The Scandal Involving Enron And Arthur Anderson Accounting Essay

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The scandal involving Enron and Arthur Anderson forced US regulators to impose the Sarbanes-Oxley Act of 2002 (SOX) to reinforce investor confidence, corporate accountability and professional responsibilities. UK followed suite as the Financial Reporting Council (FRC) published a Combine Code of Corporate Governance. In an environment with constantly rising audit fees since the collapse of Andersen, has not particularly changed the drivers of client satisfaction from those indentified and tested in the past. Although the number of 'Big' audit firms has declined, the number of publicly traded firms has not considerably changed, yet the degree of influence in audit firm selection has decreased. Dysfunctional audit procedures have been cut down due to improving international regulatory standards coupled with high audit fees and a reduction in large audit firms, making client satisfaction a more overwhelming task.

In the post SOX era, both internal control reporting and financial statement audit are mandatory and performed by the same audit firm. Consulting services were temporarily barred after August 2002 following Andersen's conviction in the Enron matter. Since then although regulations have somewhat eased and now audit firms provide non-audit services (NAS), it is uncertain if the remaining Big 4 firms have been able to sustain sufficient levels of client satisfaction under such restrictive regulations (GAO, 2003a). As many of Anderson's 2500 clients dispersed to the remaining Big 4 firms, GAO surveys a sample of Fortune 1000 companies, all of whom used a Big 4 firm as their auditor (GAO, 2003b). Although the survey found average auditor tenure to be 19 years, 30% of the sample had auditor tenure of less than 2 years. 93% of this short tenure group were former Andersen clients (GAO, 2003b). Most of these clients claimed to be dissatisfied with their current auditor.

As mentioned previously, modern corporation theory agency cost, therefore the principal objective of corporate governance in to effectively monitor and control behaviours of various interested parties, consequently improving the principal-agent relationships (Maniam et al., 2006). Therefore corporate governance can be defined as s set of external and internal rules, policies and measures to govern behaviours of various interested parties with in a firm, and effective governance should be able to bridge the authority and responsibilities of various parites involved in order to reduce potential conflicts of interest (----).Singh and Davidson (2003) argue that this can only be done by implementing contractual responsibilities and obligations to facilitate goal congruence as a whole among all stake holders including the Board of Directors (BoD), management, employees and shareholders.

Anderson et al. (2004) discovered that corporate governance is positively associated with a firm's operating efficiency and effectiveness. Higher premiums are accepted by investors for firms with sound corporate governance (McKinsey & Company, 1999-2002; Steen, 2005). After the infamous corporate scandals or WorldCom and Enron academics have extensively researched corporate governance (role of Board and Audit Committee) in the context of financial reporting, particularly concentrating on the importance on AC characteristics including independence, composition, compensation, financial expertise, size and influence amongst others. These characteristics seem to have a direct/indirect relationship with audit quality. AC independence is at the forefront of such research. Bronson, Carcello, Hollingsworth and Nea (2009) argue that the benefits of audit committee independence are consistently achieved only when the AC is completely independent, which is in line with the SOX requirement of 100% independent AC's. The underlying assumption being that "Independent directors are better monitors of management than t he are inside directors" (Bronson, Carcello, Hollingsworth and Nea 2009).

Zhang, Zhou and Zhou (2007) further identify that AC's with less expertise (accounting, financial and non-financial) are more likely to have internal control weakness resulting in fraudulent reporting or audit failures. As audit provides independent check on the work of the firm's management subsequently reinforcing the confidence in corporate financial reporting, auditing can be considered as a tool of corporate governance. Lee et al. (2005) contend that auditors should also investigate and appraise internal control procedures which would ensure effective compliance, while enhancing the role of corporate governance. Audits become valuable for a firm when they significantly contribute towards corporate governance (----). Empirical research shows that the demand for independent audit as a device for corporate governance by firms in UK and US is a function of audit quality and the assurance provided by audit firms (Cohen et al., 2002 and Ghosh and Moon, 2005).

Nonetheless, corporate governance should also have a positive impact on the quality and effectiveness of external auditing (Abbott et al., 2007; Ashbaugh and Warfield, 2003). An efficient corporate governance structure should ensure that their AC's appoint independent and qualified auditors and that auditors should ensure the firms appoint qualified auditors and ensure that auditors should employ independent and efficient monitoring while attesting the firm's financial statements for conformity with GAAP/ IFRS. Thus, corporate governance should play a role in enhancing the credibility and usefulness of the financial statements to all stakeholders (Bushman and Smith, 2001; Dewing and Russell, 2003; Maniam et al., 2006).

Contrastingly, when there is a lack of sound corporate governance, it would be difficult to prevent the firm's management from infringing upon the interests of the firm and other stakeholders while the audit function may be unable to play its monitoring and assurance roles effectively (Marnet, 2005; Rosner, 2003). Certainly the association between corporate governance and external auditing (including auditor choice and switching) is an important issue worthy of exploration

2.2 The role of financial reporting and audit quality

In modern market economies, business incorporation led to the separation of ownership and management. Shareholders are usually not directly involved in the administration or operations of the business, a task for which professional managers are employed. This separation in owner and control leads to information asymmetry, enabling self interested managers to pursue self welfare at the expense of owners, inevitably leading towards 'agency cost' (Jensen and Meckling, 1976). This has forced regulators to impose a system to bind managers in order to influence them to act in the best interest of business and its owners. A core part of this system is auditing, conducted by independent professional organisations to justify and attest the information provided by the management (Watts and Zimmerman, 1986).

Independent auditing can ease the agency costs associated with the contractual relationships between the owners and the management or among various groups of stakeholders (----). An auditor is therefore not only responsible to substantiate the fairness and totality of the financial statements produced by the management but also, scrutinize the management's financial performance in terms of the supervisory reliability. This ability to detect earnings management enhances the usefulness of accounting numbers for investor's decision making (Imhoff, 2003). This proves that an auditor performs two roles in corporate financial reporting, that of information intermediary and assurance provider. Financial reporting standards as similar to public law are a constantly evolving and developing process. Researchers have found that in the UK proposed changed to UK Company Law, increasing legislations from the EU, post-Enron reform and switch to international financial reporting standards import significant and costly implementation challenge to UK companies, auditors, and regulators (Fearnley and Hines, 2003). Nevertheless, regulators still aspire to remain engaged with the professional bodies and continue to delegate regulation to private sector bodies and support voluntary codes of practice wherever appropriate. Legislation and extensive rules are seen as a backstop only to be applied where all else fails (Beattie, Fearnley and Brandt, 2004).

Fearnley & Hines (2003) argues that the impact on the UK regulatory environment of the SOX Act is still an unresolved issue. UK has almost 50% of its top 100 companies listed in the US markets. This inevitably provides a compelling argument for US regulators to engage in the oversight of UK companies and audit firms. This is an unpopular perception for the UK regulators, EU commission and business community, especially in the light of many other regulatory changes in the UK (Fearnley and Hines 2003). But, regardless of changes in the regulatory framework, researchers agree that mere compliance with such measures cannot be sufficient in building investor confidence, therefore companies should overall improve their corporate governance structure.

Rezaee (2005) explains that a well balanced functioning of seven interrelated mechanisms (oversight, managerial, compliance, audit, advisory, assurance, and monitoring functions) can produce responsible corporate governance, reliable financial reports, and credible audit services. Former SEC chairman Levitt viewed the earnings management problem to be so severe that he created a "Blue Ribbon Panel" to study the problem and to make recommendations. If earnings management is indeed so pervasive, a significant portion of auditor changes may be motivated by a desire to manage earnings. They viewed client/auditor realignments as representing efficient responses to changes in client operations and activities over time. An incumbent auditor's competitive advantage for an existing client can be eroded over time by changes in the client's operations and activities (Johnson and Lys, 1990). However, efficient utilisation of the auditing function is dependent upon audit quality which is not easily defined, but can generally be identified through the industrial expertise, good integrity and degree of auditor independence (Francis, 2004 and Teoh, 1992).

Many scholars have categorized audit quality in terms of size of the auditing firm, the argument being that larger firms have a posses more industrial experience, have greater resources and a higher degree of independence enabling them to provide qualified service. Several empirical studies demonstrate that investors usually attach greater market value to the accounting numbers reported by the clients of larger auditing firm, as they perceive the financial disclosure to have greater information content (Francis, 2004; Lennox, 2005 and Watkins et al., 2004). Switching to a large auditing firm signals to the market that the financial statements of the audited organisation are more dependable and thus the firm may benefit from lower costs in raising capital from the equity or debt markets or from the reduction of agency costs in the enforcements of contractual obligations.

Alternatively, the shareholders and management may also consider the aptitude of large auditing firms in detecting 'tunnelling' behaviours and may prefer to switch to a small auditing firm with comparatively lower quality of audit monitoring (Imhoff, 2003; and Lee et al., 2003). Johnson et al. (2002) adopt the tenure of auditor with their clients to reflect the quality of audits. The greater the duration of the relationship between auditor and client, the easier it becomes for the auditor to curb earnings management behaviour and other financial irregularities as the auditor get the time to fully understand their client's internal control and accounting systems. Conversely, the tenure of an auditor may also have a negative association with audit quality, as long term auditors may surrender their independence to keep a healthy relationship with their client Ghosh and Mood (2005). Therefore, it is not surprising that the Combine Code of Corporate Governance lays out strict guidelines on auditor tenure to ensure complete auditor independence and subsequently audit quality (FRC 2010).

In order to distinguish the quality in financial reporting, other researcher apply the number of SEC investigations or sanctions as an indicator for audit quality (Dye, 1993 and Kadous, 2000) or the regularity of issuing unclean auditor opinions (Chow and Rice, 1982). Auditor switch generally signals the increase of the possibility of earnings management in financial reporting which may result information asymmetry (Becker et al. 1998 and Nelson et al. 2002). Therefore, many researchers conclude that investors and markets usually perceive a change in auditor as a negative signal to in response to which market price falls and cost of equity rises. They argue that switching leads to more 'noise' in the financial reporting numbers, thus significantly reducing the integrity and usefulness of reported earnings.

2.3 Prior studies on factors affecting auditor changes

Arguably the choice of audit firm is an important decision in a corporation's life cycle as the underlying reasons for such changes are a huge concern for the public, profession, stakeholders and financial markets (Bedingfield and Loeb 1974). Companies change auditors for a range of different reasons. According to Williams (1988) auditor changes are associated with audit fees, qualified opinions, and client/auditor relations. Companies opt to change auditors when the contracting environment of the corporation changes, the company requires to upgrade a damaged image, when a they desire different services or a more effective auditor Williams (1988). Bedingfield and Loeb (1974) suggest that a lack of satisfaction with the services provided by the previous auditor is another prevalent variable in the perception of auditor switching. Auditor changes can also be motivated by managements desire to improve company operations or to entrench an incumbent management team by switching to a lower quality/ size auditor to benefit from relaxed reporting requirements [1] , although the latter is termed under auditor shopping by (Davidson III) .

According to (Davidson III) audit shopping can be subdivided into two categories. Firstly, audit shopping could be an agency cost, as managers could be searching for a lower quality audit which would help reduce the quality of information that reaches the financial markets, inevitably increasing asymmetric information which would benefits their motives. The second category of audit shopping does not involve management desire to manipulate earnings; instead is due to a break down in auditor/ client relationship resulting from overly conservative accounting methods preferred by the auditor. Krishnan (1994) suggests, in such cases management desire less conservative reporting which they consider better reflects the company's true economic performance, and consequently chooses an accounting firm that is less conservative. Firms also tend to switch auditors after receiving qualified opinion, but subsequently do not receive more unqualified opinion (Chow and Rice, 1982). Failing firms have a greater tendency to switch auditors than healthier firms, showing a preference to switch from a large audit firm to a lower tier firm (Schwartz and Menon, 1985). The reality of the situation is that the literature on auditor changes is interrelated due to the nature of this activity as it involves several complex and at times interconnected explanatory variable.

In order to effectively deal with the existing literature which would facilitate the understanding of this activity and reasons behind it, each variable will be discussed separately as much as possible. Explanatory variable for factors behind auditor change include auditee company and their financial distress (Haskins and Williams, 1990; and Citron and Taffler, 1992), Big 4/ Non-Big 4 audit firm (Warren, 1980; Shank and Murdock, 1978), qualified or unqualified opinion (Chow and Rice, 1982), reporting disputes (Magee and Tseng, 1990), changes in top level management (Burton and Roberts, 1967; and Carpenter and Strawser, 1971) asymmetric information (Dye, 1991) and audit fees (McKeown et al., 1991; and Firth, 1980a and 2002).

Audit price plays a significant role in auditor selection, as prior research shows reduction of audit fees motivate some auditor changes (Johnson and Lys, 1990 and Eichenseher and Shields 1983). Fearnley and Beattie (1995) in their study of auditor changes in UK listed companies show almost 50% of respondents declare the level of audit fees to be a basis for auditor change out of which 45% assert it to be the most important reason. Clients benefit from a decrease in audit fees at least in the short term, although fee's return to normal market levels between 3 and 5 years (Simon and Francis, 1988) termed by DeAngelo (1981) as 'low balling' [2] . A simplistic interpretation of such findings can be attributed to the competitive nature of the auditing market. Clients purchase audit services from the lowest cost supplier and independent audit firms attain competitive advantages through specialisation (Johnson and Lys 1990). Carcello et al (1992) argues that in an increasingly competitive environment it is vital to recognise the perceptions of audit quality by both the auditors and auditees. After controlling for other factors related to audit fees, i.e. attributes assigned to audit quality, client satisfaction with their audit service was found to be positively associated with fees. Simultaneously lower cost audit reduces audit quality and the selection of a lower cost auditor could damage long-run company performance (Behn et al., 1999).

Larger clients benefit from economies of scale (bargaining power) which not only help over fee levels, but also in attaining management desires i.e. earnings manipulation, thus creating a self-interest threat to objectivity and independence Firth (1985) and McKeown et al. (1991). Therefore it is not surprising that UK respondents perceive high fees from a client to be detrimental to independence Firth (1980a). Beattie, Brandt and Fearnley (1999) also found audit fee dependence to be the most important threat in the UK. As clients may incur both indirect and direct cost during an auditor switch; Audit Committee's place immense significance on value for fees as compared to the gross magnitude of audit fees (Schroeder et al., 1986). In order to determine the effects of high audit fee's DeAngelo (1981) classifies high audit fees based on the ratio of fees paid to the audit firm's total fees, whereas (hudaib--) uses the ratio of audit fees paid to auditees' total assets as a proxy for high audit fees. It is anticipated that a company with a high level of asset would require a substantial and expensive audit. Whereas, a high ratio of paid fees to an organisations total assets would indicate that the organisation is paying higher than average fees for the size of assets it owns. Francis and Simon (1988) explain that, greater the level of fee the less a qualified audit opinion will be issued given that the client would not tolerate a qualified audit under difficult conditions when their auditors are receiving higher than average audit fees.

Beattie and Fearnley (1998) have suggested that the most common reason for auditor switches in the UK is due to the lack of auditor competency and professionalism. In their research financial directors of surveyed firms their previous auditors did not understand the business, there was; lack of internal control, gaps in financial controls, improper disclosure, incumbent mishandling of corporate finance advice and flexibility on accounting policies. All these issues can almost certainly be termed under audit quality. In fact, over the past decade the most common reason celebrated in literature for reasons related to auditor changes has been audit qualification. The relation between auditor change and audit opinions has been inspected around the themes of reasons for change and opinion shopping. The relation between switching and qualification in preceding and following years has received particular interest. Therefore it is not surprising to see literatures concentration on management which tends to seek auditors who are less likely to give a qualified report, since the concept considerably damages the notion of auditor independence (Teoh 1992).

Company perhaps switch auditors to shop for either more relaxed company result interpretations from auditor or better audit quality. After the issuance of a qualified report organisations may change their auditor to improve their financial image (Smith, 1986 and Chow and Rice, 1982). It could be due to a disagreement which may lead to the selection of a lower quality auditor (Whisenant and Sankaraguruswamy 2000b, 2000d) or simply to find a more lenient auditor to achieve long term managerial goals (DeAngelo, 1981). Issuance of a qualified opinion has an effect on both the firm's market price and manager's compensation packages (Chow and Rice, 1982). If managers change auditors as a result of qualifications, this raises fundamental questions about the audit firm's ability to resist management pressure and issue an objective audit report. In reality, it is this 'intimidation threat' that jeopardises independence although the threat is not observable. What is observable are actual switches i.e. actual dismissal which are, in effect, being used as a proxy for situations where switching was threatened (Hudaib and Cooke, 2005).

A sample of studies concentrating exclusively on opinion shopping by investigating the relation between switching and the subsequent audit opinion have found consistent results. Some studies have found a positive association between receipt of qualified opinion and auditor change in the year preceding change (Hudaib and Cooke, 2002; Chow and Rice, 1982; Smith, 1986; Krishnan et al., 1996,). Chow and Rice (1982) in their study of Australian and U.S. companies found auditor change to be directly related to receiving a qualified report, although their report also showed that switching firms due to qualified opinion were no more likely to receive a clean opinion in following years than non switching firms. Similar studies of companies in Hong Kong and Australia, Gul et al. (1992) and Craswell (1988) respectively, found results consistent with Chow and Rice (1982). A positive association was also found between the presence of 'going concern qualification' and auditor change in distressed UK quoted companies for the period 1977-1986 Citron and Taffler (1992).

While comparing pre- and post-switch opinions by studying conflicts between the firm and its predecessor auditor, Smith (1986) in his sample of 139 firms that changed auditor on receipt of a qualified opinion suggests that only five cases indicate the possibility of opinion shopping. Similarly other studies conducted by Williams (1988) and Ritson et al. (1997) also did not find any significant results. Krishnan and Stephens (1995) find that firms which change auditors are likely to be treated as conservatively by both the predecessor and successor auditors, while Knapp and Elikai (1988) in their study of U.S. firms disclose that that switching firms do not receive unqualified or more favourable opinions from new auditors. Smith (1986) and Krishnan (1994) claim that auditors are not switched due to the type of audit opinions issued, rather the cause is indentified at the auditors refusal to be flexible in their auditing procedures.

Evidence suggests that intimidation threat can influence auditor's opinion, which is in contrast to empirical work mentioned earlier. Disagreement over a reporting policy resulting in a possible intimidation threat to switch may not only influence auditor independence but conversely may force the auditor to qualify (Teoh, 1992; DeAngelo, 1982; and Krishnan et al. 1996). Therefore the auditor has to weigh the situation between being independent and giving a qualified opinion or the likelihood of being dismissed (Hudaib and Cooke, 2005). Krishnan (1994) found that switching firms received a more conservative treatment from their auditors than others. This presence of 'mutli-directionality' between audit opinion and switching casts some doubt on whether audit opinion shopping occurs as a motive for changing an auditor.

While rejecting the hypothesis of an association between switching and qualification, DeAngelo (1982) explains this 'mutli-directionality' arguing that qualified opinions can cause auditor switching and vice-versa, and argument which is later confirmed by Krishnan et al. (1996) by using a simultaneous equations model, found evidence of a two-way causation between the tendency of the client to switch auditors and that of the auditor to issue a qualified opinion. Given that different methodologies are used in each research, no consensus has yet emerged regarding the relationship between switching and issuing qualified audit opinions. The SEC has expressed their concern over this issue while suggested that the assessment of prior-year opinion and switching would be useful to academics, policy makers and practitioners. Very few studies have examined the success of opinion shopping by examining pre and post year opinion and those that have professed opinion shopping to be unsuccessful (Chow and Rice, 1982; Smith, 1986).

Since high quality auditors are more able to curb earnings management, firms' management should have a motivation of switching auditors in order to realize the gains from the manipulation of accounting numbers (Krishnan 1994; Willenborg 1999; Kim et al. 2003; Krishnan et al. 2005). Some prior studies report that management may choose or switch to relatively lower quality (more pliable) auditors in order to be able to obtain greater leeway in manipulating discretionary accruals to adjust the reported earnings (Francis and Krishnan 1999; Hay and Davis 2004). In particular, when the incumbent auditors would issue an unclean opinion, firms are more likely to initiate a search for new auditors whose views are more in line with that of the management in the consequent year, e.g., switch from high quality to low quality auditors, because receiving an unclean auditor opinion would depress the price of a firm's securities and impair its ability to raise funds in the future (Klock 1994; Anderson et al. 2004; Bedard and Johnstone 2004). Nonetheless, empirical results on whether firms can achieve "opinion shopping" through auditor switch are mixed as some studies found no evidence of successful "opinion shopping" after auditor switch in the US market (Craswell, 1988; Krishnan, 1994; Schauer, 2002). But other studies argue that there are differences in the industrial knowledge and auditing resources between the incumbent auditors and their successors so the management should be able to manipulate accounting numbers if switching from high quality (large) auditors to low quality (small) auditors as the later may be less effective in curbing earnings management behaviors (Willenborg 1999; Nelson et al. 2002; Kim and Kross 2005). Therefore auditor choice or switch will affect audit quality and its utility, which should have an effect on investors' perception of the credibility of financial statements. The lower quality of auditors, the lower credibility of financial statements and the less information content of the accounting numbers being reported (Watkins et al. 2004).

Auditor switch after a qualified opinion being issued represents a bad news, because the client may be perceived to shop for a clean opinion from a new auditor. DeFond and Subramanyam (1998) and Kim et al. (2003) attribute this phenomenon to the notion that a perceived decline in audit quality due to auditor switch impairs the credibility of financial reporting, i.e., it may result in a lower level of assurance to investors and a higher probability that the reported earnings and book values are overstated

As mentioned earlier, a desire for lower quality audit to assist earnings management motivates clients to change their auditors. According to Abarbanell and Lehavy (2003), earnings management implies the selection and interpretation of accounting policies and reporting methods that may induce partiality in reporting earnings numbers to accomplish certain objectives. In order to minimize political costs Watts and Zimmerman (1990) suggest that larger firms conduct income decreasing accounting choices, while other studies suggest management of businesses use income reducing discretionary accruals. The argument being that litigation concerns discourage firms to manage earning upwards due to the asymmetric loss function on companies that overstate their earnings (Watts and Zimmerman, 1990; Kadous 2000). However, it is extremely difficult to measure audit quality, and many researchers have applied a variety different methodologies to their studies to which they relate the quality of audit. DeAngelo (1981) defines audit quality as positively associated with size of the auditing firm, as larger firms have a greater incentive to report earnings misstatements.

Empirical evidence experimenting the extent to which audit quality can be defined in terms of auditor size can be found in numerous respected studies including Warren (1980), DeAngelo (1981), Chow and Rice (1982), Teoh and Wong (1993) and Krishnan et al. (1996) although the experiments found mixed results. DeAngelo (1981) argues large audit firms have more resources, greater risk exposure and incentives to avoid criticism therefore will perform qualified reporting in order to protect their reputation. Becker et al. (1998) reports, as discretionary accruals are greater for the clients of non-Big Six accounting firms earnings management transpires more frequently in such firms. Conversely Krishnan et al. (1996) discovers that smaller companies in the US are less likely to be audited by Big 6 firms, attributable to the large premiums charged by the larger auditing firms which are 16% to 19% higher than non-Big 8 audit fees (Simon and Francis 1988). While relating earnings management (audit quality) with auditor size, Chaney and Philipich (2002) found that after the announcement of a switch particularly from Big5/Big 4 to non-Big 5/Big 4 auditors, the market normally responded with a decline in the company's stock price and market return. This is because the investor would expect a decline in the quality of reported earnings information.

Smaller companies audited by the Big 6 firms have a greater propensity to change auditors following a qualified report, as compared to larger firms audited by Big 6 firms(---). Literature has noted auditee size as another important explanatory variable. Krishnan et al., (1996) recognises that the probability of a smaller company receiving a qualified auditor report and subsequently switching its auditor is much higher than a larger company. 6 Firth (2002) further justifies Krishnan et al., (1996) claims by proving the statistical significance between size of auditee and qualification.

{For instance, DeAngelo (1981) contends that audit quality is positively associated with the size and market shares of auditing firms. Other studies found that large or brand name auditors should have to bear higher reputation costs and they would be more prudent in audit engagement and more likely to issue qualified or other unclean audit reports to their clients, thus provide audit services with higher quality (Francis and Krishnan, 1999; Lee et al., 2004; Lennox, 2005; Menom, 2003). Some empirical studies have demonstrated that high quality auditors (Big 6/Big 5) can more effectively detect management's earnings management through the use of accounting accruals and thus better ensure the truthfulness and usefulness of accounting information (Balsam et al., 2003; Francis and Krishnan, 1999; Watkins et al., 2004).

DeFond and Subramanyam (1998) argue that there are incentives for firms' managers or controlling shareholders to seek self-welfare by manipulating accounting numbers or transferring resources through "tunneling" behaviors. Thus, they will weigh their self-interests in making auditor choice or switching decisions (Johnson et al., 2000; La Porta et al., 2002).

Chow and Rice 1982, Craswell 1988; Francis and Krishnan 1999)}

Previous research suggests that financial distress is another important factor in the issuance of qualified opinion and auditor switching (Schwartz and Menon 1985; Citron and Taffler, 1992). Highly levered companies are more likely to receive a modified audit report in subsequent periods, especially if they shift from high quality audit firms to low quality audit firms (Lennox 2000). Schwartz and Menon (1985) discuss the influence of financial distress on auditor switches in two different ways. Firstly, financial distress causes complex uncertainties in a business and is correlated with factors that support auditor switching such as; management changes, reposting disputes, issuance of a qualified opinion, 'insurance' motives [3] and audit fees. Failing businesses are often plagued with such issues and therefore are more susceptible to make auditor changes than healthy ones. Secondly, various reasons for changing auditors may depend upon the financial condition of an organisation. Factors that are associated with switching auditors in financially distressed companies may not the same as for the 'non-distressed' companies. Healthy organisations may switch auditors to obtain additional service or competitive advantage through an industry specialised auditor. For these reasons Hudaib and Cooke (2005) classify financial condition into distressed and non-distressed and incorporate them as an explanatory variable. Chow and Rice (1982) suggest to incorporate non-distressed companies in variable is to control for the possible effects of auditees financial condition on auditor switching. In whichever way financial distress may affect the auditor-client relationship, its existence can have some implications for understanding the dynamics behind auditor switching.

Schwartz and Menon (1985) also suggest that failing firms have a tendency to make management changes in an attempt to resuscitate their organisation, as external stakeholders identify management failures as a primary factor in the company's deteriorating financial condition. A new management results in various changes in the failing organisation in an attempt to rescue or better the situation, these may also include changes in auditor. New management may be dissatisfied with the quality and cost of services provided by the past auditor (Burton and Roberts, 1967). New management team may view the selection of reporting methods as a means for influencing decisions of suppliers of capital by revealing corporate performance in a more favourable light, with the help of a new more lenient auditor (Schwartz and Menon 1985). Alternatively, new managers may simply prefer another auditor with whom they have had some previous association (Beattie and Fearnley, 1995). Beattie and Fearnley (1998) report, that 35% of companies cite top management changes as a reason for switching auditors. However, Chow and Rice (1982) found no significance in this variable, while Schwartz and Menon (1985) found that neither top management change now audit opinion in failing companies lead to a change in auditors. Hudaib and Cooke (2005) consider the interactive effects of distressed/non-distressed companies and MD change/no-MD change on type of audit report and find mixed results. Nevertheless, issuance of a qualified opinion may be triggered by financial distress or a change in management or both.

Whereas several of the factors that have been considered as causes of auditor switching may be found to exist in failing companies, not all of these need actually lead to auditor switches. If financial condition is not explicitly controlled for, an obvious "omitted variables" problem can exist, since a correlation of both a spurious factor and a "true" determinant with financial distress could lead to making some invalid inferences on why companies decide to change auditors. This being the case, there are clear limitations to the generalizability of findings that are based on experimental samples containing both failing and healthy firms.