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restatement and internal control risks; these variables have become important in the post-SOX era. The importance of risk mitigation by Big N firms (prior to the demise of Arthur Andersen there were more than four so-called Big firms) is a theme found in earlier papers such as Krishnan and Krishnan (1997). A good example of this literature stream is Shu (2000), which finds that auditor resignations are related to increases in clients litigation risk (captured in variables such as inventory, receivables, size, stock volatility and whether the firm is a technological firm, delisted firm and received a qualified opinion). Shu confirms these results by using an event study method: stock returns are negative for resignations and related to changes in litigation risk. Shu also finds that resignations are motivated by auditor-client fit issues: fit is determined by relating the probability of being audited by a big auditor to firm characteristics such as size, acquisitions and new financing. A key result from Shu (2000) that is relevant to our study is the finding that discontinued firms switch to smaller auditors; furthermore, the greater the increase in litigation risk, the greater the tendency to switch to a smaller auditing firm. Shu (2000) explains that smaller auditors do not risk as much reputational capital as larger auditors and also do not have deep pockets that attract litigation. The phenomenon of client switches from Big N firms to smaller auditors was thus established even prior to Arthur Andersen and SOX. This implies that while SOX might have accelerated downward

switches, the long-term post-SOX equilibrium might be characterized by a secular trend of downward switching albeit at a lower rate. A recent study by Landsman, Nelson and Rountree (2009) compares auditor switches (from Big N firms) in the pre- and post-Enron eras. Since the post-Enron era is characterized by clients of Arthur Andersen seeking other (usually Big N) auditors, the resulting capacity constraint is hypothesized to change the sensitivity between switches and the twin influencing factors of client risk (financial risk, audit risk and auditor business risk variables) and client misalignment (size, acquisitions, new financing and so on). Specifically, with the new pool of potential clients following the Enron scandal, Big N firms are perceived to look more closely at their current portfolios and prune out certain clients not aligned with their needs. This is the insufficient capacity hypothesis. In an analysis of client switches from Big N to other auditors, Landsman et al. (2009) show an increase in sensitivity to client misalignment but a decrease in sensitivity to client risk. These results largely support the insufficient capacity hypothesis.

Restatements in the post-SOX era

We now turn to a recently acknowledged measure of audit risk: restatements. To emphasize the prevalence and importance of restatements in the post-SOX era we provide a simple count of restatements from the Audit Analytics restatements dataset. According to Figure 1, the number of restatements peaked during 20052007 and is

Figure 1: Number of unique firm restatements by year for Second Tier clients versus non-Second Tier clients. Note: This figure represents the number of unique firm restatements by year for all Second Tier clients versus non-Second Tier clients. Data source is Audit Analytics.
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double the number during 20022004. This is a well-known fact and has been reported in academic papers as well as in industry commentary. The high frequency of restatements triggered a number of research studies inquiring into its causes and consequences. Interestingly, much of the restatements literature focuses on its consequences rather than its causes. An exception is Plumlee and Yohn (2010), who analyze corporate disclosures and outside news sources related to restatements to ascertain the causes attributed to restatements. A key finding is that a majority of restatements during 20032006 are attributable to internal company errors. The authors state that this finding is consistent with the position that internal reviews related to SOX are working. This finding and conclusion appear to support the notion that restatements and ICW flagged by various SOX sections are connected, as confirmed by our own tests which are reported later in this paper. A large number of studies report on various consequences of restatements. The basic conclusion from this literature is that restatements matter and that they often have adverse consequences for investors, managers, and directors. Specific findings include: stock prices react negatively to announcements of restatements (Palmrose, Richardson & Scholz, 2004); labor markets impose penalties on directors (Srinivasan, 2005), and managers (Desai, Hogan & Wilkins, 2006). A

particularly interesting stream of research, one relevant to our work, connects restatements with information asymmetry as well as information risk. For example, Kravet and Shevlin (2010) find that a restatement announcement increases the factor loading on the discretionary information risk factor and thus increases the cost of capital for a firm. Thus restatements coincide with reporting weakness and have adverse consequences for firms and their stakeholders; this, in turn, supports the proposition that restatements increase client risk for auditors. This connection between restatements and risk for auditors is also supported by studies linking restatements with auditor change, but much of this evidence is preliminary.9

Internal control weaknesses in the post-SOX era

We now turn to our next audit risk variable: ICW. Disclosures of ICW increased dramatically in the post-SOX era (see Figure 2). Although SOX has two important sections pertaining to internal controls, 302 and 404, it does not elaborate on the meaning of internal controls. The prior literature on internal controls (e.g., Zhang, Zhou & Zhou, 2007) refers to the following definition provided by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission in their report published in 1992 titled Internal Control Integrated Framework: it is a process, effected by

Figure 2: Number of internal control weaknesses (Section 404) by year for Second Tier clients versus non-Second Tier clients. Note: This figure represents the number of internal control weaknesses, specifically SOX Section 404, by year for all Second Tier clients versus non-Second Tier clients. Data source is Audit Analytics.
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do, however, recognize the potentially reduced relevance of the ICW variable (especially the one related to Section 404) in tests of hypothesis 2. This is because of the higher likelihood that clients switching from the Second Tier to smaller auditing firms are small firms. As explained earlier, firms with a market capitalization of less than $75 million are deemed non-accelerated filers and are yet to be required to comply with Section 404b. Therefore, even though our test variable does not distinguish between 404a (management report) and 404b (auditor report) because of the manner in which the data is reported in Audit Analytics, it might offer explanatory power concerning switches from the Second Tier to smaller auditing firms. While the first two hypotheses are our main ones, we conduct further examination of new clients versus continuing clients by examining resignation and dismissal firms separately. This hypothesis is stated and explained below. Hypothesis 3: Resignation firms (firms whose previous auditors resigned) will indicate a higher sensitivity to auditing risks as measured by the prevalence and severity of restatements and ICW compared to continuing firms of the Second Tier; in contrast, dismissal firms (firms who dismissed their previous auditors) will not show this higher sensitivity. The process by which firms change auditors is complex and it is usually difficult to definitively state whether a certain change is initiated by the client firm or by its auditor. Nevertheless,

information is available in the Audit Analytics database that allows us to categorize changes into resignations and dismissals. The former is more likely to represent action initiated by auditing firms and the latter is more likely to represent action by client firms. Accordingly, the link between client switches and auditing risk variables (restatements and ICW) is likely to be more pronounced in the resignation sample compared to the dismissals sample.13 This analysis, of course, is constrained by the accuracy of Audit Analytics in categorizing resignations and dismissals, and, as such, the evidence could be considered tentative.

3. SAMPLE AND VARIABLES

We obtain our sample for the period 20042008 by using the following steps. We use the Audit Analytics Audit Opinions database to identify all firms audited by Second Tier auditors (Grant Thornton, BDO, McGladrey, and Crowe). We then obtain relevant audit-related data from the following Audit Analytics databases: Auditor Change, Disclosure Control, Internal Controls and Restatements. We then obtained financial data from Compustat. Our final sample is made up of firms with non-missing data. Table 1 provides the number of clients serviced by the Second Tier firms each year during 20042008. For each year, the table provides the number of new clients in the current year (A), those continuing from the previous year

Table 1: New, continuing, and departing clients for Second Tier audit firms 2004 New in current year Continuing from prior year Total during current year Departing before next year Continuing to next year 607 100% 110 18% 497 82% 2005 131 21% 497 79% 628 100% 114 18% 514 82% 2006 96 16% 514 84% 610 100% 104 17% 506 83% 2007 105 17% 506 83% 611 100% 92 15% 519 85% 2008 94 15% 519 85% 613 Total 426 17% 2036 83% 2,456/2,462 100% 420 17% 2,036 83%

Note: New, continuing, and departing clients are determined using Compustat and Audit Analytics data, as described in the text, and include only publicly traded client firms. New clients are defined as firms previously audited by a non-Second Tier auditor and audited during the current year by a Second Tier auditor. Continuing clients are defined as those continuing with a Second Tier auditor from the prior year. Departing clients are defined as those departing before the next fiscal year-end to a non-Second Tier auditor. Second Tier audit firms include BDO Seidman; Crowe Horwath; Grant Thornton; and McGladrey & Pullen.
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Table 2: Further analysis of new and departing clients Panel A: Sources of new clients 2005 Count Big 4 Small firms Unknown Total 106 14 11 131 % 81% 11% 8% 100% 56 16 24 96 2006 Count % 58% 17% 25% 100% 53 38 14 105 2007 Count % 50% 36% 13% 100% 41 30 23 94 2008 Count % 44% 32% 24% 100% 256 98 72 426 Total Count % 60% 23% 17% 100%

Panel B: Destinations of departing clients 2004 Count Big 4 Small firms Bankruptcy M&A Deregistered Unknown Total 7 47 1 13 38 4 110 % 6% 43% 1% 12% 35% 4% 100% 7 44 0 19 36 8 114 2005 Count % 6% 39% 0% 9% 32% 14% 100% 16 46 5 6 27 4 104 2006 Count % 15% 44% 5% 6% 26% 4% 100% 10 23 3 5 47 4 92 2007 Count % 11% 25% 3% 5% 51% 4% 100% 40 160 9 43 148 20 420 Total Count % 10% 38% 2% 10% 35% 5% 100%

Note: This table categorizes new and departing clients. New unknown clients include recently registered firms. For a description of the sample, see Table 1.

(Bt-1), total clients during the current year (C = A + Bt-1 = D + Bt), those departing before next year (D) and clients continuing to next year (Bt). Since our data start from 2004, items A and Bt-1 are missing for 2004. Although the turnover rate is around 20 percent, overall, the number of clients appears to be stable at around 600 firms. Roughly 20 percent of the overall client base departs each year and a similar number of new clients are acquired. Our main tests involve the comparison of new clients with those continuing from the previous year (that is, we compare A with Bt-1) and departing clients with those continuing to the next (D with Bt). Table 2 provides further information about new and departing clients and allows an understanding of long-term trends. Specifically, we provide evidence on whether the new clients are from Big 4 or Small firms (small auditing firms) or other sources. Similarly we provide evidence on whether departing clients go to Big 4 or Small firms, or depart for other reasons. Table 2 Panel A shows the source of new clients. Note that the biggest source of new clients for the Second Tier firms is the Big 4 (256 firms, or 60 percent). However, there is steady tapering off of clients from the Big 4. While there were 106 new clients from the Big 4 in 2005, there
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were only 41 in 2008. This is consistent with a settling down of the effects of SOX and Andersen. Table 2 Panel B shows information concerning departing clients. In addition to client departures to the Big 4 and Small firms, departures may also be induced by bankruptcy, mergers and acquisitions (M&A) or deregistration. The two biggest categories are departures to Small firms and departures because of deregistration; these account for almost three-quarters of all departures. Our result confirms the post-SOX pattern of deregistration (e.g., Leuz, Triantis & Wang, 2008). A total of 148 firms (35 percent of departing clients) deregistered during the sample period. We also note that the post-SOX deregistration movement appears to have peaked in 2007 (51 percent). Other than deregistration, departure of clients to Small firms is a major category (160 firms, or 38 percent). For this sample of Second Tier clients (organized by client years), we obtain various risk/ characteristic variables. Following the prior literature, we obtain six traditional risk variables as follows: Assets: total assets in millions (Data6) Leverage: ratio of total liabilities to total assets (Data181/Data6) ROA: return on assets (Data18/Data6)
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Table 3: New versus continuing clients

Variables Continuing clients Mean (median) Assets Leverage ROA Loss ARInv DSales ICW_302[0] ICW_302[-1] ICW_404[0] ICW_404[-1] ICW_404COMP[-1] RST_Exante[0] RST_Exante[-1] RST_Exante_CoreErn[-1] RST_Exante_Neg[-1] RST_Expost[0] RST_Expost[-1] RST_Expost_CoreErn[-1] RST_Expost_Neg[-1] N 308.74 (86.08) 0.67 (0.44) -0.17 (0.01) 0.46 (0.00) 0.30 (0.27) 32.60 (8.31) 0.29 (0.00) 0.30 (0.00) 0.06 (0.00) 0.07 (0.00) 0.02 (0.00) 0.06 (0.00) 0.11 (0.00) 0.05 (0.00) 0.06 (0.00) 0.07 (0.00) 0.13 (0.00) 0.05 (0.00) 0.07 (0.00) 2036 All new clients Mean (median) 414.20** (136.49)*** 0.55 (0.49)* -0.10 (0.00) 0.48 (0.00) 0.29 (0.24) 40.31 (11.42)** 0.33 (0.00) 0.26 (0.00) 0.10*** (0.00)*** 0.17*** (0.00)*** 0.05*** (0.00)*** 0.06 (0.00) 0.18*** (0.00)*** 0.09*** (0.00)*** 0.13*** (0.00)*** 0.09* (0.00)* 0.17** (0.00)** 0.09*** (0.00)*** 0.13*** (0.00)*** 426 New from Big 4 Mean (median) 379.96 (143.96)*** 0.52 (0.46) -0.07 (0.01) 0.44 (0.00) 0.28 (0.23) 12.45 (7.16) 0.39*** (0.00)*** 0.32 (0.00) 0.13*** (0.00)*** 0.20*** (0.00)*** 0.08*** (0.00)*** 0.06 (0.00) 0.17*** (0.00)*** 0.10*** (0.00)*** 0.13*** (0.00)*** 0.10* (0.00)* 0.16*** (0.00)*** 0.10*** (0.00)*** 0.14*** (0.00)*** 256 New from small firms Mean (median) 241.12 (60.99) 0.60 (0.48) -0.22 (-0.03)*** 0.62*** (1.00)*** 0.29 (0.24) 118.99 (15.70)** 0.34 (0.00) 0.23 (0.00) 0.08 (0.00) 0.15*** (0.00)*** 0.03 (0.00) 0.07 (0.00) 0.19** (0.00)** 0.12*** (0.00)*** 0.15*** (0.00)*** 0.10 (0.00) 0.15 (0.00) 0.09* (0.00)* 0.13** (0.00)** 98

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively. Note: We use the two-sample t-test to test the differences in mean and the Wilcoxon rank sum test to test the differences in median. Variables are defined as follows: Assets: total assets in millions (Data6) Leverage: ratio of total liabilities to total assets (Data181/Data6) ROA: return on assets (Data18/Data6) Loss: binary variable, equals 1 if ROA < 0, and 0 otherwise ARInv: ratio of accounts receivable and inventory to total assets (Data2 + Data3)/(Data6) DSales: percentage change in sales from prior year ICW_302[period]: if a weakness pursuant to SOX Section 302 is disclosed for the period ICW_404[period]: if a weakness pursuant to SOX Section 404 is disclosed for the period ICW_404COMP[period]: if three or more weaknesses pursuant to SOX Section 404 is disclosed for the period RST_Exante[period]: if earnings for the period is eventually restated RST_Exante_CoreErn[period]: if core earnings for the period is eventually restated RST_Exante_Neg[period]: if earnings for the period is eventually restated and negative RST_Expost[period]: if there is a restatement during the period RST_Expost_CoreErn[period]: if the restatement involves core earnings RST_Expost_Neg[period]: if the restatement decreases earnings.

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Table 4: Departing versus continuing clients Variables Continuing clients Mean (median) 263.57 (78.48) 0.61 (0.42) -0.15 (0.01) 0.45 (0.00) 0.30 (0.27) 35.74 (9.90) 0.30 (0.00) 0.22 (0.00) 0.08 (0.00) 0.07 (0.00) 0.03 (0.00) 0.09 (0.00) 0.12 (0.00) 0.06 (0.00) 0.07 (0.00) 0.11 (0.00) 0.12 (0.00) 0.06 (0.00) 0.07 (0.00) 2036 All departing clients Mean (median) 149.10*** (35.45)*** 1.87*** (0.55)*** -0.63*** (-0.04)*** 0.59*** (1.00)*** 0.31 (0.29) 197.95** (5.10)*** 0.30 (0.00) 0.27** (0.00)** 0.05* (0.00)* 0.05 (0.00) 0.01 (0.00) 0.05** (0.00)** 0.16** (0.00)** 0.06 (0.00) 0.09 (0.00) 0.07** (0.00)** 0.16* (0.00)* 0.07 (0.00) 0.09 (0.00) 420 Depart to Big 4 Mean (median) 527.47** (102.79) 0.51 (0.39) -0.16 (-0.03) 0.60* (1.00)* 0.24* (0.23) 17.48 (14.75) 0.35 (0.00) 0.33 (0.00) 0.13 (0.00) 0.15* (0.00)* 0.03 (0.00) 0.05 (0.00) 0.15 (0.00) 0.03 (0.00) 0.08 (0.00) 0.08 (0.00) 0.15 (0.00) 0.03 (0.00) 0.05 (0.00) 40 Depart to small firms Mean (median) 34.52*** (15.38)*** 3.69*** (0.64)*** -1.43*** (-0.16)*** 0.68*** (1.00)*** 0.31 (0.29) 504.00*** (2.91)*** 0.36* (0.00)* 0.32*** (0.00)*** 0.04 (0.00) 0.03** (0.00)** 0.01 (0.00) 0.05* (0.00)* 0.19*** (0.00)*** 0.08 (0.00) 0.08 (0.00) 0.08 (0.00) 0.17* (0.00)* 0.09* (0.00)* 0.11 (0.00) 160

Assets Leverage ROA Loss ARInv DSales ICW_302[0] ICW_302[-1] ICW_404[0] ICW_404[-1] ICW_404COMP[-1] RST_Exante[0] RST_Exante[-1] RST_Exante_CoreErn[-1] RST_Exante_Neg[-1] RST_Expost[0] RST_Expost[-1] RST_Expost_CoreErn[-1] RST_Expost_Neg[-1] N

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively. Note: We use the two-sample t-test to test the differences in mean and the Wilcoxon rank sum test to test the differences in median. For variable definitions, see Table 3.

for new clients. Severity variables such as ICW_404COMP[-1] and RST_Exante_Neg[-1] indicate similar results, that is, new firms are riskier than continuing firms. We also note that the results for all new clients are substantially similar to those for new firms from the Big 4 only as well as to those for new firms from the small firms only. Some nuances indicated by the subsample analysis: new
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clients from small auditing firms are not larger than continuing clients and have lower ROA and higher Loss; new clients from the Big 4 have more pronounced ICW. Table 4 provides a comparison of departing clients with continuing clients. Among the traditional risk variables, we note that with the exception of ARInv, the rest are significant.
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Table 5: Pearson correlation for internal control and restatement variables A A. ICW_302[-1] B. ICW_404[-1] C. ICW_404COMP[-1] D. RST_Exante[-1] E. RST_Exante_CoreErn[-1] F. RST_Exante_Neg[-1] G. RST_Expost[-1] H. RST_Expost_CoreErn[-1] I. RST_Expost_Neg[-1] 1 B 0.38 1 C 0.25 0.55 1 D 0.19 0.20 0.11 1 E 0.15 0.16 0.09 0.64 1 F 0.15 0.16 0.08 0.75 0.75 1 G 0.27 0.22 0.12 0.62 0.48 0.53 1 H 0.18 0.16 0.10 0.47 0.74 0.55 0.65 1 I 0.19 0.17 0.09 0.53 0.56 0.72 0.75 0.76 1

Note: Significant values (i.e., p < 0.01) are in bold. For variable definitions, see Table 3.

Departing clients are smaller, have greater leverage, lower profits (lower ROA and higher Loss) and lower (median) change in sales. Turing to ICW, we note that ICW_302[-1] is significantly higher for departing clients overall, while ICW_404[-1] is lower mainly for clients departing to smaller auditing firms. The lack of a strong finding concerning ICW_404[-1] is probably explained by the threshold for Section 404 reporting: many departing clients are probably non-accelerated filers. Finally, we note that restatement risk is higher for departing clients. For example, RST_Exante[-1] is 0.12 for continuing firms and 0.16 for departing firms; this result is stronger if one considers clients departing to small firms (value is 0.19). While there is some evidence that departing clients have higher restatement and ICW risks in terms of prevalence of these risks, there is almost no evidence that severity is greater. The univariate tests suggest strong support for hypothesis 1 (new versus continuing clients) as well as moderate support for hypothesis 2 (departing versus continuing clients). But more conclusive results are only possible using multivariate analysis. Before presenting our multivariate results, we provide evidence of correlations among restatement and ICW variables in Table 5. We note significant correlations between various specifications of the restatement and ICW variables. For example, ICW_302[-1] has correlations of 0.38, 0.19 and 0.27 with ICW_404[-1], RST_Exante[-1] and RST_Expost[-1], respectively; all values are statistically significant. This is consistent with the observation that restatement and ICW variables are in some general sense related to the auditing risk environment of client firms. Because of these high correlations, although they do not meet the
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threshold for inducing severe multi-collinearity problems, we choose to run cross-sectional models (reported below) using restatement and ICW variables one at a time. Our key results concerning hypotheses 1 and 2 are found in Tables 6 and 7. We use logistic regressions as in the prior literature on auditor switching to determine the importance of restatement and ICW variables in explaining switches to and from the Second Tier. Table 6 provides a comparison of (all) new and continuing clients. Table 7 provides a comparison of (all) departing and continuing clients. Table 6 Panel A focuses on ICW. Model 6A1 is the base model in which only traditional risk (that is, control) variables are used. In subsequent models, ICW variables are added to evaluate their explanatory power. The R2 in these models range from 0.026 (model 6A1, the base model) to 0.045 (model 6A3 containing ICW_404[-1]). Among control variables, only two, LnAssets and Loss, appear to be significantly related to auditor switches. New clients, compared to continuing clients, are larger and are more likely to be loss-making. Turning to ICW, we note that the coefficient of ICW_404[-1] is significantly positive in model 6A3 indicating that the prevalence of ICW is associated with switches to the Second Tier. Additionally, in model 6A4, we find that severity matters: the coefficient of ICW_404COMP[-1] is significantly positive. Table 6 Panels B and C focus on restatements, the former using ex-ante measures and the latter ex-post. The base model is 6A1 and it is not repeated in these panels. The range of R2 values in Panels B and C are similar to that of Panel A. Overall, there is strong evidence that the prevalence of restatement is associated with switches into the
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Table 6: Logistic regressions of new clients compared to continuing clients Panel A: Internal control weakness Variable Intercept LnAssets Leverage ROA Loss ARInv DSales ICW_302[-1] ICW_404[-1] ICW_404COMP[-1] Pseudo-R2 N (total) N (new) N (continuing) Panel B: Restatements ex ante Variable Intercept LnAssets Leverage ROA Loss ARInv DSales RST_Exante[-1] RST_Exante_CoreErn[-1] RST_Exante_Neg[-1] Pseudo-R2 N (total) N (new) N (continuing) 0.035 2365 392 1973 Model 6B1 -2.87*** (144.02) 0.22*** (33.75) -0.05 (0.28) -0.03 (0.07) 0.22* (3.27) 0.23 (0.81) 0.00 (0.18) 0.55*** (13.30) Model 6B2 -2.87*** (143.25) 0.22*** (33.67) -0.04 (0.23) -0.01 (0.01) 0.25** (4.15) 0.26 (0.98) 0.00 (0.16) 0.76*** (14.19) 0.035 2365 392 1973 Model 6B3 -2.86*** (142.55) 0.22*** (32.62) -0.05 (0.29) -0.02 (0.02) 0.23* (3.58) 0.24 (0.84) 0.00 (0.18) 0.026 2365 392 1973 0.027 2365 392 1973 Model 6A1 -2.82*** (140.49) 0.22*** (34.10) -0.03 (0.15) -0.02 (0.03) 0.25** (4.07) 0.25 (0.89) 0.00 (0.14) Model 6A2 -2.80*** (138.77) 0.22*** (35.07) -0.03 (0.16) -0.02 (0.04) 0.27** (4.90) 0.26 (0.98) 0.00 (0.17) -0.17 (1.87) Model 6A3 -2.76*** (132.22) 0.19*** (24.50) -0.01 (0.02) 0.00 (0.00) 0.18 (2.17) 0.24 (0.86) 0.00 (0.22) 0.86*** (28.97) 0.045 2365 392 1973 Model 6A4 -2.80*** (137.55) 0.21*** (31.23) -0.03 (0.15) -0.02 (0.03) 0.22 (3.23) 0.25 (0.88) 0.00 (0.18)

0.82*** (9.56) 0.032 2365 392 1973

0.80*** (20.15) 0.039 2365 392 1973

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Table 6: Continued Panel C: Restatements ex post Variable Intercept LnAssets Leverage ROA Loss ARInv DSales RST_Expost[-1] RST_Expost_CoreErn[-1] RST_Expost_Neg[-1] Pseudo-R2 N (total) N (new) N (continuing) 0.030 2365 392 1973 Model 6C1 -2.84*** (141.96) 0.22*** (33.00) -0.04 (0.24) -0.02 (0.03) 0.23* (3.41) 0.24 (0.87) 0.00 (0.18) 0.36** (5.82) Model 6C2 -2.85*** (142.12) 0.22*** (33.70) -0.04 (0.19) -0.02 (0.02) 0.24* (3.69) 0.25 (0.92) 0.00 (0.16) 0.57*** (7.80) 0.031 2365 392 1973 Model 6C3 -2.85*** (142.01) 0.22*** (32.53) -0.05 (0.40) -0.02 (0.03) 0.22* (3.08) 0.23 (0.80) 0.00 (0.18)

0.80*** (20.72) 0.039 2365 392 1973

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively. Note: This table presents the logit regression results for new firms to the Second Tier versus continuing clients. The dependent variable equals 1 when the client is new and 0 when continuing. The chi-square statistics are reported in parentheses. For variable definitions, see Table 3.

Second Tier. In model 6B1, we find that the coefficient of RST_Exante[-1] is significantly positive. Similarly, in model 6C1, we find that the coefficient of RST_Expost[-1] is significantly positive. In addition to these results concerning the prevalence of restatements, we also note that clients switching to the Second Tier are more likely to have severe restatements. In models 6B26B3 and 6C26C3, we find that the coefficients of the core earnings and negative restatement variables (in the ex-ante as well as the ex-post specifications) are significantly positive. Thus, clients switching to the Second Tier are more likely to have restatements that involve core accounts and decrease earnings. Overall, the evidence in Table 6 supports hypothesis 1.16,17 Table 7 compares departing firms with continuing firms. In general, the R2 values are higher in this table than in Table 6. To calibrate our results, as in Table 6, we start with the base model 7A1. This base model indicates that clients
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departing from the Second Tier tend to be smaller firms, with greater losses and with greater leverage. Thus, riskier firms, at least from a traditional auditing risk perspective, are departing. Panel A evaluates the ICW risk of departing firms versus continuing firms. As expected, we find that the coefficient of ICW_302[-1] is significantly positive (model 7A2). However, because departing firms are smaller firms (recall that the coefficient of LnAssets is significantly negative) with a higher likelihood of being non-accelerated filers, ICW_404 variables are insignificant (models 7A3 and 7A4). Table 7 Panels B and C show the association between restatement risk and departures from the Second Tier, the former using ex-ante measures and the latter ex-post. The range of R2 values in Panel B is similar to that of Panel A. Overall, there is strong evidence that the prevalence of restatement is associated with switches out of the Second Tier. In model 7B1, we find that the coefficient of RST_Exante[-1] is significantly positive. Similarly,
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Table 7: Logistic regression analyses of departing clients compared to continuing clients Panel A: Internal control weakness Variable Intercept LnAssets Leverage ROA Loss ARInv DSales ICW_302[-1] ICW_404[-1] ICW_404COMP[-1] Pseudo-R2 N (total) N (departing) N (continuing) Panel B: Restatements ex ante Variable Intercept LnAssets Leverage ROA Loss ARInv DSales RST_Exante[-1] RST_Exante_CoreErn[-1] RST_Exante_Neg[-1] Pseudo-R2 N (total) N (departing) N (continuing) 0.064 2366 401 1965 Model 7B1 -1.03*** (21.36) -0.23*** (34.86) 0.12** (5.18) 0.10 (2.12) 0.36*** (8.41) 0.23 (0.77) 0.00 (1.33) 0.36** (5.38) Model 7B2 -1.02*** (21.12) -0.23*** (33.97) 0.12** (5.60) 0.11 (2.50) 0.38*** (9.50) 0.24 (0.86) 0.00 (1.60) 0.18 (0.60) 0.060 2366 401 1965 Model 7B3 -1.02*** (20.99) -0.23*** (34.57) 0.12** (5.42) 0.11 (2.49) 0.37*** (9.11) 0.24 (0.83) 0.00 (1.61) 0.060 2366 401 1965 0.064 2366 401 1965 Model 7A1 -1.02*** (21.04) -0.23*** (33.71) 0.12** (5.65) 0.11 (2.48) 0.38*** (9.62) 0.24 (0.88) 0.00 (1.59) Model 7A2 -1.00*** (20.37) -0.24*** (36.85) 0.12** (5.38) 0.11 (2.58) 0.34*** (7.57) 0.21 (0.62) 0.00 (1.66) 0.31** (5.86) Model 7A3 -1.02*** (21.01) -0.22*** (32.09) 0.12** (5.65) 0.11 (2.47) 0.38*** (9.63) 0.24 (0.88) 0.00 (1.59) -0.04 (0.03) 0.060 2366 401 1965 Model 7A4 -1.04*** (21.66) -0.22*** (31.89) 0.12** (5.72) 0.11 (2.47) 0.39*** (10.09) 0.25 (0.90) 0.00 (1.59)

-0.43 (0.94) 0.061 2366 401 1965

0.31 (2.32) 0.062 2366 401 1965

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Table 7: Continued Panel C: Restatements ex post Variable Intercept LnAssets Leverage ROA Loss ARInv DSales RST_Expost[-1] RST_Expost_CoreErn[-1] RST_Expost_Neg[-1] Pseudo-R2 N (total) N (departing) N (continuing) 0.063 2366 401 1965 Model 7C1 -1.02*** (20.94) -0.23*** (35.46) 0.12** (5.15) 0.11 (2.55) 0.36*** (8.71) 0.23 (0.79) 0.00 (1.62) 0.32** (4.25) Model 7C2 -1.02*** (21.21) -0.23*** (34.30) 0.12** (5.61) 0.11 (2.53) 0.37*** (9.24) 0.24 (0.85) 0.00 (1.60) 0.33 (2.33) 0.062 2366 401 1965 Model 7C3 -1.02*** (21.11) -0.23*** (34.74) 0.12** (5.07) 0.11 (2.46) 0.37*** (9.07) 0.24 (0.89) 0.00 (1.61)

0.34* (2.94) 0.062 2366 401 1965

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively. Note: This table presents logit regression results for clients departing from the Second Tier versus continuing clients. The dependent variable equals 1 when the client is departing and 0 when continuing. The chi-square statistics are reported in parentheses. For variable definitions, see Table 3.

in model 7C1, we find that the coefficient of RST_Expost[-1] is significantly positive. In addition to these results concerning the prevalence of restatements, we provide results concerning their severity. We note weaker results in this regard. In model 7C3, we note a significant coefficient for RST_Expost_Neg[-1], but this is the only significant variable among severity variables. Principally because of the significance of prevalence measures (of ICW and restatements), we conclude that our results are supportive of hypothesis 2.18 Tables 8 and 9 provide further evidence on hypotheses 1 and 2. Here, we focus on the key subsets of new and departing clients: new from the Big 4 (Table 8) and departing to small auditing firms (Table 9). Results in Table 8 (new from the Big 4 versus continuing) are similar to those reported earlier in Table 6 (all new clients versus continuing). The R2 values and the behavior of controls are roughly comparable. With regard to controls, we again find
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that new firms tend to be larger than continuing firms. However, in Table 8, we do not find the coefficient of Loss to be significant; instead, we find that the coefficient of DSales is positive and marginally significant. Results concerning ICW and restatements are largely the same. New clients from the Big 4 have greater companywide ICW. Also, new clients have a greater prevalence of restatements (coefficients of both RST_Exante[-1] and RST_Expost[-1] are significantly positive) and there is also strong indication that new clients have greater levels of severe restatements. Table 9 reports the comparison between clients departing to small auditing firms and continuing clients. These results are similar to those reported earlier in Table 7. As in Table 7, we find that the coefficienst of ICW_302[-1], RST_Exante[-1] and RST_Expost[-1] are significantly positive, indicating the prevalence of these risk factors. A difference is that restatement variables (especially in Panel C) show greater levels of significance.
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Table 8: Logistic regressions analyses of new Big 4 clients compared to continuing clients Panel A: Internal control weakness Variable Intercept LnAssets Leverage ROA Loss ARInv DSales ICW_302[-1] ICW_404[-1] ICW_404COMP[-1] Pseudo-R2 N (total) N (new Big 4) N (continuing) Panel B: Restatements ex ante Variable Intercept LnAssets Leverage ROA Loss ARInv DSales RST_Exante[-1] RST_Exante_CoreErn[-1] RST_Exante_Neg[-1] Pseudo-R2 N (total) N (new Big 4) N (continuing) 0.039 2221 248 1973 Model 8B1 -3.02*** (100.90) 0.22*** (21.07) -0.21 (1.38) 0.14 (0.26) 0.11 (0.43) -0.20 (0.37) 0.00* (3.79) 0.59*** (10.50) Model 8B2 -3.01*** (100.24) 0.22*** (20.66) -0.21 (1.37) 0.15 (0.29) 0.14 (0.69) -0.18 (0.29) 0.00* (3.81) 0.86*** (13.18) 0.041 2221 248 1973 Model 8B3 -2.99*** (99.56) 0.22*** (20.14) -0.21 (1.37) 0.15 (0.27) 0.12 (0.56) -0.20 (0.34) 0.00* (3.72) 0.031 2221 248 1973 0.031 2221 248 1973 Model 8A1 -2.96*** (99.04) 0.22*** (21.39) -0.18 (1.08) 0.13 (0.22) 0.12 (0.58) -0.19 (0.33) 0.00* (3.63) Model 8A2 -2.97*** (99.12) 0.22*** (20.66) -0.18 (1.06) 0.14 (0.25) 0.11 (0.42) -0.20 (0.37) 0.00* (3.62) 0.11 (0.52) Model 8A3 -2.92*** (92.24) 0.18*** (14.18) -0.10 (0.41) 0.19 (0.56) 0.04 (0.05) -0.20 (0.34) 0.00* (3.56) 0.99*** (28.81) 0.053 2221 248 1973 Model 8A4 -2.93*** (94.90) 0.21*** (18.16) -0.17 (0.95) 0.12 (0.19) 0.07 (0.17) -0.21 (0.40) 0.00* (3.27)

1.14*** (16.57) 0.043 2221 248 1973

0.78*** (13.26) 0.041 2221 248 1973

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Table 8: Continued Panel C: Restatements ex post Variable Intercept LnAssets Leverage ROA Loss ARInv DSales RST_Expost[-1] RST_Expost_CoreErn[-1] RST_Expost_Neg[-1] Pseudo-R2 N (total) N (new Big 4) N (continuing) 0.036 2221 248 1973 Model 8C1 -3.00*** (100.24) 0.22*** (20.50) -0.20 (1.33) 0.14 (0.24) 0.10 (0.41) -0.19 (0.31) 0.00* (3.54) 0.48*** (7.14) Model 8C2 -3.00*** (100.19) 0.22*** (20.91) -0.20 (1.29) 0.14 (0.25) 0.11 (0.48) -0.19 (0.31) 0.00* (3.68) 0.73*** (9.90) 0.038 2221 248 1973 Model 8C3 -3.00*** (100.11) 0.22*** (20.33) -0.22 (1.45) 0.14 (0.23) 0.10 (0.39) -0.19 (0.33) 0.00* (3.61)

0.85*** (16.97) 0.044 2221 248 1973

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively. Note: This table presents the logit regression results for new firms from the Big 4 versus continuing clients. The dependent variable equals 1 when the client is a new from the Big 4 and 0 when continuing. The chi-square statistics are reported in parentheses. For variable definitions, see Table 3.

Our final table, Table 10, presents evidence on hypothesis 3. Although hypothesis 3 pertains to the departing versus continuing as well as the new versus continuing comparisons, because of space constraints we chose to focus on the new versus continuing comparisons. Also, for the same reason, we report prevalence measures only. Panel A compares the dismissals sample of new firms with continuing firms and Panel B compares the resignations sample of new firms with continuing firms. Significantly, we note that Panel A contains 85 resignations and Panel B contains 248 dismissals: the new clients of the Second Tier are more likely to have dismissed their auditors. According to hypothesis 3, restatement and ICW risks are more pronounced in the resignations rather than the dismissals sample. We do not find evidence consistent with this hypothesis. Both the dismissals and resignations samples show similar levels of significance for the restatement and ICW variables. For example, in both Panels A and B, we find that
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ICW_404[-1], RST_Exante[-1] and RST_Expost[-1] are significant. We do, however, note that the magnitude of the coefficients are greater in Panel A consistent with the hypothesis. In Panel C, we run a direct comparison of resignations with dismissals. Resignation firms are significantly smaller and there is no indication that their restatement and ICW risks are potentially higher. This is consistent with results reported in Panels A and B that both resignations and dismissals show sensitivity to restatement and ICW.

5. DISCUSSION AND CONCLUSION

The Post-SOX era coincides with the rise of the Second Tier auditing firms. Since many of their new clients are large firms from the Big 4, and since large firms are assumed to carry higher level of litigation risks with them, regulators have been concerned about client portfolio risks of the Second Tier. An earlier and influential study, Hogan and
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Table 9: Logistic regression analyses of departing clients to small firms compared to continuing clients Panel A: Internal control weakness Variable Intercept LnAssets Leverage ROA Loss ARInv DSales ICW_302[-1] ICW_404[-1] ICW_404COMP[-1] Pseudo-R2 N (total) N (depart to SF) N (continuing) Panel B: Restatements ex ante Variable Intercept LnAssets Leverage ROA Loss ARInv DSales RST_Exante[-1] RST_Exante_CoreErn[-1] RST_Exante_Neg[-1] Pseudo-R2 N (total) N (depart to SF) N (continuing) 0.191 2117 152 1965 Model 9B1 -0.48 (2.02) -0.67*** (95.35) 0.03 (0.64) 0.14 (2.53) 0.27 (1.72) 0.12 (0.09) 0.00 (1.58) 0.74*** (9.91) Model 9B2 -0.47 (1.99) -0.66*** (93.43) 0.03 (0.60) 0.15* (3.26) 0.31 (2.34) 0.17 (0.19) 0.00 (2.00) 0.57* (2.76) 0.184 2117 152 1965 Model 9B3 -0.47 (2.02) -0.66*** (93.73) 0.03 (0.61) 0.15* (3.22) 0.31 (2.30) 0.17 (0.18) 0.00 (1.99) 0.181 2117 152 1965 0.198 2117 152 1965 Model 9A1 -0.48 (2.08) -0.65*** (92.90) 0.03 (0.54) 0.15* (3.16) 0.33 (2.56) 0.19 (0.23) 0.00 (1.97) Model 9A2 -0.41 (1.54) -0.70*** (103.36) 0.03 (1.03) 0.16* (3.53) 0.23 (1.23) 0.02 (0.00) 0.00 (2.47) 0.81*** (16.35) Model 9A3 -0.50 (2.23) -0.65*** (86.97) 0.03 (0.52) 0.14* (3.13) 0.34 (2.70) 0.19 (0.22) 0.00 (1.97) -0.28 (0.28) 0.182 2117 152 1965 Model 9A4 -0.48 (2.03) -0.66*** (90.95) 0.03 (0.54) 0.15* (3.16) 0.32 (2.51) 0.19 (0.23) 0.00 (1.97)

0.09 (0.01) 0.181 2117 152 1965

0.37 (1.28) 0.183 2117 152 1965

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Table 9: Continued Panel C: Restatements ex post Variable Intercept LnAssets Leverage ROA Loss ARInv DSales RST_Expost[-1] RST_Expost_CoreErn[-1] RST_Expost_Neg[-1] Pseudo-R2 N (total) N (depart to SF) N (continuing) 0.189 2117 152 1965 Model 9C1 -0.47 (2.04) -0.67*** (97.48) 0.03 (1.02) 0.15* (3.38) 0.29 (2.05) 0.15 (0.14) 0.00 (2.01) 0.66*** (7.53) Model 9C2 -0.48 (2.04) -0.67*** (93.88) 0.03 (0.59) 0.15* (3.29) 0.31 (2.23) 0.18 (0.20) 0.00 (1.99) 0.82*** (6.84) 0.188 2117 152 1965 Model 9C3 -0.49 (2.15) -0.67*** (96.13) 0.03 (1.00) 0.15* (3.36) 0.31 (2.24) 0.19 (0.22) 0.00 (1.99)

0.67** (5.11) 0.186 2117 152 1965

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively. Note: This table presents logit regression results for clients departing to small firms versus continuing clients. The dependent variable equals 1 when the client is departing to small firms and 0 when continuing. The chi-square statistics are reported in parentheses. For variable definitions, see Table 3.

Martin (2009), evaluates the new and departing clients of the Second Tier against continuing clients and finds that: (a) new clients, especially those from the Big 4 bring in additional risks mostly because of their larger size, and (b) these risks are somewhat offset by the movement of other risky clients from the Second Tier to other auditors. But this earlier study, because of its sampling period, was unable to adequately assess the importance of restatement and ICW risks. Our study fills this void. We explicitly formulate hypotheses relating the switching behavior of the Second Tier to these new risk factors and test the hypotheses using a sample that fully exploits the restatement and ICW disclosures in the post-SOX era. We show that the new clients of the Second Tier have higher prevalence and severity of restatements and ICW. This has two implications. First, this implies that the new clients acquired by the Second Tier are in some sense riskier than implied by an analysis of the traditional variables
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used in the literature. Second, we contribute to the large literature on auditor switching by demonstrating the importance of restatement and ICW risks. We argue that restatement and ICW measures are indicators of a perturbed auditing environment, which poses additional risks to the auditor. Thus, traditional variables like firm size, ROA, loss, accounts receivables and inventory may not fully explain audit risk. We also show that departing clients of the Second Tier are somewhat riskier than continuing firms. The comparison of all departing and continuing firms shows some evidence of differences in risk; however, more risks are evident in the subset of firms departing to small auditors. Combined with the observation that the number of clients of the Second Tier has held steady in the post-SOX era, this appears to indicate a somewhat deliberate strategy on the part of the Second Tier to build their clientele and manage risks prudently. Our sample spans a number of years in the post-SOX era and
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Table 10: Resignations versus dismissals

Panel A: New clients whose auditors resigned versus continuing clients Variable Intercept LnAssets Leverage ROA Loss ARInv DSales ICW_302[-1] ICW_404[-1] RST_Exante[-1] RST_Expost[-1] Pseudo-R2 N (total) N (resign) N (continuing) 0.006 2058 85 1973 0.006 2058 85 1973 0.039 2058 85 1973 Model 10A1 -2.99*** (42.06) -0.02 (0.04) -0.18 (0.72) -0.03 (0.01) 0.26 (1.09) -0.39 (0.51) 0.00 (0.01) Model 10A2 -2.99*** (42.03) -0.02 (0.08) -0.18 (0.72) -0.02 (0.01) 0.23 (0.85) -0.43 (0.59) 0.00 (0.01) 0.17 (0.51) Model 10A3 -2.80*** (35.71) -0.09 (1.27) -0.13 (0.51) 0.00 (0.00) 0.13 (0.27) -0.43 (0.60) 0.00 (0.00) 1.39*** (23.89) Model 10A4 -3.07*** (43.26) -0.02 (0.06) -0.22 (0.93) -0.04 (0.04) 0.22 (0.81) -0.42 (0.58) 0.00 (0.01) Model 10A5 -3.03*** (42.47) -0.02 (0.09) -0.20 (0.84) -0.03 (0.01) 0.23 (0.83) -0.40 (0.54) 0.00 (0.01)

0.83*** (9.31) 0.019 2058 85 1973

0.62** (5.12) 0.013 2058 85 1973

Panel B: New clients who dismissed their auditors versus continuing clients Variable Intercept LnAssets Leverage ROA Loss ARInv DSales ICW_302[-1] ICW_404[-1] RST_Exante[-1] RST_Expost[-1] Pseudo-R2 N (total) N (dismiss) N (continuing) 0.023 2221 248 1973 0.023 2221 248 1973 0.042 2221 248 1973 Model 10B1 -3.30*** (127.02) 0.22*** (24.09) -0.03 (0.09) -0.04 (0.06) 0.20 (1.84) 0.29 (0.82) 0.00 (0.12) Model 10B2 -3.30*** (126.49) 0.23*** (24.11) -0.03 (0.09) -0.04 (0.06) 0.21 (1.86) 0.29 (0.84) 0.00 (0.12) -0.03 (0.03) Model 10B3 -3.25*** (119.66) 0.19*** (17.15) 0.00 (0.00) -0.01 (0.01) 0.13 (0.76) 0.28 (0.75) 0.00 (0.19) 0.93*** (24.46) Model 10B4 -3.36*** (129.50) 0.23*** (24.30) -0.04 (0.14) -0.05 (0.08) 0.18 (1.47) 0.29 (0.82) 0.00 (0.15) Model 10B5 -3.33*** (128.02) 0.22**** (23.61) -0.04 (0.13) -0.04 (0.06) 0.19 (1.53) 0.30 (0.86) 0.00 (0.14)

0.49*** (6.92) 0.028 2221 248 1973

0.33* (3.22) 0.026 2221 248 1973

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Table 10: Continued

Panel C: Resignations versus dismissals of new clients Variable Intercept LnAssets Leverage ROA Loss ARInv DSales ICW_302[-1] ICW_404[-1] RST_Exante[-1] RST_Expost[-1] Pseudo-R2 N (total) N (resign) N (dismiss) 0.056 333 85 248 0.059 333 85 248 0.063 333 85 248 Model 10C1 0.46 (0.67) -0.29*** (7.97) -0.17 (0.30) 0.10 (0.03) 0.11 (0.11) -0.62 (0.93) 0.00 (0.04) Model 10C2 0.47 (0.71) -0.30*** (8.49) -0.18 (0.35) 0.12 (0.05) 0.07 (0.05) -0.57 (0.74) 0.00 (0.03) 0.25 (0.71) Model 10C3 0.53 (0.88) -0.32*** (9.05) -0.16 (0.27) 0.15 (0.08) 0.06 (0.04) -0.59 (0.82) 0.00 (0.01) 0.43 (1.62) Model 10C4 0.39 (0.48) -0.29*** (7.84) -0.24 (0.57) 0.06 (0.01) 0.10 (0.09) -0.59 (0.81) 0.00 (0.02) Model 10C5 0.43 (0.57) -0.29**** (8.12) -0.22 (0.48) 0.07 (0.02) 0.09 (0.08) -0.61 (0.88) 0.00 (0.02)

0.43 (1.79) 0.064 333 85 248

0.39 (1.44) 0.062 333 85 248

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively. Note: This table presents results from logit regression. The dependent variable equals one if the client is a new client of the Second Tier from the Big 4 or small firms and zero otherwise. We exclude new clients from unknown since they are mainly IPO firms. Panel A only includes new clients whose previous auditor resigned and Panel B only includes new clients who dismissed their previous auditor. In Panel C, the dependent variable equals 1 if the auditor resigned and 0 if the auditor was dismissed from the Big 4 or small firms. The chi-square statistics are reported in parentheses. For variable definitions, see Table 3.

therefore our results do not just indicate an immediate reaction to Andersen and SOX. Rather, our results seem indicative of a longer-term trend in the auditing market where the Second Tier is gaining market share in a steady and deliberate fashion. This conclusion is also supported by our results concerning resignations and dismissals. Not only do we find that most of the switches to the Second Tier are dismissals rather than resignations (that is, in most cases, the auditor is fired), we also find that the sensitivities of switches to restatement and ICW risks are no different between the resignation and dismissal samples.

NOTES
1. The GAO report, dated January 2008 (GAO, 2008), identifies several constraints faced by
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Second-Tier firms including: (a) the ability to hire and retain employees, (b) lack of reputation, (c) lack of capabilities in multiple countries to service multinationals, and (d) the ability to deal with the litigation risk arising from large clients. 2. A report issued by Audit Analytics in February 2009 entitled 2008 Financial Restatements: An Eight Year Comparison indicates a sharp rise in the number of restatements during 20052006. While the level is also quite high in 2007, it represents a fall from 2006. An even lower level of restatements in 2008 may suggest a trend. Overall, our sample period has a high number of restatements. 3. There is also a stream of papers that solely focus on restatements and provide insights for the auditing context. For example, Abbott, Parker
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