Investors should be wary of companies that dismiss their auditors as the fiscal year draws to a close, according to a new study by University of Notre Dame and Ohio University researchers.
In compiling Auditor Dismissals: Opaque Disclosures and the Light of Timing, Jeffrey Burks (pictured), Viola D Hank and Jennifer Sustersic Stevens of Ohio University found that auditor dismissal after the end of the second fiscal quarter signalled financial statement errors and material weaknesses in internal control. Furthermore, the risks of errors double and material control weakness quadruple over the next two years.
"Our findings suggest that dismissals occurring after the second fiscal quarter are symptomatic of companies that have something to hide," Burks says. "Common sense would probably lead investors to be suspicious of extremely late dismissals, such as those that happen when auditors are deep into their year-end fieldwork. But we find that investors should apply a similar level of suspicion to dismissals occurring any time after the second quarter. This stands to reason. Companies initially decide whether to rehire last year's auditor in the first or second quarter, shortly after filing the previous year's financial statements. This is also the most common time of year to dismiss an auditor. A dismissal occurring later on usually would mean that the company is changing its mind about the first auditor it chose for the year, which is suspicious."
The authors urged investors to interrogate the reasons behind auditor dismissal thoroughly.
"Companies seldom admit that disagreements or negative audit findings surround the dismissal, despite SEC regulations that attempt to force transparency," Burks says. "What companies say about the dismissals has little predictive power for restatements and material weaknesses after controlling for dismissal timing and other factors. When trying to make sense of auditor dismissals, it's best to focus less on what companies say and more on when they say it."
