Risk Management in the Post-SOX Era: Do Audit Firms Effectively Retain Clients

Since the initial disclosure of accounting irregularities at Enron in late 2001, the landscape of public company audits has undergone substantial change. These changes include the conviction of Arthur Andersen in June of 2002 and the enactment of the Sarbanes-Oxley Act of 2002. These two changes have had a significant impact on the amount of work required to issue an audit report and the number of clients that can be serviced by the remaining Big Four audit firms. While the existing literature provides us some insight on how audit firms make client acceptance/continuance decisions, almost all this literature predates SOX. I extend this literature by investigating how audit firms make client continuance decisions in the post-SOX era, whether these decisions are effective at identifying better clients, and why audit firms retain some risky clients while dismissing others. It is interesting to note that Big Four audit firms use the same basic set of criteria when making a client continuance decision in the post-SOX era, even though the processes at the firms are slightly different. My findings also indicate that the client continuance process is much more formal and rigorous post-SOX. Additionally, I find that clients who are retained by their audit firms have better subsequent financial performance than those clients who are not retained. Finally, I find that audit firms appear to overweight client size when making the client continuance decision. Specifically, it appears audit firms retain large clients who have risk profiles consistent with smaller clients they dismiss.