CPA Switches and Associated Market Reactions

Author(s): Dov Fried and Allen Schiff

Source: The Accounting Review, Vol. 56, No. 2 (Apr., 1981), pp. 326-341
Published by: American Accounting Association
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THE ACCOUNTING REVIEW
Vol. LVI, No. 2
April 1981

CPA Switches and Associated

Market Reactions
Dov Friedand Allen Schiff

ABSTRACT: In 1978, the Securities and Exchange Commission issued its final require-
ments concerning the disclosure requirements of companies that change their auditors.
Along with a filing requirement for an auditor change, companies were also required to
enumerate and describe disagreements they may have had with their CPAs on accounting
and auditing issues in the 18 months prior to the change. To provide evidence on the
existence and degree of market impact of these disclosure requirements, the behavior of
stock prices of a sample of companies that switched auditors and a matched pair of
control companies that did not were analyzed. Results of the study appear to be in-
consistent with the SEC requirement for companies to enumerate and describe disagree-
ments with their auditors. For the general event of auditor changes, there seems to be
negative market reaction around the time of the switch; however, there is some difficulty
in interpreting the motivation for this reaction.

IN 1971, the Securities and Exchange
Commission (SEC) initiated its re-
quirement that publicly held com-
panies file 8-K reports within 15 days
following a change in the registrant's
certifying accountant [Coopers & Ly-
brand, 1979]. The requirement was
viewed as another step in disclosing the
relationship between a company and its
auditor. This perceived need was articu-
lated by John C. Burton, the SEC's
chief accountant at that time, as a step
"in the development of more complete
disclosure of the auditor-client relation-
ship." ["The SEC Bears Down Harder
on Disclosure," 1974, pp. 33-37]. Along
with the filing requirement for a switch
from one CPA firm to another, a com-
pany was also required to enumerate and
describe disagreements it may have had
with its auditor on accounting and audit-
ing issues in the 18 months before the
change.
In addition, under an amendment to
the SEC's accounting rules, effective July
31, 1978, registrants also had to disclose
whether the auditor change was recom-
mended or approved by their audit com-
mittees and their boards. However, the
SEC rejected a proposed rule that would
have required a company to state its
reason for switching to new auditors
beyond disagreements on accounting
issues [SEC ASR No. 247, 1978]. Instead,
the SEC simply urged disclosure of non-
accounting information beyond the mini-
mum requirement.
In the period 1971-1976, a large num-
ber of companies switched auditors, and
The authors would like to acknowledge the helpful
comments of Joel Owen, Joshua Livnat, Michael Schiff,
George Sorter, and the anonymous reviewers. Also,
thanks are due to Janet Landis and Linda Volkert for
their technical assistance.
Dov Fried is Assistant Professor of
Accounting, New York University, and
Allen Schiff is Associate Professor of
Accounting, Fordham University.
Manuscript received September 1978.
Revisions received November 1979 and March 1980.
Accepted June 1980.

326

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Fried and Schiff
a number of reasons have been given for
these changes:
1. CPA firms assumed a more con-
servative posture in interpreting and
applying accounting standards as a
reaction to an increased number of
lawsuits.
2. The SEC increased disclosure re-
quirements.
3. Economic conditions in the 1970s
deteriorated and corporate manage-
ments were hard-pressed to produce
constantly increasing earnings per
share in their annual reports
["Companies vs. Auditors," 1974,
pp. 33, 35].
Other suggested reasons for auditor
switches include management change,
changes in auditor fee structure, need for
additional services, regular rotation
policy, and new financing (the switch
made in response to a suggestion by a
lender or as a result of management's
impression that a larger CPA would lend
more prestige to the security offering)
[Bedingfieldand Loeb, 1974].
As one SEC staff member commented,
"Auditors and companies are disagreeing
more these days because the companies
want to do what the auditors taught them
in the late Sixties, and now the auditors,
afraid of expensive lawsuits, are saying
no" ["Companies vs. Auditors," 1974,
pp. 33, 35]. It should be noted that the
reasons listed above are interrelated, for
if, indeed, accountants had become more
conservative some switches in outside
auditors would have occurred. However,
when one adds the elements of relatively
depressed economic conditions and more
extensive disclosure requirements, the
result is likely to be synergistic, thus,
substantially increasing the probable inci-
dence of external auditor changes.
If one assumes that the motivation for
switching auditors would be to secure
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327
more flexibleinterpretationand applica-
tion of accountingstandards,one would
have to identify which of the Big Eight
CPA firms,for example,are more or less
inclined to flexibility. Gosman [1973]
attemptedto classifythe Big Eight firms
by identifyingthe frequencywith which
they issued consistencyqualificationsin
annual reports.He could not prove that
the frequencyof occurrenceof suchquali-
ficationswas a function of one or more
identifiablefirms.A morerecentstudyby
Eggleton et al. [1976] attempted to
associate CPA firms with a particular
policy regarding a specific accounting
change. If proved, this could be a cause
for a shift by clientsfavoringa particular
accountingpolicy. Theirresultswerenot
conclusive.
Because of the lack of statistically
meaningfulresults in previous attempts
to identifyparticularaccountingcharac-
teristicswith particularCPA firms as a
general motivation for switching and
becauseof associateddisclosurerequire-
ments, we have looked at this problem
froma differentviewpoint.Ourapproach
was to examinethe moregeneralquestion
of whetherCPA switcheswereassociated
with significantmarketreactions.At the
sametime,we wereinterestedin isolating
and observingto what extent the SEC
disclosurerequirement,as it relatedto the
reporting of conflict, was "justifiable."
This, of course,includesthe possibilityof
the synergisticeffects discussed above,
i.e., economic conditions causing a dis-
agreement over accounting principles.
Thus, a CPA switch may be viewed by
the market as an informationsignal of
changing economic conditions for the
companies. Independentof the motiva-
tion for the auditorchange, a disclosure
requirementwould not be inconsistent
with an environmentof marketreaction
aroundthe time of a CPA switch. If, on
the other hand, no reaction occurred,
328 The AccountingReview,April 1981

TABLE I
OF SAMPLEBY REASONOF AUDITOR CHANGEAND TYPE OF PRACTICE
CLASSIFICATION

Big Eight To Non-Big Eight Big Eight To Non-Big Eight To

Reason Big Eight To Big Eight Non-Big Eight Non-Big Eight Total

StatedNo Conflict
Rotation
AuditCommittee
Lawsuit
Conformto Subsidiary
No Referenceto Reason
Disagreement-Conflict
Disagreement-Conflict
Not Resolved
Total
16 6 2 1 25
2 2
2 2
I I
I I
5 1 1 7
6 6
4 4
37 7 2 2 48

then the disclosure of the switch would be
viewed as a "nonevent" by the market.
The market would have already dis-
counted for any economic events (if any
had ever existed) causing the switch,
thereby making the disclosure super-
fluous.
The remainder of this study is divided
into four sections. The first section is
devoted to a discussion of our sample
selection procedures. The second section
states our hypothesis, and the following
section focuses on research design. The
last section describes our results and
conclusions.
PROCEDURES
SAMPLESELECTION
The names of the companies that
switched their auditors in the four years
1972 through 1975 were obtained from
CorporateProfiles and Index of Corporate
Events [Disclosure, Inc., 1975]. The
Index provides a chronological record of
reports and filings of New York Stock
Exchange, American Stock Exchange,
and Over The Counter companies. From
this Index, we also obtained dates of the
8-K filings to be used as our announce-
ment dates. Out of the total number of
companies that switched CPA firms in
the years 1972-1975, only those com-
panies that were included on the Daily
Return tape of the Center for Research
on Security Prices (CRSP) prior to the
announcement date were included in our
sample. In addition, we eliminated those
companies that were subsequently taken
off the CRSP tape (and/or were delisted
by the New York Stock Exchange) after
the disclosure date. This was done to
remove from our sample those compan-
ies that changed auditors as a result of
mergers or were placed under receiver-
ship.'
Daily returns (adjusted for stock splits)
were then obtained from the CRSP Daily
Returns tape (December 1976 version)
for each of the companies in the sample.
These daily returns were then converted
to weekly returns and then annualized by
the procedure outlined in Kaplan and
Roll [1972]. Daily returns for the market
as a whole were also obtained from the
CRSP tape and converted to a weekly
basis in the same fashion. These proce-
dures resulted in a sample of 48 com-
panies.
Table 1, derived from the 8-K reports
of our sample companies, describes the
I This sample procedure may result in a bias of
"survivorship" in our sample. However, it was felt that
for companies which went into receivership and/or
merged, the likelihood was that any market response
would be due to other events (of which the auditor switch
was only a by-product) rather than the switch itself.

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Fried and Schiff
nature of the change in auditors in our
sample in terms of type of practiceand
reason for the change. By "type of prac-
tice,"we meanthe directionof the change
in CPA firms,i.e., a Big Eight CPA firm
to or from a non-BigEight firm.As may
be observed from Table 1, most of the
switches were toward large CPA firms.
The reasonfor this directionseems to be
that our sampleis composedof relatively
largecompanieswhich are morelikely to
use national CPA firms (see Schiff and
Fried [1976]).
Table 1 also indicates the reported
reasons for an auditor switch. It can be
seen that 25 companies reported that
therewas no disagreementwith the previ-
ous accountanton any accounting,dis-
closure, or auditing issue, and they did
not volunteer any other reasons for the
change. Ten companies reported dis-
agreementswith their CPAs, and, in six
of thesecases,the conflictwas resolvedto
the satisfactionof both the client and the
auditor. In cases where these conflicts
were not resolved, the results were a
"qualified" audit opinion, dismissal of
the CPA, and/or a reluctantacceptance
by the client of the CPA's recommenda-
tion. Among the issues of disagreement
were: asset valuation, the timing of
revenuerecognition,and the scope of the
audit. Reasonsgiven by othercompanies
for changing auditorswere: audit com-
mittee recommendation,a desire to ro-
tate auditors,a preferencefor one auditor
of all subsidiaries,and a future lawsuit.
Seven companies made no referenceat
all to any disagreementor to any other
reason.
The distributionof the typesof reasons
and, specifically,the percentageof com-
paniesthat reporteda clear-cutdisagree-
ment with their formerfirmof CPAs are
similarto the findingsof otherdescriptive
studies (e.g., Bedingfield and Loeb
[1974]; AICPA [1976]).
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329
STATEMENT OF HYPOTHESES
As stated above, our overall objective
was to examinewhethera changein audi-
tors is associatedwith significantmarket
reaction.In addition,we were interested
in examining whether the SEC's dis-
closure requirementas it related to the
reportingof conflictsbetweenCPAs and
clients was justifiable.
Morespecifically,ourgeneralhypothe-
sis (Hypothesis I) may be stated as:
Users view all switches with suspicion,
i.e., negatively.Statingthis formally,we
have:
(I) Ho: d (all companies)? 0
versusthe alternativehypothesis:
H1: d (all companies)< 0
whered (*) representsthe marketreaction
to the changein auditors.2
The potential for negative reactions
comes about becausea changein auditor
may weakenthe investors'notion of the
independencebetweenthe companyand
the auditor [SEC ASR 165, 1974]. A
weakeningin independence,in the words
of the SEC, could result in a loss of
"confidencein financialstatements"[SEC
ASR 247, 1978].The companywould be
perceivedas wantingto change auditors
to obtain what the SEC refers to as
"more favorableaccountingtreatment"
on the financial statements [SEC ASR
165, 1974]. Underlying Hypothesis I is
the implicit assumptionthat the skepti-
cism with respectto financialstatements
might ariseif it were felt that companies
wanted to suppress information that
could produce a negative impact on
investors'perceptionsof futureexpected
earnings.
Testing for the "justifiability"of the
2
For this hypothesis and the other two to follow,
rejection of the null would be consistent with the motiva-
tion which led to the particular test.
330
SEC disclosure requirement for conflicts
implies that a lack of user reliance occurs
primarilywhen a conflict between auditor
and client is present. That is, the argu-
ments presented previously for Hypothe-
sis I would prevail when the market is
informed that a conflict has indeed
occurred, since the reported conflict
would then reflectmanagement's pressure
on the auditor to give a clean opinion on
financial statements that, at a minimum,
should be qualified and, at a maximum,
fraudulently mislead the public.3
Hypothesis II may be stated as: users
view "with suspicion" only those switches
where the company states that it has been
in conflict with its auditor. More for-
mally, we have:
(II) Ho: d("conflict" companies) ? 0
versus the alternative hypothesis
H1: d ("conflict" companies) < 0
It can be argued, however, that a nega-
tive reaction by users would occur only if
they were to find no other motivation to
explain the change in auditor. Thus, those
companies that switched from non-Big
Eight CPA firms to Big Eight CPA firms
may be perceived as obtaining improved
auditing service and generating more
reliable financial statements, and conse-
quently one might expect to observe a
nonnegative reaction associated with this
type of CPA switch. This latter argument
may also be stated more formally as
Hypothesis III:
(III) Ho: d (companies that change to
Big Eight firms)< 0
versus H1: d (companies that change to
Big Eight firms) > 0
These hypotheses imply a partitioning
of our sample (based on the categories in
Table 1) into the groups presented in
Table 2.
However, testing each hypothesis indi-
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The Accounting Review, April 1981
TABLE2
SAMPLEPARTITIONS
Group Description # in Group
A Companies that switched to "same 31
size" CPA firm and did not report
a conflict with their auditors.*
B Companies that switched to the 10
same size" CPA firm and did report
a conflict with their auditors.
C Companies that switched to a Big 7
Eight CPA firm and did not report
a conflict.
* Included in Group A were two companies that
switched from a Big Eight CPA firm to a smaller firm
and did not report a conflict with their auditors. The
omission or inclusion of these companies did not alter
our results.
vidually introduces a problem of multiple
hypothesis-testing. This problem mani-
fests itself in two ways. First, testing on
an individual basis can lead to an under-
stating of the a level (probability of Type
I error) when viewed from the perspective
of all companies that switched CPA
firms. That is, testing a sequence of
hypotheses can result in one of the hy-
potheses being rejected by mere chance.
Secondly, we face a possible jointness
problem in that Hypothesis II, for exam-
ple, could be considered as our test to see
whether the SEC requirement, as it
related to reporting conflicts, was justi-
fiable. Suppose, now, we were to find
significant results by testing Hypothesis
II. This does not mean that we could
necessarily conclude that a conflict results
in "bad" news. The reason for this result
is that if the null for Hypothesis I were
also rejected (i.e., all CPA switches have
bad news associated with them), there
might be no justification for the special
SEC requirement relating to reporting a
conflict, unless it can be shown that a
I For further discussion on the motivation to disclose
conflict on accounting issues, see Barlev and Benston
[1974].
Fried and Schiff
change with conflict is "worse" news than
a change without conflict. This potential
problem then implies a need for a proce-
dure to test for differences between reac-
tions to Group A and Group B. Similar
arguments can be made with respect to
Hypothesis III.
To overcome these problems, we
turned to a multivariate test-the Hotel-
ling T2 statistic. This test examines
simultaneously all possible linear combi-
nations of the market reactions of Groups
A, B, and C. More specifically, the
Hotelling T2 statistic tests the null
hypothesis:
Ho: aAd(A)+ aBd(B)+ acd(C) 0 (1)
against the alternative:
H1: aAd(A)+ aBd(B)+ acd(C) O (2)
whereaA, aBand ac are weightings4of the
market reactions d(A), d(B), and d(C).
Setting aA= aB= ac = 1/3, for example,
would be equivalent to testing Hy-
pothesis I. Similarly, if aA= aB= O and
ac=1, or if aA=ac=O and aB=l, we
would be testing Hypotheses III and II,
respectively.5'6
Rejection of the null hypothesis for the
T2 test does not, however, indicate which
of the weighting schemes contributed to
its rejection. In order to gain insight into
this issue, one must examine the univari-
ate t-scores calculated for the pre-speci-
fied weightings of interest consistent with
Hypotheses 1-111. These t-scores can be
employed on two levels: an experiment-
wide basis (EB) and an individual basis
(IB). The t-scores calculated for both the
EB and IB approaches are identical. The
difference lies in the "theoretical" t-value
needed before any statement about rejec-
tion could be made. The EB approach
which is "consistent" with the multi-
variate T2 test requires a higher critical
level than the IB approach.7 That is to
say, the EB approach ensures an a
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331
(significance level) probability of a Type I
error for all possible weightings (hy-
potheses).
From a "theoretical" point of view, it
is necessary for the multivariate T2 tests
to show significance before testing the
univariate t-scores on an EB level. This
need arises because the multivariate T2
test finds the weighting that maximizes
the t-test result, whereas the individual
t-tests are constrained to a specific
weighting.
Controlling for the a level, by setting a
high critical level, however, increases the
probability of committing a Type II
error for an individual hypothesis (i.e.,
accepting the null when it is indeed false).8
For this reason, we present results for the
IB approach as well. The IB level ensures
an a probability of Type I error for each
weighting (hypothesis) individually. This
level may show significance even if the
multivariate T2 does not, since lower
critical levels are needed. These uni-
variate results, however, should be inter-
preted with caution, since, as noted, on a
theoretical level, they may be biased.
That is, they may be due to chance as a
result of having tested sequentially a
series of individual hypotheses.
RESEARCH DESIGN
This section of the paper will describe
the procedures undertaken to test our
4 The T2 statistic is invariant; i.e., it is unaffected by a
change in scale of the weightings (see Morrison [1967, p.
119]). In our discussion, we have "normalized" the
weighting by imposing the constraint that they sum to
one.
5 Other weightings, which would also be tested for,
could be constructed that would test for differing re-
sponses between partitions.
6 Ideally, a directional test would be more appropriate
to test our hypotheses, since they are one-sided. The T2
test, however, is nondirectional.
7 A discussion of the determination of the critical
levels is presented in the Appendix.
8 That is, a null hypothesis which may indeed be false
may get "lost" in the context of being viewed with the
other hypotheses.
332
hypotheses. The issues addressed here are
selection of a control group, development
of an operational definition for the mar-
ket reaction to a switch (d(*)), fl-stability,
and the formulation of the statistical tests
used.
Selection of Control Group
The procedure used in our study is
based upon methods carried out by
Gonedes [19751 and Harrison [19771.
The first step was to select a control group
of 48 companies which did not switch
auditors. Previous evidence, (e.g., King
[1966]) indicated that general market
conditions and, to a lesser degree, indus-
try-wide factors have an impact on a
security's returns; thus, a control group
of companies was constructed which
matched each company in the sample
with the following characteristics:
(1) the company's fi, which measures
the co-movement of the firm's re-
turns with the general market
return, and,
(2) where possible, the industry classi-
fication of the company.
Industry classifications were based on
the SIC classification code. The four-
digit code was examined first. If no suit-
able match was found on this level (the
absolute value of the difference in /3 is
greater than .5), we went to the three-
digit and finally to the two-digit code. In
most cases-39 companies-we were
able to obtain matches on at least the
two-digit level (25 of which were matched
at the four-digit level). The remaining
nine companies were matched solely on
the basis of /.
The companies placed in the control
group were selected from a group of
candidates whose monthly fs had already
been matched to our sample companies'
monthly P3sby the use of data covering
the five-year period preceding the an-
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The AccountingReview,April 1981
nouncement date.' Weekly returns were
then obtained for these candidates in the
same manner as had been done for the
sample firms. Betas were then generated
by the Ordinary Least Squares (OLS)
method for the sample and candidate
companies by using the following formu-
lation of the Capital Asset Pricing Model:
Rit = Rft + 13i(Rmt-Rft) + ej, (3)
where
Rit= rate of return of the ith company
in period t, i.e., price change plus
dividends for week t divided by
price at beginning of week t.
Rft = "risk free" rate of return as
measured by the one-week yield
on treasury bills
and
Rmi= weekly market portfolio rate of
returns calculated from the daily
market returns provided on the
CRSP tapes.
The need for the Plsto be calculated on a
weekly basis was motivated by the fact
that the statistical tests used in the study
were based upon weekly observations.
The estimates of 1#were obtained by
running the OLS regression on weekly
observations spanning (approximately)
the five-year period (249 weeks) around
the announcement date, but omitting 24
weeks on either side of the announce-
ments. Notationally, if we set the week of
the announcement as t = 0, the regression
was run using 200 observations from the
period t= -124 to t= -25 and t=25 to
IThese monthly betas were obtained from two
sources. The first source was a colleague (Joshua Livnat,
now at Hebrew University) who provided monthly
betas calculated (as in Equation (3)) every six months
(i.e., June and December) over the period 1970-1975
using the previous 60 months' observations. The second
source was the monthly issues of Merrill Lynch, Pierce,
Fenner & Smith's Security Risk Evaluation. In both cases,
the candidates were selected based on the period preced-
ing the announcement date.
Fried and Schiff
TABLE 3
FREQUENCY DISTRIBUTIONOF ABSOLUTE DIFFERENCES
BETWEENPREADJUSTEDfIS OF SAMPLECOMPANIES
AND CONTROLGROUP
Deciles 0-.1 .J-.2 .2-.3
# of Companies 23 8 9
t= 124.10 The 49 weeks closest to the
announcement date were not included in
the regression so as to avoid possible
distortion in the estimation of ft which
may result from "unusual" market activ-
ity around the time of the switch. The fls
calculated in this fashion were then
screened to find the most suitable match
for our sample companies. The frequency
distribution of the absolute difference
between the /3of our sample of companies
and the control group obtained in this
manner is presented in Table 3. The aver-
age , for our sample was 1.06 as com-
pared to 1.03 for the control companies.
For partitions A, B, and C, the relevant
figures were 1.03 and .97; .95 and .98; and
1.38 and 1.34, respectively.
Because, for certain companies the dif-
ferences in 1#were relatively large, a final
refinement was undertaken to ensure 1#-
equivalence."1 Rather than using the
actual returns of the control securities,
we combined the rate of return of the con-
trol securities (RI) with that of the risk-
free asset (Rft) into a new combined asset
Rit(C) defined as:
Rit(C) = WiRc + (1 - Wi)Rft
where
14 = sc
and f3sand fl, are the fls computed previ-
ously for the sample and control com-
panies, respectively. The above "trans-
formation" was, in effect, the formation of
a weighted portfolio consisting of the
original control security and the risk-
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333
free security with Wiand 1- Wi acting as
the respective weightings. The JJof any
(weighted) portfolio is equal to the
(weighted) average of the fls of the in-
dividual securities which make up the
.3-.4 .4-S.5
portfolio. Thus, since the 1#of the risk-
5 3 free asset by definition equals zero, the
, of the newly generated "combined"
control security was exactly equal to that
of the corresponding sample company
(i.e., WjBc = B).
Measuring the Market's Response to a
Switch
Using our sample and control "com-
panies," we were then able to generate an
empirical measure of the market's re-
sponse to a switch that is equal to the dif-
ference between the returns of the sample
company (Rjt(S))and control "company"
(Rit(C )):
dt(i) = Rit(S) - Rit(C) (5)
This measure would reflect the mar-
ket's reaction to a CPA switch, because
the procedures used in selecting the con-
trol group ensure that the overall market
(and industry) factors affecting returns
would be common to both the sample and
control companies. This difference-or
abnormal return-therefore "reflects"
the market reaction to the CPA switch.
This latter statement holds true so long
as the betas are stable over time. If the fls,
however, do shift over time, then the dO(i)
measure would also capture the differing
reactions of the sample and control com-
(4)
panies to overall market conditions and
not only to the CPA switch itself. Thus,
before statistical tests can be undertaken,
the issue of fl-stability must be addressed.
lOFor some firms whose announcement dates were
close to December 1976, we did not have the full 100 ob-
servations in the post-switch period.
'l In our statistical tests, some of the observations
examined did not include every member of the group. We
therefore could not expect the effect of the differences in
# to be "averaged away."
334
Beta Stability
The selection of the time period and the
use of data from both sides of the an-
nouncement date were motivated by a
desire to avoid potential biases resulting
from unstable fls. Previous empirical
evidence (e.g., Blume [1975]) has indi-
cated that although fls tend to be un-
stable over time, generally speaking they
were found to be relatively stable over
shorter time periods, such as five years.
Therefore, a time interval of five years
was used in this study to estimate sample
and control betas (see Gonedes [1973]).
Furthermore, by estimating our fls
using data from both sides of the switch
period, any shifting that did occur over
the five years would tend to be "aver-
aged" out when focusing on the middle
of the time period. In our case, this mid-
point represents the switch period itself.
Finally, a test was run to observe whether
beta instability was indeed a problem.
In our framework, it should be noted
that shifts in beta are a problem only if
the sample and control betas do not move
in the same direction. If the betas do move
together, then, once again, the d,(i)
measure only reflects market reaction to
a switch, since the "new beta" capturing
co-movement with general market condi-
tions is common for both the sample and
control companies. Therefore, in order
that fl-instability not be a problem, we
need only establish that the difference in
sample and control betas is zero for both
the pre-switch and post-switch periods.
This end was achieved by regressing the
values d,(i) against the (excess) market
return (Rmt- Rft) for the pre-switch pe-
riod (t = -124 to t = -25), and then
separately for the post-switch period
(t=25 to t= 124). For each of the 48
companies, for each sub-period, we have:
dt(i) = a, + bi(Rmt- Rft)
By our definition, the d,(i) measure has
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The Accounting Review, April 1981
alreadyeliminatedany reactionto overall
market conditions.Thus, so long as the
sample and "control" companies' fls
werestableor movedin tandemwe would
expect that d,(i) would not be sensitive
to general market returns. Hence, we
would expect bi to equal zero for each
subperiod.
A t-statisticwas calculatedto test the
null hypothesis that bi was not sig-
nificantlydifferentfromzero.An inability
to rejectthe null hypothesiswould indi-
cate that fl-instabilitywas not a problem,
since the sample and "control" com-
panies eitherwere stable or were shifting
together.We found that at the .05 level
of significance,rejectionof the nullwould
have occurredfor only one company in
the pre-switchperiod and for only two
companiesin the post-switchperiod. At
the .10 level of significance,the figures
were one and three companies, respec-
tively. For a sampleof 48 companies,we
would expectthat at levels of significance
of .05 and .10 just by chance alone the
null hypothesis would be rejected for
(.05x 48) 2.4 and (.10x 48) 4.8 companies,
respectively. As the results found are
below whatwouldbe expectedby chance,
we felt assured'2in proceedingwith this
sampleof controlcompanies.
StatisticalDesign
In this study,we look for abnormalbe-
havior around the time of the switch in
the returnsof the companiesthat changed
auditors.As definedin Equation(5), the
returndifference,d,(i),measuresthis ab-
normalreturnor marketresponseto the
switchfor companyi in week t. The aver-
age marketresponsefor a given partition
(group)in week t can thus be calculated
as:
12
Interestingly enough, two of the three companies
for which the null had been rejected during the post-
switch period were companies for which we did not have
(6) the full 100 weeks of observation in this period (see foot.
note 10). This point further strengthens the argument
that these results may be attributable to chance.
Fried and Schiff
dt(P) = E dt(i)
where
P= the particular partition (A, B, or
C) of firms being examined and
MP = the number of firms in the parti-
tion.
If we define t = 0 as the week in which
the 8-K report is filed, the average (ab-
normal) return due to the switch over a
given time period (-L to + L) can be
defined as:
L considered to be independent across t.
d(P) = E dt(P)
Nt= -L
where N =the length of the time period
being examined: N = 2L + 1.
An approach to testing our hypotheses
would be to examine whether these aver-
age abnormal returns (d(P)) are statisti-
cally different from zero. Applying a
univariate t test or multivariate T2 test to
the average return differences as calcu-
lated above, however, is not a straight-
forward proposition. To be able to carry
out these tests one must assume that the
observations taken for a given partition,
dt(P), are independent over time. Such an
assumption, however, is untenable as
long as the companies in our sample have
filing dates within N weeks of each other.
This point can be illustrated by the use of
the following example.'3 Suppose that
we have a sample of two firms x and y
whose filing dates correspond to the
first (Fl) and second (F2) weeks of
February, respectively. As the return dif-
ferences are summed over a period rela-
tive to a given firm's filing date and not
to a chronological or calendar frame-
work, we would have for t = 0:
do(P) = Rdo=F,(x) + do=F2y));
Similarly for t= 1 we would have:
d,(P) = !(d, =F2(X) + d, =F3(Y)) (10)
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335
Note that both do(P) and d1(P) con-
(7) tain an observation from the same cal-
endar week F2. In the case of t = 0, the
observation would be firm y's abnormal
return in calendar week F2, (do=F2(Y)).
For t= 1, the observation would be firm
x's abnormal return in calendar week F2,
(dl =F2(X))-
Empirical evidence [King, 1966] sug-
gests that these cross-sectional abnormal
returns would not be uncorrelated. In
general, then, since the companies in our
sample do have filing dates within N
weeks of each other, d,(P) cannot be
(8) Consequently, an estimate of the stan-
dard deviation of d,(P) (which would be
needed for a univariate t test or multi-
variate T2 test), calculated by
/L
S(P)= d (dt(P) -d(P))2
t= -L I1('l
would not be unbiased.
To overcome this problem, an ap-
proach based on Jaffe [1974a and b]14
and extended to the multivariate case
was used. The approach is designed to
enable one to carry out tests of signifi-
cance on the average return differences
calculated in Equation (8) without run-
ning into the problem caused by over-
lapping time periods. Essentially, what
the approach does is to form "port-
folios" (not to be confused with the parti-
tions we have formed in Table 2) on a
calendar-week basis of all companies
whose announcement dates were within a
number of weeks (L) of the calendar week
in question. Referring to our previous
example and introducing the notation
d(P)t to denote formulation of a port-
(9) 13 For illustrative
purposes, in our example, we
assume that we are interested only in examining the
behavior of return differences over the period 0 to 1.
14 Variations of this procedure have been used by
Patell [1976] and Hong et al. [1978].
336
folio on a calendar-week basis, we would
now have:
d(P)tFl =d(X)t=Fl (12)
d(P)t = F2=-ddt= F2(X)+ dt= F2(Y)); and (13)
d(P)t=F3=dt=F3(Y) (14)
Note that the observations of d(P)t(t= Ft,
F2, F3) contain no individual return dif-
ferences from the same calendar week.
Proceeding in this manner ensures in-
dependence of the observations under an
assumption that weekly returns are in-
dependent. Tests can thus be carried out
on these observations after an inter-
mediate "standardization" step. This
latter step is needed because, as the port-
folio composition of d(P)t differs from
week to week, one would not expect
different observations of d(P)t to have
identical distributions. The net effect of
these steps is that the abnormal return
"observations" used in our study can be
considered to be independent of each
other as well as identically distributed.
The details of the tests and portfolio
formulation steps are presented in the
Appendix.
Finally, looking for market reactions
to a particular event under investigation
involves a question of selecting the length
of the time period to be examined. In the
introduction to this paper, it was pointed
out that CPA switches may be associated
with other developments in the firm.
Hence, the switch could be one of many
signals emanating from the firm at this
time. As such, it was stated that any
results could not necessarily be attributa-
ble to the switch itself.
One way of gaining insight into this
issue is to vary the number of weeks
around the announcement date over
which return differences are averaged.
Thus, in the next section, we present
results looking at a period covering 24
weeks on both sides of the filing date
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The AccountingReview,April 1981
(N= 49) and at a shorter period of ten
weeks on both sides of the filing date
(N= 21).
RESULTS AND CONCLUSIONS
Results
Results for the full 49- and 21-week
periods are presented in Tables 4 and 5,
respectively. For the longer period of
time, we found no statistically significant
results for any of the partitions either on
an lB or EB level. That is, to say, if there
is any market reaction to a change in
auditors, it does not seem to be the result
of long-term economic phenomena as-
sociated with the companies in our
sample.
Examining the statistics in Table 5 for
the period closer to the filing date, we
found that the hypotheses associated with
the multivariate T2 test would be rejected
only at a 0.23 a level, which is not very
significant. That is, on an overall basis,
no abnormal market reaction was de-
tected for the partitions we examined.
Consistent with this result is, of course,
the finding that none of the EB univariate
t-tests would be rejected at a .1 a level.
However, when the hypotheses were
examined individually, a different picture
emerged. The TBresults suggests that the
interpretation of the results obtained
from the EB tests are not unequivocal
and that our results may be due to the
fact that our partitioning scheme did not
capture the motivation for the switches.
Specifically, when we examined all the
firms together as one group, the results
suggested that there is "bad news"
associated with an auditor switch. The
t-test for Hypothesis I, indicated that the
null hypothesis of no reaction to a CPA
switch [for the total (nonpartitioned)
sample] should be rejected at a .03 level
of significance. However, dividing the
sample into partitions A, B and C to see
if there were differing reactions along
Fried and Schiff 337

TABLE4
TESTSFORN=49
RESULTSOF UNIVARIATEAND MULTIVARIATE

One-TailSignificance
Meanof Level*
Differencex 102
Hypothesis Partition d(P) t-Score EB IB
I All Companies (AuBuC) -.08 - .61
II "Conflict" Companies (B) -.33 -1.07
III "Size Companies (C) -.26 - .46
Multivariate T2 Test Score= 1.40 Upper Tail** =.80

* Significance only stated if greater than .10 level of Significance.

** Based on Chi-Square Distribution with three degrees of freedom.

TABLE5
RESULTSOF UNIVARIATEAND MULTIVAmATETESTSFORN=21

One-TailSignificance
Meanof Level*
Differencex 102
Hypothesis Partition d(P) t-Score EB IB
I All Companies (AuBuC) -.21 -1.88 .0 3
II "Conflict" Companies (B) -.41 -1.28
III "Size" Companies (C) -.60 -1.58
Multivariate 72 Test Score=4.64 Upper Tail** =.23
* Significance only stated if greater than .10 level of Significance.
** Based on Chi-Square Distribution with three degrees of freedom.

the dimensions of "size" and conflict did
not prove to be fruitful. The results were
not sufficiently significant to reject the
null for Hypotheses II and III even on an
TB level. With respect to group C, for
companies that switched to large CPA
firms, we found negative market reaction
rather than the expected nonnegative
reaction that motivated this particular
partition. Hence, "upgrading the quality"
of CPA firms in a switch-our size di-
mension-did not reflect any particular
''good news" to investors.
Similarly, the lack of statistical results
for companies that changed their auditors
and reported conflicts (partition B) does
not support the contention15 that there
is informational benefit to the investor
from having companies and their CPAs
disclose any disagreement. The t-test
result, although it barely misses our .10
cut-off point (one-tail significance is
.1003), is nevertheless considerably
weaker than the significance found for
the total non-partitioned sample. This
finding is, of course, inconsistent with the
SEC disclosure requirement regarding
the reporting of conflicts.
The fact that the results for Hypothesis
I show significance, whereas the results
for the conflict grouping do not, suggests,
as we have noted, that if there is "bad
news" associated with switches, there is
some other motivation for it that has not
been accounted for in our partitioning
scheme.
15 Given the number of companies, ten, reporting
conflict in our sample, we are not willing to state the lack
of statistical support for informational benefits to the
investor in any stronger terms.

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338
In order to gain further insight into
the factors which may have accounted
for the results, we examined the A parti-
tion by itself. This partition consisted of
those firms which did not report a conflict
and switched to the same "size" CPA
firm. Had we been able to find negative
reactions for this partition, it would have
strengthened the impression that the
reporting of a conflict (or changing
"size") was not necessarily a factor
associated with the "bad news" found
for the total sample. However, we found
no statistically significant reaction at all
(t-statistic = -.62). 16 This finding sug-
gests that the conflict partition (B) and/or
"size" partition (C) contributed to the
rejection of Hypothesis 1.17 However, as
mentioned, these partitions on their own
show no significance, and in the case of
the "size" partition, the direction of the
results is counter-intuitive.
Findings in a paper by Shank and
Murdock [1978] may shed some light on
the ambiguity of our results. Their
analysis found an increased incidence of
qualified opinions for companies which
had high fls. They hypothesized that the
reason for their finding was that a large
number of qualifications dealt with ac-
counting disputes over events (such as
asset valuation) that are closely related to
economy-wide effects. Thus, high 11firms
would tend to have a greater likelihood
of receiving a qualified opinion on their
financial statements.
It is interesting to note that, with re-
spect to our sample, it was the companies
with the relatively high fis that reflected
most of the negative market reaction.
Specifically, dividing our sample into
high/low betas, we found significant
results18 for the high /1firms but none for
the low /3 firms. Group C, which had,
relatively speaking, the strongest statisti-
cal results in the negative direction by
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The AccountingReview,April 1981
group, was composed of all high /3 firms
(average /3= 1.3).
Although stronger evidence is needed,
these results might suggest that audit
switches may be a consequence of con-
flicts (not disclosed) over accounting
issues that are most directly related to
economy-wide events (e.g., uncertainty
related to financing and future liabilities).
We have not structured this analysis in
the framework of a formal hypothesis
because we feel stronger theoretical un-
derpinnings are still needed. However,
we do feel that a risk factor may be an
interesting focal point for future research
in the area of disclosure requirements
generally and specifically in the area of
filings for companies that change
auditors.
Conclusion
The general conclusion reached by our
study is that our results would seem to be
inconsistent with the SEC requirement
for a company to enumerate and describe
disagreements with its auditors on ac-
counting and auditing issues.
For the general event of auditor
switches, there is some evidence (on an
lB level) which indicates that there is
negative market reaction around the time
of the announcement of the switch. The
16 Focusing on other variations of our partitioning
scheme, such as comparing just the (A) and (B) port-
folios or (AuC) and (B) which isolated the conflict vs.
nonconflict situations given different assumptions about
the "size" effect, did not affect our results. They still
showed no significance.
17 Consistent with the above results, it should be
noted that the particular weighting scheme which
"maximized" the T2 statistic was aA =.26; aB=.40; and
ac=.34. These weightings do not deviate in a dramatic
fashion from the ones implied by Hypothesis I (aA=aB
= ac= 1/3), although there is some suggestion that parti-
tions B and C have a greater "impact" relative to parti-
tion A.
18 The univariate t-test would have been rejected at a
.10 level of significance for the high /3 portfolio with the
multivariate T2 statistic falling in the upper I -percent
portion of the curve.
Fried and Schiff
difficulty in interpreting this result is that
it is not clear what motivates this reac-
tion. The dimension of size and conflict
examined in this study did not yield a
conclusive explanation, since a partition-
ing along these lines resulted in no signifi-
cance being indicated.
This result suggests that further re-
search into the motivation for auditor
switches and the type of disclosure re-
quired at the time of the switch needs to
be undertaken. Given our results, we
could not find support for the assump-
tions implicit in the present SEC
disclosure requirement.
APPENDIX
OFTESTINGPROCEDURE
DESCRIPTION
(1) For any calendar week t, P19
portfolios of -companies that switched
CPAs in the period t - L to t + L were
formed. A company was placed in port-
folio tj (j= 1, P) depending on the type of
switch applicable to it. Note that t in this
case is to be interpretedon a calendar week
basis, rather than in terms of the number
of weeks before or after the announcement
date.
In addition, corresponding portfolios
consisting of the beta-matched securities
were formed for the week. If no firm for a
given classification j had switched in the
period t + L, then the portfolio tj con-
tained no securities and was ignored in
the statistical tests.
(2) The performance difference of port-
folio tj during the week t, defined as:
d(tj)t = M E dt(i)
Mtj ze-t1
was then calculated, where
d(tj)t= average return difference of
portfolio tj in week t;
dt(i)= the week t return difference of
the ith firm; as defined by
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339
Equation (5); and
Mtj= number of firms in portfolio tj.
(3) A measure of variability V(tj) of the
performance of portfolio tj and a measure
of covariability C(tjk) of the performance
of portfolio tj with the performance of
portfolio tk were then computed, using
the data of the previous 50 weeks;
1 50
V(tj) = 4 h (d(tj)th - (
49h= 1
1 50
C(tjk) = d(tj)t-h
49h= 1
- - d(tk))
d(tj))(d(tk)A-h
where
1 so
d(tj) = 150 d(tj)th
h= 1
It should be noted that only for those
weeks where both portfolios tj and tkcon-
tained at least one security each was
there a need to calculate C(tjk).
(4) The next step was to standardize
the performance difference for each port-
folio tj and find the average standardized
performance difference across all t.
The standardized difference for port-
folio tj is calculated as:
-
Sd(tj)t d_(')'
V1V(tj)
The average standardized performance
difference is defined as:
Sdj =-EI Sd(tj)tD(tj)
nj.
where D(tj) = 1 when there is at least one
19 The description that follows is presented for the
more general multivariate case. In that case, P is 3 and
the portfolio corresponds to the A-C groupings of Table
2. For each of the univariate cases, P is 1 and corresponds
to the particular hypothesis being tested (i.e., all com-
panies, B grouping and C grouping).
340 The Accounting Review, April 1981

security in portfolio tj and 0 otherwise; elements and S is the P x P covariance

and matrix containing SJ along its diagonal
and Sij elsewhere.
nj= D(tj) Testing the univariate null hypotheses
t
is carried out by forming the following
(5) Under an assumption that the re- t-statistic:
turns of the individual securities (or, more
precisely, the differences) are normally Sd
distributed, then each of the standardized Tj= (A2)
1/\/fnj
differences will have a t-distribution with
49 df. The average standardized residuals Since the degrees of freedom 49 nj are
will then also be t-distributed with de- large for all j(> 2000), we can use a chi-
grees of freedom approximately equal to square distribution with P= 3 degrees of
49 nj. The variance of -STwill be equal to: freedom (x2,3) to test T2 as calculated by
Equation (Al). For the t-statistic calcu-
I lated by Equation (A2) on the EB level,
V(tj)~ =
n2 12EV(tj) 'j a significance would be determined by
comparing ,j to Vx2,3,whereX2,3 denotes
and the covariance between Sd1 and Sdk
the upper lOOapercentage point of the
will equal:
chi-square distribution with 3 degrees of
freedom (see Morrison [1967, pp. 120-
.. .. C(tjk)
122]).
a}njnk t V V(tj) V(tk)
For the IB level, the t-statistic can be
(6) The overall null hypotheses can tested by use of the normal distribution.
then be tested in the multivariate cases by Since the percentage points of a normal
forming the following T2 statistic: distribution are equivalent to the square
root of a chi-square distribution with
T2 = SdS-I1Sd (Al) degrees of freedom equal to 1(1,7), it is
clear that the EB critical level will always
Where Sd is the P x l vector with Sdj as its be greater than the IB level.

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