Academic journal article Academy of Accounting and Financial Studies Journal

Is Auditor Switching Associated with Delayed Accounting Recognition of Bad News?

Academic journal article Academy of Accounting and Financial Studies Journal

Is Auditor Switching Associated with Delayed Accounting Recognition of Bad News?

Article excerpt

ABSTRACT

We study the association between auditor switching and the delayed accounting recognition of bad news about net income. Using a nonparametric sign test and a test of proportions, we analyze 305 auditor switches which occurred during the event period 1976 to 1994, a period which predated a significant increase in the number of financial-statement restatements (General Accounting Office 2002). The results (null hypothesis rejected at z > 5 for each test) suggest that some association exists between the fact of auditor switching (whether reported as resignation or dismissal) and the occurrence of decreases in net income from the year preceding the auditor switch (t-1) to the year following the auditor switch (t+1).

INTRODUCTION

Time-series research shows that accounting net income is normally expected to rise from year to year, not fall. We assert that when management expects accounting net income to fall, management may switch auditors in an attempt to delay accounting recognition of bad news. In this regard, we study the association between auditor switching and the delayed accounting recognition of bad news about net income.

The remainder of the paper is organized as follows. We begin by providing a brief background overview. Thereafter, we develop the research hypothesis. After explaining the methods used (including sample selection and statistical tests), we discuss the results, contributions and limitations. Finally, we provide several comments regarding future research.

BACKGROUND

As indicated in the Appendix, there are numerous possible reasons for auditor switching. However, as already stated, we focus on management's desire to delay the recognition of bad news about net income as a reason for auditor switching.

Knapp and Elikai's (1990) information suppression hypothesis assumes that management needs to suppress information permanently. In contrast, Kluger and Shields (1991, 255), suggest that auditor switches may be associated with attempts to "delay the release of unfavourable information." (emphasis added) Thus, management may be satisfied by suppressing information temporarily rather than permanently. Indeed, if management wants to delay accounting recognition of bad news, and succeeds in doing so, then the bad news would be recognized subsequent to the year of the auditor switch.

While managements have incentives to voluntarily disclose bad news (Skinner 1994 and 1997), they also have incentives not to disclose bad news; or, at least, to delay the disclosure. For example, by switching auditors, management may delay recognition of the bad news until such time that management is able to downwardly adjust market expectations so that investors will already be expecting bad news by the time the bad news becomes public. Management gains at least the delay involved in the switch, which is entirely contained within the annual reporting cycle (that is, year t, the year in which the auditor switch occurs). However, if recognition of the bad news can be delayed until the year following the auditor switch, management also has time to reset annual compensation and bonus targets so that managers still receive high compensation and bonuses even for meeting targets which were set lower than they otherwise would have been set. Healy (1985) demonstrated that managers change decisions as a result of compensation arrangements, including moving recognition in financial statements (both accelerating and delaying recognition) from one fiscal year to another. Knapp (1991, 41, Table 1) reported that managers do control the selection of auditors, either by selecting them outright or by giving the board of directors a list from which the board is permitted to select.

RESEARCH HYPOTHESIS

Ball and Watts (1972, 680) concluded that accounting net "income can be characterized on average as a submartingale or some similar process." That is, the net income for each year is expected to be greater than or equal to the preceding year's net income. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.