lin and liu - 2010 - the determinants of auditor switching from the perspective of corporate governance in china

Jun Lina,⁎ , Ming Liub a Department of Accountancy and Law, Hong Kong Baptist University, Kowloon Tong, Kowloon, Hong Kong b Department of Accounting and Information management, The Univ

Trang 1

The determinants of auditor switching from the perspective of corporate governance

in China

Z Jun Lina,⁎ , Ming Liub

a

Department of Accountancy and Law, Hong Kong Baptist University, Kowloon Tong, Kowloon, Hong Kong

b Department of Accounting and Information management, The University of Macau, Macau

a b s t r a c t

This paper reports the association between ﬁrms' internal corporate governance mechanisms and their auditor switch decisions in the Chinese context We identify two types of auditor switch, namely switching

to a larger auditor and switching to a smaller auditor Three variables are used to proxy forﬁrms' internal corporate governance mechanism, including the ownership concentration (shareholding by the largest owner), the effectiveness of supervisory board (SB), and the duality of chairman of board of directors (CBoD) and CEO We regressed the internal corporate governance variables overﬁrms' audit switching types during

a specific period of 2001–2004 when a bear market continued in China The empirical results demonstrate thatfirms with larger controlling owners or in which CBoD and CEO are held by the same person are more likely to switch to a smaller auditor rather than to a larger one However, the effect of the SB variable does not have a significant impact on auditor switching decisions In general, the study findings suggest that firms with weak internal corporate governance mechanism tend to switch to smaller or more pliable auditors in order to sustain the opaqueness gains derived from weak corporate governance On the other hand, with the improvement of corporate government,firms should be more likely to choose large (high-quality) auditors

in making auditor switching decisions

1 Introduction

The purpose of this study is to investigate the association between

ﬁrms' internal corporate governance mechanisms and their auditor

switching decisions in the Chinese context Shortly after the founding

of the People's Republic of China in 1949, the auditing profession in

China diminished completely under the public (the state) ownership

of all production means The independent auditing function was

virtually nonexistent in the planned economy before the 1980s, when

the state both owned and ran enterprises directly The mushrooming

Sino-foreign joint ventures brought about by the government's

adoption of the “open-door” policy in the early 1980s, led to the

emergence of independent auditing Owing to the involvement of

non-state equity interest in the joint-ventures, it became necessary to

have independent professionals, or the certiﬁed public accountants

(CPAs), to verify capital contributions and audit the annualﬁnancial

statements and income tax returns (Lin et al., 2003) Thus the Chinese

Institute of Certiﬁed Public Accountants (CICPA), a

quasi-governmen-tal organization in charge of national administration of CPAs and

auditing ﬁrms, was established in the early 1980s Following the

business restructuring campaign, shareholding (stock) companies

reappeared in the Chinese economy at the turn of 1990s, which further resulted in a sharp increase in the demand for external audits The establishment of the Shanghai and Shenzhen stock exchanges and the promulgation of new accounting and auditing standards have played an important role in this process The China Securities Regulatory Commission (CSRC) has therefore required that all listed firms have their annual reports audited by registered Chinese CPAs The separation of ownership and management in the listedfirms came with opportunistic management behavior and agency problems (Jensen and Meckling, 1976) This, in turn, created a market for independent auditors who should check on firms' management performance with the resources entrusted to them by the owners (Dye, 1993; Francis and Wilson, 1988; Imhoff, 2003) The auditors would attest the fairness of the management'sfinancial reports to various stakeholders and detect serious deviations from generally accepted accounting principles (GAAP) in their audit engagements in accordance with the Generally Accepted Auditing Standards (GAAS) Firms can employ reputable auditors to assure outside investors of the credibility of financial disclosures and hence mitigate the agency problems (Anderson et al., 2004; Willenborg, 1999) Thus auditors serve a corporate governance role in monitoring afirm's financial reporting process (Ashbaugh and Warfield, 2003; Cohen et al., 2002; Fan and Wong, 2005) Independent audits reduce agency costs by verifying the truthfulness and completeness of thefinancial state-ments, thereby allowing more precise and efficient contracts to be

⁎ Corresponding author Tel.: +852 3411 7537; fax: +852 3411 5581.

E-mail address: linzj@hkbu.edu.hk (Z.J Lin).

Contents lists available atScienceDirect Advances in Accounting, incorporating Advances in

International Accounting

j o u r n a l h o m e p a g e : w w w e l s e v i e r c o m / l o c a t e / a d i a c

Trang 2

based on theﬁnancial statements (Cohen et al., 2002; Maniam et al.,

2006; Watts and Zimmerman, 1986) Nonetheless, ﬁrm-speciﬁc

corporate governance mechanisms may also determine a ﬁrm's

decision on auditor selection or switching

Several factors motivated this study First, corporate governance

has a positive impact on corporateﬁnancial reporting and auditing

processes A study of auditor switching with respect to internal

corporate governance mechanisms may assist in the analysis of audit

quality and the auditor's role in ensuring the credibility of corporate

ﬁnancial disclosures Second, for the controlling owners, there is

always a tradeoff between hiring or switching to a high-quality

auditor to signal good corporate governance to lower the costs of

capital raising and hiring or switching to a low-quality auditor to

maintain the gains from the opacity of corporate governance (such as

the beneﬁts through earnings manipulation by the management or

“tunneling” behaviors to transfer resources to its controlling

share-holder) Usually it is difﬁcult to disentangle the effects of these two

motivations However, the continuous bear market in China during

2001–2004 provides a good opportunity to study the association

betweenﬁrms' internal corporate governance mechanisms and their

auditor switching decisions since the incentive for the beneﬁts from

lowering capital raising costs was trivial during the period Third, the

CICPA has begun to rank auditors in China since the early 2000s in

order to improve transparency in the Chinese auditing market, which

presents a possibility of identifying high-quality auditors in the

Chinese market An investigation of the determinants of auditor

switching with respect to the relationship between corporate

governance and audit quality should assist the understanding of the

necessity and utility of independent audits in China

The Independent auditing function can detect or disclose earnings

management and other misconducts committed by business managers

or the controlling shareholders Thus aﬁrm's management would like to

inﬂuence auditor choice decisions and have a motivation of switching

auditor in order to pursue their own self-interests In particular, when

the existing auditor is going to issue an“unclean” (non-standard) audit

report, theﬁrm's management or the controlling shareholders may

search for a more pliable auditor for the purpose of“opinion shopping”

in order to mitigate the negative impact of the unclean audit report on

theﬁrm's stock price in the market, and on the self-interests of the

management or the controlling shareholders

Auditor switching decisions are subject to the constraints of the

corporate governance structure in place In general, there are effective

monitoring devices over operating activities and management

perfor-mance if aﬁrm has set up sound corporate governance mechanisms

Thus theﬁrm's management or its controlling shareholder may not have

a free-hand in making the decision regarding auditor choice or auditor

switching Nonetheless the management or controlling shareholder

may be able to manipulate auditor choice or auditor switching in terms

of their own intension if theﬁrm's corporate governance mechanisms

are relatively weak in operation As a result, the risk of aggressive

earnings management or“tunneling” behaviors will increase while the

credibility ofﬁnancial statements will decrease Therefore, there should

be an association between aﬁrm's corporate governance and its auditor

choice or switching decision Hence, this study empirically investigated

the relationship betweenﬁrms' internal corporate governance

mechan-isms (proxied by ownership concentration, effectiveness of the

Supervisory Board (SB) monitoring, and duality of CBoD and CEO) and

their auditor switching decisions contextual to the corporate

gover-nance practices in the Chinese listedﬁrms

2 Literature review

2.1 Role of auditing function

In contemporary market economies, business incorporation led

to the separation of ownership and management Firms' owners

(shareholders) are not to be directly involved in business adminis-tration and professional managers are hired to run daily business operations Due to varied self-interests and information asymmetry, business managers may pursue their self-welfare even at the expense

of the owners and other stakeholders, which result in agency costs that must be eventually borne by the management (Jensen and Meckling, 1976) Thus, a series of mechanisms or measures are imposed to bind the managers and to induce them to act in the best interest of the owners One of the binding mechanisms is the auditing function performed by independent professionals over the operations and information disclosures provided by the management (Watts and Zimmerman, 1986; Willenborg, 1999)

Independent auditing can reduce the agency costs associated with the contractual relationships between the owners (the principal) and the management (the agent) or among various groups of stake-holders An auditor should not only attest to and verify the fairness and completeness of the financial statements produced by the management, but also monitor the management'sfinancial perfor-mance in terms of the stewardship responsibilities (Francis and Wilson, 1988; Imhoff, 2003; Singh and Davidson, 2003) Thus, auditors are able to detect or discover the management's manipula-tion of accounting numbers (e.g., earnings management) and other misconducts that have violated the established rules or regulations (Beattie et al., 2000; Francis and Krishnan, 1999; Lee et al., 2003) As a result, an audit should be able to ensure the credibility of thefinancial statements and enhance the usefulness of accounting numbers for investors' decision making (Anderson et al., 2004; Ashbaugh and Warfield, 2003; Johnson and Lys, 1990) In fact, as suggested by

Willenborg (1999), an independent audit should serve two roles in corporateﬁnancial reporting process; the assurance provider and the information intermediater

Nonetheless, the utility of the auditing function depends upon audit quality which is determined by the independence of auditors and the industrial expertise possessed by the auditors (Beattie et al., 2000; Dye, 1993; Francis, 2004; Teoh, 1992) A high-quality auditor should have independence (relationship based), enough expertise (technique based), and good integrity (honesty and forthrightness) In a broad sense, auditor independence includes expertise and integrity Normally, audit quality is considered to be commensurate with the size of the auditingﬁrm, i.e., large auditﬁrms should have a higher degree of independence and possess more industrial expertise and resources so they can provide better quality of auditing services For instance, DeAngelo (1981)

contends that audit quality is positively associated with the size and market shares of auditingﬁrms 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) Relatively, due to the constraints of industrial knowledge and resources, the audit services provided by small auditingﬁrms may

be of lower quality (Becker et al., 1998; Ghosh and Moon, 2005; Krishnan, 2003; Teoh and Wong, 1993) Several prior studies demon-strate that investors will attach greater market value to the accounting numbers (e.g., earnings and book values) reported by the clients of large auditingﬁrm, or the market participants will perceive the accounting numbers disclosed by the clients of large auditingﬁrms to have greater

“information content” to the market (Francis, 2004; Knechel et al., 2007; Krishnan, 2003; Lennox, 2005; Watkins et al., 2004)

DeFond and Subramanyam (1998)argue that there are incentives forﬁrms' managers or controlling shareholders to seek self-welfare by

Trang 3

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) On the one hand, selecting or switching to a large

auditingﬁrm will signal to the market that the ﬁnancial statements

should be more reliable under more effective auditing monitoring

proved by high quality (large) auditing ﬁrms, thus the ﬁrms may

beneﬁt from lower costs in capital raising from the equity or debt

market or from the reduction of agency costs in the enforcement of

contractual obligations On the other hand, the managers or

controlling shareholders may also consider the capacity of large

auditing ﬁrms in detecting earning management activities or

“tunneling” behaviors and they may prefer to choose or switch to a

small auditingﬁrm with relatively lower quality of audit monitoring

(Imhoff, 2003; Johnson and Lys, 1990; Lee et al., 2003) In particular,

when ﬁrms received a “qualiﬁed” or other type of unclean audit

report, they might initiate auditor switching by searching for more

pliable auditingﬁrms with relatively lower quality for the purpose of

“opinion shopping” (Chow and Rice, 1982; Geiger et al., 1998;

Krishnan, 1994; Lee et al., 2004; Schauer, 2002) This is because

receiving an unclean audit reports would depress the prices of aﬁrm's

securities and impair its ability to raise funds in future However, the

empirical studies on whether ﬁrms can be successful in “opinion

shopping” have yielded inconsistent results in industrialized

countries (Johnson and Lys, 1990; Klock, 1994; Rosner, 2003; Watkins

et al., 2004)

Nonetheless, many researchers agree that investors and other

market participants will normally perceive auditor switching as a

negative signal as they believe thatﬁrms with auditor switching may

become more aggressive inﬁnancial reporting which should lead to

more “noise” in the accounting numbers being reported, thus,

reducing the credibility and usefulness of theﬁnancial statements

As a result, the market will react negatively to the announcement of

auditor switching, such as depressing the ﬁrms' stock prices or

increasing theﬁrm's cost of capital Thus, there are high costs for a

listedﬁrm to switch its auditor For example, the ﬁrm should incur

negotiation costs, the new auditor needs times to get familiar with the

ﬁrm's operation and internal control systems, and investors may

respond negatively to auditor switching (Anderson et al., 2004;

Chaney and Philipich, 2002; Ghosh and Moon, 2005; Klock, 1994;

Knechel et al., 2007; Reed et al., 2000; Teoh, 1992)

In theory, auditor switching may take different forms, i.e.,

switch-ing to a smaller auditswitch-ingﬁrm or switching to a larger auditing ﬁrm

Many studies conﬁrmed that switching to a smaller or lower quality

auditingﬁrm would result in negative responses from investors and

other market participants However, in the case of the latter form of

auditor switching, since the successor auditingﬁrm is larger than the

predecessor auditingﬁrm, the audit quality should improve while the

possibility of earnings management or“tunneling” behaviors should

reduce As a result, the credibility and usefulness of accounting

numbers should increase Nonetheless there is a general lack of

research on this regard in the extant literature

2.2 Corporate governance and the auditing function

Corporate governance also came with the separation of

owner-ship and management underlying the modern corporate system

(Singh and Davidson, 2003) Since many interested parties are

associated with businessﬁrms there have varied kinds of principal–

agent relations, i.e., between owners and the management,

control-ling (large) shareholders and minority shareholders, creditors and

owners/management, regulatory bodies and businessﬁrms, etc A

primary objective of corporate governance is thus to monitor the

behaviors of different interested parties and to reduce the agency

costs underlying various principal-agent relationships (Karpoff

et al., 1996; Lashgari, 2004; Maniam et al., 2006) Thus, corporate

governance can be deﬁned as “a set of mechanisms, both industrial and market-based, that induce the self-interested controllers of a company to make decisions that maximize the value of the company

to its owners” (Denis and McConnell, 2003)

More specifically speaking, corporate governance is a set of external and internal rules, regulations, procedures and measures to govern the behaviors of various interest parties within afirm A sound corporate governance mechanism should be able to balance the powers and obligations of different interested parties in order to reduce potential conflicts of interest and other agency costs through a series of binding devices to implement the contractual responsibilities and obligations among the shareholder (owners), the Board of Directors (BoD), the management, and the employees, in order to promote goal congruence among the related parties and maximize the values for thefirm as a whole (Dewing and Russell, 2003; Singh and Davidson, 2003) Several empirical studies have found that corporate governance is positively associated with afirm's operating efficiency and effectiveness ( Ander-son et al 2004; Bushman and Smith, 2001; La Porta et al., 2002) Investors are willing to pay a higher premium forfirms with sound corporate governance (Bai et al., 2004; Gompers et al., 2003; Lemmon and Lins, 2003; McKinsey & Company, 1999–2002; Steen, 2005) In particular, after the notorious corporate scandals in the early 2000s, such as Enron and WorldCom, more and more market regulators, researchers and practitioners in developed and developing countries have devoted great efforts in corporate governance studies and proposed various procedures to raise the standards of corporate governance in recent years (Bai et al., 2004; Denis and McConnell, 2003; Jiraporn et al., 2005) Market regulators and public investors have all paid great attention to the important role of corporate governance in improving corporate financial reporting and the auditing process (Ashbaugh and Warfield, 2003; Pergola, 2005; Steven, 2006; Ugeux,

2004)

Generally speaking, the independent auditing function can be treated as a device of corporate governance, i.e., an audit will provide external monitoring over afirm's financial reporting by independent professionals (auditors) In fact, an audit provides an independent check on the work of thefirm's management (agents) and of the information provided by the management, and therefore, serves a fundamental role in reinforcing the confidence in corporate financial reporting Auditor can and should also investigate and evaluate a firm's internal control procedures and measures to ensure rule compliance and reliable information disclosures Thus, the indepen-dent audit can enhance the roles of corporate governance (Beasley

et al., 2000; La Porta, 2002;Fan and Wong, 2005) The more audits contribute to corporate governance, the more valuable audits are to thefirms As high quality auditing firms are more professional and more independent, they are more likely to discover and report irregularities infinancial reporting and therefore better serve as a monitoring device Empirical research further indicates that the demand for independent audits as a corporate governance mecha-nism byfirms in UK and US is a function of audit quality and the assurance provided by auditfirms (Chaney and Philipich, 2002; Cohen

et al., 2002; Ghosh and Moon, 2005; Willenborg, 1999)

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; Francis et al., 2005) A sound corporate governance mechanism should ensure the firms appoint qualified auditors and ensure that auditors should exercise independent and effective monitoring over the firm's financial reporting process and attest that thefinancial statements are fairly presented in conformity with GAAP 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; Fan and Wong, 2005; Maniam et al., 2006)

On the other hand, when there is a lack of sound corporate governance, it would be difﬁcult to prevent the ﬁrm's managers or

Trang 4

controlling shareholders 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 serious study In

particular, the business administrative system and corporate

governance practices in China differ substantially from those in

the developed countries, which may have different impacts on the

utility of the auditing function as well as the consequences of

auditor switching in the Chinese context To study the determinants

of auditor switching from the perspective of corporate governance

contextual to the Chinese market environment should not only

promote the development of corporate governance and

indepen-dent auditing in emerging economies like China but also enrich the

extant auditing literature on the related issues

3 Hypotheses development

Since the establishment of the Shanghai Stock Exchange and

Shenzhen Stock Exchange, Chinese listedﬁrms have achieved an

accumulatedﬁnancing amount of RMB 1.16 trillion (RMB 7.5 = US

$1) between 1992 and 2004, and the total market capitalization once

hit RMB 1.61 trillion in 2000 However, theﬁve years' bear market

since 2000 has seen the market value slump by RMB 0.44 trillion to

RMB 1.17 trillion in 2004 (CSRC 2005) Because of the weak market,

listedﬁrms were less enthusiastic to offer new equity securities to

the public from 2001 to 2004 The CSRC even stopped the listedﬁrms

from issuing new equity securities to the public in June 2002 In such

a market, we posit that the beneﬁts of lowering capital raising costs

are insigniﬁcant because the listed ﬁrms have little intention or

possibility of offering new equity securities to the public Therefore,

the opaqueness gains from weak corporate governance are

sup-posed to outweigh the beneﬁts of lowering capital raising costs in

the bear market period Hence, lower-quality auditingﬁrms may be

preferred by the listedﬁrms, and especially by ﬁrms with weak

internal corporate governance mechanisms, because they have more

opaqueness gains to protect (Beasley et al., 2000; Felo et al., 2001)

To address the research question empirically, we intended to test

the relationship between ﬁrms' internal corporate governance

mechanisms and their auditor switching decisions In other words,

we wanted to ﬁnd out whether the ﬁrms with weak internal

corporate governance mechanisms were more likely to switch to

auditingﬁrms of lower quality We used three proxies to measure a

ﬁrm's internal corporate governance mechanisms: the degree of

ownership concentration (shareholding of the largest owner), the

effectiveness of SB monitoring (SB size), and the duality of CBoD and

CEO (BoD oversight over management performance) There are

other variables appropriate for measuring internal corporate

governance mechanisms, such as the function of the independent

(non-executive) directors and the audit committees However, the

latter internal monitoring variables are not included in our study

because they were introduced to the Chinese listedﬁrms only after

2002 and their full adoption is beyond the test period.1

High ownership concentration is a distinct feature of listedﬁrms in China A Chinese listedﬁrm usually has a large controlling owner.2The largest controlling owner is usually the government or the parent SOE.3Nonetheless, ownership structures affect corporate governance and corporate value in many complex ways.Johnson et al (2000)

argue that more narrowly heldﬁrms may face greater agency costs because the controlling shareholders will have a dominant inﬂuence

on corporate affairs and it is easier for them to bypass the monitoring

of other shareholders.La Porta et al (1999, 2002)showed that in emerging transitional economies, the controlling shareholders may expropriate the minority shareholders through aggressive“tunneling” behaviors They further argue that“the central agency problem in large corporations around the world is that of restricting expro-priation of minority shareholders by controlling shareholders” (La Porta et al., 1999) This is particularly true for Chinese listedﬁrms where the controlling shareholders, on average, hold a very large proportion of the equity

In China, the controlling shareholders have frequently intervened

in the operations of listedfirms to benefit parent companies, using listedfirms to guarantee loans for related entities, and exposing listed firms to unnecessary financial and operating risks In fact, the controlling shareholders of many listedfirms are keen only to raise funds from the stock market They frequently engage in benefit transfers through misappropriation of funds or related-party transac-tions to expropriate listedfirms and infringe upon the interests of other shareholders (Lin et al., 2007) Extracting private control benefits, if detected, is likely to invite external intervention by minority shareholders, analysts, stock exchanges, or regulators (Haw

et al., 2004) The desire to maximize self interests through‘tunneling’

or benefit transfer leads listed firms to avoid being monitored by high-quality auditingfirms The higher the degree of ownership concen-tration (e.g., with large controlling owner), the weaker the internal corporate governance mechanisms and the more opacity gains there will be Therefore,firms with large controlling owners may be more likely to switch to a pliable auditingfirm to protect or realize the private benefits gained through earnings management, tunneling behaviors or other misconducts Hence, ourfirst hypothesis can be stated as the following:

Hypothesis 1 (H1): ceteris paribus, aﬁrm with a high percentage of total shares held by its controlling owner is more likely to switch to a smaller auditingﬁrm

Pursuant to the Chinese Company Law, all Chineseﬁrms have adopted the German-style dual-board system of governance, thus each listedﬁrm has to set up both a BoD and a supervisory board (SB) The SB is composed of shareholders' representatives (including Party

officials) and an appropriate proportion of employee representatives who are nominated by the employee union of thefirm The Company Law specifically defines the SB as a monitoring mechanism to carry out a series of responsibilities, including the following:

1 monitoring the performance of directors and senior managers, to ensure the compliance with laws, regulations, and the articles of incorporation;

2 reviewing theﬁnancial affairs of the ﬁrm;

1 In the western literature, independent non-executive directors and audit

committee are emphasized as important components of internal corporate

govern-ance Although some Chinese listed ﬁrms might have voluntarily adopted the

independent director or audit committee system before the introduction of the new

guidelines on good corporate governance practices issued by CSRC in 2002, most

Chinese listed ﬁrms have not appointed sufﬁcient numbers of independent directors

until 2004 or 2005 Furthermore the data for independent directors or audit

committees were generally not available during our test period Hence, we assume

that the SB, instead of the independent directors or audit committee system, as a

signiﬁcant component of internal corporate governance for the Chinese listed ﬁrms

during 2001–2004.

2 According to an investigation report that the share interest of the ﬁrst large shareholder (mainly the parent SOEs) accounts for, on average, around 50% of the total equity of the Chinese listed companies in 2000.

3

Most of Chinese listed firms were restructured from the former state-owned enterprises (SOEs) Thus there are normally three types of equity holding for a Chinese listed firm, i.e., the state-owned shares (representing the state's interest in the firm), the social-legal-entity shares (mainly the interest of the parent SOEs or other social agencies), and the public shares held by institutional and individual investors, with a major part of the total equity shares in the firm are controlled by the state

Trang 5

3 requesting directors and senior managers to alter and/or rectify

their personal actions if they are in conﬂict with the ﬁrm's

objectives;

4 proposing speciﬁc shareholder meetings whenever they deem

necessary;

5 fulﬁlling any other duties that are stipulated in the articles of

incorporation of theﬁrm; and

6 submitting a SB report to the shareholders' annual general meeting

(The Company Law 1993, 1999, 2005)

The Standard Codes of Corporate Governance for Listed Companies in

China issued by the CSRC and State Economic and Trade Commission

in 2002 further requires that SB members should have some

professional knowledge or work experience in such areas as law

and accounting

Under the requirements of Company Law, the SB shall

indepen-dently and effectively conduct its supervision over the activities

carried out by the directors and the management as well as monitor or

examine theﬁnancial affairs of the ﬁrm Such German-styled two-tier

board system with co-existence of the BoD and the SB, in fact has

become the backbone of corporate governance in most Chinese listed

ﬁrms since the mid 1990s Using an events study,Dahya et al (2003)

suggest that investors consider the SB as an important device of

corporate governance in China.Chen (2005)found that there was a

positive association between the size of the SB and the level of

corporate governance More members in a SB will enhance its

monitoring role This suggests that a SB of a large size should be

more effective in carrying out its legitimate monitoring

responsibi-lities Hence, we adopt the number of SB members as a proxy for the

monitoring strength of the SB The fewer SB members a listedﬁrm has,

the weaker the internal corporate governance is, vice verse Therefore

the second hypothesis can be stated as below:

Hypothesis 2 (H2): ceteris paribus, aﬁrm with fewer SB members is

more likely to switch to a smaller auditingﬁrm

Within a sound corporate governance structure, the BoD must

ensure that the management acts in the best interests of the

shareholders The BoD is responsible for the execution of the

resolutions passed by the shareholders' meetings; for appointing,

removing and remunerating the senior managers However, many

directors are concurrently the executives of theﬁrm (including the

CEO) As a result, they are less likely to be impartial in supervising and

evaluating the performance of the management For the BoD to

effectively perform an oversight function, the separation of the

positions of CEO and CBoD is essential with respect to effective

internal corporate governance mechanisms (Claessens et al., 2002;

Jiraporn et al., 2005; La Porta et al., 1999) Thus, the CEO's

performance can be impartially monitored and evaluated by the BoD

Traditionally the duality of the CBoD and the CEO was common in

American businesses However, in most European, British, and

Canadian businesses, these two positions are usually split, in an effort

to ensure better governance of the company Combining the two

positions does have its advantages, giving a CEO multiple perspectives

on theﬁrm as a result of his/her multiple roles, and empowering him/

her to act with determination Nonetheless, this allows for little

transparency in the CEO's acts, and as such his/her actions can go

unmonitored, which may pave the way for serious scandals and

corruption An effectively independent board is a shareholder's best

protection Separating the two important positions allows the CBoD,

on behalf of the stockholders, to impartially oversee the work of the

CEO and the management's overall performance Ultimately, when

CBoD does not occupy the position of CEO, theﬁrm is governed in a

more impartial manner (La Porta et al., 2002; Steven, 2006)

Investors, researchers, and government ofﬁcials gradually accept

the view that the best practices of corporate governance require the

separation of the roles of CBoD and CEO Such a corporate governance

device has received a boost since 2003 after recent corporate scandals

It is now widely considered as a bad corporate governance practice if the positions of afirm's CBoD and CEO are held by the same person, which will lead to less transparency and ineffective BoD oversight function in thefirm In practice, market regulators and professional bodies in many developed countries have all imposed the require-ment for the separation of the two important positions as good corporate governance (Jiraporn et al., 2005) The CSRC has also adopted this measure in its Standard Codes of Corporate Governance for the Listed Companies in China since 2002 Consistent with the association between internal corporate governance and the audit function, we'll have the third hypothesis being stated as the following; Hypothesis 3 (H3): ceteris paribus, a firm with CBoD and CEO positions occupied by the same person is more likely to switch to a smaller auditingfirm

4 Research methodology 4.1 Model speciﬁcation

We examine the determinants of audit switching from the perspective of the internal corporate governance mechanisms in Chinese listedfirms Thus, our sample includes firms that conducted auditor switching in 2001 to 2004 We classified all firms that switched their auditors only once during the 4-year test period into two types: those switching to a larger auditing firm (switching upwards, or SUfirms) and those switching to a smaller auditing firms (switching downwards, or SDfirms) according to the ranking order of the auditors in China, which was compiled in terms of their annual audit revenues by the CICPA (seeAppendix) As elaborated earlier, the size of an auditingfirm is regarded as an effective surrogate for the independence and monitoring strength of auditors (DeAngelo, 1981; Willenborg, 1999; Copley and Douthett, 2002; Farbar 2005) Switch-ing to a smaller auditSwitch-ingfirm may facilitate listed firms to elude more stringent monitoring from their predecessor auditor Visa verse, switching to a large auditingfirm should have opposite effect Thus,

we construct a model to test whether aﬁrm's internal corporate governance mechanisms (proxied by ownership concentration, SB monitoring strength and duality of the CBoD and the CEO) is associated with the different types of auditor switching (namely switching to a larger auditingﬁrm or a smaller one) as stated by the three hypotheses

We run logit regression on the following auditor switching model

to test Hypotheses 1–3

AS = β0 + β1LSH + β2SB + β3CEOCHR + β4GOV + β5OPI + β6LNASSET + β7LEV + β8MB + β9LOSS + β10Yr02 + β11Yr03 + β12Yr04 + ε

ð1Þ

where:

AS if theﬁrm switches to a smaller auditor; 0 otherwise LSH largest owner's shareholding as a percentage of total shares

SB number of members of the supervisory board CEOCHR 1 if the CEO also holds the position of Chairman of the Board

of Directors; 0 otherwise GOV 1 if the largest shareholder is a government agency; 0

otherwise

OPI 1 if theﬁrm receives an unclean auditor's opinion for the

previous year; 0 otherwise LNASSET log of total assets at the end of the previous year LEV long-term liabilities divided by total assets at the end of the

previous year

MB market to book ratio at the end of the previous year,

Trang 6

calculated as the market value of stocks divided by the book

value

LOSS 1 if the ﬁrm experiences a loss for the previous year; 0

otherwise

Yr02 1 if the auditor switching occurs in Year 2002; 0 otherwise

In the regression, the dependent variable is deﬁned by the types of

auditor switching Thus, it is coded 1 if aﬁrm switched to a smaller

auditingﬁrm, comparing to its preceding auditor For the independent

variables, we expectβ1(for ownership concentration) and β3(for

duality of CBoD and CEO) should have positive sign asﬁrms with high

ownership concentration and combination of CBoD and CEO positions

may be more likely to switching to a smaller auditingﬁrm But β2(for

SB size or monitoring strength) should be negative as a large or

stronger SB may discourage theﬁrm to switching to a smaller auditing

ﬁrm

Some studies argue that ownership concentration may not be

equal to government control of the listed ﬁrms as some

non-government owned or controlledﬁrms were listed in China in recent

years in the course of China's transition towards a market-based

economy Thus, government controlled and non-government

con-trolled (privately owned or concon-trolled) ﬁrms may have different

corporate governance structures and their auditor switching decisions

may have varied considerations In general, government agencies

have stronger inﬂuence over the government-controlled ﬁrms, and it

is easier for them to get aﬁrm's ﬁnancial information for their policy

needs (Chan et al 2006) So government-controlledﬁrms may have

less demand for high quality independent audits and they may have

greater propensity to switching to smaller auditingﬁrms compared to

non-government controlledﬁrms Therefore, we add another variable

of GOV to capture the effect of government controlled ownership on a

ﬁrm's auditor switching decisions This variable is coded 1 if the

largest owner of theﬁrm is a government agency, while

nongovern-ment ownedﬁrms are coded 0 It is expected that this variable should

be positively associated with downward switching of auditors

We also controlled for the effects of someﬁrm-speciﬁc factors that

have been shown or are likely to affect ﬁrms' audit switching

decisions; e.g., auditor's opinion,ﬁrm size, growth potential,

proﬁt-ability, andﬁnancial leverage (risk) There are some studies on auditor

switching in the literature, but they focus mainly on the development

of auditing markets in western countries (Beattie and Fearnley, 1995;

Chaney et al., 2004; Craswell, 1988; DeFond, 1992) Nonetheless, the

basic theories andﬁndings in prior research on auditor switching

should be applicable to this study as the Chinese auditing profession

has gradually adopted international accounting and auditing

stan-dards in pace with rapid progress of China's transition towards a

market-based economy in recent years

One very common reason cited for auditor switching is the

qualiﬁcation of auditor opinions Prior research found that clients

receiving an unclean audit report were likely to switch auditors

(Chow and Rice, 1982; Geiger et al., 1998; Vanstraelen, 2003),

perhaps because the management or the controlling shareholders

believed that once an incumbent auditor was dismissed, theﬁrm

couldﬁnd a more pliable auditor whose opinion would be more in

line with the management's views (Chow and Rice, 1982; Craswell,

1988;DeFond and Subramanyam, 1998; Vanstraelen, 2003)

Alter-natively, the management or controlling owners might dismiss an

auditor solely as a punishment for the auditor for issuing a

going-concern report, or due to irreparable damages when management

was in conﬂict with the auditor The auditor's opinion is likely to be

related to theﬁrm's auditor switching decision and it is controlled in

the regression model We expected the variable (receiving an

unclean auditor opinion in prior year = 1) should be positively related to downward switching of auditors

Largefirms have less incentive to switch to a smaller auditing firm, sincefinancial analysts and the financial press will scrutinize their auditor switches more closely Beatty (1993) reports that audit efforts and fees are found to increase with the size and complexity of the clients (Copley & Douthett, 2002).Willenborg (1999) suggest that largefirms will be forced to hire or switch to large auditing firms as large firms were usually more complicated in operation, and therefore, needed to hire auditors with more expertise which is usually possessed by large auditingfirms Economies of scale also increase the probability that largefirms select high-quality auditors,

as the high-quality auditingfirms (usually of large size) are able to audit largefirms at low average costs (Chaney and Philipich, 2002) FollowingFriedlan (1994)andLennox (1999), we use the log of total assets to control for the size effect of thefirms The sign of firm size variable is thus expected to be negative in the regression

Anderson et al (2004)report thatfirms with a high asset turnover ratio or greater growing potential are inclined to choose high-quality auditors asfirms prefer to benefit from the signaling effect of better reputation or quality of large auditingfirms We also include market-to-book ratio to control for the propensity of growingfirms to switch

to less conservative auditors (DeFond and Subramanyam, 1998) In addition, several studies document thatﬁrm performance (proﬁtabi-lity) or stock returns may affect the selection of auditors (Sainty et al.,

2002).Willenborg (1999)documented thatfirms audited by large auditingfirms were more profitable, ceteris paribus More profitable firms may be more eager to switch to a high-quality auditor to testify

to their good performance to the market In addition, more profitable firms usually can better afford to switch to a large or a higher-quality auditor Nonetheless, firms that incurred a loss in prior year may have the propensity of switching to a small (lower-quality) auditing firms (DeFond et al., 2000) Hence, both growth and profitability factors are controlled for in the regression model We expect the loss variable should be positively associated with downward switching

of auditors

Reed et al (2000)found thatﬁrms selecting Big 6 auditors tended

to be highly leveraged They argue that more leveragedfirms have stronger incentives to hire a high-quality auditor to mitigate the market's suspicion on their performance and to lower their costs of capital In contrast, Titman and Trueman (1986) predicted that entrepreneurs of highly-leveragedfirms were more likely to choose low-quality auditors Their prediction follows the argument that agency costs tend to be higher in highly leveraged clients so they would be less likely to hire a high-quality auditor Thus, afirm with bad information (e.g., higher financial leverage) may obtain less benefit in switching to a high-quality auditor (Copley and Douthett, 2002; Friedlan, 1994)

However, some researchers argue that the signaling value associated with the utility of a high-quality auditing firm will increase if firm-specific risk rises In general, the incentive to switch to a high-quality (large) auditor increases withfirm risk (Datar et al., 1991; Hogon, 1997).Willenborg (1999)argues that high-quality auditors can provide better“assurance” to investors:

if the auditedfinancial information turns out to be misleading, investors can sue the auditors for a damage award The value of such assurance is increasing with respect to the degree of firm-specific risk However, empirical results are not generally consistent with this prediction (Feltham et al., 1991; Simunic and Stein, 1987).Copley and Douthett (2002)confirmed that the demand for large auditingfirms increased with the extent of firm-specific risk (financial leverage) Hence, highly leveraged or more riskyfirms may benefit from switching to a high-quality auditor because their information uncertainty can be reduced to a greater extent than less leveraged ones Due to opposing arguments associated with auditor switching in the literature for

Trang 7

highly-leveragedfirms, we did not predict the sign of this firm-specific

risk variable

As mentioned earlier, independent non-executive director and

audit committee practices were introduced to Chinese listedﬁrms by

the CSRC in 2002 with the issuance of the Standard Codes of Corporate

Governance for the Listed Companies in China The new Standard Codes

require that each listedﬁrm appoint at least one-third independent

non-executive directors for the BoD and that the audit committee

should be set up under the BoD Because mostﬁrms did not fulﬁll the

new requirement until 2004 or 2005, this new internal corporate

governance device could not be directly included in our test model

Nonetheless, the announcement and implementation of the new

Standard Codes may have some impact on the improvement of

corporate governance mechanisms for the listedﬁrms in China Thus,

we add a dummy variable for the years 2002 to 2004 to capture the

potential impact of this new corporate governance device onﬁrms'

auditor switching decisions during the test period

4.2 Sampling

Our sample covers A-shareﬁrms that switched auditors during the

period from the beginning of 2001 to the end of 2004.4There are two

main reasons to limit the sampleﬁrms that made auditor switches in

this time period The ﬁrst one is the availability of the ranking of

Chinese auditors, which has been compiled by the CICPA since 2002

Thus it provides a possibility of identifying or classifying the different

types of auditor switching (i.e., switching to a larger or a smaller

auditingﬁrm) The second reason is that during this time period, ﬁrms

have only trivial intentions to offer equity issuing to the public,

therefore the opaqueness gains from weak corporate governance

signiﬁcantly outweigh the beneﬁts from lowering the costs of capital

raising The bear market period from 2001 to 2004 is hence

appropriate to test the association of ﬁrms' internal corporate

governance mechanisms with their auditor switching decisions

Data are collected from China Stock Market and Accounting Research

(CSMAR) Database, TEJ database (carrying theﬁnancial information

and stock market data compiled by Taiwan Economic Journal), and

the authoritative national newspapers or magazines designated by

the CSRC to publish theﬁnancial reports of the Chinese listed ﬁrms,

such as China Security Daily, Shenzhen Security Times, and Shanghai

Security News The collected data of the sample ﬁrms were cross

checked or veriﬁed by different data sources to ensure their reliability

Description of the data is provided inTable 1

At the end of 2004, there were 1387 A-sharefirms listed in the two stock exchanges in China, among which 316firms (22.7%) switched their auditors during the four year period of 2001–2004 This implies that generallyfirms are not willing to switch auditors because of the potential high costs associated with auditor switching such as the costs for searching for and renegotiating with a new auditingfirm and the potentially unfavorable market/investor responses to auditor switching, etc (Abbott et al., 2007; Anderson et al., 2004; Ghosh and Moon, 2005; Teoh, 1992) Panel A ofTable 1presents the sample size for this study Financial, transportation, and utilityfirms are excluded

in this study because their operations are very different from other types offirms in nature We also delete firms that switched auditors more than once during the four year period Firms switching auditors frequently may indicate some serious underlying reasons which are beyond the scope of this study Also,firms switching twice or more may switch to a larger auditingfirm once and to a smaller auditing firm another time, making it difficult to categorize its switching type Thefinal sample consists of 233 firms

5 Empirical results

Table 2presents the basic statistics of the testing variables Among the 233 samplefirms, 134 firms switched to larger auditing firms, while 99firms switched to smaller auditing firms according to the ranking of Chinese auditors The largest controlling owners, on average, held 48.94% of the total shares of the samplefirms, indicating high ownership concentration in the Chinese listedfirms About 79%

of our sample firms are directly owned by the government or governmental agencies, which reflect the fact that the majority of Chinese listedfirms were originally carved out from the state owned enterprises (SOEs) and various government agencies remain the largest owners of the listedfirms In the sample, 15.9% (37/233) of the firms received unclean auditor opinions before their auditor switches This high percentage may support the assertion that there is an association between unclean auditor opinions being received and auditor switching being made among the Chinese listedfirms The average size of SB is about 4.41 with a minimum of 3 persons in a SB and the maximum of 12 persons In 9% of the samplefirms (21/233), their CEOs also hold the position of CBoD

Table 3presents the correlation coefficient matrix for the variables used in the regression model Firms' switching to a smaller auditing firm are significantly and positively correlated with the largest owner's shareholding, the same as the size of the SB, CEO holding the position of CBoD and the growth (market-to-book ratio); and significantly and negatively related to firm size (log of total assets) Correlation coefficients among independent variables are moderate with no value exceeding 0.5 (the largest one is only 0.441), so the multicollinearity problem is not serious and won't distort the relationship between the dependent and independent variables in the regression model

4

The stock market in China is segregated The A-share ﬁrms are for domestic

investors while a small numbers of B-share ﬁrms are for overseas investors According

to the existing regulations, the ﬁnancial statements of B-share ﬁrms must be audited

by international auditing ﬁrms (the Big 5/4) Thus, auditor switch for B-share ﬁrms

was very few because of limited availability of alternative auditors Therefore, those

ﬁrms issuing both A-shares and B-shares are excluded from our test.

Table 1

Description of data.

Panel A: Sample selection

Financial, transportation, and utility ﬁrms 11

Firms switching auditors more than once during 2001–04 25

Panel B: Sample distribution by sector and year

Table 2 Descriptive statistics of variables.

Trang 8

Table 4provides empirical results from the regression which tests

whether, among the switching ﬁrms, ﬁrms with weak internal

corporate governance mechanisms are inclined to switch to a smaller

auditing ﬁrm Since there are only two values for the dependent

variable (1 for switching to a smaller auditing ﬁrms, and 0 for

switching to a larger auditingﬁrms), OLS regression does not work for

the model Instead, we use logit regression With a Chi-square of

34.641, pb0.01, and a pseudo R-squared of 0.186, the regression

model is satisfactory in differentiating ﬁrms switching to smaller

auditingﬁrms from those switching to larger ones at the acceptable

signiﬁcance level

The coefﬁcient for the largest owner's shareholding is positively

signiﬁcant at the 5% level of signiﬁcance, which supports H1 It

suggests thatﬁrms with a higher degree of ownership concentration

(i.e., higher percentage of equity shares held by the largest controlling

owners) are more likely to switch to a smaller auditingﬁrm Since a

higher degree of ownership concentration normally represents weak

corporate governance, the result conﬁrms that ﬁrms with weak

corporate governance would be inclined to switch to smaller auditing

ﬁrms to avoid more effective monitoring by the larger auditing ﬁrms

The coefﬁcient for the size of the SB is insigniﬁcant, therefore,H2is

not supported, indicating that the SB monitoring effectiveness is not

related to whetherﬁrms switch to a larger or a smaller auditing ﬁrm

Thisﬁnding may suggest that the monitoring role of the SB is in doubt

in practice and the SB has no impact on ﬁrms' auditor switching

decisions at present Since members of the SB are mainly from inside

the ﬁrm, the question of whether the SB can effectively play a

monitoring role is controversial The coefﬁcient for the SB remaining

insigniﬁcant may indicate that the SB could not effectively play a

corporate governance role in the Chinese listed ﬁrms Some

researchers contend that the SB is mainly decorative in the Chinese

ﬁrms at present (Dahya et al 2003; Xiao et al 2004) Our study

findings confirm such an assertion Consistent withH3, the coefficient

for the duality of CBoD and CEO is positive and significant at the 10% level of significance Thus, a firm is more likely to switch to a smaller auditingfirm if its CEO also holds the position of CBoD

It is interesting to note that the coefficient of the GOV variable is positive but not significant Thus, it is not convincing that the government owned and controlledfirms will more likely switch to smaller (low quality) auditing firms in comparison with non government controlledfirms Mainly, the ownership concentration

is an inﬂuential factor underlying a ﬁrm's auditor switching decisions

in China In addition, the coefficient for the auditor opinion (OPI) variable is positively related to switching to small auditingfirms but not at the conventional significance level Therefore, we obtained no sufficient evidence to explain whether firms receiving unclean audit reports would be inclined to switch to smaller auditingfirms for the purpose of “opinion shopping” among the Chinese listed firms Nonetheless, thisfinding is consistent with some studies in the US (Craswell, 1988; Watkins et al., 2004) or in China (Chan et al., 2006) Consistent with our predictions,firm size is negatively related to switching to a smaller auditingfirm at the significance level of 0.05 Thisfinding confirms that large firms are less likely to switch to a smaller auditingfirm when they make auditor switching decisions An explanation may be that the operations of large firms are more complicated and they may be more concerned about their image in the market, so they would prefer to switch to larger (higher quality) auditingfirms when necessary In addition, both variables of growth (market-to-book ratio) and risk (financial leverage) have positive and significant coefficients Hence, firms with great growth potential and high financial leverage ratio were inclined to switch to smaller auditingfirms among the Chinese listed firms Normally, fast growing firms have a relatively higher degree of risk in business expansion and they would prefer to switch to smaller auditing firms to have a relatively lower degree of audit monitoring Finally, the profitability of firms (proxied by loss incurred in the prior year) does not have a

Table 3

Correlation coefﬁcient matrix of variables.

LNASSET −.174*** 0.201*** −0.071 −0.148** 1.000

***, **, and * denote signiﬁcance at the 1%, 5%, and 10% levels, respectively.

Table 4

Internal corporate governance mechanisms and switching to a smaller auditing ﬁrm test of H1 to H3 (main test).

AS =β 0 +β 1 LSH + β 2 SB +β 3 CEOCHR + β 4 GOV +β 5 OPI +β 6 LNASSET +β 7 LEV +β 8 MB + β 9 LOSS +β 10 Yr02 + β 11 Yr03 +β 12 Yr04 +ε

N = 233

Chi-square = 34.641

Pseudo R-square = 0.186

The Wald-Wolfowitz test examines whether the mean (median) of each variable for Top 10 clients equals to that of non Top-10 clients.

Trang 9

signiﬁcant effect on auditor switching decisions among the Chinese

listedfirms at present In other words, profitability is not a significant

concern when aﬁrm decides to switch its auditor

As indicated byTable 4, the coefﬁcients for year dummy variables

are not signiﬁcant except for 2004 which is marginally signiﬁcant at

the 10% level This suggests even the Chinese listedﬁrms had been

required to adopt the independent non-executive director and

auditing committee practices in their corporate governance since

2002 The auditor switches incurred during the test period were not

affected by the new corporate governance practices being introduced

One explanation may be because most listedﬁrms had not adopted

the new practices until 2004, or the new practices did not function

well in the test period, even though they were speciﬁed by the new

corporate governance standard codes being effective since 2002

In summary, the empirical results support that there is an

association between aﬁrm's internal corporate governance

mecha-nisms and their auditor switching decisions Namely, ﬁrms with

weaker internal corporate governance (proxied by higher degree of

ownership concentration and duality of CBoD and CEO) would be

more likely to switch to a smaller auditingﬁrm rather than to larger

auditingﬁrm to avoid more effective audit monitoring provided by

large or higher-quality auditors The result implies that the

opaque-ness gains derived from weak corporate governance (such as earnings

management and tunneling behavior) might be a major consideration

whenﬁrms decided to switch their auditors in China

6 Sensitivity tests

To examine the robustness of the regression model and the

empirical results, we tried different sensitivity tests First, we use a

more strict measure to proxy for the dependent variable of auditor

switching (AS), which is deﬁned as switching from a Top 10 auditor to

a non-Top 10 auditor The empirical results remain unchanged (see

Table 5) In order to make sure that the largest shareholder does

control the listedﬁrm, we limit the sample to ﬁrms in which the

largest owners own a signiﬁcant percentage of total shares After deleting observations in which the largest owners held less than 10%

of total shares, the empirical results remain qualitatively the same (seeTable 6)

We also adopt alternative proxies to measure the control variables

We use the log of revenues to proxy forfirm size, the total debt to asset ratio to proxy forfinancial leverage, and the increase in assets for growth After adopting different measures for these control variables, the empirical results still reveal a significantly positive relationship between auditor switching (AS) and ownership concentration (LSH) and duality of CBoD and CEO (CEOCHR) Again, the coefficient for SB is insignificant We also reran the regression after deleting cases that were more than three standard deviations from the mean and the results remained qualitatively the same Therefore,H1andH3are robustly supported, whileH2is not supported in the tests

7 Summary and conclusions The purpose of this paper is to investigate the determinants of ﬁrms' auditor switching from the perspective of their internal corporate governance mechanism in China Three measures are used to proxy for internal corporate governance mechanism, including the concentration of ownership (shareholding of the controlling owner), the role of supervisory board (proxied by SB size), and the duality of CEO and CBoD We divided all auditor switches during the period of 2001–2004 into two types: switching to

a larger auditor or switching to a smaller auditor, and empirically examined the effects of corporate governance variables on ﬁrms' auditor switching decisions

Three hypotheses are used to test the association betweenfirms' internal corporate governance mechanism and their auditor switch-ing decisions H1andH3 are supported, but there is insufficient evidence for H2 Hence firms with larger controlling owners (regardless of direct government ownership) and in which the CBoD and CEO positions are held by the same person are more likely

Table 5

Internal corporate governance mechanisms and switching to a smaller auditing ﬁrm test of H1 to H3 (Sensitivity: Top 10 to Non-Top 10).

AS =β 0 + β 1 LSH + β 2 SB +β 3 CEOCHR + β 4 GOV +β 5 OPI +β 6 LNASSET +β 7 LEV +β 8 MB + β 9 LOSS +β 10 Yr02 +β 11 Yr03 +β 12 Yr04 +ε

N = 62

Chi-square = 26.005

In this sensitivity test we use a more strict measure to proxy for AS Here AS = 1 if switching from a Top 10 auditor to a non-Top 10 auditors and AS = 0 if switching from a non-Top 10 auditor to a Top 10 auditor will be coded as 0.

Table 6

Internal corporate governance mechanism and switching to a smaller auditing ﬁrm test of H 1 to H 3 (Sensitivity: Ten Percent Cutoff).

AS =β 0 + β 1 LSH + β 2 SB +β 3 CEOCHR + β 4 GOV +β 5 OPI +β 6 LNASSET +β 7 LEV +β 8 MB + β 9 LOSS +β 10 Yr02 +β 11 Yr03 +β 12 Yr04 +ε

N = 230

Chi-square = 33.746

To ensure effective control, this sensitivity test excludes observations in which the largest shareholders hold less than 10% of total shares.

Trang 10

to switch to smaller auditors However, whetherﬁrms with smaller

or less effective supervisory boards will opt to switch to smaller

auditors is not conclusive Generally, we conclude thatﬁrms with

relatively weak internal corporate governance mechanism are more

likely to switch to smaller auditors in order to protect or realize the

opaqueness gains associated with weak corporate governance

mechanism That the coefﬁcient for SB variable is not signiﬁcant

may imply that the SB does not play an effective monitoring role in

the Chinese listed ﬁrms at present, possibly because the SB

members are mainly from inside theﬁrms and they do not have

enough expertise in corporate governance and independent

auditing

Our regression results show thatﬁrms with larger controlling

owners (higher degree of ownership concentration), or in which the

positions of CBoD and CEO are held by the same person are more

likely to switch to a smaller auditor rather than to a larger auditor

However, the SB monitoring strength is not a signiﬁcant factor

underlying auditor switching decisions The ﬁndings generally

suggest that ﬁrms with weak internal corporate governance

mechanism tend to switching to smaller or more pliable auditors

to sustain the opaqueness gains derived from weak corporate

governance The ﬁnding that SB function (proxied by its size to

represent its monitoring effectiveness) does not have a signiﬁcant

inﬂuence on auditor switching decisions may imply that the

monitoring role of SB is not consistently effective in practice

This study should contribute to the literature on auditing

research As we carefully choose a time period to minimize the

incentives for lowering capital raising costs, the association

between ﬁrms' internal corporate governance mechanism and

their auditor switching decisions can be more appropriately

pinpointed Although some prior studies have examined whether

there is an association betweenﬁrms' auditor switching decisions

and theirﬁrm-speciﬁc characteristics, those studies did not consider

the different types of auditor switching However, the varied types

of auditor switching may be driven by different motivations In this

study, we classiﬁed two major types of auditor switching, namely

switching to a larger auditor and switching to a smaller auditor The

empirical results demonstrate that the two different types of

auditor switching would have varied implications on corporate

governance or theﬁrm-speciﬁc corporate governance devices will

affect aﬁrm's decision of auditor switching in varied manners The

ﬁndings of this study should update the knowledge on the

determinants of auditor switching with respect to the inﬂuences

of internal corporate governance mechanism In addition, this study

should not only assist readers to understand the recent

develop-ment of audit function and corporate governance in the context of

Chinese environment but also facilitate market regulators and

participants to keep a close monitoring of the independent auditing

process as well as the credibility of ﬁnancial reporting in the

emerging markets like China

This paper has several limitations First, more rigorous results

could be derived from simultaneous equation methods Simultaneous

equation methods can be used to control both the demand and supply

sides of independent auditing function However, as many Chinese

listed ﬁrms do not disclose audit fee information, controlling for

supply side effects is difﬁcult to perform at present Second, the SB

may not be a proper independent variable to proxy for corporate

governance as the SB could not play a good monitoring role in the

listedﬁrms in China Thus the independent (non-executive) director

system or the auditing committee function may be used as alternative

corporate governance variables in the future studies when those data

become available In addition, we adopted the size of auditingﬁrms to

differentiate high- or low-quality auditors There are other variables

being employed as alternative indicators of auditor quality in the

literature, which could also be used to examine the determinants of

auditor choice decisions

Appendix A Ranking of auditors in China.

36 Guangdong Zhengzhong 79 Sichuan Hongri

43 Beijing Tianhua Note: The rankings are based on average audit revenues of Year 2002–04 as compiled

by CICPA.2) Auditors must be ranked among the top 100 based on revenues for all three years of 2002–04.

References Abbott, L J., Parker, S., Peters, G F., & Rama, D V (2007) Corporate governance, audit quality, and the Sarbanes-Oxley Act: Evidence from Internal Audit Outsourcing The Accounting Review, 82(4), 803−835.

Anderson, U., Kadous, K., & Koonce, L (2004) The role of incentives to manage earnings and quantiﬁcation in auditors' evaluations of management-provided information Auditing: A Journal of Practice & Theory, 23(1), 11−27.

Ashbaugh, H., & Warﬁeld, T D (2003) Audits as a corporate governance mechanism: Evidence from the German market Journal of International Accounting Research, 2, 1−21 Bai, C E., Liu, Q., Lu, J., Song, F M., & Zhang, J (2004) Corporate governance and market valuation in China Journal of Comparative Economics, 32(4), 599−616.

Balsam, S., Krishnan, J., & Yang, J S (2003) Auditor industry specialization and earning quality Auditing: A Journal of Practice & Theory, 22(2), 71−97.

Beasley, M., Carcello, J., Hermanson, D., & Lapides, P D (2000) Fraudulent ﬁnancial reporting: consideration of industry traits and corporate governance mechanisms Accounting Horizons, 14, 441−454.

Beattie, V., & Fearnley, S (1995) The importance of audit ﬁrm characteristics and the drivers

of auditor change in UK listed companies Accounting and Business Research, 25, 227−239 Beattie, V., Fearnley, S., & Brandt, R (2000) Behind the audit report: a descriptive study

of discussions and negotiations between auditors and directors International Journal of Auditing, 4, 177−202.

Becker, C L., DeFond, M L., Jiambalvo, J., & Subramanyam, K R (1998) The effect of audit quality on earnings management Contemporary Accounting Research, 15, 1−24 Bushman, R M., & Smith, A J (2001) Financial accounting information and corporate governance Journal of Accounting and Economics, 32, 237−333.

Chan, K H., Lin, K Z., & Mo, P L (2006) A political–economic analysis of auditor reporting and auditor switches Review of Accounting Studies, 11, 21−48.

Định dạng
Số trang	11
Dung lượng	275,43 KB