Can Auditors Become Over-Conservative? Evidence From the Investors’ Perception of Auditor Changes

Abstract

This paper investigates whether investors perceive high levels of auditor conservatism as excessive. Auditors can reduce their litigation risk by issuing going concern opinions to firms with relatively low default risk. However, this strategy is costly for investors. Investors cannot observe the estimated probability of default but can only estimate the average threshold at which the audit office started to issue going concern opinions in the past. If they perceive the office’s threshold as too low, they should discount the firm’s market value because going concern opinions negatively affect the future cash flows. As the valuation should rebound if a firm replaces such an over-conservative auditor, I investigate the market reaction to auditor changes. I introduce a novel measure of auditor conservatism that is closely related to the audit offices’ going concern thresholds. Using a sample of 1,687 auditor changes from 2004 to 2014, I document a positive abnormal return if firms replace the most conservative auditors. However, additional analyses reveal that investors only perceive the most conservative non-Big 4 audit offices in the period after the financial crisis as over-conservative. That is, in the post-crisis period the non-Big 4 auditors increased their level of conservatism to levels that investors perceive as excessive.