Investor Monitoring and Auditor Choice: Evidence from Hedge Fund Activism

Abstract

To gain insight into the impact that investors have on the firm's auditor choice decision, this study investigates the association between changes in investor monitoring and auditor turnovers. Hedge fund activism provides a unique setting to observe how highly motivated investors, willing to incur significant expense to effect changes in target firms, are able to influence a firm's decision to dismiss their external auditor. I find that activist hedge fund targets see an increase in auditor turnovers and dismissals during the years following hedge fund activism relative to both the two years' pre-activism and a propensity matched sample of firms. I document that the increase in auditor turnovers is primarily driven by target firms with a Big 4 auditor, and that hedge fund targets primarily seek a lateral change in auditors. Consistent with institutional concerns that excess compensation impairs auditor independence, I find that activist targets are more likely to dismiss their auditors when the auditor is earning high non-audit service fees and high abnormal audit fees. I then examine how the market interprets the lateral change in auditors. I find that financial statement reliability increases for lateral auditor changes associated with independence concerns. Finally, I examine the conditions under which the hedge funds are able to facilitate an auditor change. I find that hedge funds pursuing less aggressive activist campaigns, and hedge funds seeking less public forms of interventions are more likely to seek an auditor dismissal. This relation between non-confrontational campaigns and auditor dismissals is consistent with prior research suggesting that hedge funds seeking to work with management are better able to enact changes in a target firm.