This study addresses whether an auditor change (a resignation or a dismissal) mitigates information asymmetry as measured by market liquidity or trading activity. For auditor dismissals our results show no effect on our sample firms' market liquidity or trading activity. By contrast, for auditor resignation firms, the market liquidity tests indicate that the 12 month period preceding the 8K filing is characterized by rising information asymmetry. Also, our trading activity analysis suggests that the 8K auditor resignation filing is informative for individual investors but fails to support such informativeness for institutional investors. Our findings lend support for the SEC's decision to differentiate between auditor resignations and dismissals in the 8K. However, the resignation announcement does not appear to decrease information asymmetry subsequent to the 8K filing, which is inconsistent with the presumed SEC objective of maintaining public confidence in the securities markets as a level playing field by mitigating information asymmetry.
This paper is motivated by the question, does the additional disclosure about
whether an auditor change is a resignation or a dismissal mitigate information
asymmetry? Over the years, the Securities and Exchange Commission (SEC)
has sought to discourage "opinion shopping" by requiring firms to publicly
disclose an auditor change in their Form 8K filings
. However, it was only in
1988 that disclosure of whether the auditor resigned or was dismissed was made
mandatory
.
Although prior research indicates a differential stock price response to auditor
resignation versus dismissal announcements, thus suggesting the usefulness of
distinguishing between the two in the 8K filings, usefulness is a necessary but
not a sufficient condition for mandatory disclosure (Lev, 1988)
. Rather, SEC
disclosure regulation is motivated primarily by its mandate to protect the
investing public and maintain public confidence in the securities markets as a
level playing field by mitigating information asymmetry (Lev, 1988
; Levitt,
1998
; Shefrin & Statman, 1992)
.
Information asymmetry implies an information gap between some (informed)
investors and others based on private information search, i
.e
. the ability of
informed investors to obtain information that is not publicly available or to
extract private information from publicly available data
. Differential access to
information allows informed investors to increase their wealth at the expense
of uninformed investors and is perceived by the U
.S
. Congress and the SEC to
be unfair (Beaver, 1998)
. As a practical matter, unequal access to information
can have adverse social consequences in the form of reduced liquidity (higher
transaction costs and thinner markets) as market makers respond defensively to
a perceived increase in information asymmetry (Lev, 1988)
.
An auditor resignation, unlike a dismissal, is likely to be auditor (rather than
client) initiated
. Business Week (1993) and MacDonald (1997) indicate that
resignations are related to unfavorable events within the client firm and may
be triggered by one or more of the following
: the auditor suspects management
fraud (or otherwise distrusts client management), the client has weak internal
controls, or the client's financial health is deteriorating
. Potentially, a resigna-
tion is indicative of future investor losses that might be realized as and when
the full extent of the client's problems (such as fraudulent financial statements
or financial distress) are eventually revealed
.
Consistent with the notion that lawsuits against auditors are almost always trig-
gered by investor losses (Lys & Watts, 1994), DeFond et al
. (1997) and Krishnan
and Krishnan (1997) suggest that auditor resignations are motivated by the desire
to avoid costly litigation and may be triggered by negative private information(obtained during the course of an audit) indicating a deterioration in the client's
risk characteristics
. Since a resignation indicates an increased probability that the
client has a hidden risk, Bockus and Gigler (1998) predict analytically a decline
in the client's stock price following an auditor resignation
.
Krishnan and Krishnan (1997) indicate that auditor resignation firms are more
susceptible to events that trigger litigation than firms which dismiss their
auditors
. Their findings suggest that sophisticated investors may be able to
use litigation prediction models to anticipate auditor resignations
. Potentially,
the time period leading up to the 8K auditor resignation filing is likely to
be characterized by increasing information asymmetry between informed
and uninformed investors
. As noted previously, the increase in information
asymmetry can be expected to have an observable effect in terms of reduced
market liquidity
.
Further, as pointed out by Hakansson (1981), it takes resources to acquire
private information
. Potentially, institutional investors are likely to possess the
necessary resources to acquire private pre-disclosure information and are there-
fore less likely to be dependent on SEC mandated disclosures
. By contrast,
individual investors are much more likely to be dependent on SEC mandated
disclosures
. Hence, relative to their institutional counterparts, individual
investors (because of their greater dependence on SEC mandated disclosure)
can be expected to display heightened trading activity at the time of the 8K
auditor resignation filing
.
In this study, we utilize intraday stock transactions data to examine whether
the auditor resignation/dismissal announcement has differential effects on
market liquidity (as measured by the effective spread, the adverse selection
component of the spread, and quoted depth) over a time frame beginning 12
months before and ending 2 months after the announcement
. In addition, we
utilize the methodology described in Cready and Mynatt (1991) to examine the
trading response surrounding the time of the 8K filing to identify the type of
investor responding to the resignation/dismissal announcement
. Our sample
consists of all auditor change firms during 1995 and 1996
.
Consistent with the notion that auditor resignations may be anticipated by
informed investors (Krishnan & Krishnan, 1997), our results suggest decreasing
market liquidity (increasing information asymmetry) for the resignation firms
during the 12 months preceding the 8K filing
. Although the public announce-
ment of the auditor resignation appears to halt the trend towards lower liquidity,
it does
not
improve liquidity
. Also, the trading-based analysis suggests a strong
response surrounding the disclosure of an auditor resignation but little
or no response surrounding a dismissal
. Our analysis indicates that this
trading response occurs largely within lower size transactions, suggesting thatindividual investors rely on the 8K resignation announcement while institutional
investors rely more on private pre-disclosure information
.
In the next section, we review prior research on auditor changes
. Subsequent
sections discuss our sample and data, the research methodology and design, and
the empirical findings
. The final section contains our concluding remarks
The prior literature
(e
.g
.
Lev, 1988
; Levitt, 1998
; Shefrin & Statman, 1992)
suggests that SEC disclosure regulations are motivated primarily by its mandate
to protect investors and to preserve public confidence in the capital markets as
a level playing field by reducing information asymmetry between informed
investors and others
. Information asymmetry can have deleterious effects on
market liquidity as measured by bid-ask spreads and quoted depths . Although
the SEC has long required that auditor changes be made public in the Form
8K, mandatory disclosure of whether the auditor resigned or was dismissed is
relatively recent
. In this paper, we examined the differential effects on market
liquidity and trading activity (across different investor groups) associated with
auditor resignations and dismissals
. Since our analysis was based on a limited
sample of 22 resignation observations and 118 dismissal observations, the results
must be interpreted with caution
.
In our analysis, we could not reject the null hypothesis that auditor dismissals
have no effect in terms of either market liquidity or trading activity
. These find-
ings are consistent with prior research (using alternative methodologies) which
indicate that the 8K auditor dismissal filing is
not a
significant information
event
. By contrast, for auditor resignations, our results suggest that the 12 month
period preceding the 8K resignation filing is characterized by rising informa-
tion asymmetry
. Also, the results suggest that the resignation announcement is
a significant information event for individual investors (as indicated by the
abnormal increase in trading activity subsequent to the 8K filing for lower size
transactions)
. However, we were unable to reject the null that the resignation
announcement is not an information event for institutional investors
. These find-
ings are consistent with the notion that informed investors may be able to
anticipate auditor resignations based on publicly known litigation risk factors
as discussed by Krishnan and Krishnan (1997)
."
From a policy perspective, the overall results suggest that the SEC's deci-
sion to differentiate between auditor resignations and dismissals in the 8K is
informative for individual investors
. However, in our analysis, we could not
reject the null that the resignation announcement has no effect on information
asymmetry subsequent to the 8K filing
. Institutional investors may have some
knowledge of the circumstances motivating the resignation (based on their
ability to acquire private pre-disclosure information)
. By contrast, individual
investors are informed of the auditor resignation by the 8K but not of the reasons
underlying the resignation . Current SEC disclosure standards do not require the
client to disclose the reasons for the resignation and professional standards
prohibit the auditor from disclosing the private information (acquired duringthe audit) that may have triggered the resignation
. Possibly for these reasons,
the 8K filing appears to halt the trend towards increasing information asym-
metry during the 12 months preceding the resignation announcement, but does
not actually reduce information asymmetry subsequent to the filing.