Auditor Changes and Discretionary Accruals: Mark L. Defond, K.R. Subramanyam

* Corresponding author. Tel.: 213 740 5017; fax: 213 747 2815; e-mail: krs@almaak.usc.
edu
Journal of Accounting and Economics 25 (1998) 3567
Auditor changes and discretionary accruals
Mark L. DeFond, K.R. Subramanyam*
Leventhal School of Accounting, University of Southern California, Los Angeles, CA 90089-1421, USA
Received 1 February 1997; received in revised form 1 August 1998
Abstract
In a sample of auditor change rms we nd that discretionary accruals are income
decreasing during the last year with the predecessor auditor and generally insignicant
during the rst year with the successor. In addition, the income decreasing discretionary
accruals are concentrated among rms expected to have greater litigation risk. These
ndings are consistent with litigation risk concerns providing incentives for auditors to
prefer conservative accounting choices, and with managers dismissing incumbent audi-
tors in the hope of nding a more reasonable successor. However, we cannot rule out
nancial distress as a potential alternative explanation for our results. 1998 Elsevier
Science B.V. All rights reserved.
JEL classication: L84; M40; M41
Keywords: Auditing; Auditor-client realignment; Auditor changes; Discretionary ac-
cruals; Litigation risk; Auditor conservatism; Earnings management
1. Introduction
Auditor changes have received considerable attention from both regulators
and academics. The regulators interests are due to a concern that auditor
changes are motivated by management opportunism. For example, the Secur-
ities and Exchange Commission (SEC) states it is concerned with auditor
changes that involve
2
the search for an auditor willing to support a proposed
accounting treatment designed to help a company achieve its reporting
objectives even though that treatment might frustrate reliable reporting
0165-4101/98/$ see front matter 1998 Elsevier Science B.V. All rights reserved.
PII: S 0 1 6 5 - 4 1 0 1 ( 9 8 ) 0 0 0 1 8 - 4
Other examples of regulatory interest include US Congress reports of the Moss Committee (US
Congress, 1976), the Metcalf Committee (US Congress, 1977a,b), and the Dingell Committee (US
Congress, 1985), the AICPA Cohen Commission (Commission on Auditors Responsibilities, 1978),
and the Treadway Commission (National Commission on Fraudulent Financial Reporting, 1987).
` Studies that do not nd evidence consistent with a management opportunistic explanation for
auditor changes include Chow and Rice (1982), Smith (1986), Johnson and Lys (1990), Francis and
Wilson (1988), and DeFond (1992).
(Securities and Exchange Commission, 1988). In spite of this concern, academic
research nds little or no evidence of opportunistically motivated auditor
changes.` This paper investigates an alternative explanation for auditor changes.
Specically, we test implications from theory suggesting that auditor changes
are motivated by auditors preferences for conservative accounting choices.
Analytical work by Dye (1991) and Antle and Nalebu (1991) concludes that
auditor changes can occur when managers and auditors hold legitimate diver-
gent beliefs regarding the appropriate application of GAAP. Such disagree-
ments are most likely to occur when the predecessor auditor believes that the
appropriate application of GAAP results in lower earnings than the application
favored by management (Antle and Nalebu, 1991). The auditors desire to
reduce reported earnings, however, is not necessarily a response to manage-
ments eorts to opportunistically increase reported earnings. The audi-
torclient conict may instead stem from the auditors incentives to report
conservatively. This perspective acknowledges that auditors also have ac-
counting choice preferences that are motivated by incentives (Magee and Tseng,
1990; DeAngelo et al., 1994), and that the reported accounting choices are the
joint outcome of both the clients and the auditors preferences.
An incentive likely to motivate auditors to prefer conservative accounting
choices is client litigation risk. This is because conservative accounting choices
are expected to protect the auditor against future litigation and the potential
damages arising therefrom. The extent of conservatism, however, is expected to
dier across auditors based on factors such as individual assessment of client
risk and relative risk propensities. If management believes the incumbent audi-
tors accounting choice preferences are more conservative than those expected
from the average auditor, management has an incentive to dismiss the incum-
bent auditor in hopes of nding a more reasonable successor.
Three empirical implications are generated by the above arguments. First, if
the predecessor auditor prefers conservative accounting choices, discretionary
accruals in the last year with the predecessor auditor are expected to be income
decreasing. Second, if litigation risk motivates the auditors accounting choice
preferences, income decreasing discretionary accruals will be more pronounced
among rms that are likely to pose the greatest litigation risk threat to the
auditor. Finally, if the manager is correct in believing that the incumbent
auditor is more conservative than the average auditor, we expect discretionary
36 M.L. DeFond, K.R. Subramanyam / Journal of Accounting and Economics 25 (1998) 3567
` Krishnan (1994) also nds evidence of auditor conservatism in a study examining audit opinions
around the time of auditor changes.
accruals in the rst year with the successor auditor to be less income decreasing
than in the last year with the predecessor. We explore these implications by
examining the behavior of discretionary accruals in a sample of auditor change
rms.
Our sample consists of 503 rms that change auditors during the four-year
period from 1990 to 1993. Discretionary accruals are measured using a variation
of the model in Jones (1991) used by DeFond and Jiambalvo (1994). Our initial
analysis nds that discretionary accruals are insignicantly dierent from zero
two years prior to the auditor change but, consistent with expectations, become
signicantly income decreasing during the last year with the predecessor audi-
tor. We also nd that, while discretionary accruals continue to be negative
during the rst year with the successor auditor, the magnitudes are much lower.
These ndings are consistent with auditor changes being precipitated by auditor
conservatism.`
We investigate the auditors incentives to prefer conservative accounting
choices in the last year with the predecessor auditor by partitioning our sample
based upon characteristics expected to be associated with client litigation risk.
Consistent with expectations, we nd that negative discretionary accruals are
concentrated among the sample partitions that are expected to pose the greatest
client litigation risk threat to the auditor. Specically, we nd discretionary
accruals in the last year with the predecessor are more negative for clients that
receive a modied opinion from the predecessor auditor, have a Big 6 prede-
cessor auditor, change to a non-Big 6 successor auditor, or report a disagree-
ment or auditor resignation in the auditor-change 8K.
A potential alternative explanation for our ndings is that the negative
discretionary accruals found in our analysis are attributable to poor perfor-
mance among the sample rms. Descriptive information on earnings, cash ows
and Altmans z-score indicates our sample rms are nancially distressed
around the time of the auditor change. Prima facie the presence of distress is
consistent with our conjecture. That is, nancial distress increases litigation risk,
which results in the auditors preference for conservative accounting, which then
results in the client dismissing the incumbent auditor in order to nd a more
reasonable successor. However, nancial distress may also precipitate auditor
changes for reasons unrelated to conservative accounting choices. Dechow et al.
(1995) document that discretionary accruals are biased in rms with extreme
performance. Therefore, the negative discretionary accruals in our sample may
be mechanically induced by nancial distress.
In addition, there are alternative economic explanations for our results. For
example, auditors may respond to the increased litigation risk posed by dis-
M.L. DeFond, K.R. Subramanyam / Journal of Accounting and Economics 25 (1998) 3567 37
" DeAngelo et al. (1994) also conjecture that income reducing choices among distressed rms may
be due to auditors forcing managers to take noncash write-os, which is consistent with our ndings.
Other reasons for managers reducing earnings suggested by DeAngelo et al. are union negotiations
(Liberty and Zimmerman, 1986; DeAngelo and DeAngelo, 1991), and lobbying for import relief
(Jones, 1991). However, these explanations are less likely to be distress induced.
` An alternative explanation is that the economic circumstances of the client change in the rst
year with the successor in a manner that lowers litigation risk. However, empirical evidence is not
consistent with this explanation. For example, analysis of cash ows indicates that the nancial
health of the rms do not change over the periods of analysis, and the Altmans z-score indicates the
rms are, on average, becoming more distressed in the rst year with the successor (see Table 1).
tressed clients by simply resigning from the engagement (MacDonald, 1997).
Alternatively, distressed rms may undergo structural changes that induce them
to realign with auditors who are better matched to their changing needs
(Johnson and Lys, 1990). Distress is also associated with management change,
which is associated with income decreasing accruals (Pourciau, 1993). Another
potential alternative explanation for our ndings is that, independent of audi-
tors incentives, management may also have incentives to reduce earnings in
times of poor nancial health. For example, DeAngelo et al. (1994) suggest that
management of distressed companies may reduce reported earnings in order to
convince lenders that management is serious about streamlining operations."
Therefore, it is important to perform tests that will distinguish whether the
negative discretionary accruals in our sample genuinely result from auditor
conservatism, or whether they are attributable to other factors related to poor
performance.
Two types of tests are performed to ascertain the credibility of our initial
analysis. Our rst set of tests control for the potential eects of various con-
founding factors on our estimates of discretionary accruals. We rst conduct
univariate tests that control for the mechanical eects of nancial performance
on discretionary accruals estimated using the Jones model. These tests consist of
orthogonalizing discretionary accruals to cash ows, a cash ow matched pairs
test, and a test that excludes sample rms in the extreme deciles of earnings.
Consistent with our initial results, we nd that discretionary accruals are
signicantly negative in the last year with the predecessor auditor. We also nd
that the magnitudes of the discretionary accruals decline, and that discretionary
accruals in the rst year with the successor auditor become generally insignic-
ant. The drop in magnitude of the discretionary accruals in the last year with the
predecessor auditor is consistent with nancial distress impacting, but not
explaining, our unconditioned estimates from the Jones model. The generally
insignicant discretionary accruals found in the rst year with the successor
auditor are consistent with the client nding a successor auditor that is less
conservative than the predecessor auditor.`
We also perform multivariate tests that control for several factors that could
potentially confound our results such as management changes, corporate re-
structurings, and the eects of potentially omitted correlated variables identied
in Johnson and Lys (1990). We perform these tests alone, and in conjunction
with our univariate tests that control for cash ows and extreme earnings. The
results indicate our ndings are robust to these additional controls. In addition,
our results are not replicated when we randomly decompose accruals to gener-
ate the discretionary component (Guay et al., 1996).
Our second set of tests look for evidence that corroborates the conclusions we
draw from examining discretionary accruals. We do this by examining four
accounting measures that are subject to management discretion: special items,
the provision for bad debts, amortization of intangibles, and a composite
measure of discrete accounting method choices. With respect to each of these
measures, we nd that, on average, our sample rms make income decreasing
changes during the last year with the predecessor auditor. In addition, of the
rms making income decreasing changes during the last year with the prede-
cessor, the proportion that switch back to relatively less conservative ac-
counting choices during the rst year with the successor auditor generally
exceeds the proportion that make further conservative changes. These ndings
present suggestive evidence that corroborates our results from examining dis-
cretionary accruals.
Taken together, our conjecture that auditor conservatism can lead to auditor
dismissals is robust to the above tests. We nd that our results are not driven by
management change, corporate restructuring or by the variables that explain
auditor changes in Johnson and Lys (1991), and the tests that control for
performance indicate our results are not mechanically induced by nancial
distress. In addition, nding that discretionary accruals are negative during the
last year with the predecessor auditor and insignicant during the rst year with
the successor auditor is not consistent with management attempting to reduce
earnings in order to convince lenders they are streamlining operations. This is
because nancial distress, according to the Altman z-score, actually increases
slightly during the rst year with the successor. Finally, since most of our sample
consists of client-initiated auditor changes that report signicant negative
discretionary accruals, our results are not solely attributable to auditor
resignations. However, we can never be sure that we completely control for the
eects of distress. And, given that distress is a potential explanation for auditor
changes even in the absence of auditor conservatism, we cannot rule out that
poor performance among our sample rms may at least partially explain our
ndings.
In summary, our ndings present evidence on the role of discretionary
accruals in auditor change decisions. The results are consistent with theory
suggesting auditor change is motivated by divergent beliefs among the auditor
and management concerning the appropriate application of GAAP and that the
reported accounting choices are the joint outcome of both the management and
the auditors preferences (Dye, 1991; Antle and Nalebu, 1991). Our ndings
also provide further evidence on the relation between accruals and auditor
concerns about litigation risk (Lys and Watts, 1994). Finally, our paper contrib-
utes to the earnings management literature by suggesting that the external
auditor acts as a constraint to managerial discretion regarding accounting
choice (Becker et al., 1998; Francis et al., 1996).
2. Motivation
The role of independent auditing is to attest to managements appropriate
application of GAAP. However, because the interpretation of GAAP requires
professional judgement, management and auditors (or two dierent auditors)
can hold legitimate divergent beliefs regarding its application (Magee and
Tseng, 1990). This implies that audited nancial statements are ultimately the
outcome of negotiations between management and the incumbent auditor
(Antle and Nalebu, 1991; Dye, 1991). While most auditorclient negotiations
are expected to end in amicable compromise, Dye (1991) concludes that the
disagreements involved in some negotiations lead to auditor changes. Though
empirically only a small portion of auditor change rms report auditor-client
disagreements in their auditor change 8-Ks, prior research reports a tendency
for auditors and clients to circumvent the disclosure requirement (Smith and
Nichols, 1982; DeFond and Jiambalvo, 1993). An incentive to underreport
disagreements is that such disclosure is found to result in share price declines
(Smith and Nichols, 1982).
Antle and Nalebu (1991) observe that auditorclient disputes that lead to
auditor changes are most likely to occur when the auditor believes that the
appropriate application of GAAP results in a more conservative presentation of
nancial performance than the application favored by management. This is
consistent with DeFond and Jiambalvo (1993), who nd that auditor-client
disagreements reported in 8-Ks are almost always cases where the auditor insists
on an accounting treatment that results in lower earnings than the accounting
treatment preferred by management. In addition, the auditors accounting
preferences nearly always prevail over those of management because auditors
must disclose in their opinion those cases where management insists on imple-
menting an accounting choice that contradicts the auditors judgement
(DeFond and Jiambalvo, 1993).
Magee and Tseng (1990) point out that, like management, auditors also have
accounting choice preferences that are motivated by incentives. An incentive
that is expected to motivate auditors to prefer conservative accounting choices
is litigation risk. Krishnan and Krishnan (1997) point out that prior literature
identies several ways in which auditors respond to litigation risk, including
' Matsumura et al. (1997) show that heterogeneity in auditor behavior is a necessary condition for
auditor change.
audit plan and audit fee adjustments (Pratt and Stice, 1994; Simunic and Stein,
1996), and increased issuance of modied opinions (Krishnan and Krishnan,
1996). We conjecture that auditors are also likely to respond to litigation risk
by insisting that their clients make conservative accounting choices. This is
because income reducing accounting choices are expected to reduce the audi-
tors litigation exposure. For example, Lys and Watts (1994) report that
clients are more likely to be sued when total accruals are relatively income
increasing. Similarly, St. Pierre and Anderson (1984) report that while
auditors are frequently sued for allowing income overstatements, they nd no
cases of auditors being sued for allowing income understatements. In addition,
Kellogg (1979) nds that courts are more likely to award damages for accruals
that overstate (as opposed to understate) earnings and assets. Taken together,
these studies suggest that auditors are less likely to be sued, or incur damages
if they are sued, if they are associated with nancial statements that understate
(rather than overstate) rm performance. Thus, litigation risk is an incentive
that is expected to induce auditors to prefer accounting choices that reduce
earnings.
The above arguments suggest that auditor changes are triggered by the
predecessor auditors preference for income decreasing accounting choices, and
that a likely cause of the auditors conservatism is client litigation risk. When
management believes that the incumbent auditor is more conservative than the
average auditor, management will dismiss the incumbent in hopes of obtaining
a less conservative successor. The successor auditor may be willing to adopt
a less conservative stance than the predecessor because auditors are expected to
dier in their risk assessments and/or risk propensity (Magee and Tseng, 1990;
Balachandran and Ramakrishnan, 1987; Simunic and Stein, 1990).' These
arguments imply that auditor changes are likely to be preceded by a year in
which discretionary accounting choices are income decreasing. If the auditors
conservatism is a reaction to client litigation risk, we also expect an association
between income decreasing discretionary accruals and the client rms most
likely to pose a litigation risk threat to the auditor. Finally, if management
expectations are rational, we expect the successor auditor to be less conservative
on average with respect to accounting choice preferences. Thus, we expect
discretionary accruals in the rst year with the successor to be less negative than
those in the last year with the predecessor. We explore these implications by
examining discretionary accruals and changes in factors expected to impact
client litigation risk and discretionary accruals among a sample of auditor
change rms.
` Compustat auditor codes distinguish the identities of the top 24 largest accounting rms
(including the Big 6). This group approximates the population of all international, national and large
regional audit rms. All other audit rms are combined into a single auditor code (9). Due to this
coding convention, auditor changes among these smaller auditors are excluded from our sample. In
addition, we delete all observations from our sample that relate to the mergers of Deloitte Haskins
& Sells with Touche Ross & Co. and Arthur Young with Ernst & Whinney. As an additional
precaution we conduct a sensitivity check where we delete all changes from audit rms coded as
number 9 (since larger rms occasionally acquire these smaller rms). Our results are robust to this
sensitivity analysis.
3. Sample selection and prole
3.1. Sample selection
The initial sample includes all auditor changes reected in the 1993 Standard
and Poors Compustat for the four-year period 19901993. This sample is chosen
to incorporate the eects of the most recent 8-K auditor change disclosure
regulation implemented during 1989 (SEC, 1988). Auditor changes are identied
by the incidence of a change in Compustat auditor code.` Financial institutions
(SICs between 6000 and 6999) are deleted because discretionary accruals estima-
tion is problematic for these rms. In addition, in order to prevent overlapping
periods of analysis, we only include auditor changes preceded by at least two
years with the predecessor auditor. This selection process yields a sample of 514
auditor changes with sucient Compustat data to measure discretionary ac-
cruals in each of the last two years with the predecessor auditor and the rst year
with the successor auditor. Consistent with prior research, we exclude observa-
tions where the absolute value of discretionary accruals exceeds 200% of lagged
assets (DeFond and Park, 1997). This reduces the sample to 503 auditor
changes.
3.2. Descriptive statistics
Table 1 presents descriptive statistics for our auditor change rms compared
to a benchmark sample drawn from the population of Compustat rms that do
not change auditors. For each auditor change rm we collect Compustat data
for all of the non-change rms with sucient data matched on industry and
year. We then calculate the median value of the descriptive variables from the
distribution of non-change rms and use the resulting distribution of median
values as our benchmark sample.
Table 1 presents mean and median values of the levels and changes in several
nancial variables for both our auditor change rms and for the medians in the
` The number of observation equals 503 for each year for Sales, Net Income, Total Accruals, Cash
Flows and Total Liabilities. However, due to missing data in Compustat the market-to-book ratio,
Z-score, and Dividends variables contain between 400 and 437 observations each year. The unequal
number of observations across the years aects the additivity of the levels and changes. As
a sensitivity, we replicate the analysis after equalizing the sample across the three years for these
variables (the equalized sample comprises 398, 369 and 403 rms for the market-to-book ratio,
Z-score, and Dividends respectively). The results of this sensitivity are qualitatively similar to that
using the non-equalized sample.
benchmark sample. In addition, we report the mean and median dierences
between the two samples along with their corresponding p-values. Year !2
refers to the penultimate year with the predecessor auditor, year !1 refers to
the last year with the predecessor, and year 0 refers to the rst year with the
successor auditor.`
Several observations can be made from examining Table 1. Three variables
that are commonly used to infer nancial health net income, cash ows and
z-score all indicate that the auditor change rms are in signicantly worse
nancial condition than the industry benchmark sample in each of the three
years examined. However, the extent to which the health of the auditor change
sample deteriorates (or fails to deteriorate) across the three years, varies depend-
ing upon the variable considered. For example, the changes in cash ows in the
auditor change sample are not signicantly dierent than the changes in the
benchmark sample during either of the change periods examined. Thus, the
interpretation of the cash ow variable is that the auditor change rms are in
relatively poor nancial health, but that that they are not getting any worse or
any better across the three years examined. In contrast, the z-score indicates that
the nancial health of the auditor change sample is deteriorating progressively
when compared to the benchmark sample during the three years under analysis.
The change in net income from year !2 to year !1 indicates that auditor
change rms are deteriorating signicantly more rapidly compared to the
benchmark sample, but the change from year !1 to year 0 is insignicantly
dierent across the samples. Because the change in cash ows are not signi-
cantly dierent from the benchmark sample, the signicantly greater decline in
net income must be the result of greater income decreasing accruals. This is
conrmed by looking at the change in total accruals from year !2 to year !1.
Thus, the decline in earnings from year !2 to year !1 is consistent with the
auditor change rms making unusually large negative discretionary and/or
non-discretionary accruals during year !1.
Various other observations may also be made from the data presented in
Table 1. While mean sales among the auditor change rms are generally higher
than among the industry benchmark rms, the medians are not signicantly
dierent. The market-to-book ratio, a measure of growth opportunities (Collins
and Kothari, 1989), is generally no dierent across the two samples over the
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" One extreme outlier was deleted from the sample analysis of dividends during the last year of the
predecessor and the rst year of the successor auditor.
" Subramanyam (1996) reports that this cross-sectional model is generally better specied than
the time-series model.
period examined. Finally, the analysis of dividends indicates that most of the
auditor change as well as the industry benchmark rms do not pay dividends."
In summary, Table 1 suggests that the auditor change sample is in relatively
poor nancial health. While the analysis of cash ows indicates that the poor
nancial health is relatively constant across the three years examined, the
analysis of z-scores indicates that nancial health is steadily declining over the
period analyzed. And, the analysis of net earnings indicates that there is
a signicant decline in earnings during year !1 that results from unusually
large income decreasing total accruals. This is an important observation given
that the focus of our analysis is discretionary accruals during year !1.
3.3. Estimation of discretionary accruals
We measure discretionary accruals using the cross-sectional variation of the
Jones (1991) model reported in DeFond and Jiambalvo (1994)." This technique
estimates normal accruals as a function of the change in revenues and level of
property, plant and equipment. These variables control for changes in accruals
that are due to changes in the rms economic condition (as opposed to accruals
manipulation). The change in revenue is included because changes in working
capital accounts, part of total accruals, depend on changes in revenue. Property,
plant and equipment is used to control for the portion of total accruals related
to nondiscretionary depreciation expense. The portion of total accruals unex-
plained by normal operating activities is discretionary accruals.
Specically, discretionary accruals are estimated from the following model:
A
GR
/A
GR
"a(1/A
GR
)#b
(RE
GR
/A
GR
)#b
`
(PPE
GR
/A
GR
)#e
GR
(1)
where
A
GR
"total accruals for estimation portfolio rm i for year t;
A
GR
"total assets for estimation portfolio rm i for year t!1;
RE
GR
"change in net revenues for estimation portfolio rm i for year t;
PPE
GR
"gross property plant and equipment for estimation portfolio rm
i for year t and
e
GR
"error term;
This model is separately estimated for every industry (two-digit SIC) and year
combination. Total accruals are measured using Compustat data and dened as
income before extraordinary items minus operating cash ows. Discretionary
accruals are dened as the error term from the above regression. In our primary
analysis, tests of signicance are computed using both standardized and unstan-
dardized discretionary accruals. Because the results employing standardized
discretionary accruals are similar to those employing unstandardized dis-
cretionary accruals, all subsequent analyses are performed using unstandardized
discretionary accruals. Unstandardized discretionary accruals are used because
they have the appealing property of being interpretable as a proportion of total
assets.
4. Univariate analysis of discretionary accruals
4.1. Univariate analysis without controls
Table 2 presents a univariate analysis of discretionary accruals for the auditor
change rms during the last two years with the predecessor auditor and the rst
year with the successor auditor. Unstandardized and standardized discretionary
accruals scaled by lagged assets are presented in columns (A) and (B), respective-
ly. Mean and median levels and changes in discretionary accruals are presented
for each measure along with p-values for two-tailed tests of signicance. The rst
row reports that the mean and median levels of both unstandardized and
standardized discretionary accruals are insignicantly dierent from zero two
years prior to the auditor change (year !2) for all measures except the
unstandardized mean value, which is marginally negative. However, both
measures become signicantly negative during the last year with the predecessor
auditor (year !1). Both columns also report that the levels of discretionary
accruals in the rst year with the successor auditor (year 0) continue to be
signicantly negative, though smaller in magnitude than the prior year. Thus,
the initial analysis indicates that discretionary accruals are generally insignic-
antly dierent from zero during the penultimate year with the predecessor
auditor but become strongly negative during the last year with the predecessor
auditor. While discretionary accruals continue to be signicantly negative in the
rst year with the successor auditor, their magnitude declines.
4.2. Univariate analysis after controls for nancial performance
Table 1 suggests that our sample rms are in relatively poor nancial health.
If the Jones model does not adequately control for nancial performance, our
estimates of discretionary accruals may be negatively biased (Dechow et al.,
1995). We address this issue by presenting three dierent univariate tests in
Table 3 that attempt to control for the eects of poor performance. First we run
a regression that contains control variables for cash ows and includes the
population of rms that do not change auditors. Next, we perform a matched
Table 2
Discretionary accruals for rms changing auditors during the period 19901993
Year relative to auditor
change
(A) Unstandardized discretionary
accruals
(B) Standardized discretionary
accruals
Mean Median Mean Median
Year !2 !0.021 !0.001 !0.026 !0.004
(p-value) (0.06) (0.86) (0.55) (0.82)
Change from !2 to !1 !0.040 !0.034 !0.151 !0.128
(p-value) (0.01) (0.00) (0.01) (0.00)
Year !1 !0.060 !0.023 !0.188 !0.102
(p-value) (0.00) (0.00) (0.00) (0.00)
Change from !1 to 0 0.032 0.013 0.038 0.031
(p-value) (0.05) (0.13) (0.53) (0.65)
Year 0 !0.029 !0.012 !0.124 !0.053
(p-value) (0.01) (0.04) (0.01) (0.05)
Discretionary accruals are computed using estimates from the following model for total accruals:
A
GR
/A
GR
"a(1/A
GR
)#b
(RE
GR
/A
GR
)#b
`
PPE
GR
/A
GR
)#e
GR
,
where A
GR
is the total accruals for estimation portfolio rm i for year t; A
GR
is the total assets for
estimation portfolio rm i for year t!1; RE
GR
is the change in net revenues for estimation
portfolio rm i for year t; PPE
GR
is the gross property plant and equipment for estimation portfolio
rm i for year t; and e
GR
is the error term;
Standardized discretionary accruals are computed as
GH
"e
GH
/S(e
GH
),
where s(e
GH
) is the standard deviation of the error term from the model estimated in footnote a.
Parametric signicance tests of the standardized errors are computed as
Z
GH
"
GH
/[(
H
!k)/(
H
!(k#2))]`,
where k is the model degrees of freedom and j is the total number of observations in the matched
portfolio.
The sample consists of 503 rms in columns (A), but the number of observations are slightly lower in
column B because truncated observations dier for the analysis of standardized discretionary
accruals.
p-values for the means are from two-tailed t-tests of the null hypothesis that the mean equals 0.
p-values for the medians are from two-tailed Wilcoxon sign rank tests of the null hypothesis that the
central tendency equals 0. Year !2 refers to the penultimate year with the predecessor auditor, year
!1 refers to the last year with the predecessor auditor and year 0 refers to the rst year with the
successor auditor.
pairs design that controls for cash ows, and third we analyze discretionary
accruals after eliminating observations with extreme values of earnings.
Our rst test attempts to determine whether the discretionary accruals gener-
ated by our sample rms are unusual when compared to the population of
The mean (median) dierences in operating cash ows scaled by assets between the match rms
and the treatment rms, for both levels and changes, do not exceed 0.008 (0.0002) for any of the event
years examined.
non-change rms, after orthogonalizing the discretionary accruals to cash ows.
Cash ows are an appealing control variable because they are a commonly used
indicator of nancial health and because Table 1 nds our sample rms exhibit
relatively poor cash ows compared to the population of rms that do not
change auditors. We run an OLS regression that includes both our sample rms
and a control group of 24,841 rm-year observations consisting of all Compus-
tat rms with sucient data that do not change auditors, matched on year and
industry with our auditor change rms. The dependent variable in the regression
is discretionary accruals and the independent variables are the levels of cash
ows, the absolute value of cash ows, and dummies for the auditor change
rms by year. We include the absolute value of cash ows in the analysis because
research has shown that the relation between cash ows and discretionary
accruals is not linear (for example, Dechow et al., 1995, show that discretionary
accruals are biased for extreme values of earnings and cash ows). The dummies
are used to compute discretionary accruals for our auditor change rms that are
orthogonal to cash ows.
The results of this test are presented in column (A) of Table 3 and are
generally consistent with the results before controlling for nancial performance
reported in column (A) of Table 2. Specically, discretionary accruals are
insignicantly dierent from zero in year !2 and become signicantly negative
in year !1. However, when compared to column (A) of Table 2, the magnitudes
in column (A) of Table 3 are generally smaller. In addition, the year 0 discretion-
ary accruals now become insignicant during year 0. These dierences are
consistent with the magnitudes of the negative discretionary accruals in Table 2
being overstated due to poor performance, but with our primary nding of
negative discretionary accruals in year !1 persisting even after controlling for
performance.
The matched pairs test controlling for cash ows is presented in column (B) of
Table 3. The objective of employing a matched control group is to compare the
auditor-change rms with a group of non-change rms with comparable under-
lying nancial performance. The matched control rms are chosen from the
population of Compustat rms in the same year and two-digit SIC as the
auditor change rms. The control rms are selected to minimize the dierence in
cash ows between the auditor change rm and its corresponding control
rm. These results are generally consistent with the analysis in column (A).
Dechow et al. (1995) demonstrate that the Jones model yields biased estimates
of discretionary accruals for rms that report extreme earnings. To address this
issue, column (C) of Table 3 examines the auditor change sample after deleting
Table 3
Univariate tests of unstandardized discretionary accruals with controls for nancial performance
Year relative to
auditor change
(A) Regression
dummy coecients
using population
data with controls
for cash ows and
absolute level of
cash ows
(B) Matched dierences using
a control group matched on
operating cash ows
(C) After deleting
observations with
earnings in the extreme
deciles
Mean Mean Median Mean Median
Year !2 !0.001 0.001 0.002 !0.005 0.009
(p-value) (0.91) (0.97) (0.90) (0.63) (0.45)
Change from
!2 to !1
!0.045 !0.040 !0.034 !0.039 !0.030
(p-value) (0.00) (0.01) (0.00) (0.02) (0.00)
Year !1 !0.046 !0.039 !0.022 !0.045 !0.014
(p-value) (0.00) (0.01) (0.00) (0.00) (0.00)
Change from
!1 to 0
0.031 0.033 0.013 0.046 0.015
(p-value) (0.03) (0.03) (0.19) (0.00) (0.02)
Year 0 !0.015 !0.015 !0.022 !0.006 !0.003
(p-value) (0.14) (0.27) (0.02) (0.52) ((0.10)
Discretionary accruals are computed as described in Table 2. The discretionary accruals in column
(A) are constructed from the following regression:
u
G
"#
CFO
G
#
`
Abs(CFO
G
)#
`
(DM!2, 1, 0
G
)#
"
(DM!1, 0
G
)
#
`
(DM!0
G
)#e
GR
,
where
u
G
"unstandardized discretionary accrual for rm i;
"the intercept;
CFO
G
"the value of operating cash ows for rm i;
Abs(CFO
G
) "the absolute value of cash ows for rm i;
DM-2,1,0
G
"1 if the observation is an auditor change rm, otherwise it takes a value of 0 (the
coecient on this variable is interpretable as the level of discretionary accruals for
the auditor change rms during year !2);
DM-1,0
G
"1 if the last year with the predecessor or rst year with the successor, otherwise it
takes a value of 0 (the coecient on this variable is interpretable as the change in
discretionary accruals from year !2 to year !1 for the auditor change rms);
DM0
G
"1 if the rst year with the successor auditor, otherwise it takes a value of 0 (the
coecient on this variable is interpretable as the change in discretionary accruals
year !1 to year 0 for the auditor change rms).
The sample consists of 503 observations in columns (A) and (B), and 392 observations in column (C).
p-values for the means are from two-tailed t-tests of the null hypothesis that the mean equals 0.
p-values for the medians are from two-tailed Wilcoxon sign rank tests of the null hypothesis that the
central tendency equals 0. Year !2 refers to the penultimate year with the predecessor auditor, year
!1 refers to the last year with the predecessor auditor and year 0 refers to the rst year with the
successor auditor.
` We also replicate our analysis after randomly decomposing accruals into discretionary and
nondiscretionary components as in Guay et al. (1996). Both levels and changes in levels of
discretionary accruals generated in this fashion are insignicantly dierent from zero in each period
of analysis. This increases the condence that our results are not driven by measurement error in the
Jones model proxy for discretionary accruals (see Guay et al., 1997; Dechow et al., 1997).
rms that fall into the highest or lowest decile of earnings, matched on industry,
during any year it is included in the analysis. Deleting rms that fall into the
extreme deciles of earnings reduces the sample of 503 by approximately 22% (to
392 rms). As with columns (A) and (B), column (C) reports that discretionary
accruals are signicantly negative in the last year with the predecessor auditor,
but with smaller magnitudes than in column (A) of Table 2, and that both mean
and median discretionary accruals in the rst year with the new auditor are
generally insignicant.
In summary, the analysis in Table 3 indicates that, after controlling for poor
performance, the negative discretionary accruals year -1 remain signicantly
negative but decline in magnitude (compared to the unconditioned discretionary
accruals) and the discretionary accruals in year 0 generally become insigni-
cant.`
5. Multivariate tests with control variables
Johnson and Lys (1990) nd that asset growth, changes in cash ows, changes
in new nancing, changes in acquisition expenditures and changes in times
interest earned are associated with changes in auditor size. Many of the vari-
ables they identify (such as growth in assets and changes in operating cash ows)
are likely to be correlated with our measure of discretionary accruals. In
addition, Burton and Roberts (1967) report the most frequent reason managers
cite to explain auditor changes is a change in client management, and several
studies document an association between management changes and income
decreasing accounting choices (e.g., Pourciau, 1993). Finally, another explana-
tion for negative discretionary accruals in auditor change rms is that they are
undergoing operational changes that include restructuring charges to income.
Therefore, to test the robustness of our results, we perform a multivariate
analysis that include controls for the Johnson and Lys variables, management
changes, and restructuring charges during the last year with the predecessor.
Specically, we estimate the coecients in the following regression:
e
GR
"#
(DM!1,0
GR
)#
`
(DM0
GR
)#
`
(MG
GR
)#
"
(RES
GR
)
#
`
(GROH
GR
)#
'
(CFO
GR
)#
`
(FIN
GR
)#
`
(ACQN
GR
)
#
"
(IE
GR
)#u
GR
(2)
` During the three-year period, we identify a total of 149 CEO changes (approximately a third of
our sample). This supports the ndings of Burton and Roberts (1967) that auditor changes are often
associated with manager changes. However, we nd no systematic patterns in the number changes
across the years (we nd 51, 50 and 49 changes in the three years respectively).
" Of the 397 sample rms with news announcements during our sample period, 41 report
restructuring and 16 of those report charges that reduce earnings.
where e
GR
is the estimated discretionary accrual for rm i during year t; is the
intercept that is interpretable as the discretionary accrual level in year !2;
DM-1,0
GR
takes on a value of 1 if the last year with the predecessor auditor or
rst year with the successor auditor, otherwise it takes a value of 0; DM0
GR
takes on a value of 1 if the rst year with the successor auditor, otherwise it takes
a value of 0. MG
GR
equals 1 if there is a new Chief Executive Ocer, otherwise
equals 0; RES
GR
equals 1 if the rm reported restructuring charges; GROH
GR
is one year growth in assets; CFO
GR
is change in operating cash ows scaled by
assets; FIN
GR
is change in new nancing scaled by assets; ACQN
GR
is change in
acquisition expenditures scaled by assets; IE
GR
is change in times interest
earned scaled by assets.
The discretionary accruals estimates are created as described earlier and the
nancial control variables are computed from the Compustat database. Man-
agement changes are dened as a change in CEO and are identied using the
Compact Disclosure database of Disclosure Inc.` Restructuring charges are
identied using a keyword search of news announcements contained in the
Lexis-Nexus database." Observations with information not available on Com-
pustat or Compact Disclosure (or with ambiguous information on Compact
Disclosure) are dropped from the analysis. The availability of data reduces the
multivariate sample from a total of 1,509 rm-year observations (503 rms each
year as reported in Table 2), to a total of 929 rm-year observations (between
301 and 317 rms each year).
Table 4 reports mean discretionary accruals that are calculated by combining
parameter estimates from the above regression model. Specically, the dis-
cretionary accruals reported in Table 4 are calculated as follows:
Year !2 ",
Change from !2 to !1 "
,
Year !1 "#
,
Change from !1 to 0 "
`
,
Year 0 "#
#
`
.
Because Table 3 indicates that our results are inuenced by nancial perfor-
mance, we also perform the regression analysis using cash ow adjusted match-
ed dierences in discretionary accruals as the dependent variable, and after
deleting rms in the extreme deciles of earnings. Model one in Table 4 is
Table 4
Unstandardized discretionary accruals levels and changes derived from OLS regressions of dis-
cretionary accruals on dummy variables for years relative to auditor change and several control
variables
Year relative to auditor
change
Model 1
(Unstandardized
discretionary accurals)
Model 2
(Dierence between
treatment and control
rms matched on cash
ows)
Model 3
(After deleting
observations with
earnings in the
extreme deciles)
Year !2 !0.024 0.004 !0.011
(p-value) (0.05) (0.41) (0.23)
Change from !2 to !1 !0.055 !0.064 !0.051
(p-value) (0.00) (0.00) (0.00)
Year !1 !0.078 !0.060 !0.062
(p-value) (0.00) (0.00) (0.00)
Change from !1 to 0 0.035 0.036 0.057
(p-value) (0.04) (0.06) (0.00)
Year 0 !0.043 !0.024 !0.005
(p-value) (0.00) (0.08) (0.36)
The sample size in each regression for each year depends upon data availability for the independent
variables in that particular year. The yearly sample sizes in models One and Two range from 301 to
317. The yearly sample sizes in model Three range from 242 to 252. Year !2 refers to the
penultimate year with the predecessor auditor, year !1 refers to the last year with the predecessor
auditor and year 0 refers to the rst year with the successor auditor.
Discretionary accruals for each year are calculated from the dummy year coecients estimated in
the following regression:
e
GR
"#
(DM!1, 0
GR
)#
`
(DM0
GR
)#
`
(MG
GR
)#
"
(RES
GR
)#
`
(GROH
'R
)
#
'
(CFO
GR
)#
`
(FIN
GR
)#
`
(ACQN
GR
)#
"
(IE
GR
)#u
GR
,
where e
GR
is the estimated discretionary accrual for rm i and year t; is the intercept that is
interpretable as the discretionary accrual level in year !2; DM-1, 0
GR
takes on a value of 1 if the
last year with the predecessor or rst year with the successor, otherwise it takes a value of 0 (the
coecient on this variable is interpretable as the change in discretionary accrual level from year !2
to year !1); DM0
GR
takes on a value of 1 if the rst year with the successor auditor, otherwise it
takes a value of 0 (the coecient on this variable is interpretable as the change in discretionary
accrual level from year !1 to year 0). MG
GR
equals 1 if there is a new Chief Executive Ocer,
otherwise equals 0; RES
GR
equals 1 if the rm reported restructuring charges; GROH
GR
is one year
growth in assets; CFO
GR
is change in operating cash ows scaled by assets; FIN
GR
is change in new
nancing scaled by assets; ACQN
GR
is change in acquisition expenditures scaled by assets; IE
GR
is
change in times interest earned scaled by assets.
The dependent variable is discretionary accruals from the auditor change rms minus discretionary
accruals from a set of control rms pair-wise matched on cash ows, year and industry.
Top and bottom earnings deciles are calculated using all available Compustat rms matched on
year and 2-digit SIC.
estimated using the unstandardized discretionary accruals from the auditor
change rms (corresponding to column A of Table 2). Model two employs
a dependent variable measured as discretionary accruals from our auditor change
rms minus discretionary accruals of a control sample matched on cash ows,
year and industry (corresponding to column B of Table 3). Model three presents
the regression results after deleting rms with earnings in the top and bottom
deciles of earnings by year and industry (corresponding to column C of Table 3).
All three models in Table 4 report that the changes and the levels in the last
year with the predecessor auditor are all signicantly negative after controlling
for the variables included in the regression. The changes in discretionary
accruals during the rst year with the new auditor are all signicantly positive,
and the level in the rst year with the successor auditor is only marginally
signicant in the model that controls for cash ows, and is insignicant in the
model that deletes extreme earnings. Thus, the analysis in Table 4 is consistent
with the univariate ndings in Tables 2 and 3 that indicate auditor change rms
report income decreasing discretionary accruals during the last year with the
predecessor auditor. Further, consistent with Table 3, the regression models
that control for extreme earnings and cash ows nd that the levels of dis-
cretionary accruals in the rst year with the successor auditor revert to levels
that are either insignicant, or only marginally signicant.
6. Cross-sectional variation in discretionary accruals around auditor changes
We conjecture that a likely incentive for the predecessor auditor to prefer
income decreasing discretionary accruals is client litigation risk. Prior literature
nds several factors associated with litigation against auditors (Stice, 1991;
Carcello and Palmrose, 1994; Lys and Watts, 1994). These factors are typically
accounting-based variables such as earnings, total assets, total accruals and
various summary measures that employ accounting numbers such as Altmans
z-score (Altman, 1968). A problem with using accounting-based variables to
surrogate for client litigation risk is that many accounting variables are expected
to be mechanically correlated with our measure of discretionary accruals.
Therefore, we focus our analysis on qualitative factors expected to be associated
with litigation risk. Specically, we examine discretionary accruals partitioned
on: (1) audit report type issued by the predecessor auditor, (2) Big 6 member-
ship of the predecessor and successor auditors, and (3) 8-K disclosures regard-
ing auditor resignations and auditor-client disagreements.
6.1. Audit report type
Table 5 reports discretionary accruals partitioned on the type of audit report
issued during the last year with the predecessor auditor. In univariate tests, Lys
Table 5
Unstandardized discretionary accruals around auditor changes partitioned on audit report type
Audit report type
Modied Clean
n"203 n"300
Mean Median Mean Median
Year !2 !0.026 !0.001 !0.017 !0.001
(p-value) (0.18) (0.41) (0.17) (0.59)
Change from !2 to !1 !0.068 !0.059 !0.021 !0.029
(p-value) (0.01) (0.00) (0.26) (0.02)
Year !1 !0.094 !0.040 !0.038 !0.015
(p-value) (0.00) (0.00) (0.01) (0.00)
Change from !1 to 0 0.060 0.022 0.012 0.010
(p-value) (0.06) (0.08) (0.45) (0.94)
Year 0 !0.033 !0.023 !0.025 !0.009
(p-value) (0.15) (0.01) (0.03) (0.01)
See Table 2 for calculation of discretionary accruals. p-values for the means are from two-tailed
t-tests of the null hypothesis that the mean equals 0. p-values for the medians are from two-tailed
Wilcoxon sign rank tests of the null hypothesis that the central tendency equals 0. Year !2 refers to
the penultimate year with the predecessor auditor, year !1 refers to the last year with the
predecessor auditor and year 0 refers to the rst year with the successor auditor.
and Watts (1994) nd that auditor litigation is signicantly positively associated
with the existence of a modied opinion. This suggests clients receiving modied
opinions pose a greater litigation threat. Thus, if conservative accounting
choices are used to attenuate the auditors litigation risk exposure in our sample,
we expect to observe relatively larger negative discretionary accruals among
clients that receive modied opinions during the last year with the predecessor
auditor. Table 5 presents evidence consistent with this expectation. While dis-
cretionary accruals during the last year with the predecessor auditor are signi-
cantly negative irrespective of the nature of the opinion, the magnitudes are
much larger among rms with modied opinions. The dierence is signicant
at the 0.03 and 0.05 levels (two-tailed) using a t-test and a Wilcoxon test,
respectively.
6.2. Big 6 membership of the predecessor and successor auditor
Palmrose (1988) nds a lower incidence of auditor litigation among Big
6 auditors compared to non-Big 6 auditors. One explanation for this nding is
that Big 6 auditors are more conservative. Therefore, we expect negative dis-
cretionary accruals to be relatively more pronounced among the clients of
Big 6 predecessor auditors (compared to non-Big 6 predecessors) and among
non-Big 6 successor auditors (compared to Big 6 successors).
Table 6 investigates these expectations by analyzing contingency tables show-
ing discretionary accruals for each of the four combinations of predecessor and
successor auditors for years !1 and 0. The row and column totals of the year
!1 contingency table indicate that while discretionary accruals are negative
irrespective of the identity of the auditor, the magnitudes dier in a manner that
is consistent with our expectations. Mean and median discretionary accruals
during year !1 for clients of Big 6 predecessor auditors are signicantly
negative at p(0.01, while mean and median discretionary accruals during year
!1 for clients of non-Big predecessor auditors are negative but only signicant
at p"0.27 and p"0.05, respectively. While the dierence in means between
the two groups is signicant at p"0.09 (two-tailed), the median is only
signicant at p"0.59 (two tailed), using a t-test and a Wilcoxon two-sample
test, respectively. In addition, the year !1 contingency table shows that the
magnitude of discretionary accruals among the clients of non-Big 6 successor
auditors is greater than the magnitude among Big 6 successors. While the
dierences in means and medians between the groups is not signicant at
conventional levels, the direction of the dierence is consistent with non-Big
6 successor auditors accepting riskier clients more readily than Big 6 successor
auditors.
Examination of the individual cells within the year !1 contingency table
provides further insight into this observation. A comparison of cells (i) and (iii)
indicate that Big 6 successor auditors accept clients with signicantly negative
discretionary accruals if the predecessor is another Big 6 auditor, but not if the
predecessor is a non-Big 6 auditor. On the other hand, a comparison of cells (ii)
and (iv) indicate that non-Big 6 successor auditors accept clients with signi-
cantly negative discretionary accruals, regardless of the predecessor auditor
type. While this is also consistent with Big 6 successor auditors being more
selective than non-Big 6 successors, it further indicates that this selectivity
results from caution about accepting relatively riskier clients from non-Big
6 auditors.
The year 0 contingency table also reports that the mean and median dis-
cretionary accruals in each cell are negative. However, the only statistically
signicant value appears in cell (i) a median value of !0.015. By contrast, the
median value with the smallest magnitude is found in cell (ii) a median value of
!0.005. This is consistent with Big 6 successor auditors continuing to be
conservative with their newly accepted clients from other Big 6 auditors, while
non-Big 6 auditors tend to be relatively less conservative with new clients that
are accepted from Big 6 predecessors. While not conclusive, this is consistent
with some portion of the sample rms changing from Big 6 to non-Big 6
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` Out of our sample of 503 rms, we are unable to obtain any information from the Lexis-Nexus
database on 65 rms. In addition, for 154 rms we are also unable to obtain any information on
either of the two dimensions that we classify the 8Ks. Our analysis of 8Ks therefore is restricted to
284 rms.
auditors in order to nd a successor auditor that allows more liberal reporting
(also see Becker et al., 1997).
6.3. 8-K disclosures of auditor resignations and auditor-client disagreements
Table 7 presents discretionary accruals partitioned on the initiator of the
auditor change and whether an auditor-client disagreement is reported in the
auditor change 8-K. Financial Reporting Release No. 31 requires 8-K disclosure
of whether the auditor was dismissed, resigned, or refused to stand for reelection.
In addition, clients must report whether there existed a disagreement between
the auditor and the client at the time of the termination or within the prior two
years. 8-K information is obtained from the LexisNexus database that reports
abstracted information from all 8-K reports led by public companies. In some
cases the 8-Ks are silent with respect to the data items we are interested in. We
classify these cases in the columns titled not stated and exclude them from our
analysis.`
The left side of Table 7 reports discretionary accruals partitioned on whether
the 8-K reports that the auditor change arises from an auditor-initiated resigna-
tion or a client-initiated dismissal. Prior research suggests that a likely auditor
response to severe client litigation risk is to resign from the engagement (De-
Fond et al., 1997; Krishnan and Krishnan, 1997). Because resignation involves
the loss of a client, this response is only expected to occur in extreme cases. This
is consistent with the relative rarity of reported resignations compared to
client-initiated dismissals. If income decreasing discretionary accruals reduce an
auditors litigation exposure, we expect that negative discretionary accruals will
be more pronounced among clients whose auditors resign when compared to
clients who dismiss their auditors.
The results are consistent with this expectation. While year !1 discretionary
accruals are signicantly negative irrespective of who initiates the auditor
change, the magnitude of the mean and median discretionary accruals is larger
among the resignation rms (the mean dierence is insignicant at conventional
levels, but the Wilcoxon test of dierences is signicant at the 0.04 level). The
relatively stronger results for the auditor resignation sample is consistent with
our contention that auditor changes are related to auditor conservatism arising
from litigation risk concerns. However, it is important that the majority of the
changes are client-initiated and that the discretionary accruals in year !1 are
signicantly negative even for this sub-sample, suggesting that our main results
T
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are not primarily driven by auditor resignations. Rather, the results suggest that
both type of changes (auditor and client initiated) are associated with conserva-
tive accounting choices, with the auditors resigning in the most extreme cases.
The right side of Table 7 reports discretionary accruals partitioned on
whether the 8-K reports an auditor-client disagreement or not. As stated earlier,
analytical work concludes that auditor changes can occur when managers and
auditors hold legitimate divergent beliefs regarding the appropriate application
of GAAP and such disagreements are most likely to occur when the predecessor
auditor believes that the appropriate application of GAAP results in lower
earnings than the application favored by management (see Section 2). While
reported auditor-client disagreements are likely to be understated (Smith and
Nichols, 1982), the reported cases are expected to result from the most conten-
tious disputes (DeFond and Jiambalvo, 1993). Therefore, we expect rms dis-
closing disagreements to report income decreasing discretionary accruals of
relatively greater magnitudes than rms that do not report disagreements.
The results generally support our expectation. While year !1 discretionary
accruals are signicantly negative irrespective of whether a disagreement was
reported, the magnitude of the mean and median discretionary accruals is larger
among the rms reporting disagreements. The dierence across the two groups
is signicant at the 0.07 level (two-tailed) using both a t-test and a Wilcoxon test.
Notably, the magnitudes of the negative discretionary accruals in the disagree-
ment sub-sample are approximately twice as large as those in the non-disagree-
ment sub-sample.
Table 8
Analysis of changes in income eects of various discretionary accounting measures during year !1
and an analysis of switch-backs to income increasing choices during year 0
(A) (B) (C) (D)
Special items
scaled by assets
Provision for
bad debts
scaled by sales
Amortization
of intangibles
scaled by assets
Composite
measure of
discrete method
choices
Panel A: Changes in accounting choices during year !1
N 396 331 342 458
Mean !0.013 !0.005 !0.001 !0.048
(p-value) (0.01) (0.05) (0.02) (0.02)
Median !0.000 !0.001 !0.000 !0.000
(p-value) (0.00) (0.00) (0.00) (0.02)
Income decreasing
changes
Frequency 141 181 67 49
Proportion 35% 55% 20% 11%
Table 8 (continued)
(A) (B) (C) (D)
Special items
scaled by assets
Provision for
bad debts
scaled by sales
Amortization
of intangibles
scaled by assets
Composite
measure of
discrete method
choices
Panel B: For rms that made income increasing choices in year !1, an analysis of switch-backs to
income increasing choices in year 0
Income increasing
changes
Frequency 98 129 43 27
Proportion 24% 39% 13% 6%
Chi-square for dierence
in proportions
7.74 8.72 5.24 6.37
(p-value) (0.01) (0.00) (0.02) (0.01)
Income decrasing changes
from panel A
141 181 67 49
Missing data in year 0 (14) (3) (4) (0)
Available data in year 0 127 178 63 6
Mean 0.046 0.002 0.003 0.041
(p-value) (0.00) (0.69) (0.05) (0.42)
Median 0.020 0.001 0.001 0.000
(p-value) (0.00) (0.05) (0.13) (0.69)
Income decreasing changes
Income increasing changes
Chi-square for dierence
in proportions
26.3 4.27 2.68 1.67
(0.00) (0.04) (0.11) (0.21)
All data are from the Compustat database. p-values for the means are from two-tailed t-tests of the
null hypothesis that the mean equals 0. p-values for the medians are from two-tailed Wilcoxon sign
rank tests of the null hypothesis that the central tendency equals 0.
For ease of interpretation, in columns (A) through (C) expenses are coded as negative values.
Therefore, an increase in the expense amount from year !2 to year !1, which decreases reported
earnings, appears as a negative number.
The measure in column (D) assigns each rm a value of 1 for each income increasing accounting
method choice and a value of 1 for each income decreasing choice with respect to depreciation,
inventory valuation, and the treatment of the investment tax credit (ITC). Methods classied as
income increasing (decreasing) are; straight-line (accelerated) depreciation, FIFO (LIFO) inventory
valuation, and the ow-through method (immediate expense) treatment of ITC. Other accounting
method choices, such as the weighted-average method of inventory valuation, are assigned a value of
zero.
While the value of the median is zero, the Wilcoxon sign rank test indicates the central tendency of
the distribution is negative.
7. Analysis of specic accounting choices
7.1. Accounting choices in the last year with the incumbent auditor
Our primary analysis employs the Jones method to measure discretionary
accounting choices. Although the Jones model has the advantage of providing
an aggregate measure of accounting choice, which is important if a portfolio
approach is adopted to manage earnings, it suers from several measurement
problems. Accordingly, this section attempts to gather corroborative evidence
on our Jones model tests by examining discrete accounting method choices.
While the analysis of discrete choices is not completely independent of our
analysis of discretionary accruals, it does provide a distinctly dierent perspect-
ive from which judge managements accounting choices. Columns A through
C in panel A of Table 8 report the changes from year !2 to year !1 in special
items scaled by assets, the provision for bad debts scaled by sales, and amortiza-
tion expense scaled by assets. Similar to the measure used in Hagerman and
Zmjewski (1979), column D reports the change in a metric that captures the
three discrete accounting method choices. This metric is created by assigning
each rm a value of 1 for each income increasing accounting method choice and
a value of !1 for each income decreasing choice with respect to depreciation,
inventory valuation, and the treatment of the investment tax credit (ITC).
Methods classied as income increasing (decreasing) are; straight-line (acceler-
ated) depreciation, FIFO (LIFO) inventory valuation, and the ow-through
method (immediate expense) treatment of ITC. Other accounting method
choices, such as the weighted-average method of inventory valuation, are
assigned a value of zero. All companies in our sample with non-missing
Compustat values are included in the analysis.
Columns AD in panel A report that the mean and median eect of changes
in the measures signicantly decreases reported income in each case. The
bottom rows of panel A report the frequency and proportions of the income
decreasing and income increasing changes. While many rms experience no
change in these measures during year !1, the proportion of income decreasing
changes is larger than the proportion of income increasing changes and the
chi-square tests for dierences in the proportions is signicant at the 0.02 level
or better in every case. Thus, the ndings in panel A are consistent with our
analysis of discretionary accruals using the Jones model.
7.2. Reversal of conservative accounting choices during
the rst year with the successor
We argue that one reason mangers change auditors is to nd a successor who
will be less conservative than the incumbent. This suggests that managers will be
motivated to reverse the conservative accounting choices during the rst year
with the successor. We test for such reversals by examining the year 0 accounting
choices of rms that adopt conservative accounting choices in year !1. Panel
B of Table 8 reports the results of these tests. The top of panel B reconciles the
income decreasing rms in panel A (separately for each of the four measures) to
the available data for those rms during year 0. The rest of panel B reports the
mean and median year 0 changes in our four measures along with the frequency
and proportion of income decreasing and income increasing changes.
We nd consistent, albeit somewhat weak, evidence of reversal of year !1
conservative accounting choices in year 0. While the reversal in special items is
signicant, the results are somewhat weaker for the provision for bad debts and
amortization of intangibles. Of the 49 rms that switched to discrete income
decreasing accounting choices in year !1, only 6 report changes in their
composite measure during year 0. Although four of the six switched to income
increasing accounting methods, none of the statistical tests are signicant at
conventional levels. The small number of switchbacks of discrete accounting
methods is not surprising. Frequent accounting method changes violate consist-
ency requirements which rms nd dicult to justify, and such changes may
draw scrutiny from regulatory authorities such as the SEC.
In summary, the results in panels A and B of Table 8 suggest that rms, on
average, adopt more conservative accounting policies during the last year with
the predecessor auditor which are subsequently reversed in the rst year with
the successor. This nding is consistent with our conjecture that auditor changes
are precipitated by managers who wish to leave auditors who pressure them into
making conservative accounting choices.
8. Conclusion
This study analyzes discretionary accruals for a sample of 503 rms that
changed auditors during the period 19901993. We nd that discretionary
accruals are signicantly income decreasing during the last year with the
predecessor auditor and, after controlling for nancial distress, are generally
insignicant during the rst year with the successor auditor. We also nd that
the rms subject to the greatest litigation risk tend to report relatively larger
magnitudes of negative discretionary accruals. Together, these ndings suggest
that income decreasing accounting choice preferences by the incumbent auditor,
triggered by concerns about litigation risk, are an important factor explaining
auditor changes. However, while our ndings are robust to several tests that
control for nancial performance, and while we nd evidence from examining
specic accounting choices that corroborate our ndings, we can not be sure
that nancial distress does not at least partially explain our results.
Our ndings make several contributions to the literature. We provide empiri-
cal evidence on the role of accounting choice in auditor change decisions.
Consistent with theory, our results suggest that some auditor changes are
motivated by divergent beliefs among the auditor and management concerning
the appropriate application of GAAP (Dye, 1991; Antle and Nalebu, 1991). We
also provide evidence on the relation between accruals and auditor litigation
concerns (Lys and Watts, 1994). Specically, we nd results consistent with
litigation risk concerns inducing auditors to pressure managers into adopting
conservative accounting choices that ultimately trigger auditor dismissal.
Finally, our paper contributes to the earnings management literature by charac-
terizing the external auditor as a constraint to managerial discretion. This
contrasts with most earnings management studies that tend to focus exclusively
on management incentives. Instead, our framework recognizes that reported
earnings are the joint outcome of both management and the auditors preferences.
9. For Further Reading
The following references are also of interest to the reader: Francis and
Krishnan (1997), McNichols and Wilson (1988), Teoh (1992).
Acknowledgements
The authors appreciate the comments of Nick Dopuch, Mike Duy, John
Eichenseher, Jere Francis, Pat Hughes, Jagan Krishnan, Graeme Rankine, Jim
Manegold, Ted Mock, Terry Wareld, John Wild, T. J. Wong, and especially
Ross Watts (the editor) and an anonymous referee. We also acknowledge the
excellent research assistance of Irina Moroaica, Sudha Krishnan, Archana Bepa
and Brady Onishi.
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Auditor Changes and Discretionary Accruals: Mark L. Defond, K.R. Subramanyam

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