The Effect Of The Earnings Management On Auditor Switch

As a method of managerial opportunism, earnings management has been often overused,& that requires auditor’s expertise to play an important role of authentication.According to prior study, auditor litigation risk is highly associated with the degree of the earnings management, and thus it results in the high probability of the auditor switch. Managers exercise discretion not only via their choice of accounting estimates and methods; i.e., accrual-based earnings management, but also through operational decisions. As an alternative tool of earnings management, Real activities manipulation (RAM) occurs through changing operating activities and decisions, including opportunistically reducing discretionary expenses, overproducing, and offering price discounts to boost current-period sales. Unlike abnormal accruals which reflect the realized level of earnings management after auditors conduct financial statement audits, RAM is subject to less auditor scrutiny because it is done through real operating decisions rather than accounting method choices. As such, RAM better reflects managers’ behavior and attitudes toward financial reporting because it is not filtered through the audit process. In this paper, we mainly examine effect of the earnings management on auditor switch based on evidence from accrual-based earnings management and real activities manipulation. Data used in this study are available from public sources and we do this research by logistic regression analysis method.We measure accrual-based earnings management by using adjusted Jones Model, & we develop 3 variables as the proxies for RAM. Specifically, our three measures are (1) abnormal levels of cash flow from operations (CFO), (2) abnormal production costs, (3) abnormal discretionary expenses. Considering the expected directions of the three variables, we calculate a single combined proxy. Thus our combined RAM proxy increases as firms engage in more aggressive earnings management through real activities. Our regression results can be summarized as follows:(1) If a company has a high degree of accrual-based earnings management, it tends to switch auditor. If a company manages earnings by accrual items, it can raise its auditing risk which results in the auditor switch. On the other hand, from the perspective of the clients, it can realize earnings management by changing auditor, that is opinion shopping.(2) If a company has a high degree of real activities manipulation, it tends to switch auditor. Although the cost of the RAM is high, it has received considerable attention from the management because it is hard to be detected. RAM mainly includes following 3 activities:boosting sales, overproducing, aggressively reducing aggregate discretionary expenses. So auditor may change the client because of high audit risk, or the client may fire the auditor because of unclear audit opinion. There is also consistent evidence support our hypothesis.(3) Compared with RAM, accrual-based earnings management has a more significant impact on the auditor switch.We find out that the risk from accrual-based earnings management can be much more easily to be detected by the auditor, on the same time, RAM is cost & it is not filtered through the audit process,therefore accrual-based earnings management is much more closely related with auditor change..The contribution of this paper is as follow:we enrich the researches related to studies about earnings management and auditor switch. Moreover, our findings should be of interest to auditors, investors, and regulators. Disclosure about auditor switch may reveal useful information about clients’ financial reporting practices. Since auditor switch potentially signal risk arising from clients’ opportunistic financial reporting behavior, investors can make more informed decisions when they underst and the linkage between RAM and auditor switch. Further, our study has an implication for regulators because they are concerned about auditor changes that are triggered by management opportunism.