Adverse Internal Control Over Financial Reporting Opinions and Auditor Dismissals/Resignations

This paper studies the factors that affect a firm's choice to dismiss or remain with their incumbent auditors when faced with adverse auditor opinions on the design and effectiveness of their internal controls. The study focuses on a unique sample of firms that received an adverse opinion in one year, followed by an unqualified opinion in the following year, thereby isolating a critical time in the client/auditor relationship. We find that the severity of the internal control problems, the auditor-related fees, the length of auditor-client relationships and the presence of a Big Four auditor affect the probability that a firm switches auditors. Further analysis examines the factors that affect auditor dismissals versus resignations, and switches from Big Four auditors to smaller audit firms or to other Big Four auditors. The existence of non-switching behavior among firms facing adverse internal controls over financial reporting opinions is supported by embeddedness theory, whereby client/auditor relationships demonstrate positive duration dependence and develop relationship-specific assets