.153
0.023
*
0.147
0.029
2 0.054
0.422
2 0.048
0.474
EXDisc
0.163
0.015
2 0.053
0.433
0.039
0.568
**
2 0.232
0.001
2 0.095
0.160
2 0.020
0.770
FOREIGN
0.058
0.387
0.078
0.248
**
2 0.309
0.000
*
2 0.166
0.014
*
2 0.150
0.026
SpecItems
0.000
0.996
0.032
0.638
0.062
0.361
0.041
0.541
AAfee
0.125
0.064
2 0.127
0.059
**
2 0.203
0.002
POWER
**
0.200
0.003
**
0.207
0.002
REG
0.826
0.000
**
SPECMS
Forced auditor
change
723
Table III.
Table IV.
OLS regression
Expected sign Coeff. estimate
Sig.
VIF Coeff. estimate
Sig.
Coeff.
VIF estimate
724
t
Sig.
VIF
Panel A: year 2001 based on audit fees paid Andersen (n 221)

LnAF b0 b1 LnTA b2 LOSS b3 ROA b4 AR b5 NewFIN b6 TENURE b7 LEV b8 INV b9 MERGER b10 EXDisc
b11 FOREIGN b12 SpecItems b13 AAfee b14 POWER b15 REG b16 SPECMS (or SPECMS_c) 1
Dependent variable LnAF is based on audit fees paid to Andersen in year 2001
(Constant)
1.809
7.548 0.000
1.847
7.777 0.000
1.767
7.428 0.000
LnTA
0.589
17.266 0.000 1.9
0.583
17.257 0.000 1.9
0.578
16.976 0.000 1.9
LOSS
(0.055)
(0.394) 0.347 2.0
(0.065)
(0.469) 0.320 2.0 (0.042) (0.300) 0.382 2.0
ROA
2
(0.652)
(1.046) 0.148 1.9
(0.638)
(1.034) 0.151 1.9 (0.621) (1.007) 0.158 1.9
AR
1.176
3.266 0.001 1.1
1.058
2.943 0.002 1.2
1.118
3.132 0.001 1.1
NewFIN
2
(0.200)
(1.911) 0.029 1.2
(0.215)
(2.076) 0.020 1.2 (0.210) (2.032) 0.022 1.2
TENURE
0.009
1.088 0.139 1.2
0.006
0.763 0.223 1.2
0.006
0.774 0.220 1.2
LEV
(0.680)
(2.504) 0.007 1.6
(0.735)
(2.728) 0.003 1.6 (0.737) (2.733) 0.003 1.6
INV
0.546
1.553 0.061 1.2
0.556
1.600 0.056 1.2
0.544
1.564 0.060 1.2
MERGER
(0.012)
(0.130) 0.448 1.1
(0.013)
(0.142) 0.444 1.1 (0.018) (0.199) 0.421 1.1
EXDisc
0.228
2.488 0.007 1.2
0.217
2.397 0.009 1.2
0.218
2.403 0.009 1.2
Foreign
0.235
2.197 0.015 1.1
0.249
2.351 0.010 1.1
0.251
2.365 0.009 1.1
SpecItem
0.107
1.234 0.109 1.2
0.114
1.337 0.091 1.2
0.122
1.417 0.079 1.2
POWER
^
0.962
2.821 0.005 1.3
1.047
3.088 0.002 1.3
1.142
3.302 0.001 1.4
REG
2
(0.220)
(1.793) 0.037 1.6
(0.266)
(2.164) 0.016 1.7 (0.252) (2.061) 0.020 1.6
SPECMS
0.205
2.407 0.008 1.2
SPECMS_c
0.875
2.346 0.010 1.2
Adjusted R 2 (percent)
72.8
73.5
73.4
F-statistic
43.15
41.59
41.52
Significance
0.000
0.000
0.000
(continued)
Variable
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Expected sign Coeff. estimate
Sig.
VIF Coeff. estimate
Sig.
Coeff.
VIF estimate
t
Panel B: year 2002 based on audit fees paid to the remaining Big 4 auditors (n 221)
LnAF b0 b1 LnTA b2 LOSS b3 ROA b4 AR b5 NewFIN b6 TENURE b7 LEV b8 INV b9 MERGER
b10 EXDisc b11FOREIGN b12 SpecItems b13 AAfee b14 POWER b15REG b16SPECMS (or SPECMS_c) 1
Dependent variable LnAF is based on audit fees paid by Andersen former clients to new auditor in year 2002
(Constant)
1.722
6.87
0.00
1.778
7.129 0.00
1.660
6.624
LnTA
0.581
16.390 0.00
1.9
0.565
15.773 0.00
2.0
0.568
15.915
LOSS
0.236
1.657 0.05
2.2
0.254
1.803 0.04
2.2
0.255
1.804
ROA
2
(0.028)
(0.059) 0.48
1.9
(0.090)
(0.192) 0.42
1.9 (0.044) (0.095)
AR
1.197
3.134 0.00
1.1
1.080
2.827 0.00
1.2
1.162
3.062
New FIN
2
(0.090)
(0.943) 0.17
1.2
(0.076)
(0.801) 0.21
1.2 (0.088) (0.928)
TENURE
0.025
2.863 0.00
1.2
0.024
2.790 0.00
1.2
0.023
2.693
LEV
(0.618)
(2.201) 0.01
1.7
(0.613)
(2.203) 0.01
1.7 (0.633) (2.272)
INV
(0.531)
(1.382) 0.08
1.3
(0.550)
(1.443) 0.08
1.3 (0.580) (1.517)
MERGER
0.224
2.242 0.01
1.1
0.197
1.975 0.02
1.1
0.205
2.061
EXDisc
0.314
3.326 0.00
1.3
0.314
3.362 0.00
1.3
0.317
3.384
Foreign
0.241
2.301 0.01
1.1
0.250
2.414 0.01
1.2
0.229
2.204
SpecItem
0.081
0.857 0.20
1.3
0.102
1.083 0.14
1.3
0.098
1.041
AAfee
(0.031)
(0.321) 0.37
1.1
(0.048)
(0.510) 0.31
1.1 (0.044) (0.463)
POWER
^
1.908
4.050 0.00
1.4
2.126
4.464 0.00
1.5
2.187
4.489
REG
2
(0.014)
(0.115) 0.45
1.6
(0.049)
(0.398) 0.35
1.6 (0.055) (0.439)
SPECMS
0.209
2.262 0.01
1.2
SPECMS_c
0.635
2.034
Adjusted R 2 (percent)
76.2
76.6
76.5
F-statistic
47.90
46.13
45.85
Significance
0.000
0.000
0.000
Variable
0.0
2.0
2.2
1.9
1.1
1.2
1.2
1.7
1.3
1.1
1.3
1.2
1.3
1.1
1.5
1.6
1.2
0.04
VIF
0.00
0.00
0.04
0.46
0.00
0.18
0.00
0.01
0.07
0.02
0.00
0.01
0.15
0.32
0.00
0.33
Sig.
Forced auditor
change
725
Table IV.
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For both years in each model run, the coefficients for LnTA, AR, EXDisc, and Foreign
are positive and significant at the 0.01 levels indicating that size, risk and complexity
are positively associated with audit fees. POWER is also positive and significant at the
0.01 level in each model. Rather than observing negative coefficients, indicating the
bargaining power of large audit clients to negotiate lower audit fees consistent with the
results of Casterella et al. (2004), these findings indicate that large audit clients of
Andersen are charged a premium fee, possibly to compensate the auditor for greater
audit effort due to increased risk and complexity of the audit. Another possible
explanation for the result of the POWER variable is that former Andersen clients did
not have much bargaining power due to the forced change and the need to quickly
engage a new auditor. In 2001, but not in 2002, the coefficients for INV (proxy for risk)
and SpecItem (proxy for complexity) are consistently positive and significant as
expected at the 0.10 levels. In year 2001, but not in 2002, the coefficients for NewFIN
(proxy for increased scrutiny) and REG (regulated industries) are significantly
negative as expected in each run at the 0.05 level or better. In 2002, but not in 2001, the
coefficients for LOSS (proxy for low profitability), Merger (proxy for audit complexity)
and TENURE (proxy for professional skepticism) are consistently positive and
significant as expected at the 0.05 levels or better. The TENURE variable indicates that
audit fee premiums are associated with clients who were with the Andersen accounting
firm for many years, and is consistent with increased risk perception and a healthy
dose of professional skepticism by the new auditor (Kealy et al., 2007).
Support is provided for H1. As Table IV, Panel B shows for year 2002, former
Andersen clients who were absorbed by a Big 4 industry specialist paid an audit fees
premium. The coefficients for SPECMS (0.209) and SPECMS_c (0.635) are positive and
significant at the 0.01 and 0.05 levels, respectively. For year 2001, Panel A shows that
clients for which Andersen represented an industry specialist paid an audit fees
premium to Andersen. The coefficients for SPECMS (0.205) and SPECMS_c (0.875) are
positive and significant at the 0.01 level. These findings suggest that Andersen and the
new auditors who specialized in an industry based upon market share (of audit fees)
charged the Andersen clients an incremental fee consistent with the product
differentiation explanation. We use the procedure described by Craswell et al. (1995)
and Simon and Francis (1988) to calculate the audit fee premium[6]. On average, the
former Andersen audit clients paid a premium of 23.2 percent to their Big 4 industry
specialist auditor in 2002; this compares to a 22.8 percent premium paid to Andersen
by clients for which it represented an industry specialist in 2001.These results are
substantially unchanged when replacing the regulated industry indicator variable with
indicator variables for all industries except for one, the effect of which is embedded in
the intercept.
Additional analyses
Members of the Big 4 could exercise their dominant market power to charge former
Andersen clients uncompetitive fees (Yardley et al., 1992; AccountingWEB.com, 2002;
Wall Street Journal, 2003). As we reported previously, former Andersen clients
experienced larger audit fee increases from 2001 to 2002, on average, relative to audit
clients that were not forced to change auditors. Since regulators have expressed
concern for potential price-gouging (GAO, 2003a, 2008), we test for it following the
methodology employed by Ettredge and Greenberg (1990), which requires analyzing
the difference in deflated residuals (residual/audit fees) between 2001 and 2002 for
evidence of price-gouging and/or low-balling. Regressions are run for each year and the
residuals saved. Next, ratios are calculated by dividing the residuals derived from the
regression by its dependent variable. Then the 2001 ratios are subtracted from the 2002
ratios to calculate the change in deflated residuals. Results of parametric
(nonparametric) tests of the mean (median) values (not shown) indicate that neither
price-gouging nor low-balling were pervasive in the pricing of audits of Andersens
former clients after controlling for factors that are related to audit fees.
Next, we use a logistic model to explore the probability of factors that may
influence former Andersen clients switching to an industry specialist since auditor
expertise in an industry is an important factor affecting the positive perception of
audit effectiveness and audit quality relative to non-industry specialists (AICPA, 1998;
Owhoso et al., 2002; Balsam et al., 2003; Cenker and Nagy, 2008). We expect that
former Andersen clients are motivated to signal a perception of lower risk, high audit
quality and increased reliability of financial statements. In the logistic model, auditor
industry specialist, a dichotomous variable, is the dependent variable. This test
provides an indication of the likelihood of former Andersen audit clients switching to a
new industry specialist Big 4 auditor in 2002. The model appears to appropriately
capture variation in the dependent variable as evidenced by the inability to reject the
null of an appropriate model fit indicated by the Omnibus test of model coefficients
(results not shown). In SPSS binary logistic regression report, significance levels by
the traditional x 2 method are an alternative to the Hosmer-Lemeshow x 2-test
goodness-of-fit. The pseudo R 2 is 27.6 percent for the logistic regression. Results
indicate that large audit clients who had long auditor tenure with Andersen and high
leverage were more likely to switch to an industry specialist. This finding is not
inconsistent with a management risk perspective in which former Andersen clients
likely want to signal to the market their financial reporting quality because of their
long tenure with an auditor who had been barred from performing audits, and because
of higher than normal business risk.
Since our sample consists of very large companies as a design feature controlling
extraneous size effects, additional tests are performed to determine whether company
size still could be driving the results as suggested by prior studies (Huang et al., 2007;
Hay and Jeter, 2011): for example, Hay and Jeter (2011) state that the specialist
premium applies most consistently to larger client companies; and Carcello and Nagy
(2004) find a positive and significant interaction between industry specialization and
client size. Although client size (LnTA) and bargaining power (POWER) are controlled
in our model, an additional size variable (MedTA) is included to ascertain whether
there is any change in coefficient of our specialization test variable. MedTA equals 1 if
total assets is above its median, and 0 otherwise. When the regressions in Table IV are
rerun with MedTA included, MedTA is significant ( p 0.01) and the industry
specialization variables continue to be positive and significant at the 0.05 level or
better. Similarly, another additional size measure, MedPOWER, is included in the
original regressions. MedPOWER equals 1 if POWER is above its median, and 0
otherwise. When MedPOWER is tested, the findings on the specialization test variables
remain unchanged. Hence, our findings are robust to the inclusion of additional
alternative measures of company size in the regression models, suggesting that size is
not driving our results as in prior research studies.
Forced auditor
change
727
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728
We further explore the industry specialization variable by partitioning it into two

indicator variables:
.
first variable indicates industry specialist in 2002 that was also considered an
industry specialist in 2001 (n 44); and
.
second variable indicates industry specialist in 2002 that was not considered an
industry specialist in 2001 (n 61).
The adjusted R 2 increased slightly to 77.4 percent from 76.6 percent, and only the first
indicator variable is positive and significant (at the 0.01 level). This finding suggests
that auditors who became industry specialist because of the new Andersen clients in
their portfolio did not charge a specialist premium to former Andersen clients. Perhaps
as knowledge and experience is acquired from serving these new clients an audit fees
premium may be charged.
Finally, we ran a change regression to ascertain whether a forced change is
associated with a significant fee premium for clients with specialist auditors. The
adjusted R 2 is 54 percent, and the auditor industry specialization variable is not
significant. When the specialization variable is partitioned into two indicator variables
as discussed above, neither indicator variable is significant. This finding suggests that
the forced change is not driving the result on the auditor specialization variable in the
level regressions. Further, while we test for and find a significant increase in audit fees
(after controlling for other factors) from 2001 to 2002, there is no evidence of
price-gouging as previously reported in this section.
VI. Conclusion, contribution, and implications
This study explores the effect of industry specialization and competitive pricing (or
lack thereof) of audits of the S&P 1500 former Andersen clients who switched to one of
the remaining Big 4 auditors in 2002. The collapse of Andersen increased audit market
concentration significantly in the large client segment and induced an abrupt forced
auditor change for hundreds of audit clients at one time, allowing us the opportunity
to examine the effect of auditor specialization on audit fees in this unique
environment and its implications for mandatory auditor rotation. Because prior auditor
specialization studies report size effects, we limit our study to the largest of
Arthur Andersens former clients to provide more control over size, by design, and to
reduce or eliminate possible confounding effects between any premiums resulting from
industry specialization and those that may arise from a companys potential
bargaining power to obtain lower audit fees. We argue that given the size, resources,
and national/international presence of the S&P 1500, that these companies are more
likely concerned with the firm-wide and international reputation of their auditors as
oppose to the auditors local-office reputation. A basis for this study is that we believe,
given the tarnished reputation of Andersen, its large former clients:
.
wanted to send a positive signal about the quality of their financial reporting;
and
.
would likely have done so by engaging a Big 4 industry specialist.
We also believe that a more likely competitive response by a Big 4 network firm would
be to increase audit fees (rather than discount them) to better reflect the value of the
audit and earn an appropriate return on the investment in specialization. Consequently,

we examine if there is a positive association between national industry specialization
and audit fees charged to former Andersens largest clients.
As hypothesized, we find that the association between audit fees and auditor
industry specialization is positive and significant at the 0.05 level or better, which
supports the product differentiation explanation. Our finding is consistent with the
Francis et al. (2005) model, which considers national-only industry leaders. On average,
the former Andersen audit clients paid a premium of 23.2 percent to their Big 4
industry specialist auditor in 2002; this compares to a 22.8 percent premium paid to
Andersen by clients for whom it represented an industry specialist in 2001.
This study makes a contribution to the literature beyond Francis et al. (2005) by
focusing on the alignment of former Andersen clients with a Big 4 industry specialist
(in a forced auditor change) after the demise of Andersen. In contrast, Francis et al.
investigate Big 5 industry expertise prior to Andersens demise. While both this study
and Francis et al. (2005) use the newly required mandatory audit fees disclosures, we
focus our study on large S&P 1500 clients, and are able to avoid size effect issues
reported by Francis et al. and other prior studies because the premium for industry
leadership is driven by the upper half of company size.
This study contributes to the literature beyond the primary finding as it relates to
client bargaining power, price-gouging, and the likely characteristics of companies
influencing the choice of an auditor industry specialist. When testing the auditor
industry specialization hypothesis, we include a POWER variable in the model as a
proxy for client bargaining power to attain lower audit fees, similar to Casterella et al.
(2004). We find that the POWER variable is positive and significant ( p , 0.01),
suggesting that POWER represents a size effect of the large and complex former
Andersen audit clients. Further, results of the POWER variable remained unchanged
when conducting additional analyses. Contrary to Casterella et al. (2004), our
explanation is that large former Andersen clients did not have much bargaining power
due to the forced change and the need to quickly engage a new auditor. This may have
implications for mandatory auditor rotation (discussed below), whereby large
companies would likely lose their ability to bargain for lower audit fees.
Additionally, given the significant increase in audit market concentration for large
public companies along with involuntary auditor switching, regulators have expressed
concern about potential price-gouging (GAO, 2003a, 2008). We test for excessive
pricing (and low-balling) using a method employed by Ettredge and Greenberg (1990),
but could not find any evidence of price-gouging by the Big 4 as had been feared by
regulators after the demise of Anderson. It is difficult to extend pricing implications if
one or more of the international accounting firms is abruptly barred from providing
audit services to their clients because the accounting profession will be faced with a
host of complex problems (including lost investor confidence) along with an increase in
audit market concentration and the possibility of excessive pricing.
Finally, our study provides further evidence of how companies perceive the
importance of having the financial statements audited by an industry specialist in order
to signal quality financial reporting to the market. First, we analyzed the companies
that had a specialist (non-specialist) in 2001 and retained a specialist in 2002. The data
indicates that the tarnished audit quality reputation of Andersen resulted in a net 10
percent increase in the number of Andersens former clients who obtained an industry
Forced auditor
change
729
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730
specialist in 2002 (over 2001). Second, we employed a logistic model using an auditor
industry specialist dichotomous variable as the dependent variable to determine
company characteristics that are more likely to influence the engagement of an
industry specialist among the large former Andersen clients. We find that former
Andersen clients with the characteristics of long tenure and high business risk were
more likely to switch to an industry audit specialist. Supporting the basic premise of
our study, this finding implies that companies align with a specialist for the major
benefit of signaling financial reporting and audit quality to the market. Our study is
also consistent with a GAO (2003a) survey which indicated that 81 percent of
respondents cited industry specialization or expertise as an important factor in
choosing a new auditor.
Implications of this research are that mandatory audit firm rotation (which is
currently being debated in the profession) or involuntary change of auditors will have a
costly effect on the pricing of audit services for those companies that use a Big 4
network firm. The GAO (2003b) report states that most public companies will only use
the Big 4 firms for audit services. Given this preference, these public companies may
only have one or two real choices for an auditor of record under any mandatory
rotation system given the importance of industry expertise and the Sarbanes-Oxley
Acts auditor independence requirements. Under the Sarbanes-Oxley Acts auditor
independence requirements, audit firms are prohibited from providing both audit and
non-audit services to the same client. With the limited choices for an auditor of record
among the Big 4, involuntary auditor changes for those firms wanting an auditor that
specializes in their industry will more than likely incur additional cost in the form of
higher audit fees.
The sample only includes relatively large companies, which may limit the ability to
generalize the findings to smaller companies.
Notes
1. The Herfindahl-Hirschman Index measures the relative concentration of market power held
by the largest firms in an industry and represents the degree to which the industry is
oligopolistic.
2. For a general discussion of network synergies, please refer to studies by Katz and Shapiro
(1985) and Bental and Spiegel (1995) about scope and size of relevant (appropriate) networks,
network externalities, and the quality of a network product.
3. Methodologies used to identify firms as industry audit specialists lack consistency and are
thus difficult to compare and evaluate findings (Neal and Riley, 2004).
4. Industry membership is determined by SIC code as follows: mining and construction
(1000-1999, excluding 1300-1399), food (2000-2111), textiles and printing/publishing
(2200-2799), chemicals (2800-2824 and 2840-2899), biotechnology/pharmaceuticals
(2830-2836 and 8731-8734), extractive (1300-1399 and 2900-2999), durable manufacturers
(3000-3999, excluding 3570-3579 and 3670-3674), computers (3570-3579 and 7370-7379),
transportation (4000-4899), retail-wholesale (5000-5999, excluding 5200-5961), services
(7000-8999, excluding 7370-7379), financial services (6021-6798), utilities electric and gas
(4900-4940), retail-other (5200-5961), and other (000-0999, 9000-9999).
5. The specialist cutoff is based on studies by Palmrose (1986a) and Neal and Riley (2004).
When the audit market consisted of the Big 8, each firm without specialization holds an
equal market share of 12.5 percent. Palmrose (1986a) specified an auditor as a specialist if the
market share was 20 percent or greater above this, thereby specifying the specialist cutoff at
15 percent (0.125 1.2 0.15). Using this same methodology, the calculated specialist cutoff
is 24 percent (30 percent) when the industry consisted of the Big 5 (Big 4) auditors.
Forced auditor
change
6. The procedure described by Craswell et al. (1995) and Simon and Francis (1988) is used to
calculate the audit fee premium. The percentage shift in audit fees in the fitted regression
model is estimated to infer the magnitude of change in audit price attributable to industry
specialization. Therefore, in addition to the statistical tests of parameter b15 to determine
whether there is a significant intercept shift, the magnitude of the intercept shift is
calculated. The shift in the intercept term affects audit fees in the fitted model in the
following manner.
731
exz 2 ex
ex
where, ex audit fees of clients without an industry specialist auditor; e(x z) audit fees
of clients with an industry specialist auditor, where z is the upward shift in the intercept term
due to the SPECMS variable. The above equation simplifies to ez 2 1, which is solved using
the mean parameter value (z) of the SPECMS variable in the fitted regression model. This
expresses the mean shift in industry specialist audit fees as a percentage of non-industry
specialist audit fees.
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Corresponding author
Winifred D. Scott can be contacted at: wpooh06@cox.net
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Managerial Auditing Journal

Forced auditor change, industry specialization and audit fees

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About Emerald www.emeraldinsight.com

Forced auditor change, industry

College of Business, Zayed University, Dubai, United Arab Emirates, and

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School of Accountancy, College of Business, Ohio University,

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The purpose of this study is to explore the effects of industry specialization on

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sample would fixate on local-office rather than national/international expertise of its

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LnAF b0 b1 LnTA b2 LOSS b3 ROA b4 AR b5 NewFIN b6 TENURE

Natural log of audit fees, the dependent variable.

Natural log of total assets.

Return on assets, measured as net income divided by total assets.

Accounts receivable divided by total assets.

The number of years Andersen audited the company.

Leverage, measured as long-term debt divided by total assets.

Inventory divided by total assets.

Indicator variable equals 1 if the client engaged in merger activity, and

Indicator variable equals 1 if the client reported extraordinary items or

Indicator variable equals 1 for foreign operations if the client reported

Indicator variable equals 1 if the client recognized special items, and 0

Indicator variable equals 1 if audit client paid fees to Anderson for

Natural log of company audit fees divided by the sum of industry

Indicator variable equals 1 if client is a member of the financial

Industry specialist indicator variable measured based on national

SPECMS_c Industry specialist continuous variable measured based on national

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A separate regression model is run using each measure of auditor industry

IV. Data collection

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Panel A: distribution of S&P 1500 audit clients in 2001a

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Audit fees ($ in 000s.)

2002 fees paid to new auditors

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Panel A: year 2001

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Panel B: year 2002

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VIF Coeff. estimate

Panel A: year 2001 based on audit fees paid Andersen (n 221)

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Expected sign Coeff. estimate

VIF Coeff. estimate

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We further explore the industry specialization variable by partitioning it into two

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audit and earn an appropriate return on the investment in specialization. Consequently,