The Determinants of Auditor Switching from the Perspective of Corporate Governance in China

• Published date: 01 July 2009
• Author: Ming Liu,Z. Jun Lin
• DOI: http://doi.org/10.1111/j.1467-8683.2009.00759.x
• Date: 01 July 2009

The Determinants of Auditor Switching from

the Perspective of Corporate Governance in

China

Z. Jun Lin and Ming Liu*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper reports on the association between the internal corporate governance mechanism of

f‌irms and their auditor switching types in the Chinese context.Two types of auditor switching – namely switching to a larger

auditor or switching to a smaller auditor – are identif‌ied and examined.

Research Findings/Insights: Controlling shareholders have the incentive to seek opaqueness gains. The empirical results

demonstrate that to realize opaqueness gains, f‌irms with weaker corporate governance generally are more likely to switch

to a smaller auditor rather than to a larger one.

Theoretical/Academic Implications: The empirical resultsdemonstrate that f‌irm-specif‌ic corporate governance devices will

affect a f‌irm’s auditor switching decision. An effective corporate governance mechanism may inhibit the controlling

shareholder from switching to a smaller auditor to exploit the minority shareholders. The emerging economies are usually

featured with concentrated ownership and insuff‌icient legal protection of minority shareholders. Compared with prior

studies, this paper generates f‌indings more applicable to the emerging economies.

Practitioner/Policy Implications: This study may facilitate market regulators and participants to maintain close monitoring

of the structural arrangement of corporate governance of the listed f‌irms, the independent auditing process and the

credibility of f‌inancial reporting in an emerging market like China. The f‌indings also suggest that in order to bolster the

conf‌idence of the market participants, the Chinese government should promote the reform of the corporate governance

system and enforce effective regulations, in particular on f‌irms’ auditor switches.

Keywords: Corporate Governance, Supervisory Board, Government Ownership, State-Owned Enterprise (SOE),

Auditor Switching, China

INTRODUCTION

The purpose of this study is to investigate the association

between a f‌irm’s internal corporate governance mecha-

nism and its auditor switching decisions in the Chinese

context. An independent auditing function can detect and

disclose earnings management and other types of miscon-

duct by business managers or controlling shareholders. In

general, if a f‌irm has established a sound corporate gover-

nance mechanism, the f‌irm’s management or its controlling

shareholders will not have a free hand in making decisions

on auditor selection, and vice versa. Hence, there should be

an association between a f‌irm’s corporate governance and its

auditor selection decision. This study empirically investi-

gates the relationship between a f‌irm’s internal corporate

governance mechanism (proxied by ownership concentra-

tion, effectiveness of the supervisory board [SB] monitoring

and shared board of directors [BoD] chairman and CEO)

and their auditor switching decisions in the context of cor-

porate governance practice in China.

This study was motivated by several factors. First, as cor-

porate governance has a positive impact on corporate f‌inan-

cial reporting and auditing processes, a study of auditor

switching with respect to the internal corporate governance

mechanism may assist analysis of auditing quality and the

auditor’s roles in ensuring the credibility of corporate f‌inan-

cial disclosures. Second, for the controlling owners, there is

a tradeoff between hiring a high-quality auditorto lower the

*Address for correspondence: Department of Accounting and Information Manage-

ment, Faculty of Business Administration, University of Macau,Macau, China. E-mail:

Mliu@umac.mo

476

Corporate Governance: An International Review, 2009, 17(4): 476–491

© 2009 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2009.00759.x

costs of raising capital and hiring a low-quality auditor to

maintain the gains from the opaqueness of corporate gover-

nance (called “opaqueness gains,” such as tunneling behav-

iors to transfer resources from a listed f‌irm to its controlling

shareholder). The ongoing bear market in China during the

2001–2004 period provides a good opportunity to disen-

tangle these two incentives, thus allowing us to pinpoint the

association between a f‌irm’s internal corporate governance

mechanism and its auditor switching decisions. Third, the

Chinese Institute of Certif‌ied Public Accountants (CICPA)

began to rank auditors in China in the early 2000s in order to

improve the transparency of the Chinese auditing market,

thus allowing the possibility of identifying high-qualityaudi-

tors in the Chinese market. An investigation of the determi-

nants of auditor switching from the perspective of corporate

governance should contribute to an understanding of the

necessity and utility of independent audits in China.

Our regression results show that f‌irms with larger control-

ling shareholders (a higher degree of ownership concentra-

tion) or f‌irms where the positions of board of directors’

chairman 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 supervisory board monitoring strength is

not a signif‌icant factor underlying auditor switching deci-

sions. The f‌indings suggest that f‌irms with a weak internal

corporate governance mechanism generally tend to switch

to smaller or more pliable auditors to sustainthe opaqueness

gains. The f‌inding that the supervisory board function

(proxied by its size to represent monitoring effectiveness)

does not have a signif‌icant inf‌luence on auditor switching

decisions may imply that the supervisory board’s monitor-

ing function is not consistently effective in practice.

The remainder of the paper is arranged as follows. The

second section reviews the relevant literature. The third

section develops the hypotheses to examine the association

between the internal corporate governance mechanism and

auditor switching decisions. The fourth section introduces a

regression model to test the hypotheses. The f‌ifth section

presents and discusses the empirical results. Sensitivity tests

are presented in the sixth section. Finally, the seventh section

provides some conclusions.

LITERATURE REVIEW

The Development of Auditing Profession in China

Shortly after the founding of the People’s Republic of China

in 1949, the auditingprofession in China disappeared entirely

due to the public (state) ownership of all production means.

An independent auditing function was virtually nonexistent

in the planned economy before the 1980s when the state

owned and ran enterprises directly. But the mushrooming of

Sino-foreign joint ventures, brought about by the govern-

ment’s adoption of the “open-door” policy in the early 1980s,

led to the emergence of independent auditing. Due to the

involvement of non-state equity interests in joint-ventures, it

became necessary to have independent professionals, or

certif‌ied public accountants (CPAs), to verify capital contri-

butions and audit annual f‌inancial statements and income

tax returns (Lin, Tang, & Xiao, 2003). Thus, the CICPA,

a quasi-governmental organization in charge of national

administration of CPAs and auditing f‌irms, was established

in the early 1980s. Following the business restructuring cam-

paign, shareholding (stock) companies reappeared in the

Chinese economy at the turn of 1990s, resulting in a further

sharp increase in the demand for external audits. The estab-

lishment of the Shanghai and Shenzhen stock exchanges and

the promulgation of new accounting and auditing standards

also played an important role in this process. The China

Securities Regulatory Commission (CSRC) required that the

annual reports of all listed f‌irms be audited by registered

Chinese CPAs.

The Role of the Auditing Function

In contemporary market economies, business incorporation

leads to the separation of ownership and management.

Professional managers, rather than owners (shareholders),

are directly involved in daily business operations. Due to

various self-interests and information asymmetries, busi-

ness managers are able to pursue their own interests at the

expense of those of the owners and other stakeholders

(Jensen & Meckling, 1976). One of the binding mechanisms

over management operations and information disclosure is

the auditing function performed by independent profession-

als (Watts and Zimmerman, 1986).

Nonetheless, the utility of the auditing function depends

upon quality of the audit which is determined by the inde-

pendence and expertise of the auditors (DeAngelo, 1981;

Watkins, Hillison, & Morecroft, 2004). Audit quality is con-

sidered to be commensurate with the size of the auditors,

i.e., larger auditors should have a higher degree of indepen-

dence, possess more industrial expertise and resources, and

bear higher reputation costs, so they can provide higher-

quality auditing services (DeAngelo, 1981; Lennox, 2005).

Investors perceive the accounting numbers (e.g., earnings

and book values) audited by large auditors to have better

information quality, and therefore attach greater market

value to them (Lennox, 2005; Watkins et al., 2004).

DeFond and Subramanyam (1998) argue that there are

incentives for the controlling shareholders of f‌irms to

pursue their own interests by manipulating the accounting

numbers or transferring resources through “tunneling”

behaviors. Thus, the controlling shareholders will weigh

their own self-interests when making auditor selection deci-

sions (Johnson, La Porta, Lopez-de-Silanes, & Shleifer, 2000;

La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 2002). On the

one hand, selecting a large auditor will signal to the market

that the f‌inancial statements are more reliable, thus the f‌irms

may benef‌it from lower capital-raisingcosts on the equity or

debt market. On the other hand, large auditors may be more

stringent in detecting and reporting “tunneling behavior”

and hence may deprive the controlling shareholders of their

opaqueness gains (Johnson & Lys, 1990). In particular, when

f‌irms receive unfavorable audit reports, they might initiate

an auditor switch, searching for a more pliable auditor with

the goal of “opinion shopping” (DeFond & Subramanyam,

1998; Johnson & Lys, 1990; Watkins et al., 2004). Auditor

switching may take different forms, including switching to a

smaller auditor and switching to a larger auditor. Nonethe-

less in the extant literature there is a general lack of research

differentiating the two types of auditor switching.

THE DETERMINANTS OF AUDITOR SWITCHING FROM THE PERSPECTIVE OF CORPORATE GOVERNANCE IN CHINA 477

Volume 17 Number 4 July 2009© 2009 Blackwell Publishing Ltd