The scandal involving Enron and Arthur Anderson forced US regulators to enforce the Sarbanes-Oxley Act of 2002 (SOX) to strengthenÂ investor confidence, corporate accountability and professional responsibilities. UK followed suit as their Financial Reporting Council (FRC) published a Combine Code of Corporate Governance. An environment with constantly rising audit fees since the collapse of Andersen has not explicitly changed the drivers of client satisfaction from those identified and tested in the past. Although the number of 'Big' audit firms has declined the number of publicly traded firms has not changed substantially, yet the degree of influence in audit firmÂ selection has decreased. The decline in dysfunctional audit procedures has been largely due to improving international regulatory standards coupled with high-audit fees and a reduction inÂ large audit firms, makingÂ client satisfaction a moreÂ overwhelming task.
Post SOX both internal-control reporting and financial statement audit are mandatory, and performed by the same audit firm, while consulting services were temporarily barred after august 2002 following Anderson's conviction in the Enron matter. Since then although regulations have somewhat eased as now audit firms provide non-audit services (NAS), it isÂ uncertainÂ if the remaining Big 4 firms have been able to maintain sufficient levels ofÂ clientÂ satisfactionÂ under such restrictive regulations (GAO, 2003a). As many of Anderson's 2500 clients dispersed to the remaining Big 4 firms, GAO surveyed aÂ sampleÂ of Fortune 1000 companies, all of whom used a Big 4Â firmÂ as their auditor (GAO, 2003b). While theÂ surveyÂ found average auditorÂ tenureÂ to be 19 years, 30% of the sample had auditorÂ tenureÂ of less than 2 years. 93% of this shortÂ tenureÂ groupÂ wereÂ formerÂ Andersen clients (GAO, 2003b). Most of these clients claimed to be dissatisfied with their current auditor.
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In modern market economies, business incorporation led to the separation of ownership and control. Shareholders are usually not directly involved in the administrative or operational aspects of a business as such tasks require the need to employ professional managers. These separations lead to information asymmetry enabling self-interested managers to pursue self welfare at the expense of owners, inevitably directing towards 'agency cost' (Jensen and Meckling, 1976). An effective system of corporate governance assures efficient monitoring and control behaviours focused at improving the principal-agent relationships to help reduce potential conflicts of interest (Maniam etÂ al., 2006). Anderson et al. (2004) discovered that corporate governance is positively associated with aÂ firm's operational efficiency and effectiveness. InvestorsÂ acceptÂ higher premiums for firms with sound corporate governance (McKinsey & Company, 1999-2002; Steen, 2005).Â
The infamous scandals of WorldCom and EnronÂ ledÂ academics to extensively research corporate governance in the context of financial reporting, giving particular attention to the importance of AC characteristics includingÂ independence, composition, compensation, financial expertise, size andÂ influenceÂ amongst others.Â These characteristics seem to have a direct/indirectÂ relationshipÂ with audit quality. ACÂ independenceÂ is at the forefront of such research. Bronson et al. (2009) argue that benefits of an audit committee's independence are only consistently achieved when it isÂ fullyÂ independent, which is in line with the SOX requirement of 100%Â independentÂ AC's. The underlying assumption being that "IndependentÂ directors are better monitors ofÂ managementÂ than areÂ 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 an independent check on the work of a firm's management subsequently reinforcing the confidence in financial reporting, auditing can thus 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 etÂ al., 2007; Ashbaugh and Warfield, 2003). It is the responsibility of AC's toÂ appointÂ qualified independent auditors who theyÂ believeÂ wouldÂ performÂ objective and systematic monitoring, while also attesting theÂ firm's financial statements for conformity with GAAP/ IFRS. Thus, corporate governance must play a crucial role in enhancing theÂ credibilityÂ and usefulness of the financial statements for all stakeholder's (Bushman and Smith, 2001; Dewing and Russell, 2003; Maniam etÂ al., 2006). Contrastingly, when there is a lack of sound corporate governance, it would be difficult toÂ preventÂ theÂ firm's management from infringing upon the interests of theÂ organizationÂ and other stakeholder's while the audit function may be unable to perform its monitoring andÂ assuranceÂ roles effectively (Marnet, 2005; Rosner, 2003). Certainly the relationship between corporate governance and external auditing (including auditor selection and switching) is aÂ fundamentalÂ issue worthy ofÂ exploration.
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2.2 The role of financial reporting and audit quality
Independent auditing can reduce the agency costs associated with the contractual relationships between owners andÂ managementÂ or amongÂ variousÂ groups of stakeholder's (Fearnley and Hines, 2003). Therefore, an auditor is not only responsible toÂ substantiateÂ the fairness and totality of financial statements produced by the management, but also toÂ investigateÂ management's financial performance in terms of their supervisory reliability. This ability to detect earnings management enhances the usefulness of accounting numbers for investor's decision making (Imhoff, 2003). Thus, proving that an auditor performs two roles in financial reporting, that of information intermediary andÂ assuranceÂ provider. Financial reporting standards are similar toÂ publicÂ laws as they are constantly evolving. Concerning the United Kingdom, researchers state that proposed changed to UK Company Law, increasing legislations from the EU, post-EnronÂ reformÂ and transition to international financial reporting standards import significant and costly implementation challenge to UK companies, auditors, and regulators (Fearnley and Hines, 2003).
Nevertheless, regulators stillÂ aspireÂ to remain engaged with the professional body's which suggests their willingness in continuing toÂ delegateÂ regulationÂ toÂ private sectorÂ bodies andÂ supportÂ voluntary codes of practice wherever appropriate. Legislation and extensive rulesÂ are consideredÂ 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 regulatoryÂ frameworkÂ of the SOX Act is still an unresolved issue. UK has almost 50% of itsÂ topÂ 100 companies listed in the US markets. This inevitably providesÂ compellingÂ reasonsÂ for US regulators to engage in theÂ oversightÂ of UK companies and audit firms. This is an unpopular perception for the UK regulators, EU commission and businessÂ community, especially in theÂ lightÂ of many other regulatory changes in the UK (Fearnley and Hines 2003). However, regardless of changes in the regulatory framework researchers agree that mere compliance with such measures cannot be sufficient in building investor confidence,Â in fact,Â they suggest thatÂ companiesÂ needÂ to improve their overall governance structure.
Rezaee (2005) explains that a well balanced functioning of seven interrelated mechanisms (oversight, managerial, compliance, audit, advisory, assurance, and monitoring functions) canÂ produceÂ responsible corporate governance, reliable financial reports, and credible audit services. Arthur Levitt, the former chairman of the Securities and Exchange Commission (SEC) created a "Blue Ribbon Panel" in order to tackle theÂ severeÂ issue of earnings management. Researchers believe is earnings management isÂ indeedÂ so pervasive; some reasons behind auditor changes may be motivated by a desire toÂ manageÂ earnings. However, efficient utilisation of an auditing function is dependent uponÂ auditÂ quality. Though notÂ easilyÂ defined, but can be identified through auditor'sÂ industrialÂ expertise,Â ethicalÂ integrity andÂ degreeÂ of independence (Francis, 2004 and Teoh, 1992).
Many scholars have categorized auditÂ qualityÂ in terms of size of the auditing firm. TheyÂ suggestÂ that larger firms possess moreÂ industrialÂ experience, have greater resources and a higher degree of autonomy enabling them to provideÂ qualifiedÂ service. Several empirical studiesÂ demonstrateÂ an investor'sÂ frequencyÂ toÂ attachÂ greaterÂ marketÂ value to accounting numbers reported by clients of larger auditing firm, as they perceive their financialÂ disclosureÂ to have greater information content (Francis, 2004; Lennox, 2005 and Watkins etÂ al., 2004).Â A company switching to a larger auditing firm signals to theÂ marketÂ that their financial statements are now moreÂ dependable.Â ThisÂ signalÂ may alsoÂ benefitÂ firms in theÂ formÂ ofÂ lowÂ costs in raisingÂ capitalÂ from equity/debt markets or reduction in agency costs.
Alternatively, shareholder and management may also consider the capability of large auditing firms in detecting 'tunnelling' behaviour, thus preferring a switch to a small auditing firm with comparatively lower quality of audit monitoring (Imhoff, 2003 and Lee etÂ al., 2003). Johnson et al. (2002) adopt tenure of the auditor with their clients toÂ reflectÂ the quality of audits. Longer the duration of the relationship between the auditor and client, the easier it becomes for the auditor toÂ curbÂ earningsÂ client'sÂ behaviour and other financial irregularities as the auditor gets the time toÂ analyseÂ 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 auditorÂ tenureÂ to ensure complete auditor independence and subsequently audit quality (FRC 2010).
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In order to distinguish quality in financial reporting, other researchers apply the number of SEC investigations or sanctions as an indicator for audit quality (Dye, 1993 and Kadous, 2000) or the regularity of issuingÂ uncleanÂ auditor opinions (Chow and Rice, 1982). AuditorÂ switchÂ signals theÂ increaseÂ of the possibility of earnings management in financial reporting, which may result inÂ informationÂ asymmetry (Becker et al. 1998 and Nelson et al. 2002). Therefore, many researchersÂ concludeÂ that investors and marketsÂ usuallyÂ perceiveÂ a change in the auditor as a negative signal to in response to which market price falls and cost ofÂ equityÂ 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 theÂ choiceÂ of audit firm is a crucial decision in aÂ corporation's life cycle as the underlying reasons for such changes are of enormous concern for the public, profession, stakeholder's and financial markets (Bedingfield and Loeb 1974). The level ofÂ agencyÂ costs andÂ disparityÂ in signalling incentives suggest that there is aÂ heterogeneousÂ demandÂ for audit services, characterised by DeAngelo (1981) as different levels ofÂ auditÂ quality. According to (Davidson III)Â auditÂ shopping can be subdivided into two categories, firstly,Â auditÂ shopping could be anÂ agencyÂ cost motivated by managements desire toÂ entrenchÂ an incumbent management team by switching to a lower quality/size auditor to benefit from relaxed reporting requirements  , inevitably increasing asymmetric information benefiting their motives. The secondÂ categoryÂ ofÂ auditÂ shopping does notÂ involveÂ managementÂ desireÂ to manipulate earnings, instead, is due to a break down in auditor/client relationship resulting from overly conservative accounting methods preferred by the auditor.
Recent literature has particularly focused on the link between audit opinion and auditor change, especially given the concerns over opinion-shopping that emerged in the competitive environment of the 1990s. Most of the existing empirical works explaining theÂ decisionÂ to change auditors have been archival studies, which use statistical analysis toÂ investigateÂ theÂ associationÂ between theÂ switchÂ and notÂ switchÂ decision variable and related variables of interest. While earlier studies employed only univariate tests to examine single variables of interest (Schwartz and Menon, 1985; Craswell, 1988; Gul etÂ al., 1992), the use of multivariate logit models has now become the norm (Williams, 1988; Ritson etÂ al., 1997, Woo and Koh, 2001, Moizer, Porter and Mohamed, 2001, Hudaib and Cooke, 2005). ResearchersÂ argueÂ based on contingency theory that 'auditor changes are likely to be induced by combinations of cross factors' (Hudaib and Cooke, 2005).
However, empirical studies show mixed results.Â The susceptibility to auditor switching isÂ notablyÂ positively associated with financial distress (Schwartz and Menon, 1985, Hudaib and Cooke, 2002), audit opinion (Chow and Rice, 1982), growth (Chaney etÂ al., 1997), breakdown in auditor client relationship (DeAngelo, 1982),Â lengthÂ of auditor tenure (Williams, 1988), change in theÂ top levelÂ management (Hudaib and Cooke, 2002) andÂ receiptÂ ofÂ adverseÂ media publicity by the client company (Williams, 1988).Â Conversely significant negativeÂ associationÂ was foundÂ for top tier auditor (Krishnan, etÂ al., 1996, Hudaib and Cooke, 2002), industry specialisation (Williams, 1988; Chaney etÂ al., 1997, Ritson etÂ al., 1997, Woo and Koh, 2001) andÂ sizeÂ (Krishnan, etÂ al., 1996, Chaney etÂ al., 1997, Hudaib and Cooke, 2002).
However, in other studies researchers found noÂ significanceÂ for:Â distress (Krishnan, etÂ al., 1996), growth (Williams, 1988; Krishnan etÂ al., 1996; Ritson etÂ al., 1997, Woo and Koh, 2001), top tier auditor (Ritson etÂ al., 1997), size of the organisation (Woo and Koh, 2001), industry specialisation (Krishnan etÂ al., 1996), top management change (Williams, 1988, Ritson etÂ al., 1997),Â auditÂ fees (Ritson etÂ al., 1997, Woo and Koh, 2001, Hudaib and Cooke, 2002) orÂ levelÂ of non audit service provision by the incumbent (DeBerg etÂ al., 1991).Â Reality of the matter is that the literature on auditor switching is interrelated due to the nature of this activity, as it involved several complex and at time correlated explanatory variables. In order to effectively deal with existing literature which would facilitate the understanding of this activity and reason behind it, each variable/factor with be discussed separately as much as possible.
The price ofÂ auditÂ plays a significant role in auditor selection, asÂ priorÂ research shows reduction of audit feesÂ motivateÂ some auditor changes (Johnson and Lys, 1990; Eichenseher and Shields 1983).Â Fearnley and Beattie (1995) in their study of auditor changes in UK listed companiesÂ declareÂ that almost 50% of respondentsÂ declareÂ theÂ levelÂ of audit fees to be a basis for auditor change out of which 45%Â assertÂ it to be the mostÂ influentialÂ reason. Clients benefit from a decrease in audit fees at least in the short term, although fee's return toÂ normalÂ market levels between 3 to 5 years (Simon and Francis, 1988) termed by DeAngelo (1981) as 'low balling'. A simplisticÂ interpretationÂ of such findings can be attributed to the competitive nature of the auditing market. ClientsÂ purchaseÂ auditÂ services from the lowest-cost supplier and independent audit firmsÂ attainÂ competitive advantages through specialisation (Johnson and Lys 1990).
Carcello et al (1992) argues, in an increasingly competitive environment, it isÂ vitalÂ to recognise the perceptions of audit quality by both the auditors andÂ auditee's.Â 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, subsequently damaging the company's long-run performance (Behn etÂ al., 1999). Larger clients benefit from economies of scale (bargaining power) which not only help overÂ feeÂ levels, but also in attainingÂ managementÂ desires i.e. earnings manipulation, thus creating aÂ self-interestÂ threat to objectivity and independence (Firth, 1985; and McKeown et al.,1991). Therefore, it is not surprising that UK respondents perceive high fees from aÂ clientÂ to be detrimental toÂ independenceÂ (Firth,Â 1980a).
Beattie, Brandt and Fearnley (1999) also foundÂ auditÂ fee dependence to be the mostÂ significantÂ threat to UK businesses. Clients mayÂ incurÂ both indirect and direct cost during an auditor switch, AC'sÂ placeÂ immenseÂ significanceÂ on theÂ valueÂ for fees as compared to the grossÂ magnitudeÂ of audit fees (Schroeder etÂ al., 1986). In order to determine the effects of high audit fee's DeAngelo (1981) classifies high-audit fees based on theÂ proportionÂ of fees paid to the audit firm's total fees, whereas Hudaib and Cooke (2005) use the ratio of audit fees paid toÂ auditees' total assets as aÂ substituteÂ forÂ high-auditÂ fees. Researchers anticipate that a company with a high level of assets would require aÂ substantialÂ and expensiveÂ audit. Whereas, a highÂ ratioÂ of paid fees to organisations' total assets wouldÂ indicateÂ that the organisation is paying higher than average fees for the size of assets it owns. Francis and Simon (1988)Â explainÂ thatÂ greater levelÂ of feesÂ reduces theÂ probabilityÂ of being issues a qualified audit opinion, given that theÂ clientÂ would not tolerate a qualifiedÂ auditÂ 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 isÂ dueÂ to the lack of auditor competency and professionalism.Â In their researchÂ financialÂ directors of surveyed firms argued that their previous auditors did not understand the business, there was; lack ofÂ internalÂ control, gaps in financial controls, improper disclosure, incumbent mishandling of corporate finance advice andÂ flexibilityÂ on accounting policies. All these issues can almost certainly be termed underÂ auditÂ quality. In fact, over the past decade the most commonÂ reasonÂ celebrated in literature for reasons related to auditor changes has beenÂ auditÂ qualification. RecentÂ studiesÂ based around the themes of reasons for change and opinion shopping inspects the relationship between auditor change and audit opinions. Therefore, it is not surprising to see literaturesÂ concentrationÂ on management, which tends to seek auditors who are less likely toÂ produceÂ aÂ qualifiedÂ report since theÂ conceptÂ considerablyÂ damages theÂ perceptionÂ of auditor independence (Teoh 1992).
Companies perhapsÂ switchÂ auditors to shop for either more relaxedÂ companyÂ resultÂ interpretations from their auditor or betterÂ auditÂ quality. After, the issuance of a qualified report, an organisation may change theirÂ auditor to improve theirÂ financialÂ imageÂ (Smith, 1986 and Chow and Rice, 1982).Â It could be due to aÂ disagreementÂ which wouldÂ likely lead to the selection of a lowerÂ qualityÂ auditor (Whisenant and Sankaraguruswamy 2000b, 2000d), or simply toÂ findÂ aÂ moreÂ lenient auditor to achieve long term managerial goals (DeAngelo, 1981).Â Issuance of aÂ qualifiedÂ opinion has anÂ effectÂ on both theÂ firm's market price andÂ 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 managementÂ pressureÂ and issue anÂ objectiveÂ audit report. In reality, it is this 'intimidation threat' that jeopardises independence although theÂ threatÂ is notÂ observable. What isÂ observableÂ areÂ actualÂ switches i.e. actualÂ dismissalÂ which are, in effect, used as aÂ proxyÂ for situations where switchingÂ is threatenedÂ (Hudaib and Cooke, 2005).
AÂ sampleÂ of studies concentrating exclusively onÂ opinionÂ shopping by investigating theÂ relationÂ between switching and the subsequent audit opinion found consistent results. Some studies have found a positiveÂ associationÂ between receipt ofÂ qualifiedÂ opinion and auditor change in the year preceding change (Hudaib and Cooke, 2002; Chow and Rice, 1982; Smith, 1986; and Krishnan etÂ al., 1996). Chow and Rice (1982) in their study of Australian and U.S. companies found auditor change to be directly related to receiving aÂ qualifiedÂ report, although their report also showed that switching firmsÂ dueÂ toÂ auditÂ opinion were no more likely to receive a cleanÂ opinionÂ 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 'goingÂ concernÂ qualification' and auditor change in distressed UK quoted companies for the period 1977-1986 Citron and Taffler (1992).
While comparingÂ preÂ and post-switch opinions by studying conflicts between theÂ firmÂ and its predecessor auditor, Smith (1986) in hisÂ sampleÂ of 139 firms that changed auditor on receipt of a qualified opinion suggests that only five casesÂ indicateÂ the possibility ofÂ opinionÂ 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. firmsÂ discloseÂ that that switching firms do not receiveÂ unqualifiedÂ or more favourable opinions fromÂ newÂ auditors.Â Smith (1986) and Krishnan (1994), state that auditors are not switchedÂ dueÂ toÂ auditÂ opinions, rather theÂ causeÂ is identifiedÂ as auditors refusal to be flexible in their auditing procedures.
Evidence suggests that intimidationÂ threatÂ canÂ influenceÂ auditor's opinion, which is in contrast toÂ empiricalÂ work mentioned earlier. Disagreement over a reportingÂ policyÂ resulting in a possible intimidationÂ threatÂ toÂ switchÂ may not onlyÂ influenceÂ auditor independence but conversely mayÂ forceÂ the auditor toÂ qualifyÂ (Teoh, 1992; DeAngelo, 1982; and Krishnan et al. 1996). Therefore, the auditor has toÂ weighÂ the situation between being independent and giving aÂ qualifiedÂ opinion or theÂ likelihoodÂ of dismissal (Hudaib and Cooke, 2005). Krishnan (1994) found that switching firms received a more conservative treatment from their auditors than others. ThisÂ presenceÂ of 'mutli-directionality' between audit opinion and switching casts doubt on the ability of audit opinion as aÂ motiveÂ forÂ firmsÂ changing their auditors. While rejecting theÂ hypothesisÂ of anÂ associationÂ between switching andÂ qualification, DeAngelo (1982) explains this 'mutli-directionality' arguing thatÂ qualifiedÂ opinions can cause auditor switching and vice-versa. Krishnan et al. (1996) later confirms this argument, by using a simultaneous equations model found evidence of a two-way causation between the tendency of theÂ clientÂ toÂ switchÂ auditors and that of the auditor to issue a qualified opinion.
In particular when an incumbent auditor issues anÂ uncleanÂ opinion, theÂ firmÂ is more likely toÂ instigateÂ a search for new auditors whose views are in line with that of the management. AS the receipt of aÂ qualifiedÂ opinion would lower theÂ priceÂ of aÂ firm's securities and impairs its ability to raise funds in the future, theÂ organizationÂ in such cases would theoretically switch from a high-quality auditor to aÂ low-qualityÂ auditor (Klock 1994; Anderson et al. 2004; Bedard and Johnstone 2004). Nontheless, empirical results on whether organisations can accomplish "opinion shopping" through auditorÂ switchÂ are variedÂ as some studies found no evidence of successful 'opinion shopping' after auditor switch in the US market (Craswell, 1988; Krishnan, 1994; Schauer, 2002). However, other researchers argue that there isÂ noticeableÂ disparityÂ in theÂ industrialÂ knowledgeÂ and auditing resources between the incumbentÂ auditors and their successors.Â Thus, the management must be able toÂ influenceÂ accounting numbers if switching from high-quality auditors toÂ low-qualityÂ auditors (Willenborg 1999; Nelson et al. 2002; Kim and Kross 2005). Given eachÂ researchÂ used different methodologies, 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 suggesting that theÂ assessmentÂ of prior-yearÂ opinionÂ and switching would beÂ usefulÂ to academics, policy makers and practitioners. Very few studies have examined the success ofÂ opinionÂ shopping by examiningÂ preÂ andÂ postÂ yearÂ opinionÂ and those that haveÂ professedÂ opinion shopping to be unsuccessful (Chow and Rice, 1982; Smith, 1986). Auditor switch after the receipt of aÂ qualifiedÂ opinion representsÂ badÂ news for the market, as the organisation may be alleged to shop forÂ cleanÂ opinion from a new auditor. DeFond and Subramanyam (1998) and Kim et al. (2003) characterise thisÂ phenomenonÂ to the belief that an apparent decline in audit quality due toÂ opinionÂ shopping impairs theÂ credibilityÂ of financial reporting. As mentioned earlier, a desire for lowerÂ qualityÂ auditÂ toÂ assistÂ 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 mayÂ induceÂ partialityÂ in reporting earnings numbers toÂ accomplishÂ certainÂ objectives. In order to minimise 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 earnings upwards due to the asymmetric los function on companies that overstate their earnings upwards (Watts and Zimmerman, 1990; and Kadous, 2000). However, it is extremely difficult to measure audit quality, and many researchers have applied various methodologies to their studies to which they relate the quality of audit. DeAngelo (1981) defines audit quality as positively associated withÂ sizeÂ 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 inÂ severalÂ respected studies including Warren (1980), DeAngelo (1981), Chow and Rice (1982), Teoh and Wong (1993) and Krishnan et al. (1996)Â although the experiments found mixed results.Â DeAngelo (1981) arguesÂ largeÂ audit firms have more resources, greater risk exposure and incentives to avoid criticism, therefore, willÂ performÂ qualifiedÂ reporting in order to protect their reputation. Becker et al. (1998) reports, as discretionary accruals are greater for the clients of non-Big6 accounting firm's 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 high 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 earningsÂ managementÂ (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 typically responded with a decline in the company's stock price andÂ marketÂ return. This is because the investor would expect aÂ declineÂ in theÂ qualityÂ of reported earningsÂ information. Smaller companies audited by the Big6 firms have a greaterÂ propensityÂ to change auditors following aÂ qualifiedÂ report, as compared to larger firms audited by Big6 firms (Citron and Taffler, 1992). Literature has notedÂ auditeeÂ size as anotherÂ crucialÂ explanatory variable. Krishnan et al. (1996) recognises that the probability of a smaller company receiving a qualified auditor report andÂ subsequentlyÂ switching its auditor is much higher than a larger company. Firth (2002) further justifies Krishnan etÂ al. (1996) claims by proving the statistical significance between size ofÂ auditeeÂ andÂ qualification. Previous research suggests that financial distress is another significant factor in the issuance ofÂ qualifiedÂ 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 to low quality audit firms (Lennox, 2000). Schwartz and Menon (1985)Â discussÂ theÂ influenceÂ of financialÂ distressÂ on auditor switches in two different ways. Firstly, financial distress causes complex uncertainties in a business andÂ are correlatedÂ with factors that support auditor switching such as; management changes, reporting disputes, issuance of a qualified opinion, 'insurance' motives andÂ auditÂ fees. Failing businesses are often plagued with such issues and, therefore, are more susceptible toÂ makeÂ auditor changes than healthy ones. Secondly, various reasons for changing auditors may depend upon the financial condition of an organisation. FactorsÂ associatedÂ with switching auditors in financially distressed companies may not the same as for the 'non-distressed' companies. Healthy organisations mayÂ switchÂ auditors to obtain additional service or competitive advantage through anÂ industryÂ specialised auditor.
In order to tackle such issues Hudaib and Cooke (2005) classify financialÂ conditionÂ into distressed and non-distressed and incorporate them as an explanatory variable. Chow and Rice (1982)Â suggestÂ to incorporate non-distressed companies inÂ variableÂ is toÂ controlÂ for the possible effects ofÂ auditeesÂ financial condition on auditor switching.Â In whichever wayÂ 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 makeÂ managementÂ changes in an attempt toÂ resuscitateÂ their organisation, as externalÂ stakeholdersÂ identifyÂ management failures as a primary factor in the company's deteriorating financial condition.Â New management results inÂ variousÂ changes in the failing organisation,Â in an attempt toÂ rescueÂ orÂ betterÂ the situation,Â these may also include changes in auditor.Â NewÂ managementÂ may be dissatisfied with the quality andÂ costÂ of services provided by the past auditor (Burton and Roberts, 1967). New management team mayÂ viewÂ theÂ selectionÂ of reporting methods as a means for influencing decisions of suppliers ofÂ capitalÂ 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 simplyÂ preferÂ another auditor with whom they have had some previous association (Beattie and Fearnley, 1995). Beattie and Fearnley (1998) reportÂ that 35% of companiesÂ citedÂ top management changes as a reason for switching auditors. However, Chow and Rice (1982) found noÂ significanceÂ in this variable, while Schwartz and Menon (1985) found that neither top management change neitherÂ auditÂ opinion in failing companiesÂ ledÂ to a change in auditors.Â Hudaib and Cooke (2005) examined the interactive effects of distressed/non-distressed companies and MD change/no-MD change on the type of audit opinion and found mixed results. Nevertheless, issuance of a qualified opinion may be triggered by financial distress or a change in management, or maybe even both. Whereas several of the factors that considered as causes of auditor switching may be found to exist in failing companies or financially healthy firms, not allÂ bringÂ about a definite change in auditor. If the financialÂ conditionÂ is not explicitly controlled for, anÂ obviousÂ "omitted variables" problem canÂ exist, since a correlation of both a spurious factor and a 'true' determinant with financial distress could lead to making someÂ invalidÂ inferences on why companies decide to change auditors. This being the case, there areÂ clearÂ limitations to the generalizabillity of findings based onÂ experimentalÂ samples containing both failing and healthy firms.