Change of Auditors in Businesses and Earnings Conservatism

Abstract

This paper investigates the level of earnings conservatism during the first year of auditor change. We hypothesize that newly appointed auditors demand for more conservative accounting compared to other auditors due to lack of specific knowledge on the new client and higher litigation risks. We measure earnings conservatism based on the asymmetric recognition speed of good news and bad news on earnings, using Basu’s reverse regression. The sample includes 3054 firm-year observations from 2003-2008. Our results indicate that firms with newly appointed auditor experienced significantly higher earnings conservatism than other firms. We also find that the level of earnings conservatism required by newly appointed auditors depends on the size of the ex-auditor and the successor. Specifically we find that firms that change from small audit firm to Big 4 exhibit significantly higher earnings conservatism than firms that changed from Big 4 to small audit firms. This evidence is consistent with the argument that auditor require more conservative audit when risk of litigation is higher. Keywordsauditor changes, auditor switching, asymmetric timeliness of earnings, Big 4 auditors.