bagherpour et al - 2014 - government and managerial influence on auditor switching under partial privatization

Monroeb, Greg Shailerc,d,⇑ a School of Administrative and Economic Science, Ferdowsi University of Mashhad, Mashhad, Iran b School of Accounting, and Centre for Accounting & Assurance Re

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Government and managerial inﬂuence on auditor

switching under partial privatization

Mohammad A Bagherpoura, Gary S Monroeb, Greg Shailerc,d,⇑

a

School of Administrative and Economic Science, Ferdowsi University of Mashhad, Mashhad, Iran

b

School of Accounting, and Centre for Accounting & Assurance Research, The University of New South Wales, Sydney,

NSW 2052, Australia

c Research School of Accounting and Business Information Systems, The Australian National University, Hanna Neumann Building 21, Canberra, ACT 0200, Australia

d

Australian National Centre for Audit & Assurance Research, The Australian National University, Hanna Neumann Building 21, Canberra, ACT 0200, Australia

a b s t r a c t

We investigate how auditor switching is affected by government inﬂuence, misalignment between type of auditor (government vs private) and type of controlling shareholder (government vs pri-vate), and misalignment between an incumbent auditor and imputed preferences of managers in a market characterized by continued substantial government ownership in listed entities

We exploit a natural policy and regulatory experiment in Iran that allows us to investigate what happens when previously govern-ment-owned entities are partially privatized as listed entities where, in many cases, the government retains signiﬁcant owner-ship interests At the same time, there were signiﬁcant changes

in the audit market, resulting in large increases in the number of private sector auditors competing for previously state-adminis-tered audits We find the likelihood of auditor switches is strongly associated with measures of misalignment between type of auditor and type of controlling shareholder and auditor–managerial mis-alignment, but these associations are constrained by significant government influence Exposing the constraining effect of signifi-cant government influence on auditor switching is an important contribution to our understanding of privatizations, government shareholder influence and auditor choice These results have impli-cations for policy development in other emerging and transition

http://dx.doi.org/10.1016/j.jaccpubpol.2014.04.004

0278-4254/Ó 2014 Published by Elsevier Inc.

⇑Corresponding author at: Research School of Accounting and Business Information Systems, The Australian National University, Hanna Neumann Building 21, Canberra, ACT 0200, Australia Tel.: +61 2 6125 4333.

E-mail address: greg.shailer@anu.edu.au (G Shailer).

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Please cite this article in press as: Bagherpour, M.A., et al Government and managerial inﬂuence on auditor

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economies where privatization remains largely partial, and compe-tition among private sector auditors is still emergent

Ó 2014 Published by Elsevier Inc

1 Introduction

The link between political economy and auditor choice is an important policy question in emerging and transition markets where privatization has been a signiﬁcant phenomenon (Guedhami et al.,

2009) Privatizing corporate ownership raises the risks of serious agency conﬂicts between minority investors and politically connected managers or continuing government ownership, with signiﬁcant implications for auditor choice (Chan et al., 2007; Wang et al., 2008; Guedhami et al., 2009) The risk

of expropriation of minority shareholders by large shareholders is higher in emerging markets than in developed markets (Claessens et al., 2000; Claessens and Fan, 2002) and this may be reflected in finan-cial reporting decisions Therefore, the role of auditors in reducing conflicts of interest in finanfinan-cial reporting decisions is potentially more important in emerging markets than in developed markets Consequently, factors that affect auditor changes, and may impair auditor independence and ulti-mately, audit quality, can have significant policy relevance in emerging and transition markets Where there is significant government influence through retained ownership in partially privatized companies, managers may prefer auditors who are more aligned with government interests The widespread phenomena of privatizations and economic liberalization in several emerging markets have been accompanied by rapid growth in audit suppliers as governments have licensed more private sector audit firms While there has been some research on auditor choice following privatizations, emphasizing auditor size differences (e.g.,Chan et al., 2007; Wang et al., 2008; Guedhami et al.,

2009), there is little examination of what happens when previously state-administered audits are relocated to a market governed by competition and demand (Mennicken, 2010) We contribute to the public policy literature concerned with auditing by addressing this issue

We complement and extend the existing literature by investigating the effects of signiﬁcant gov-ernment inﬂuence on incentives for auditor switching in an immature audit market in which auditor competition is increasing, alongside an emerging equity market We focus on incentives arising from misalignments between type of auditor (government vs private) and type of controlling shareholder (government vs private), and between auditor and imputed preferences of managers Hereafter, we refer to these two types of misalignment as ‘‘auditor–controlling shareholder misalignment’’ and

‘‘auditor–managerial misalignment’’ We do this in a market characterized by continued substantial government ownership in listed entities and rapid growth in the number of competing audit ﬁrms separated from government control In particular, we examine whether government inﬂuence prevails over the switching incentives arising from auditor–controlling shareholder misalignment and audi-tor–managerial misalignment

We examine auditor–controlling shareholder misalignment from a perspective that is different to the prevailing emphasis on ‘‘Big N’’ vs ‘‘non-Big N’’ as the auditor choice, relative to client interests.1

We consider whether auditor switches are driven by government control of listed corporations and audit firm ownership (i.e., government or private sector auditors) We examine auditor–managerial misalign-ment in more traditional terms by focusing on conditions that have the potential to create conflict between auditors and client management; these include changes in management, discretionary accrual preferences and audit qualifications

Our study exploits a natural experiment concerning auditor switching that was generated by policy and regulatory changes in Iran The policy changes involve: (1) the incremental partial privatization of government corporations; (2) removal of the government auditor’s monopoly over the audit of

1

Chan et al (2007) find that a decrease in government shareholdings leads to an increased demand for higher-quality audits in China In a comparison of auditor choice by privatized firms across 32 countries, Guedhami et al (2009) reveal that privatized firms are less likely to appoint a Big Four auditor.

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government-controlled listed companies, which increased the ability of management to switch audi-tors; and (3) changes in the licensing of auditors, which resulted in a signiﬁcant increase in the num-ber of private sector auditors competing for clients We argue that agency costs and signaling incentives for Iranian listed companies are likely to have increased due to the rapid increase in the supply of private sector audit services, changes in the managerial labor and capital markets, and equity market growth with the accompanying emergent importance of private investors We link this

to alignment incentives for auditor switching, which are conditioned by continuing government inﬂu-ence in many of the privatized companies

Substantial transfers of stock in Iranian companies from the government to the private sector increased shareholder diffusion and information asymmetry Changes in ownership from government

to private investors affect shareholders’ incentives and the mandates given to managers The objec-tives of government-controlled companies include implementing government policies (such as pro-viding employment and propro-viding cheaper goods and services) as well as earning profits The government policy position regarding the privatization of Iranian companies indicates that they no longer have this range or complexity of objectives and are therefore free to concentrate on profit-seek-ing (Komijani, 2003) However, when government retains significant influence through ownership of shares, the complexity of management decision-making motives may affect auditor choice decisions Interest in depoliticizing privatized firms or signaling to potential investors may encourage switching

to private sector auditors, while government interests may encourage the retention of government-controlled auditors

The extant research on auditor switching is largely focused on markets characterized by relatively stable overall numbers of accounting firms competing for audits, but with increases in concentration and implied reductions in competition in the large client sector that is dominated by big international accounting firms (e.g.,Gilling and Stanton, 1978; Pong, 1999; Wolk et al., 2001) The Iranian audit market is substantially different from this characterization In Iran, the removal of the government auditor’s monopoly and changes in licensing led to rapid growth in competition for the supply of audit services, as evidenced by a 100% growth in the number of audit firms engaged by companies listed on the Tehran Stock Exchange (TSE) from 2000 to 2003 with a continuing exclusion of international audit firms.2

Other characteristics of the emerging Iranian audit market that enhance its value as a natural experiment and distinguish our study from previous emerging market studies include: the exclu-sion of the international audit ﬁrms or their afﬁliates from the Iranian audit market; and the absence of civil litigation risk for auditors Studies of changes in auditor competition in the extant literature emphasize reduced supplier competition associated with increases in market domination

by the Big N audit ﬁrms (e.g., Gilling and Stanton, 1978; Healy and Lys, 1986; Pong, 1999; Wolk

et al., 2001; Sullivan, 2002; Chaney et al., 2003; Chen et al., 2007; Kohlbeck et al., 2008; Asthana

et al., 2009) This supply-side focus is complemented by studies of companies’ auditor switching decisions in relation to auditor specialization and the imputed declining supplier competition as the number of Big N ﬁrms declined (e.g., Johnson and Lys, 1990; Gigler and Penno, 1995; GAO,

in a market characterized by increasing competition, following Greece’s liberalization of its audit market in 1992, which ended the state-controlled monopoly of statutory audits However, their study links the demand for the newly entered Big Six international ﬁrms with substantial foreign ownership – neither of which is relevant to the Iranian setting With the exception of Citron and Manalis (2001), our study is the only known examination of auditor switching in the context of increased auditor competition.3 Given the exclusion of international audit ﬁrms, the Iranian audit market is less conditioned by auditor reputation effects compared to settings underlying much of the prior literature Furthermore, the absence of civil litigation risk for Iranian auditors eliminates the insurance hypothesis (seeWallace, 1987) as an explanation for auditor switching To the extent

2 The 100% increase in audit ﬁrms is based on our data (including companies with missing ﬁnancial data), which covers 88% of the companies listed on the TSE.

3

Chaney et al (2003) analytically consider switching under aggressive auditor competition attributed to auditor’s direct solicitation of potential clients.

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that we neutralize the supply-side effects of risk on auditor choice, we obtain a more powerful test of the demand-side relation between auditor choice and client-related characteristics (seeClarkson and Simunic, 1994)

We find the likelihood of auditor switches is strongly associated with our measures of auditor–con-trolling shareholder misalignment and auditor–managerial misalignment, but these associations are constrained when the government retains significant ownership in privatized companies Our results suggest that the retention of significant government influence through shareholdings may affect a firm’s accounting choices by influencing its auditor Exposing the constraining effect of significant gov-ernment influence on auditor switching is an important contribution to our understanding of privati-zations, government shareholder influence and auditor choice Our findings on the relation between government influence, auditor supply and the demand for private sector auditors in a transition econ-omy support arguments concerning the importance of the development of accounting institutions for the efficient allocation of resources and economic growth (Rajan and Zingales, 1998; Wurgler, 2000; Wang et al., 2008) Thus, our results have implications for policy development in emerging markets where privatization remains largely partial, with immature competition among private sector auditors

In the following section, we provide background information on the institutional environment in Iran In Section3, we develop our hypotheses In subsequent sections, we describe our research method, present our results and discuss those results

2 Institutional environment

Following Iran’s Islamic Revolution in 1979, all banks and insurance companies and many heavy industry companies were fully nationalized Many other companies were not fully nation-alized, but were transferred to government control when private sector owners abandoned or for-feited their interests in companies and through the government-owned banks acting on debt defaults Although the TSE was established in 1967, these changes largely eliminated share trad-ing In 1989, to stimulate economic recovery, the Iranian government implemented a privatization policy to transfer ownership of government companies to the private sector through a series of five-year plans (Davani, 2003; TSE, 2003) The first five-year plan (1989–1993) required the gov-ernment to transfer ownership of nationalized and state industrial units (excluding strategic industries) to private sector shareholders (Abadi, 1995) The second five-year plan (1995–1999) was a continuation of the first plan (Amirahmadi, 1996) Under the Economic, Social and Cultural Development Plan for 2000–2004, the number of TSE-listed companies grew from 296 in 1999 to

386 in 2003 This growth came from the listing of government-controlled companies as part of the government’s privatization policy and the listing of new private sector companies Substantial transfers of stock in Iranian companies from the government to the private sector increased shareholder diffusion and the potential for information asymmetry; however, a small number

of transactions appear to have been pseudo-privatizations, with government agencies still holding more than 95% of the total issued shares

The privatization process has been gradual, with the government retaining significant ownership interests in many of the companies The retention of significant government influence enables state ministries to directly or indirectly appoint directors (FallahDoost, 2009, as cited in

(and dismissals) of board members (and sometimes CEOs and CFOs) to government-controlled entities are often inﬂuenced by political, military or security wings and are usually based on political motives, and appointees are often politicians or bureaucrats with political connections (Mohammadrezaei

et al., 2012)

Accompanying the nationalization of companies after 1979, audit functions were transferred to government auditors, culminating in the establishment of the Iranian Auditing Organization (IAO)

in 1987 This gave the IAO a monopoly over the audit of the nationalized companies and the par-tially privatized companies; however, there were a small number of non-government-controlled, TSE-listed companies audited by private sector auditors certiﬁed by the Economic Ministry The

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IAO experienced difficulties in auditing the variety of government-controlled entities and was not suited to auditing the increasing number of profit-seeking companies post-1989 To address this issue, regulatory changes were introduced in 1993 that allowed certified public accountants to practice However, this regulation was ineffective because the designated certifying agency, the Ira-nian Association of Certified Public Accountants (IACPA), was not established until 2001 As a con-sequence, the IAO dominated the audit market for TSE-listed companies until 2001 Since the establishment of the IACPA in 2001, government auditors are certified members and auditors of TSE-listed companies must be members of the IACPA (Davani, 2003) A TSE-listed company can now choose either a private sector auditor or a government auditor, regardless of whether the company is government-controlled.4

In 2001, the IACPA licensed 402 private sector auditors Of these, 309 auditors were sole prac-titioners, mostly providing services to small non-listed clients, and 93 were in partnerships By the end of 2003, there were 156 sole practitioners and the number in partnerships had increased to

395 The number of licensed auditors employed by the IAO was relatively ﬂat, changing from

207 in 2001 to 237 in 2003, but the modest growth suggests the private sector growth was not merely a transfer of auditors from government employment to private practice We observe a cor-responding change in market shares between government and private sector auditors, based on the number of clients in our sample; the private sector auditors’ market share rose from 33% in 2001

to 62% in 2003

Although the statutory requirements for an audit identify shareholders as the intended recipients

of reports, the law does not establish a recognizable duty of care or direct liability to shareholders and Iranian law does not provide for civil action against auditors to recover damages The primary legal exposure for auditors in Iran is prosecution under criminal provisions in the Iranian Trade Law; however, we are not aware of any such prosecutions to date

Iranian audit firms are not affiliated with major international audit firms (they are prohibited by law) and there are no obvious domestic substitutes as market leaders The market shares of Iranian audit firms were dynamic during our study period, with many audit firm entries, restructurings and mergers Using client revenues or the number of clients as measures of auditor size, no firm was con-sistently ranked in the Big N across our sample period

Although data limitations preclude direct assessment of the economic signiﬁcance of audits in Iran, several domestic studies indicate that ﬁnancial statement users regard the independent audit as important (Salehi et al., 2009; Moradi et al., 2011a,b) Consistent with experiences in other jurisdic-tions, these studies also indicate that the traditional audit expectations gaps and issues regarding self-interested agents are prevalent in Iran

3 Auditor switching and alignment

We argue that the institutional changes described above created incentives for companies to switch auditors to achieve preferred auditor–controlling shareholder alignment or auditor–manage-rial alignment, and changes in the audit market provided increasing opportunities to switch, but did not necessarily abate government influence in the decisions of partially privatized companies Exploiting the dynamics of the Iranian market, we develop hypotheses concerning government influ-ence, auditor–controlling shareholder misalignment and auditor–managerial misalignment Auditor– client alignment and managerial interests have received prior attention in the audit choice/switching literature The literature identifies a variety of potential incentives for audit switching We revisit these switching incentives to assess whether they apply in our novel setting and for our new measure

of auditor–controlling shareholder misalignment, and to evaluate the extent to which government inﬂuence prevails over private incentives for switching induced by auditor–managerial misalignment However, several of these incentives (litigation risk, audit fees and auditor size) do not apply to the Iranian context or cannot be tested with available data

4

Iranian Trade Law requires listed companies to appoint a licensed auditor, who is approved by shareholders at the annual general meeting.

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The absence of civil litigation risk for Iranian auditors eliminates the insurance hypothesis for audi-tor selection (seeWallace, 1987), but it has other implications for auditor switching The absence of litigation risk may increase the propensity for Iranian corporations to switch auditors to gain other advantages, because the costs of switching are lower.Kallunki et al (2007)argue that the importance

of reliable auditing services and the resources a client has to devote to familiarizing the new auditor with the client are lower in countries where the severity of the legal environment is lower, compared

to countries where it is higher Consequently, switching costs are lower in countries with less strict legal environments The absence of litigation risk for managers and auditors in Iran implies lower switching costs for clients and auditors, which should increase the willingness of auditors to compete for clients and the likelihood of switching Therefore, we expect the Iranian market to exhibit a larger number of switches due to managers seeking improved auditor–controlling shareholder alignment or auditor–managerial alignment This expectation is conﬁrmed by our data set We had a sample-based switching rate of 9.8% during 1999–2003, with a maximum annual rate of 18.7% in 2003 (as discussed

in Section5 5

Prior studies indicate that audit fees can motivate switching decisions While audit fee data are not generally available for Iranian corporations, we obtained voluntarily disclosed audit fees for 74 listed corporations for 2003 The average audit fee as a percentage of sales for these 74 corporations was 0.31%; and their average audit fee as a percentage of assets was 0.15%.6On this basis, while Iranian audit fees appear less material than fees in developed markets (Gul et al (2009)report average audit fees

as a percentage of assets for non-lowballing US firms for 2003–2004 of 0.34%), they appear non-trivial for Iranian corporations Therefore, audit fees may be a significant switching incentive, but we cannot test this effect While this is a potential limitation of our study, the alignment switching incentives we exam-ine are not likely to be correlated with audit fees; we argue that the unavailability of audit fee data biases our study against finding significant alignment switching factors

Research in mature audit markets has long used auditor size (Big N or market share) as an indicator

of audit quality (followingDeAngelo, 1981; Francis, 2004) While switching to signal audit quality to investors may be an incentive, we cannot proxy this traditional aspect of auditor quality in the Iranian market Major international audit firms are excluded from the Iranian market and, using client reve-nues or the number of clients as measures of auditor size, no firm is consistently ranked in the Big N across our sample period because of the audit firm entries, growth and mergers If a positive reputa-tion is built over a long period (Fombrun and Shanley, 1990), then firm name reputational effects are likely to be weak in a market with only five years of development.Bedard et al (2010)indicate that, despite considerable research interest, there is little understanding of investors’ and managers’ per-ceptions of audit quality in mature markets and it is beyond the scope of this study to resolve how investors or managers assess audit quality in Iran The absence of international or large, established Iranian audit firms implies reputational or quality aspects do not rely on simple brand name effects, with auditor switching being motivated by other criteria

The following sections discuss other incentives identiﬁed in the extant literature that may be applicable to the Iranian context, as well as incentives that we argue are speciﬁc to the Iranian market

3.1 Government inﬂuence

In a competitive market, companies or management tend to select or retain auditors that best meet their needs (Burton and Roberts, 1967; Shockley, 1981; Addams and Davis, 1994; Beattie and Fearnley,

1998), resulting in a market characterized by a high level of auditor–client alignment Auditor

5

Our maximum switching rate is around double the switching rates reported for the Chinese market for a similar period Chan

et al (2006) report a sample-based switching rate of 9% in China during 1996–2002 (with a maximum annual rate of 11% in 2000 and 2001) Despite the substantial legal, cultural and economic differences between the Iranian and Chinese markets, we suggest this comparison indicates a particularly rapid increase in the propensity for switching in the Iranian market.

6

While not sufficient for modeling, these cases are reasonably consistent with the average size of firms in our sample, as described in Section 5 The mean natural log of revenues for the 74 firms for which we obtained 2003 fee data is 11.49, compared to 11.62 for our full sample; the standard deviations are 1.12 and 1.29 respectively.

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switching is more likely to occur when an auditor and client are not well aligned Changes in either client or auditor characteristics may result in a misalignment, which can be corrected by switching auditors (Landsman et al., 2009)

The government-owned audit firm initially audited corporations that became listed as a consequence of Iran’s privatization policy There are multiple arguments as to why (partially) privatized corporations might retain or switch auditors We argue that the incentives for priv-atized firms to switch auditors are conditioned by the extent of continuing government influence

Privatizations in emerging markets have prompted concerns regarding potential agency conﬂicts between minority investors and politically connected managers or continuing government owner-ship Government inﬂuence through ownership may render corporations more likely to pursue social or political goals such as infrastructure development, employment or other social agendas

In particular, government owners may have strong motives to obscure ﬁrm performance informa-tion (Bushman et al., 2004), which may be facilitated by stock exchanges that are illiquid and opa-que during privatization programs (Megginson and Netter, 2001; Guedhami et al., 2009) There is evidence that government ownership affects board member selection (Fan et al., 2007) and corpo-rate structure (Fan et al., 2012) Although government-controlled listed corporations do not have to

be audited by the government-owned audit firm, managers of government-influenced companies may generally prefer the government auditor because of its experience with such entities or for political reasons Where there is significant government influence through retained ownership, managers are more likely to choose auditors that are more aligned with government interests (Wang et al., 2008; Guedhami et al., 2009) and it has been suggested that governments can influ-ence government auditors (Wang et al., 2008) Political or social objectives may divert govern-ment-controlled firms from pursuing profits (e.g., Eckel and Vining, 1985; Shleifer and Vishny,

1994), making acquiescent managers less likely to switch to auditors more suited to private inves-tor interests Consistent with these arguments, Chan et al (2007) report increased demand for higher-quality audits following decreased government share ownership in China Therefore, our government inﬂuence hypothesis is:

H1 The likelihood of an auditor switch is negatively associated with signiﬁcant government inﬂuence

With respect to determining signiﬁcant government inﬂuence, we focus on the percentage of shares retained by the government Consistent with the International Financial Accounting Standard 28 (IASB, 2011) on equity accounting, we use government ownership of 20% or more

of the shares as indicative of significant government influence This follows previous influential studies (e.g., La Porta et al., 1999; Claessens et al., 2000, 2002) However, as argued by

Chapelle and Szafarz (2005), the threshold of 20% is an empirical rule of thumb that has no spe-cific formal justification Therefore, we examine other thresholds in our robustness tests There may be non-shareholding sources of government influence, such as government contracts, manager–government relationships and board members’ political connections, but we do not have access to such data

3.2 Auditor–controlling shareholder misalignment

In the absence of significant government influence, privatization relieves an Iranian company of responsibility for implementing government policy (Komijani, 2003) and Iranian government-con-trolled companies were known to be mismanaged and poor performers (EghtesadeIran, 2002) If gov-ernment control or the pursuit of govgov-ernment objectives is costly to private sector shareholders, managers of privatized companies have incentives to signal increased emphasis on investors’ interests and reduced government involvement by switching to a private sector auditor Private sector auditors may have also developed different expertise in regulatory compliance and be perceived as having more affinity with the interests of investors, brokers and investment bankers Therefore, we expect private auditors’ experience and reputation to better match the needs of a privatized company

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Consequently, where there is auditor–controlling shareholder misalignment, there is more incentive

to switch auditors for alignment purposes We consider that an auditor–controlling shareholder misalignment occurs when a government-controlled company has a private sector auditor and where

a private sector company has a government auditor.7Therefore, our auditor–controlling shareholder mis-alignment hypothesis is:

H2 The likelihood of an auditor switch is positively associated with auditor–controlling shareholder misalignment

3.3 The effect of managerial interests on auditor choice

Managers’ preferences may motivate auditor selection and switching behavior Incoming managers may choose to switch auditors if they have a preferred relationship with a particular auditor

Hudaib and Cooke, 2005) Existing managers may also switch auditors if they are seeking accommo-dation of their choices and applications of accounting policies (Schwartz and Menon, 1985) Therefore, our auditor–managerial misalignment hypothesis is:

H3 The likelihood of an auditor switch is positively associated with auditor–managerial misalign-ment

We test this hypothesis by examining three indicators of potential misalignment of auditors and managerial preferences: changes in management, accounting choice preferences and disagreements between auditors and managers indicated by qualiﬁed opinions

To test the proposition of incoming managers preferring particular auditors, we focus on changes in CEO and Chair of the Board We consider both CEO and Chair changes because we have no evidence of the relative power of each of these ofﬁces in Iranian companies We observe very high rates of change in CEOs (22%) and Chairs (25%) in our pooled sample of TSE-listed companies; the pooled rate of simultaneous change in CEO and Chair is 11%.8 These high rates

of change suggest there might not be sufﬁcient stability in the managerial labor market or mana-gerial entrenchment for managers to inﬂuence auditor choice However, consistent with studies indicating that management changes are one of the main reasons for auditor switches (Burton and Roberts, 1967; Carpenter and Strawser, 1971; Beattie and Fearnley, 1995, 1998; Woo and Koh, 2001; Hudaib and Cooke, 2005), we expect the likelihood of an auditor switch is higher fol-lowing a change in client management.9

With respect to managers seeking auditors who are more accommodating of their accounting choices, we examine evidence of accounting choice and auditor opinions that indicate auditor– manager disagreement over the choice and application of accounting policies If managers prefer auditors who are more accommodating with respect to their choice and application of accounting policies (Schwartz and Menon, 1985), then we expect accounting choices to be linked to auditor switches, irrespective of management changes We contend that auditors are not indifferent to accounting choices, and will prefer conservative accounting practices if this exposes them to less risk of punitive actions This contention is consistent with US evidence that auditors are more likely to be sued when there are earnings overstatements compared to when there are earnings understatements (St Pierre and Anderson, 1984) While Iranian auditors do not face civil

litiga-7

A controlling shareholder is deﬁned as one who holds 50% or more of the issued shares In our additional testing, we also test auditor–controlling shareholder misalignment when a government-controlled company has a private sector auditor.

8

While the same person could be CEO and Chair during the period of our study, we ﬁnd no instances of this in our sample The simultaneous changes in both Chair and CEO in our sample also appear unrelated to privatization or other ownership changes 9

The results of earlier studies of the association between management changes and auditor switches are inconsistent Some studies do not find any significant association (e.g., Chow and Rice, 1982; Schwartz and Menon, 1985; Williams, 1988 ), while others find significant associations (e.g., Burton and Roberts, 1967; Carpenter and Strawser, 1971; Beattie and Fearnley, 1995,

1998 ).

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tion risk, they can be jailed for issuing unqualiﬁed opinions on misleading ﬁnancial reports (Iranian Trade Laws Article 267) or have their license suspended or cancelled by the IACPA If prosecutions or other adverse outcomes are more likely when there are earnings overstatements rather than earnings understatements, then Iranian auditors have incentives to prefer conserva-tive accounting methods and choices If an incumbent auditor’s accounting preferences lead to income decreasing accounting choices, then there is a greater likelihood of an auditor switch, because it is more likely to be inconsistent with managers’ preferences (Defond and

earnings – it argues that, if managers believe the incumbent auditor’s accounting choice prefer-ences are more conservative than those expected from the average auditor, then management has

an incentive to switch auditors in the hope of ﬁnding a more reasonable successor (Defond and Subramanyam, 1998, p 36) It follows that an auditor switch is more likely for a company with large negative discretionary accruals than for other companies Therefore, we expect the likeli-hood of an auditor switch increases following large negative discretionary accruals, as indicated

by the lower quartile of discretionary accruals

Qualified and adverse audit opinions reflect either disagreements with management or inherent uncertainties Qualified audit opinions may be viewed as negative signals of managements’ steward-ship of the company (Williams, 1988) and have been linked to adverse effects on company value and management compensation (Chow and Rice, 1982) Some prior studies report an increased likelihood

of auditor changes following a qualified audit opinion (e.g.,Chow and Rice, 1982; Teoh, 1992; Lennox, 2000; Hudaib and Cooke, 2005) Others report a negative association (Woo and Koh, 2001) or no asso-ciation (e.g.,Schwartz and Menon, 1985; Haskins and Williams, 1990) Earlier studies mostly do not distinguish between qualified audit opinions resulting from disagreements with management and qualified opinions resulting from environmental conditions such as inherent uncertainties or scope limitations not imposed by the client However,Hudaib and Cooke (2005)find that the severity of

an audit opinion, in relation to disagreements, is positively associated with auditor switching We con-tend that management has more incentive to bring about an auditor switch if the audit opinion reflects adversely on management In Iran, qualified and adverse audit opinions are issued for scope limitations, inherent uncertainties and violations of GAAP (disagreements with management over the choice and application of accounting policies) We contend that qualified and adverse opinions that reflect directly on management (i.e., client-imposed scope limitations and violations of GAAP) are more likely to result in management seeking a change of auditor, compared to qualified opinions issued because of environmental conditions (i.e., inherent uncertainties or scope limitations not imposed by the client) Therefore, we expect the likelihood of an auditor switch is higher if a client receives a qualified audit opinion resulting from violations of GAAP or client-imposed limitations of scope

4 Empirical model

We specify the following logistic regression as our main model to test the hypothesized effects on auditor switching propensities To test the impact of significant government influence (H1), we use the indicator variable Government influence In relation to the auditor–controlling shareholder misalign-ment hypothesis (H2), we test auditor–controlling shareholder misalignment with the variable Misaligned We use the variables DManagement, NegativeDA and QualDisagree to test the auditor– managerial misalignment hypothesis (H3) The control variables in the model are described in Section4.1

Auditor switcht¼ b0þ b1Government influence þ b2Misalignedt1

þ b3DManagementt1þ b4QualDisagreet1þ b5NegativeDAt1

þ b6Government ownership þ b7QualOthert1þ b8PositiveDAt1

þ b9Sizet1þ b10SalesGrowtht1þ b11 Losst1þ b12 Leveraget1

þ b13ROAt1þ b14Competition years þRbi Industryi ð1Þ

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Dependent variable:

Auditor switch 1 If a corporation had a change of auditor in the current year, 0 otherwise We

identify switches from the audit ﬁrm names on the published audit reports in the relevant corporation’s annual report obtained from the TSE library Test variables:

Government

inﬂuence

1 If government owns 20% or more of the issued shares and 0 otherwise We use 20% to be consistent with the threshold used in equity accounting standards to determine signiﬁcant inﬂuence We test other thresholds in our robustness tests

Misaligned 1 If a corporation is private sector controlled and had a government auditor

in the previous year, 0 otherwise Types of auditor and corporations were identiﬁed from the published annual reports obtained from the TSE library

DManagement 1 If there was a change in both the Chair of the Board and the Chief Executive

Ofﬁcer in the previous year, 0 otherwise The Chair and the CEO are identiﬁed from notes in the annual report obtained from the TSE library

QualDisagree 1 If the audit opinion for the previous year was qualiﬁed because of a

violation of GAAP or a client-imposed scope limitation, 0 otherwise We identify the type of audit opinion from the auditor’s report in the annual report obtained from the TSE library

NegativeDA 1 If discretionary accruals for the previous year, estimated using theDechow

and Dichev (2002)approach, was in the bottom quartile (income decreasing), and 0 otherwise We exclude the middle quartiles to reduce noise and control for the top quartile using PositiveDA

Control variables:

Government

ownership

Percentage of issued shares held by government agencies QualOther 1 If the audit opinion for the previous year was qualiﬁed for reasons other

than violations of GAAP or client-imposed scope limitations, 0 otherwise We identify the type of audit opinion from the auditor’s report in the annual report obtained from the TSE library

PositiveDA 1 If discretionary accruals for the previous year, estimated using theDechow

and Dichev (2002)approach, was in the top quartile (income increasing), and

0 otherwise Size Natural logarithm of total revenue for the previous year, as disclosed in the

ﬁnancial statements in the annual reports obtained from the TSE library SalesGrowth 1 If sales growth during the previous year was greater than or equal to 30%,

using sales as disclosed in the ﬁnancial statements in the annual reports obtained from the TSE library Other thresholds are also tested

Loss 1 If a loss was reported in the previous year and 0 otherwise, as disclosed in

the ﬁnancial statements in the annual reports obtained from the TSE library Leverage Long-term debt divided by total assets at the end of the previous year, as

disclosed in the ﬁnancial statements in the annual report obtained from the TSE library

ROA Previous year net proﬁt divided by total assets

Competition

years

1 For cases occurring during the years of increased competition in the audit market following the introduction of the IACPA in 2001 (i.e., 2002–2003), 0 otherwise

Industry (0,1) Classiﬁcation variables for industries based on the industry

classiﬁcations published by the TSE

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