6.2. 2012-Mia Dao-Shareholder Voting On Auditor Selection

THE ACCOUNTING REVIEW American Accounting Association
Vol. 87, No. 1 DOI: 10.2308/accr-10159

2012
pp. 149–171
Shareholder Voting on Auditor Selection,

Audit Fees, and Audit Quality
Mai Dao
University of Toledo
K. Raghunandan
Dasaratha V. Rama
Florida International University
ABSTRACT: The Advisory Committee on the Auditing Profession (ACAP), formed by

the U.S. Department of the Treasury, has recommended that all public companies be
required to have shareholder ratification of auditor selection. Using data from 1,382 firms
for the year ending December 31, 2006, we find that audit fees are higher in firms with
shareholder voting on auditor ratification. We also find that firms that started having a
shareholder vote pay higher fees than firms that stopped having a shareholder vote. In
the second part of our study, we find that in firms with shareholder voting on auditor
selection (1) subsequent restatements are less likely and (2) abnormal accruals are
lower. Our findings are consistent with the experimental results in Mayhew and Pike
(2004), and provide empirical grounding for the debate about mandating shareholder
voting on auditor selection.
Keywords: auditor selection; shareholder voting; audit fees; audit quality.
I. INTRODUCTION
T
he objective of this study is to examine the association between shareholder involvement in
auditor selection and (1) audit fees and (2) audit quality. Motivation for this study comes
from the U.S. Department of the Treasury’s (DoT 2008) Advisory Committee on the
Auditing Profession (ACAP), which recently recommended that all public companies must have an
annual shareholder ratification of the external auditor. The ACAP (DoT 2008, VIII:20) justified this
recommendation by stating that that the annual submission of auditor selection for ratification
enhances ‘‘competition in the audit industry.’’ The ACAP did not provide any empirical evidence in
support of the above recommendation, and research related to shareholder involvement in auditor
selection is sparse.
We gratefully acknowledge many useful comments and suggestions from Steve Kachelmeier (senior editor) and two
anonymous reviewers. We thank Abhijit Barua, Vishal Munsif, and Paul Tanyi for help with data collection and analysis.
Editor’s note: Accepted by Steven Kachelmeier.
Submitted: October 2009
Accepted: June 2011
Published Online: August 2011
149
150 Dao, Raghunandan, and Rama
The ACAP did not elaborate on exactly what benefits would accrue from any increased
competition among auditors. However, the traditional view of the courts, legislators, and regulators
has been that competition in any sector leads to higher quality and lower price (U.S. Supreme Court
1978; Federal Trade Commission 2003). In contrast, economic theory suggests that the joint effect
of competition on price and quality is not uniform; the effect of increased competition on price and
quality will depend on the relative elasticities of price and quality (Dranove and Satterthwaite 1992;
Kranton 2003). Even within the context of professional services, prior studies examining different
types of services have shown divergent results about the joint effects of enhanced competition on
price and quality (Kwoka 1984; Haas-Wilson 1986; Rizzo and Zeckhauser 1992; Kessler and
McClellan 2000).
While the ACAP recommends shareholder voting on auditor selection based on arguments
about increased competition, the same recommendation can be arrived at by using a governance and
accountability framework. We argue that any arrangement that strengthens the role of the
shareholders in auditor selection also changes the incentives of the auditors and strengthens auditor
independence.
The Sarbanes-Oxley Act (SOX, U.S. House of Representatives 2002) made audit committees
formally responsible for the selection and compensation of the external auditor; however, evidence
indicates that even in the post-SOX era, managers exercise significant control over the hiring and
firing of auditors (KPMG 2004; Cohen et al. 2010). If managers retain significant influence over
auditor selection, then auditors will be more likely to go along with the preferences of managers
(Saul 1996). Hence, institutional arrangements that strengthen the role of shareholders in auditor
selection will also strengthen auditor independence.
Mayhew and Pike (2004) examine, in a laboratory market setting, the effects of alternative
auditor hiring rules on competition in the audit market. They find that, in their experimental setting,
investor involvement in auditor selection leads to both higher audit quality and an increase in audit
fees. Mayhew and Pike (2004, 820) note that ‘‘further research into the institutional structures that
promote audit committee independence or produce the types of incentives for auditor independence
documented in our investor selection treatments is clearly warranted.’’
The ACAP recommendation represents a step in the direction toward increased shareholder
involvement in auditor selection. Saul (1996, 135) suggests that having shareholder ratification of
the auditor is ‘‘more than a symbolic act’’ in the context of strengthening auditor independence.
Accordingly, our objective is to empirically examine the association between shareholder
involvement in auditor selection and both audit fees and audit quality, using archival data. To the
extent that increased shareholder involvement in auditor selection alters the governance and
accountability dynamics between auditors, management, and shareholders, we find that shareholder
voting on auditor selection leads to both higher audit fees and better audit quality.
We use data from a sample of 1,382 companies included in the 2006 edition of the Board
Analyst database. We find that audit fees are higher in firms that submitted auditor selection for a
shareholder vote, after controlling for other factors associated with audit fees. This finding is
inconsistent with the argument generally advanced by legislators, regulators, and the judiciary, but
is consistent with the experimental evidence in Mayhew and Pike (2004).
As noted by Hermalin and Weisbach (2003), endogeneity is a pervasive problem in any
governance-related archival-empirical research. For example, it is possible that the same factors that
are associated with some firms voluntarily having a shareholder vote on auditor selection, since
such a vote is not currently legally required, are also associated with higher audit fees. We perform
a Hausman test of endogeneity between audit fees and shareholder voting on auditor selection, and
find that there is support for the two being endogenous. Accordingly, we perform two-stage
regression analysis and find that the positive relationship between shareholder involvement in
auditor selection and audit fees persists.
The Accounting Review

January 2012
Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality 151
We also perform a different type of test, relying on changes in firms’ policies relating to
shareholder voting on auditor ratification. Specifically, we focus on firms that changed from not
having a shareholder vote on auditor selection in 2005 to having such a vote in 2006, and vice
versa. Because auditor-selection-related issues are supposed to be the prerogative of the audit
committee after SOX, we require that the firms selected for such change analyses do not have a
change in the composition of the audit committee. With this additional restriction, we have 54 firms
that newly initiated an auditor ratification vote in 2006 and 45 firms that stopped having an auditor
ratification vote in 2006, and did not have a change in the membership of the audit committee. For
this subset of 99 firms, we perform the audit fee regression in the ‘‘changes’’ form. We find that the
indicator variable measuring change in auditor ratification policy is positive and significant,
indicating that firms that initiated an auditor ratification vote paid higher audit fees compared to
firms that stopped having an auditor ratification vote.
While audit pricing is directly observable, audit quality is a more difficult construct. The
quantity or quality of audit work is not directly observable, so researchers have used different
measures for audit quality. In this study, we use subsequent restatements as our measure for audit
quality. A restatement implies that the previously filed financial statements are unreliable and,
hence, the presence (or absence) of a restatement can be viewed as a direct measure of audit quality.
We restrict our analysis to restatements with a negative effect on financial statements. We find that
firms with a shareholder vote on auditor ratification during 2006 were less likely to have a
subsequent restatement of fiscal year 2006 financial statements.
Hennes et al. (2008) point out that not all restatements are the same, and suggest using stock
price reactions as a direct measure of problem restatements. Accordingly, we further restrict our
analysis to subsequent restatements that also had a negative stock price reaction. With this analysis
we also find that firms with a shareholder vote on auditor ratification were less likely to have a later
restatement that elicits a negative market reaction.
As with audit fees, we conduct Hausman tests of endogeneity but cannot reject the hypothesis
of exogeneity between subsequent restatements and shareholder involvement in auditor selection.
Unlike with audit fees, we do not perform the analyses with only the subset of firms changing
auditor ratification policies because only four firms from each of the change groups had a
subsequent restatement.
As additional analysis, we use clients’ abnormal accruals as another measure of audit quality.
Although using accruals measures as a proxy for audit quality is subject to many limitations (Ball
2009), previous studies have used clients’ abnormal accruals as a measure of audit quality given the
paucity of observable measures related to audit quality (e.g., DeFond and Subramanyam 1998;
Francis and Krishnan 1999). Following this tradition, we examine the association between
shareholder voting on auditor selection and abnormal accruals. We find that performance-matched
abnormal current accruals are lower in firms that submit auditor selection for shareholder
ratification. A Hausman test indicates the presence of endogeneity, but the association between
shareholder voting and accruals quality persists after controlling for endogeneity.
In summary, we examine an issue that is currently of interest to regulators and the accounting
profession but lacks relevant archival evidence. Research methods involve trade-offs, and the
benefit of an experimental setting such as the one used by Mayhew and Pike (2004) is that it
enables researchers to control and manipulate factors of research interest while ignoring other
external factors that are present in the real-world setting. Conversely, the benefits from archival
research are the use of more natural settings that currently exist and greater external validity.
Ideally, results from multiple methods should complement each other and there is greater
confidence in the inferences when different research methods yield the same basic findings. The
results from our archival tests validate the experimental results of Mayhew and Pike (2004) in a
closely related setting—that increased shareholder involvement in auditor selection leads to an

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increase in both audit fees and quality—but are inconsistent with the traditional arguments of
legislators, regulators, and the judiciary in the U.S. that enhanced competition will lead to lower
prices and higher quality.
Section II discusses the background. This is followed by a description of hypotheses, research
method, data, and discussion of results related to the two issues examined in this study: audit fees in
Section III and audit quality in Section IV. Section V concludes with a summary and discussion.
II. BACKGROUND
Shareholder Voting: Competition Perspective

Even when there were eight large international auditing firms, legislators had expressed
concerns about the (lack of ) competition in the audit market (U.S. Senate 1976, 1977; U.S. House
of Representatives 1985). Such concerns have become more pronounced as the Big 8 have now
become the Big 4 since 2002. For example, Section 701 of SOX mandates the General Accounting
Office (GAO) to study and report back to Congress about the concentration of the audit market and
the problems resulting from limited competition among public accounting firms. The GAO (2003,
Highlights) concluded that ‘‘the significant changes that have occurred in the profession may have
implications for competition and public company choice, especially in certain industries, in the
future.’’ In a follow-up report, the GAO (2008, Highlights) stated that ‘‘the loss of another large firm
would further reduce large companies’ auditor choice and could affect audit fee competitiveness.’’
Thus, it is clear that the extent of competition in the market for audit services for public
companies (and the resultant impact on fees) continues to be an issue of significant interest to
legislators and regulators. Such concerns led to the U.S. Department of the Treasury forming, in
October 2007, an Advisory Committee on the Auditing Profession (ACAP). The ACAP held a
series of meetings during 2007 and 2008, and issued a report in October 2008, proposing six
recommendations related to concentration and competition in the audit market. Recommendation
#5 suggests the adoption of ‘‘annual shareholder ratification of public company auditors by all
public companies’’ and notes as follows (DoT 2008, VIII:20–21):
The Committee believes shareholder ratification of auditor selection through the annual
meeting and proxy process can enhance the audit committee’s oversight to ensure that the
auditor is suitable for the company’s size and financial reporting needs. This may enhance
competition in the audit industry . . . The Committee also urges exchange self-regulatory
organizations to adopt such a requirement as a listing standard.
Competition, Price, and Quality

From an economic perspective, increased competition generally leads to higher quality and/or
lower price. However, if price and quality are jointly determined, then the effect of increased
competition on price and quality is not clear-cut; the effects of increased competition on price and
quality will depend on the relative elasticities of price and quality (Dranove and Satterthwaite 1992;
Kranton 2003).
Nevertheless, the U.S. Supreme Court (1978, 695) noted in a case brought by the National
Society of Professional Engineers: ‘‘The Sherman Act reflects a legislative judgment that ultimately
competition will produce not only lower prices, but also better goods and services . . . The
assumption that competition is the best method of allocating resources in a free market recognizes
that all elements of a bargain—quality, service, safety, and durability—and not just the immediate
cost, are favorably affected by the free opportunity to select among alternative offers.’’ Similarly,
the Federal Trade Commission (2003, 1) states that ‘‘vigorous competition forces producers to

January 2012
minimize costs and prices and to increase quality.’’ Thus, the legislative, judicial, and executive
views appear to be that increased competition will lead to lower prices and higher quality.
Empirical evidence on the joint effects of competition on price and quality is sparse and mixed
(Kranton 2003; Kallapur et al. 2009). Prior research shows that, when the ban on advertising was
removed (i.e., competition increased), the price of optometric services declined without an adverse
impact on quality (Kwoka 1984; Haas-Wilson 1986). However, in the case of physicians’ services,
the removal of the ban on advertising led to higher prices and an increase in at least some measures
of quality (Rizzo and Zeckhauser 1992). Similarly, Kessler and McClellan (2000) show that in the
case of hospitals, prior to 1991, higher levels of competition led to both higher costs and improved
quality.1
Shareholder Voting: Governance and Accountability Perspective

While the ACAP recommendation is based on the effects of increased competition, there is an
alternative perspective that is useful in the context of shareholder voting on auditor ratification.
Until the enactment of SOX, client management was responsible for selecting the auditor. Under
Section 301 of SOX, audit committees are directly responsible for the appointment, compensation,
and oversight of the auditor.
Accordingly, Section 301 of SOX is a recognition of the governance and accountability
perspective of auditor selection. Specifically, if management is responsible for hiring or firing the
auditor and negotiating the audit fee, then it is more likely that the auditor will go along with the
wishes of management (Saul 1996). Mayhew and Pike (2004, 798) note that the auditor’s ‘‘financial
dependence on the client depends heavily on the client’s ability to hire and fire the auditor. As a
result, the control over hiring and firing the auditor serves as the core incentive for auditors to
maintain or compromise their independence.’’ By removing the authority to hire and fire the auditor
from management, and vesting such authority with representatives of shareholders, Section 301 of
SOX sought to shift the locus of power in the auditor-manager relationship—and thereby enhance
auditor independence.
However, as noted by Mayhew and Pike (2004), in many companies, the board of directors is
dominated by management. This enables management to retain significant influence over auditor-
related decisions, including the hiring and firing of auditors. In these circumstances, auditors’
natural response is to be more likely to go along with managements’ preferred accounting choices.
Along these lines, a survey of audit committee directors and executives by KPMG (2004, 5) found
that, even after SOX, ‘‘69 percent of respondents said the chief executive officer or the chief
financial officer had the most influence over the compensation of the external auditor, and only 27
percent thought the audit committee had the most influence.’’ In a later study based on interviews
with 30 audit partners and managers from the Big 4 firms, Cohen et al. (2010, 752) report that
‘‘management continues to be seen as a major corporate governance actor and, contrary to the intent
of SOX, often the driving force behind auditor appointments and terminations.’’
The ACAP noted that, even though SOX gives the audit committees the responsibilities related
to the appointment and compensation by the auditor, shareholders should have a say in auditor
selection and that ‘‘ratification allows shareholders to voice a view on the audit committee’s work,
including the reasonableness of audit fees and apparent conflicts of interest’’ (DoT 2008, VIII:20).
Thus, shareholder voting on auditor ratification, while perhaps not as effective as direct shareholder
selection of the auditor, is a step toward increasing the role of shareholders in the auditor selection
process. Reflecting this view, shareholder activists have continued to press companies to let
1
This is the so-called ‘‘Medical Arms Race’’ hypothesis, and this logic has been used by the courts in litigation
involving hospital mergers. See, for example, U.S. vs. Carilion Health System, 892 F 2d 1042.

January 2012
shareholders vote on auditor selection because this is considered to be a good corporate governance
practice (Krishnan and Ye 2005; Institutional Shareholder Services [ISS] 2007a, 2007b).
Support for this governance-and-accountability-based perspective comes from the actions of
the Financial Reporting Council (FRC) in the United Kingdom. The FRC established the Market
Participants Group (MPG) in October 2006 to provide advice on ‘‘possible actions that market
participants could take to mitigate the risks arising from the characteristics of the market for audit
services to public interest entities in the United Kingdom’’ (FRC 2006, 1). The MPG issued its
report in October 2007 with a set of recommendations; Recommendation #8 notes that the FRC
should amend the rules ‘‘to include a requirement for the provision of information relevant to the
auditor re-selection decision,’’ while Recommendation #10 states that ‘‘investor groups, corporate
representatives, firms, and the FRC should promote good practices for shareholder engagement on
auditor appointment and re-appointments’’ (FRC 2007, 10). The MPG report noted that the
recommendations were ‘‘directed at improving the accountability of boards for their auditor
selection decisions’’ (FRC 2007, 10).
Finally, we interviewed three audit partners from three of the Big 4 audit firms and a
subcommittee chair of the ACAP about shareholder involvement in auditor selection. Of the audit
partners, one is a regional managing partner, the second is an office managing partner of a large
metropolitan office, and the third is a regional leader for audit practice. Two of the audit partners
and the ACAP member noted that shareholder voting on auditor selection led to slightly higher
risks for the auditor. To paraphrase, the partners and the ACAP member noted that ‘‘everyone
expects the auditor to receive 98 or 99 percent approval from the shareholders, so even if you get 90
or 95 percent approval, there are bound to be questions from the audit committee; in addition, even
if remote, there is a non-zero probability of a significant proportion of shareholders voting against
the auditor.’’ Two partners also discussed anecdotal evidence about Ernst & Young, which had 38
percent of Sprint shareholders voting against ratification in 2003, resulting in unfavorable media
coverage.2 To the extent that perceptions affect auditors’ judgments and actions, we can expect both
audit quality and price to be higher when there is a shareholder ratification vote on auditor selection.
III. SHAREHOLDER VOTING AND AUDIT FEES

Regulators in the U.S. and U.K. are considering recommendations to require all public
companies to have a shareholder vote on auditor selection. Some recent studies have examined
issues related to shareholder ratification of the auditor, including characteristics of firms submitting
auditor selection for a shareholder vote (Krishnan and Ye 2005) and the determinants of
shareholder votes for ratification (e.g., Raghunandan 2003; Hermanson et al. 2009). However, there
is little archival evidence related to the effect of having a shareholder vote on price and/or quality in
the market for audit services. This study seeks to fill this void, given the calls from regulators to
require companies to have such a shareholder vote.
As noted earlier, the experimental evidence in Mayhew and Pike (2004) and the governance/
accountability perspective suggest that shareholder voting on auditor selection leads to higher audit
fees and improved audit quality. Nevertheless, given the paucity of evidence on this issue, and
given the stated opinions of the judiciary and the executive that increased competition is expected to
result in lower price and better quality, we do not make a directional prediction for our first
hypothesis. Formally stated, our first hypothesis is:
H1 (null form): There is no association between shareholder involvement in auditor selection
and audit fees.
2
Following the shareholder vote, Ernst & Young was replaced as the auditor for Sprint.

January 2012
Model
We use the following regression model to test H1:
LogðAuditFeesÞ ¼ a0 þ a1 LogðTotalAssetsÞ þ a2 InvRecTA þ a3 SqrtSegments
þ a4 Foreign þ a5 CurrentRatio þ a6 Leverage þ a7 ROA
þ a8 GC þ a9 ICW þ a10 Big4 þ a11 Initial þ a12 VOTE þ error: ð1Þ
The variables are defined as follows:
Log(AuditFees) ¼ natural logarithm of audit fees;
Log(TotalAssets) ¼ natural logarithm of total assets;
InvRecTA ¼ ratio of assets in inventory plus accounts receivable to total assets;
SqrtSegments ¼ square root of the number of business segments;
Foreign ¼ 1 if foreign income is reported, 0 otherwise;
CurrentRatio ¼ ratio of current assets to current liabilities;
Leverage ¼ ratio of total liabilities to total assets;
ROA ¼ ratio of income before extraordinary items to total assets;
GC ¼ 1 if the firm receives a going-concern modified opinion, 0 otherwise;
ICW ¼ 1 if the firm has an adverse SOX 404 opinion, 0 otherwise;
Big4 ¼ 1 if the auditor is a Big 4 audit firm, 0 otherwise;
Initial ¼ 1 if the audit engagement is a first- or second-year audit, 0 otherwise;
VOTE ¼ 1 if the firm submits auditor selection for shareholder ratification vote, 0 otherwise.3
Starting from Simunic (1980), prior research has used various measures related to client size,
complexity, and risk as control variables in audit fee models. We use the same audit fee model as in
Raghunandan and Rama (2006). Following a long tradition in the auditing literature, we use the log
transformed audit fees, Log(AuditFees), as the dependent variable. Log(TotalAssets) is employed to
measure client size, and we expect the coefficient of Log(TotalAssets) to be positive. Three
variables—InvRecTA, SqrtSegments, and Foreign—proxy for client complexity, and we expect
positive coefficients for these three variables.
Five variables, CurrentRatio, ROA, Leverage, GC, and ICW, control for client financial
condition and internal control; the coefficients of CurrentRatio and ROA are expected to be
negative, while the coefficients of Leverage, GC, and ICW are expected to be positive. A large body
of literature has shown that there is a Big N audit fee premium, so we include Big4 and expect the
coefficient of this variable to be positive. Prior research also suggests that audit fees are discounted
for initial years of audit engagements (e.g., Simon and Francis 1988; Whisenant et al. 2003);
however, recent research suggests that initial audit engagements have an audit fee premium in the
post-SOX period (Huang et al. 2009), so we include Initial in the model but do not make a
prediction about the sign of the coefficient.
The independent variable of interest is VOTE. The governance/accountability perspective and
experimental results of Mayhew and Pike (2004) suggest that the coefficient of VOTE should be
positive.
Data
We start our sample with all U.S. companies that are included in the 2006 version of Corporate
Library’s Board Analyst database. As part of our analyses of audit quality, we examine subsequent
restatements; since it takes some time before restatements are discovered and disclosed, using data
3
Continuous variables (used in this and any subsequent regression) are winsorized at the 1st and 99th percentiles.

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from fiscal year 2006 enables us to examine subsequent restatements over a three-year period (until
the end of 2009). Section 404 of SOX first became applicable for fiscal years ending on or after
November 15, 2004, and auditors have noted that there has been a steep learning curve related to
audits in the post-Section 404 period. Hence, we restrict the analysis to the 2,084 companies with
fiscal years ending December 31, 2006.4 Consistent with prior research related to audit fees and
because firms in financial sectors have different financial statement reporting formats (and are
subject to additional regulations), we exclude 602 firms with SIC codes from 6000–6999.
We obtain data about audit fees, audit opinions, and auditor changes from the Audit Analytics
database, while financial data are from the Compustat database and 10-K filings available on the
SEC’s website. We manually collect data about submission of auditor selection for shareholder
ratification voting from proxy filings available on the SEC’s website. After eliminating 100
observations with missing data, our final sample includes 1,382 firms.
Descriptive Statistics
Panel A of Table 1 provides descriptive statistics about the variables used in the audit fee
regression model. The mean (median) audit fees for the sample firms are $2.86 ($1.53) million. The
mean and median values for the control variables are generally in line with those found in other studies
(e.g., Ghosh and Lustgarten 2006; Raghunandan and Rama 2006) that examine audit fees in the post-
SOX period.5 Seventy-five percent of the sample firms submitted auditor selection for shareholder
ratification in 2006. As seen in Panels B and C of Table 1, firms that submitted auditor selection for
shareholder ratification tend to be larger, are more likely to be audited by a Big 4 auditor, and are less
likely to have adverse Section 404 reports, going-concern modified audit reports, or auditor changes.
We test for multicollinearity between the independent variables by examining the correlation
matrix (untabulated). We find that all of the bivariate correlations are less than 0.50. We also find
that the variance inflation factors for the variables in the regression model are all less than 2.0,
indicating that multicollinearity does not cause problems with our inferences.
Audit Fee Regression Results

Table 2 presents the regression results for the model with Log(AuditFees) as the dependent
variable. The overall model is significant, and the adjusted R2 of 71 percent is in line with prior
audit fee studies. All control variables in the model (except for Leverage and Initial) are significant
and have the expected coefficient signs. The variable of interest, VOTE, is positive and significant
(p , 0.05). The magnitude of the coefficient of VOTE is 0.085, indicating that companies
4
There are two reasons why we restrict the analysis to clients with a 12/31 fiscal year-end. First, the Big 4 firms
noted in submissions to the SEC in 2005 and 2006 that SOX 404-related work had a significant impact on audit
fees and that there is a steep learning curve effect for SOX 404-related work; hence, a firm with a 12/31/2006 fiscal
year-end would be in the initial phase of the third year of SOX 404 work, while a firm with a 2/28/2006 (6/30/
2007) fiscal year-end would still be in the second year (later phase of the third year) cycle of SOX 404. We do not
want to contaminate our sample by mixing firms that would have been in different stages of the learning curve.
The second reason relates to the change from AS 2 to AS 5; the PCAOB approved the change in May 2007 to use a
more top-down approach, and this had a pronounced effect on audit work and fees; the PCAOB provided
permission for immediate application of the standard.
5
We also compared our firms with the overall Compustat population (after excluding foreign firms and firms in financial
sectors). In terms of industry, when we use the 12 industry groups based on Professor French’s (http://mba.tuck.
dartmouth.edu/pages/faculty/ken.french/data_library.html) classification, our sample has fewer firms in the ‘‘wholesale,
retail, and some services’’ category (5.9 percent in our sample versus 10.4 percent in Compustat). However, 75 percent of
the sample firms from this sector had a shareholder ratification of the auditor—identical to the proportion for the rest of the
sample. Firm size in our sample is, however, larger than in the Compustat population (e.g., average total assets are $1.00
billion for our sample compared to $199 million for the Compustat sample).

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TABLE 1
Descriptive Data
(n ¼ 1,382)
Panel A: Sample Statistics

Variable Mean Standard Deviation 25th Percentile Median 75th Percentile
Audit Fees ($000) 2,863.05 3,969.04 805.22 1,528.92 2,996.57
Log(Audit Fees) 14.31 1.00 13.60 14.24 14.91
Log(TotalAssets) 20.88 1.66 19.67 20.73 22.01
InvRecTA 0.22 0.17 0.08 0.18 0.32
SqrtSegments 1.44 0.53 1.00 1.00 2.00
Foreign 0.29 0.45 0.00 0.00 1.00
CurrentRatio 2.64 2.38 1.25 1.87 3.07
ROA 0.01 0.18 0.01 0.05 0.09
Leverage 0.53 0.27 0.34 0.53 0.68
GC 0.02 0.14 0.00 0.00 0.00
ICW 0.09 0.28 0.00 0.00 0.00
Big4 0.90 0.30 1.00 1.00 1.00
Initial 0.15 0.35 0.00 0.00 0.00
VOTE 0.75 0.43 0.00 1.00 1.00
Panel B: Comparison of Subsamples Partitioned by VOTE: Mean (Median) of Continuous

Variables Used in the Audit Fee Regression Model
VOTE ¼ 0 VOTE ¼ 1 p-value for t-test
(n ¼ 346) (n ¼ 1,036) (Mann-Whitney U test)
Log(TotalAssets) 20.49 21.02 ,0.01
(20.39) (20.93) (,0.01)
InvRecTA 0.23 0.21 0.07
(0.20) (0.17) (0.10)
SqrtSegments 1.48 1.43 0.14
(1.41) (1.00) (0.06)
CurrentRatio 2.54 2.67 0.39
(1.89) (1.86) (0.65)
ROA 0.01 0.01 0.85
(0.05) (0.04) (0.86)
Leverage 0.53 0.54 0.74
(0.51) (0.53) (0.30)
Panel C: Comparison of Subsamples Partitioned by VOTE: Proportion with Value of 1 for

Discrete Variables Used in the Audit Fee Regression Model
VOTE ¼ 0 VOTE ¼ 1 p-value
(n ¼ 346) (n ¼ 1,036) (Chi-square test)
Foreign 0.29 0.29 0.98
GC 0.05 0.01 ,0.01
ICW 0.13 0.07 ,0.01
Big4 0.84 0.93 ,0.01
Initial 0.23 0.12 ,0.01
The p-values are two-tailed.

(continued on next page)

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TABLE 1 (continued)
This table provides descriptive statistics about variables used in the audit fee model. The sample includes 1,382 firms that
(1) are in the 2006 edition of the Corporate Library database, (2) are U.S. firms, (3) have a December 31 fiscal year-end,
(4) are in nonfinancial industries, and (5) have required data.
Variable Definitions:
Initial ¼ 1 if the audit engagement is a first- or second-year audit, 0 otherwise; and
VOTE ¼ 1 if the firm submits auditor selection for ratification vote, 0 otherwise.
submitting auditor selection for shareholder ratification pay, on average, 9 percent higher audit fees.
This result is consistent with the evidence in Mayhew and Pike (2004) that increased shareholder
involvement in auditor selection is associated with higher audit fees.
Further Analyses: Endogeneity

Hermalin and Weisbach (2003) note that almost all research related to corporate governance is
subject to the problems associated with endogeneity. Thus, it is possible that the same factors that
are associated with greater shareholder involvement in auditor selection are also associated with
higher audit fees. Krishnan and Ye (2005) find that audit committee characteristics are associated
with the likelihood of shareholder voting on auditor ratification. Prior research also shows that good
corporate governance is associated with higher audit fees (e.g., Carcello et al. 2002), possibly due to
the demand for higher quality or quantity of monitoring by auditors. To the extent that good
corporate governance—such as, an audit committee with a greater number or proportion of
accounting experts—is associated with both greater shareholder involvement in auditor selection
and higher audit fees, the association documented earlier could reflect the same underlying
governance characteristics.
Hence, we perform the following two-stage analysis. In the first stage, in addition to the audit
fee model discussed above, we use the following PROBIT regression model:
VOTE ¼ c0 þ b1 LogðTotalAssetsÞ þ b2 ACExpert þ b3 DirectorVote þ b4 Return
þ b5 CEOCHR þ b6 InsiderOwn þ b7 Big4 þ b8 Initial þ error: ð2Þ
The variables VOTE, Log(TotalAssets), Big4, and Initial are as defined earlier. Other variables are
defined as in Krishnan and Ye (2005), as follows:
ACExpert ¼ proportion of audit committee directors who are accounting or auditing experts;
DirectorVote ¼ minimum percent of votes against the election of a director in the prior year;
Return ¼ prior-year common stock return minus the mean of two-digit SIC’s common stock
return for the prior year;
CEOCHR ¼ 1 if the CEO is also the Chair of the Board of Directors, 0 otherwise;
InsiderOwn ¼ proportion of common stock held by officers and directors.

January 2012
TABLE 2
Audit Fee Regression Results
Model:
LogðAuditFeesÞ ¼ a0 þ a1 LogðTotalAssetsÞ þ a2 InvRecTA þ a3 SqrtSegments
þ a4 Foreign þ a5 CurrentRatio þ a6 Leverage þ a7 ROA þ a8 GC
þ a9 ICW þ a10 Big4 þ a11 Initial þ a12 VOTE þ error:
Variable Expected Sign Coefficient p-value

Intercept 4.049 ,0.01
Log(TotalAssets) þ 0.455 ,0.01
InvRecTA þ 0.750 ,0.01
SqrtSegments þ 0.186 ,0.01
Foreign þ 0.350 ,0.01
CurrentRatio 0.015 0.02
Leverage þ 0.022 0.74
ROA 0.379 ,0.01
GC þ 0.323 ,0.01
ICW þ 0.458 ,0.01
Big4 þ 0.182 ,0.01
Initial ? 0.056 0.23
VOTE ? 0.085 0.01
Model F ¼ 283.9; p , 0.01; Adjusted R2 ¼ 0.71.

p-values are two-tailed.
The sample includes 1,382 firms that (1) are in the 2006 edition of the Corporate Library database, (2) are US firms, (3)
have a December 31 fiscal year-end, (4) are in nonfinancial industries, and (5) have all required data.
Initial ¼ 1 if the audit engagement is a first- or second-year audit, 0 otherwise; and
Our control variables are based on results from prior research. Krishnan and Ye (2005) find
that the likelihood of having shareholder voting on auditor selection is (1) positively related to
Log(TotalAssets), ACExpert, Return, and CEOCHR, and (2) negatively related to DirectorVote and
InsiderOwn. We include Big4 and Initial based on the evidence in Table 1 that firms with and
without shareholder voting on auditor selection differ along these dimensions.6
6
Table 1 shows that firms with and without auditor ratification also differ in terms of GC and ICW. However, we do
not include them in the model because these two variables are not known until the end of the year (after the
decision to have a shareholder ratification vote).

January 2012
The regression results (untabulated) indicate that Log(TotalAssets) and Return are positive and
significant (p , 0.10), while InsiderOwn and Initial are negative and significant (p , 0.01). The
overall model is significant (Chi-square ¼ 79.8, p , 0.001; Pseudo R2 ¼ 0.06).
We then use the same procedure as in DeFond et al. (2002). We examine if audit fees and
shareholder involvement in auditor selection are endogenous by first using the Hausman test for
endogeneity. The test indicates that the null hypothesis of exogeneity can be rejected (p , 0.05).
Hence, we use the fitted values for VOTE from the first-stage regression as the predictor in the
second-stage fee regression. We find that the coefficient of the fitted values of VOTE continues to
remain positive and significant in the second-stage regression (p , 0.05). The sign and significance
of all other variables in the regression attain the same levels of statistical significance as those in
Table 2.
Further Analysis: Change Sample

If shareholder voting on auditor selection is associated with audit fees, then changes in
shareholder voting should be associated with changes in audit fees.7 We focus on firms that
changed from not having a shareholder vote on auditor ratification in 2005 to having such a vote in
2006, and vice versa. We are able to obtain data about the presence or absence of an auditor
ratification vote in 2005 for 1,341 of our sample firms. There are 934 firms that had a shareholder
vote in both years, and 274 firms that did not have a vote in both years. There are 77 firms that did
not have an auditor ratification vote in 2005, but had such a vote in 2006; conversely, there were 56
firms that had an auditor ratification vote in 2005 but did not have such a vote in 2006.
Insofar as audit committees are involved in the hiring and compensation of the external auditor,
it is possible that changes in audit committee composition could be driving both changes in
shareholder voting policies and audit fees. Hence, from the sample discussed in the previous
paragraph, we delete firms with a change in the composition of the audit committee. This yields a
sample of 54 firms that started shareholder voting on auditor ratification in 2006 and 45 firms that
stopped shareholder voting on auditor ratification in 2006, with available data to conduct a changes
analysis of audit fees.
For the changes model, we use the same model (1) discussed above, except that the dependent
and independent variables are all measured in changes form (i.e., value for 2006 minus the value for
2005). The results from the changes regression are presented in Table 3. The overall model is
statistically significant, with an adjusted R2 of 0.41. The coefficient of D_VOTE is 0.04, indicating
that firms that changed from not having a vote in 2005 to having a vote in 2006 (i.e., D_VOTE ¼ 1)
had, on average, changes in audit fees that were about 8 percent higher than firms that changed from
having a vote in 2005 to not having a vote in 2006 (i.e., D_VOTE ¼ 1).
Additional Analyses
Prior research suggests that the level of competition is higher in the small-client segment of the
audit market (Francis and Simon 1987). Thus, we partition our sample into two subsamples: small
(firms with total assets less than the median) and large (firms with total assets more than the
median). We find that the primary result—namely, audit fees are higher in firms that submitted
auditor selection for shareholder ratification—continues to hold in both groups.
Many prior studies have documented that the market for audit services is segmented, with a
pronounced difference between the Big N and non-Big N firms (e.g., Ferguson and Stokes 2002).
7
A changes regression is particularly appropriate for audit fees because, in general, last year’s audit fees predicts
well this year’s audit fees; for example, in our sample a regression of last year’s fees on this year’s fees yields a
regression coefficient of 0.91.

January 2012
TABLE 3
Audit Fee Change Regression Results
Model:
D LogðAuditFeesÞ ¼ b0 þ b1 D LogðTotalAssetsÞ þ b2 D InvRecTA þ b3 D SqrtSegments
þ b4 D Foreign þ b5 D CurrentRatio þ b6 D Leverage
þ b7 D ROA þ b8 D GC þ b9 D ICW þ b10 D Big4
þ b11 D Initial þ b12 D VOTE þ error:
Variable Coefficient p-value

Intercept 0.013 0.70
D_Log(TotalAssets) 0.386 ,0.01
D_InvRecTA 1.511 ,0.01
D_SqrtSegments 0.004 0.98
D_Foreign 0.027 0.85
D_CurrentRatio 0.039 0.02
D_Leverage 0.159 0.47
D_ROA 0.305 0.19
D_GC 0.083 0.42
D_ICW 0.108 0.08
D_Big4 0.802 ,0.01
D_Initial 0.400 ,0.01
D_VOTE 0.040 0.08
Model F ¼ 6.73, p , 0.01; Adjusted R2 ¼ 0.41

This table presents the results from a ‘‘changes’’ regression. The sample includes 54 firms that changed from not having a
shareholder ratification vote of the auditor in 2005 to having such a vote in 2006, and 45 firms that went vice versa (i.e.,
had a ratification vote in 2005 but not in 2006). In addition, the change firms did not have any change in the composition
of the audit committee. The dependent variable is the change in Log(AuditFees), measured as Log(AuditFees) for 2006
minus Log(AuditFees) for 2005. All the independent variables are measured as the change in the value of the relevant
variable (value for 2006 minus the value for 2005). The variables are defined as in Table 2.
We therefore delete non-Big 4 clients from the sample. The overall results with this subsample are
substantively similar to those reported in Tables 3 and 4.
Summary
In summary, our analyses indicate that shareholder involvement in auditor selection is associated
with higher audit fees. We find that the coefficient of VOTE is positive and significant in the levels model
for 2006 audit fees. This finding persists after controlling for endogeneity. Finally, the change in
shareholder voting policy variable is significant in the audit fee changes model. Overall, the results are
consistent with the results reported by Mayhew and Pike (2004) from an experimental laboratory setting,
but are inconsistent with the view that shareholder voting on auditor selection will lead to lower audit fees.
IV. SHAREHOLDER VOTING AND AUDIT QUALITY

Mayhew and Pike (2004) find that shareholder selection of the auditor is also associated with
better quality audits. Specifically, Mayhew and Pike (2004) show that average auditor effort is

January 2012
TABLE 4
Shareholder Voting on Auditor Ratification and Subsequent Restatements
Panel A: Shareholder Voting and Subsequent Restatements

Subsequent Restatement
Shareholder Voting Yes No
Yes 53 983
(5.1%) (94.9%)
No 28 318
(8.1%) (91.9%)
Chi-square ¼ 4.17, p ¼ 0.04
Panel B: Shareholder Voting and Subsequent Restatements with Negative Market Effect
Subsequent Restatement with Negative Five-Day CAR
Shareholder Voting Yes No
Yes 36 1,000
(3.5%) (96.5%)
No 21 325
(6.1%) (93.9%)
Chi-square ¼ 7.78, p ¼ ,0.01
Panel C: Comparison of Subsamples Partitioned by VOTE: Mean (Median) Values

VOTE ¼ 0 VOTE ¼ 1 p-value
(n ¼ 346) (n ¼ 1,036) (t or Chi-square test)
ACExpert 0.21 0.22 0.49
SpecialistAud 0.24 0.33 ,0.01
Raise 0.16 0.15 0.51
Panel D: Logistic Regression Results

Model:
RESTATE ¼ c0 þ c1 LogðTotalAssetsÞ þ c2 ACExpert þ c3 Leverage
þc4 SpecialistAud þ c5 Raise þ c6 VOTE þ error:
Negative Effect and
All Negative Negative Market
Effect Restatements Reaction Restatements
Expected
Variable Sign Coefficient p-value Coefficient p-value
Intercept 1.508 0.34 2.535 0.18
Log(TotalAssets) 0.214 ,0.01 0.279 ,0.01
ACExpert 0.458 0.40 0.066 0.46
Leverage þ 0.553 0.08 0.642 0.08
SpecialistAud 0.144 0.30 0.090 0.78
Raise þ 0.273 0.26 0.200 0.35
VOTE 0.385 0.06 0.385 0.06
Chi-square ¼ 14.7, Chi-square ¼ 13.7,
p ¼ 0.02, Nagelkerke R2 ¼ 0.03 p ¼ 0.03, Nagelkerke R2 ¼ 0.03
(continued on next page)

January 2012
TABLE 4 (continued)
Panel A provides the association between shareholder voting on auditor ratification during 2006, and subsequent
restatements relating to 2006 that were disclosed in filings with the SEC until December 31, 2009. We include only those
restatements that had a negative effect on financial statements.
Panel B provides the association between shareholder voting on auditor ratification during 2006, and subsequent
restatements relating to 2006 that were disclosed in filings with the SEC until December 31, 2009. We include only those
restatements that had a negative effect on financial statements and had a negative stock price reaction, as measured by the
five-day Cumulative Abnormal Return (CAR) with value-weighted market adjustment.
Panel C compares three of the control variables used in the logistic regression model to explain subsequent restatements.
Panel D provides the results from a logistic regression where the dependent variables take the value of 1 if there is a
subsequent restatement with a negative effect on financial statements (subsequent restatement with both negative effect
on financial statements and a negative five-day cumulative abnormal return) in the first (second) regression, and 0
otherwise.
ACExpert ¼ proportion of audit committee members who are accounting or auditing financial experts;
SpecialistAud ¼ 1 if the auditor is an industry specialist (defined as having more than 33.3 percent of the market share,
using two-digit SIC codes), and 0 otherwise;
Raise ¼ (sum of cash raised by issuing common and preferred stock and long-term debt)/average total assets; and
higher, and auditor independence violations are lower, when there is shareholder involvement in
auditor selection. Economic theory suggests that enhanced competition can also have an effect on
the quality of a product, so another implication from the ACAP’s suggestion (that shareholder
involvement in auditor selection will lead to enhanced competition) is that shareholder voting
should be associated with higher quality audits. Further, the governance and accountability
perspective suggests that greater shareholder involvement in auditor selection should strengthen
auditor independence and lead to improved audit quality.
Audit quality is not directly observable, so prior studies have used a variety of measures as proxies
for audit quality. We use restatements as a measure of audit quality because a restatement is an admission
by the company that previously reported financial statements were materially misstated (Srinivasan
2005). Prior research shows that restatements increase the cost of capital (Hribar and Jenkins 2004) and
are associated with significant negative market reaction (Hennes et al. 2008). Several prior studies have
used restatements as a proxy for financial reporting problems (e.g., Kinney et al. 2004; Srinivasan 2005;
Arthaud-Day et al. 2006; Desai et al. 2006; Hennes et al. 2008). Finally, in our interviews, the audit
partners and the ACAP member recommended using restatements because (to paraphrase) they are
publicly observable and involve less of a judgment by a researcher about audit quality.
In the context of our study, both the ACAP/governance arguments and prior results from
Mayhew and Pike (2004) suggest that shareholder involvement in auditor selection should be
associated with higher quality audits. Hence, shareholder voting on auditor selection should be
associated with fewer restatements of financial statements in the future.
Formally stated, our second hypothesis (in the alternative form) is:
H2 (alternative form): Subsequent client restatements will be less likely in firms with
shareholder voting on auditor ratification.
Method and Data

Because we focus on shareholder voting for fiscal year 2006, we analyze restatements that are
related to fiscal year 2006 and were disclosed in SEC filings after the audited financial statements

January 2012
for fiscal year 2006 were filed with the SEC. We examine SEC filings until December 31, 2009. We
obtain restatement data from Audit Analytics, and we consider only those restatements that had a
negative effect on financial statements.
Hennes et al. (2008) note that not all restatements are equal, and point out the advantages of
relying on market reaction to determine the severity of a restatement. Accordingly, as an alternative
measure, we use a more stringent criterion by including only those restatements that, in addition to
having a negative effect on financial statements, also elicited a negative market reaction. We obtain
the five-day cumulative abnormal return (CAR) surrounding the restatement announcement date,
using a value-weighted market adjustment.8
Unlike for audit fees, there is no standard model that has been consistently found to be good at
explaining restatements over multiple years and studies. Recent studies that have used the
occurrence of a restatement as a dependent variable include Abbott et al. (2004), Kinney et al.
(2004), Larcker et al. (2007), Archambeault et al. (2008), Romanus et al. (2008), Scholz (2008),
and Chin and Chi (2009). For our logistic regression model, we include as control variables all
those factors that are significant in at least two of the above studies. Accordingly, our model is as
follows:
RESTATE ¼ c0 þ c1 LogðTotalAssetsÞ þ c2 ACExpert þ c3 Leverage þ c4 SpecialistAud
þ c5 Raise þ c6 VOTE þ error
ð3Þ
where:
RESTATE ¼ 1 if there is a subsequent restatement relating to fiscal year 2006 that had a
negative effect on financial statements (and, in the second test, also had a five-day negative
cumulative abnormal return);
SpecialistAud ¼ 1 if the auditor is an industry specialist (with more than 33.3 percent of the
market share, using two-digit SIC codes), 0 otherwise; and
Raise ¼ (sum of cash raised by issuing common and preferred stock and long-term debt)/
average total assets.
The other variables, Log(TotalAssets), ACExpert, Leverage, and VOTE, are as defined earlier.
Results
Panel A of Table 4 presents the univariate association between shareholder voting on auditor
ratification and subsequent restatements. Fifty-three of the 1,036 (5.1 percent) firms with
shareholder ratification vote of the auditor had a subsequent restatement, while 28 of the 346 (8.1
percent) firms without a ratification vote had a subsequent restatement. The difference is statistically
significant (Chi-square ¼ 4.17, p ¼ 0.04).
Panel B of Table 4 presents the results when we use only those restatements that elicited a
negative market reaction. Thirty-six of the 1,036 (3.5 percent) firms with shareholder voting on
auditor ratification had a subsequent restatement that elicited a negative market reaction; 21 of the
346 (6.1 percent) firms without a ratification vote had a negative market reaction. This difference is
statistically significant (Chi-square ¼ 7.78, p , 0.01).
Panel C of Table 4 presents data about univariate differences between the two groups of firms
partitioned by VOTE. This panel shows that there is no significant difference between the two
8
As part of sensitivity analyses, we use the three-day or seven-day CAR and classify a restatement as negative only
if such CAR is negative. The results with such alternative specifications are substantively similar to those
presented in Table 4; VOTE continues to be negatively related to a subsequent restatement.

January 2012
groups in terms of ACExpert or Raise; however, firms that have a shareholder vote are more likely
to have an industry-specialist auditor.
Panel D of Table 4 presents the results from two logistic regressions. In both regressions, the
dependent variable is the presence of a subsequent restatement relating to fiscal year 2006 financial
statements. In the first regression, the dependent variable equals 1 if there is a subsequent
restatement that has a negative effect on financial statements; in the second regression, the
dependent variable equals 1 only if, in addition to having a negative effect on financial statements,
the restatement announcement has a five-day cumulative market-adjusted return that is negative.
Both regressions are significant at conventional levels, although the explanatory powers of the
models are low. In both regressions, the coefficient of VOTE is negative and significant at p ¼ 0.06,
indicating that firms that had a shareholder vote on auditor ratification are less likely to have a
future restatement. The coefficient of VOTE is 0.385, so having a shareholder vote on auditor
ratification is associated with a 32 percent reduction in the likelihood of a later restatement, on
average.
It is possible that financial reporting quality and having a shareholder vote on auditor selection
are endogenously determined. Hence, as with audit fees, we perform a Hausman test for
endogeneity using the restatement model and the shareholder voting model discussed earlier. We
find that the null hypothesis of exogeneity cannot be rejected (p ¼ 0.22).
Unlike for audit fees, we do not perform a formal test focusing on those firms that changed
their ratification policies in 2006. This is because only four firms from each of the two groups—the
group of 54 firms that started auditor ratification in 2006 and the group of 45 firms that stopped
auditor ratification in 2006—have a subsequent restatement.
Additional Analysis: Abnormal Accruals

Prior studies in a variety of contexts have used client discretionary accruals as the proxy for
audit quality (e.g., Becker et al. 1998; DeFond and Subramanyam 1998; Francis and Krishnan
1999). Following this line of research, we use performance-matched discretionary accruals as an
alternative proxy for audit quality and examine the association between shareholder involvement in
auditor selection and client abnormal accruals.
We follow the same approach as in Geiger and North (2006), who examine accruals quality
after the hiring of a new CFO. As in Geiger and North (2006), we use a measure of abnormal
current accruals after adjusting for performance as suggested by Kothari et al. (2005). Following
Geiger and North (2006), we estimate abnormal current accruals by using the cross-sectional
version of the Jones (1991) model introduced by DeFond and Jiambalvo (1994). We estimate the
following model by two-digit SIC industry and by year:9
TCAit =Ait1 ¼ u0 þ u1 ð1=Ait1 Þ þ u2 ðDREVit DRECit Þ=Ait1 þ eit ð4Þ
where:
TCAit ¼ firm i’s total current accruals in year t measured as ¼ (DCAit DCLit DCashit þ
DSTDEBTit), where:
DCAit ¼ change in current assets for firm i from year t1 to year t;
DCLit ¼ change in current liabilities for firm i from year t1 to year t;
DCashit ¼ change in cash and short-term investment for firm i from year t1 to year t;
DSTDEBTit ¼ change in current portion of long-term liabilities for firm i from year t1 to
year t;
9
We use the Compustat population to calculate abnormal accruals.

January 2012
Ait1 ¼ total assets of firm i for year t1;

DREVit ¼ change in revenues for firm i from year t1 to year t;
DRECit¼ change in receivables for firm i from year t1 to year t; and
eit ¼ error term.
The residuals from the industry and year-specific regressions using Equation (4) are a measure
of abnormal current accruals (ACA). We then adjust ACAit for performance matching following the
approach used by Francis et al. (2005). We form performance decile groups by industry based on
the current year’s ROA (income before extraordinary items divided by total assets). We estimate
performance-matched abnormal current accruals (PMACAit) as the difference between ACAit and
median ACA for the ROA decile to which firm i belongs (where the median is calculated excluding
firm i ).
Following Geiger and North (2006), we then use the model below to examine the association
between shareholder involvement in auditor selection and audit quality:
PMACA ¼ h0 þ h1 MVE þ h2 BM þ h3 Distress þ h4 CFFO þ h5 Growth þ h6 Finance
þ h7 ACQ þ h8 LROA þ h9 VOTE þ error:
ð5Þ
The variables are defined as in Geiger and North (2006), as follows:
PMACA ¼ performance-matched abnormal current accruals;
MVE ¼ natural logarithm of market value of equity;
BM ¼ book-to-market ratio;
Distress ¼ financial distress measure (calculated from Zmijewski [1984]);
CFFO ¼ cash flow from operations divided by total assets;
Growth ¼ sales growth rate;
Finance ¼ 1 if the number of outstanding shares increased by at least 10 percent or long-term
debt increased by at least 20 percent during the year;
ACQ ¼ 1 if the company engaged in an acquisition, 0 otherwise;
LROA ¼ return on assets from the prior year; and
VOTE ¼ 1 if the firm submits auditor selection for shareholder ratification vote, 0 otherwise.
Panel A of Table 5 presents descriptive details about abnormal current accruals when the
sample is partitioned based on shareholder involvement in auditor selection. The sample size for the
abnormal current accruals analysis drops to 1,261, of which 945 firms submitted auditor selection
for shareholder ratification. Firms that submitted auditor selection for shareholder ratification have
significantly (p ¼ 0.02) lower abnormal current accruals.
Panel B of Table 5 presents the results from the regression model (5) above. The model is
significant (p , 0.01), and the coefficients of the control variables generally have the signs
expected based on prior research. The coefficient of VOTE is negative and significant (p , 0.01),
indicating that performance-matched abnormal current accruals are lower in firms with shareholder
ratification of the auditor.
As with the audit fee model, the same factors that are associated with shareholder involvement
in auditor selection may also be associated with accruals quality. We address the endogeneity issue
using 2SLS analysis as before. We find that (1) the null hypothesis of exogeneity can be rejected (p
, 0.05), and (2) in the second-stage analysis, the coefficient for fitted values of VOTE is negative
and significant (p , 0.05) in the regression.
We also examine if abnormal accruals differ for firms that changed their ratification policies.
For such analyses, as in Geiger and North (2006), we use changes in discretionary accruals as the
dependent variable; the control variables are also measured in changes form, and the variable of

January 2012
TABLE 5
Abnormal Accruals Regression Analysis
Panel A: Descriptive Data for Abnormal Current Accruals

Shareholder Vote Standard 25th 75th p-value
on Auditor Ratification Mean Deviation Percentile Median Percentile from t-test
Yes (n ¼ 945) 0.0196 0.0941 0.0476 0.0125 0.0183 0.015
No (n ¼ 316) 0.0056 0.0850 0.0409 0.0053 0.0332
Panel B: Regression Results

Model:
PMACA ¼ h0 þ h1 MVE þ h2 BM þ h3 Distress þ h4 CFFO þ h5 Growth
þh6 Finance þ h7 ACQ þ h8 LROA þ h9 VOTE þ error:
Variable Coefficient p-value

Intercept 0.0276 0.03
MVE 0.0043 0.02
BM 0.0005 0.93
Distress 0.0076 ,0.01
CFFO 0.2659 ,0.01
Growth 0.0197 ,0.01
Finance 0.0039 0.47
ACQ 0.0014 0.79
LROA 0.0816 ,0.01
VOTE 0.0161 ,0.01
n ¼ 1,261; Model F ¼ 19.95, p , 0.001; Adjusted R2 ¼ 0.12

Panel A provides descriptive data about portfolio-matched abnormal current accruals, calculated using the cross-sectional
Jones (1991) model as applied in Kothari et al. (2005).
Panel B provides results from a regression where the dependent variable is portfolio-matched abnormal current accruals,
calculated using the cross-sectional Jones (1991) model as applied in Kothari et al. (2005).
MVE ¼ natural logarithm of market value of equity;
BM ¼ book-to-market ratio;
Distress ¼ financial distress measure (calculated from Zmijewski [1984]);
CFFO ¼ cash flow from operations divided by total assets;
Growth ¼ sales growth rate;
Finance ¼ 1 if the number of outstanding shares increased by at least 10 percent or long-term debt increased by at least
20 percent during the year;
ACQ ¼ 1 if the company engaged in an acquisition, 0 otherwise;
LROA ¼ return on assets from the prior year; and
interest is the change in shareholder ratification policy. However, unlike for audit fees, we find that
there are no significant differences between the firms that started and the firms that stopped auditor
ratification in 2006 when we examine (1) in univariate analysis, the levels of abnormal accruals in
2006 or changes in abnormal accruals from 2005 to 2006, or (2) the changes version of the
regression model for abnormal accruals.

January 2012
V. SUMMARY AND DISCUSSION

The U.S. Department of the Treasury appointed an Advisory Committee on the Auditing
Profession (ACAP) in 2007 because of concerns about the market for public company audits. In
October 2008, the ACAP issued a set of recommendations related to human capital, firm structure
and finances, and concentration and competition. As a part of the recommendations, the ACAP
suggests that all public companies be required to have shareholder ratification of auditors. This
recommendation is based on the belief that shareholder involvement in auditor selection will
‘‘enhance competition in the audit industry’’ (DoT 2008, VIII:20).
The ACAP did not provide any empirical support for recommending mandatory shareholder
involvement in auditor selection. However, the traditional argument espoused by legislators, the
executive, and the judiciary in the U.S. is that enhanced competition leads to lower price and higher
quality. While the ACAP used the language of competition, an alternative perspective is to view
shareholder voting from a governance and accountability framework. In this view, when there is
shareholder involvement in auditor selection, the investors become monitors of the auditor’s work.
Such an arrangement makes the auditor more a direct agent of the shareholder than of the board of
directors and/or management. Shareholder voting can be viewed as aligning the auditor’s incentives
more with shareholders than in cases where the audit committee or management makes the auditor
hiring decision without shareholder approval. Increased shareholder participation is likely to
strengthen auditor independence and lead to both higher audit quality and higher audit fees.
We examine if firms that have shareholder voting on auditor ratification pay lower (or higher)
audit fees than firms without such shareholder participation. Using data from 1,382 firms for the
year ending December 31, 2006, we find that audit fees are about 9 percent higher for firms that
have shareholder voting on auditor ratification. Our results continue to hold after we control for
potential endogeneity between audit fees and shareholder voting on auditor selection. When we
restrict the analysis to firms that changed their auditor ratification policy in 2006 and did not have a
change in the composition of the audit committee, we find that firms that started auditor ratification
pay higher audit fees than firms that stopped auditor ratification in 2006.
We also examine the association between shareholder voting and audit quality. We find that
firms with a shareholder vote on auditor ratification are less likely to have subsequent restatements
that have a negative effect on financial statements. Our results hold when we restrict the analysis to
restatements that elicit a negative five-day cumulative abnormal return. Further tests indicate that
having a shareholder vote is not endogenous with a subsequent restatement. However, we are
unable to perform a change analysis with restatements because only four firms from each the two
groups of firms, that started or stopped auditor ratification in 2006, had a restatement relating to
fiscal year 2006 in the subsequent three years.
We find that abnormal accruals are lower in firms with shareholder involvement in auditor
selection. Having a shareholder vote appears to be endogenous with accruals, but the association
between having a shareholder vote and abnormal accruals persists after we control for endogeneity.
Taken together, the results indicate that shareholder involvement in auditor selection is
associated with higher audit fees and improved audit quality. As in Mayhew and Pike (2004), our
conjectures (based on interviews with three audit partners and an ACAP subcommittee chair) are as
follows. Shareholder involvement in auditor selection strengthens the power of the auditor in any
negotiations with management and increases the ‘‘pressure to perform’’ on the auditor. As noted by
the audit partners and the ACAP member, if there is a shareholder vote, then questions will be
raised if an auditor who routinely gets 98 percent ratification drops down to 95 or 90 percent
support from shareholders; further, a shareholder vote means there is a non-zero probability of
receiving a negative vote from shareholders, which increases the risk to the auditor. If auditors are
likely to be more careful to avoid the possibility of any criticism (as may be the case when a higher

January 2012
than expected proportion of shareholders do not vote to ratify the auditor), then it is likely that
auditors would spend extra effort and be more cautious in negotiations with the client. The
additional costs associated with the extra effort would likely be passed along to the client and lead
to higher audit fees; the extra caution, coupled with the extra effort, would likely lead to better
quality audits.
Thus, our findings support the experimental results obtained in a laboratory setting by Mayhew
and Pike (2004). In terms of policy implications, our findings suggest that shareholder involvement
in auditor selection benefits audit quality, although with higher fees. Our results, when combined
with those of Mayhew and Pike (2004), can be viewed as providing support for requiring
shareholder involvement in auditor selection, provided that the argument is based in terms of
governance and accountability rather than increased competition.
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THE ACCOUNTING REVIEW American Accounting Association

Vol. 87, No. 1 DOI: 10.2308/accr-10159

Shareholder Voting on Auditor Selection,

ABSTRACT: The Advisory Committee on the Auditing Profession (ACAP), formed by

Keywords: auditor selection; shareholder voting; audit fees; audit quality.

The Accounting Review

The Accounting Review

Shareholder Voting: Competition Perspective

Competition, Price, and Quality

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Shareholder Voting: Governance and Accountability Perspective

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III. SHAREHOLDER VOTING AND AUDIT FEES

The Accounting Review

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Audit Fee Regression Results

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Panel A: Sample Statistics

Panel B: Comparison of Subsamples Partitioned by VOTE: Mean (Median) of Continuous

Panel C: Comparison of Subsamples Partitioned by VOTE: Proportion with Value of 1 for

The p-values are two-tailed.

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Further Analyses: Endogeneity

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Variable Expected Sign Coefficient p-value

Model F ¼ 283.9; p , 0.01; Adjusted R2 ¼ 0.71.

The Accounting Review

Further Analysis: Change Sample

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Variable Coefficient p-value

Model F ¼ 6.73, p , 0.01; Adjusted R2 ¼ 0.41

IV. SHAREHOLDER VOTING AND AUDIT QUALITY

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Panel A: Shareholder Voting and Subsequent Restatements

Panel C: Comparison of Subsamples Partitioned by VOTE: Mean (Median) Values

Panel D: Logistic Regression Results

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Method and Data

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Additional Analysis: Abnormal Accruals

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Ait1 ¼ total assets of firm i for year t1;

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Panel A: Descriptive Data for Abnormal Current Accruals

Panel B: Regression Results

Variable Coefficient p-value

p-values are two-tailed.

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V. SUMMARY AND DISCUSSION

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The Accounting Review

The Accounting Review

The Accounting Review

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