bagherpour et al - 2014 - government and managerial influence on auditor switching under partial privatization

J Account Public Policy xxx (2014) xxx–xxx Contents lists available at ScienceDirect J Account Public Policy journal homepage: www.elsevier.com/locate/jaccpubpol Government and managerial influence on auditor switching under partial privatization Mohammad A Bagherpour a, Gary S Monroe b, Greg Shailer c,d,⇑ a School of Administrative and Economic Science, Ferdowsi University of Mashhad, Mashhad, Iran School of Accounting, and Centre for Accounting & Assurance Research, The University of New South Wales, Sydney, NSW 2052, Australia c Research School of Accounting and Business Information Systems, The Australian National University, Hanna Neumann Building 21, Canberra, ACT 0200, Australia d Australian National Centre for Audit & Assurance Research, The Australian National University, Hanna Neumann Building 21, Canberra, ACT 0200, Australia b a b s t r a c t We investigate how auditor switching is affected by government influence, misalignment between type of auditor (government vs private) and type of controlling shareholder (government vs private), and misalignment between an incumbent auditor and imputed preferences of managers in a market characterized by continued substantial government ownership in listed entities We exploit a natural policy and regulatory experiment in Iran that allows us to investigate what happens when previously government-owned entities are partially privatized as listed entities where, in many cases, the government retains significant ownership interests At the same time, there were significant changes in the audit market, resulting in large increases in the number of private sector auditors competing for previously state-administered audits We find the likelihood of auditor switches is strongly associated with measures of misalignment between type of auditor and type of controlling shareholder and auditor–managerial misalignment, but these associations are constrained by significant government influence Exposing the constraining effect of significant government influence on auditor switching is an important contribution to our understanding of privatizations, government shareholder influence and auditor choice These results have implications for policy development in other emerging and transition ⇑ Corresponding author at: Research School of Accounting and Business Information Systems, The Australian National University, Hanna Neumann Building 21, Canberra, ACT 0200, Australia Tel.: +61 6125 4333 E-mail address: greg.shailer@anu.edu.au (G Shailer) http://dx.doi.org/10.1016/j.jaccpubpol.2014.04.004 0278-4254/Ó 2014 Published by Elsevier Inc Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx economies where privatization remains largely partial, and competition among private sector auditors is still emergent Ó 2014 Published by Elsevier Inc Introduction The link between political economy and auditor choice is an important policy question in emerging and transition markets where privatization has been a significant phenomenon (Guedhami et al., 2009) Privatizing corporate ownership raises the risks of serious agency conflicts between minority investors and politically connected managers or continuing government ownership, with significant implications for auditor choice (Chan et al., 2007; Wang et al., 2008; Guedhami et al., 2009) The risk of expropriation of minority shareholders by large shareholders is higher in emerging markets than in developed markets (Claessens et al., 2000; Claessens and Fan, 2002) and this may be reflected in financial reporting decisions Therefore, the role of auditors in reducing conflicts of interest in financial reporting decisions is potentially more important in emerging markets than in developed markets Consequently, factors that affect auditor changes, and may impair auditor independence and ultimately, audit quality, can have significant policy relevance in emerging and transition markets Where there is significant government influence through retained ownership in partially privatized companies, managers may prefer auditors who are more aligned with government interests The widespread phenomena of privatizations and economic liberalization in several emerging markets have been accompanied by rapid growth in audit suppliers as governments have licensed more private sector audit firms While there has been some research on auditor choice following privatizations, emphasizing auditor size differences (e.g., Chan et al., 2007; Wang et al., 2008; Guedhami et al., 2009), there is little examination of what happens when previously state-administered audits are relocated to a market governed by competition and demand (Mennicken, 2010) We contribute to the public policy literature concerned with auditing by addressing this issue We complement and extend the existing literature by investigating the effects of significant government influence on incentives for auditor switching in an immature audit market in which auditor competition is increasing, alongside an emerging equity market We focus on incentives arising from misalignments between type of auditor (government vs private) and type of controlling shareholder (government vs private), and between auditor and imputed preferences of managers Hereafter, we refer to these two types of misalignment as ‘‘auditor–controlling shareholder misalignment’’ and ‘‘auditor–managerial misalignment’’ We this in a market characterized by continued substantial government ownership in listed entities and rapid growth in the number of competing audit firms separated from government control In particular, we examine whether government influence prevails over the switching incentives arising from auditor–controlling shareholder misalignment and auditor–managerial misalignment We examine auditor–controlling shareholder misalignment from a perspective that is different to the prevailing emphasis on ‘‘Big N’’ vs ‘‘non-Big N’’ as the auditor choice, relative to client interests.1 We consider whether auditor switches are driven by government control of listed corporations and audit firm ownership (i.e., government or private sector auditors) We examine auditor–managerial misalignment in more traditional terms by focusing on conditions that have the potential to create conflict between auditors and client management; these include changes in management, discretionary accrual preferences and audit qualifications Our study exploits a natural experiment concerning auditor switching that was generated by policy and regulatory changes in Iran The policy changes involve: (1) the incremental partial privatization of government corporations; (2) removal of the government auditor’s monopoly over the audit of Chan et al (2007) find that a decrease in government shareholdings leads to an increased demand for higher-quality audits in China In a comparison of auditor choice by privatized firms across 32 countries, Guedhami et al (2009) reveal that privatized firms are less likely to appoint a Big Four auditor Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx government-controlled listed companies, which increased the ability of management to switch auditors; and (3) changes in the licensing of auditors, which resulted in a significant increase in the number of private sector auditors competing for clients We argue that agency costs and signaling incentives for Iranian listed companies are likely to have increased due to the rapid increase in the supply of private sector audit services, changes in the managerial labor and capital markets, and equity market growth with the accompanying emergent importance of private investors We link this to alignment incentives for auditor switching, which are conditioned by continuing government influence in many of the privatized companies Substantial transfers of stock in Iranian companies from the government to the private sector increased shareholder diffusion and information asymmetry Changes in ownership from government to private investors affect shareholders’ incentives and the mandates given to managers The objectives of government-controlled companies include implementing government policies (such as providing employment and providing cheaper goods and services) as well as earning profits The government policy position regarding the privatization of Iranian companies indicates that they no longer have this range or complexity of objectives and are therefore free to concentrate on profit-seeking (Komijani, 2003) However, when government retains significant influence through ownership of shares, the complexity of management decision-making motives may affect auditor choice decisions Interest in depoliticizing privatized firms or signaling to potential investors may encourage switching to private sector auditors, while government interests may encourage the retention of governmentcontrolled auditors The extant research on auditor switching is largely focused on markets characterized by relatively stable overall numbers of accounting firms competing for audits, but with increases in concentration and implied reductions in competition in the large client sector that is dominated by big international accounting firms (e.g., Gilling and Stanton, 1978; Pong, 1999; Wolk et al., 2001) The Iranian audit market is substantially different from this characterization In Iran, the removal of the government auditor’s monopoly and changes in licensing led to rapid growth in competition for the supply of audit services, as evidenced by a 100% growth in the number of audit firms engaged by companies listed on the Tehran Stock Exchange (TSE) from 2000 to 2003 with a continuing exclusion of international audit firms.2 Other characteristics of the emerging Iranian audit market that enhance its value as a natural experiment and distinguish our study from previous emerging market studies include: the exclusion of the international audit firms or their affiliates from the Iranian audit market; and the absence of civil litigation risk for auditors Studies of changes in auditor competition in the extant literature emphasize reduced supplier competition associated with increases in market domination by the Big N audit firms (e.g., Gilling and Stanton, 1978; Healy and Lys, 1986; Pong, 1999; Wolk et al., 2001; Sullivan, 2002; Chaney et al., 2003; Chen et al., 2007; Kohlbeck et al., 2008; Asthana et al., 2009) This supply-side focus is complemented by studies of companies’ auditor switching decisions in relation to auditor specialization and the imputed declining supplier competition as the number of Big N firms declined (e.g., Johnson and Lys, 1990; Gigler and Penno, 1995; GAO, 2003; Wolosky, 2003; Bloom and Schirm, 2005) Citron and Manalis (2001) study auditor choice in a market characterized by increasing competition, following Greece’s liberalization of its audit market in 1992, which ended the state-controlled monopoly of statutory audits However, their study links the demand for the newly entered Big Six international firms with substantial foreign ownership – neither of which is relevant to the Iranian setting With the exception of Citron and Manalis (2001), our study is the only known examination of auditor switching in the context of increased auditor competition.3 Given the exclusion of international audit firms, the Iranian audit market is less conditioned by auditor reputation effects compared to settings underlying much of the prior literature Furthermore, the absence of civil litigation risk for Iranian auditors eliminates the insurance hypothesis (see Wallace, 1987) as an explanation for auditor switching To the extent The 100% increase in audit firms is based on our data (including companies with missing financial data), which covers 88% of the companies listed on the TSE Chaney et al (2003) analytically consider switching under aggressive auditor competition attributed to auditor’s direct solicitation of potential clients Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx that we neutralize the supply-side effects of risk on auditor choice, we obtain a more powerful test of the demand-side relation between auditor choice and client-related characteristics (see Clarkson and Simunic, 1994) We find the likelihood of auditor switches is strongly associated with our measures of auditor–controlling shareholder misalignment and auditor–managerial misalignment, but these associations are constrained when the government retains significant ownership in privatized companies Our results suggest that the retention of significant government influence through shareholdings may affect a firm’s accounting choices by influencing its auditor Exposing the constraining effect of significant government influence on auditor switching is an important contribution to our understanding of privatizations, government shareholder influence and auditor choice Our findings on the relation between government influence, auditor supply and the demand for private sector auditors in a transition economy support arguments concerning the importance of the development of accounting institutions for the efficient allocation of resources and economic growth (Rajan and Zingales, 1998; Wurgler, 2000; Wang et al., 2008) Thus, our results have implications for policy development in emerging markets where privatization remains largely partial, with immature competition among private sector auditors In the following section, we provide background information on the institutional environment in Iran In Section 3, we develop our hypotheses In subsequent sections, we describe our research method, present our results and discuss those results Institutional environment Following Iran’s Islamic Revolution in 1979, all banks and insurance companies and many heavy industry companies were fully nationalized Many other companies were not fully nationalized, but were transferred to government control when private sector owners abandoned or forfeited their interests in companies and through the government-owned banks acting on debt defaults Although the TSE was established in 1967, these changes largely eliminated share trading In 1989, to stimulate economic recovery, the Iranian government implemented a privatization policy to transfer ownership of government companies to the private sector through a series of five-year plans (Davani, 2003; TSE, 2003) The first five-year plan (1989–1993) required the government to transfer ownership of nationalized and state industrial units (excluding strategic industries) to private sector shareholders (Abadi, 1995) The second five-year plan (1995–1999) was a continuation of the first plan (Amirahmadi, 1996) Under the Economic, Social and Cultural Development Plan for 2000–2004, the number of TSE-listed companies grew from 296 in 1999 to 386 in 2003 This growth came from the listing of government-controlled companies as part of the government’s privatization policy and the listing of new private sector companies Substantial transfers of stock in Iranian companies from the government to the private sector increased shareholder diffusion and the potential for information asymmetry; however, a small number of transactions appear to have been pseudo-privatizations, with government agencies still holding more than 95% of the total issued shares The privatization process has been gradual, with the government retaining significant ownership interests in many of the companies The retention of significant government influence enables state ministries to directly or indirectly appoint directors (FallahDoost, 2009, as cited in Mohammadrezaei et al., 2012) and CEOs (Mohammadrezaei et al., 2012) In Iran, appointments (and dismissals) of board members (and sometimes CEOs and CFOs) to government-controlled entities are often influenced by political, military or security wings and are usually based on political motives, and appointees are often politicians or bureaucrats with political connections (Mohammadrezaei et al., 2012) Accompanying the nationalization of companies after 1979, audit functions were transferred to government auditors, culminating in the establishment of the Iranian Auditing Organization (IAO) in 1987 This gave the IAO a monopoly over the audit of the nationalized companies and the partially privatized companies; however, there were a small number of non-government-controlled, TSE-listed companies audited by private sector auditors certified by the Economic Ministry The Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx IAO experienced difficulties in auditing the variety of government-controlled entities and was not suited to auditing the increasing number of profit-seeking companies post-1989 To address this issue, regulatory changes were introduced in 1993 that allowed certified public accountants to practice However, this regulation was ineffective because the designated certifying agency, the Iranian Association of Certified Public Accountants (IACPA), was not established until 2001 As a consequence, the IAO dominated the audit market for TSE-listed companies until 2001 Since the establishment of the IACPA in 2001, government auditors are certified members and auditors of TSE-listed companies must be members of the IACPA (Davani, 2003) A TSE-listed company can now choose either a private sector auditor or a government auditor, regardless of whether the company is government-controlled.4 In 2001, the IACPA licensed 402 private sector auditors Of these, 309 auditors were sole practitioners, mostly providing services to small non-listed clients, and 93 were in partnerships By the end of 2003, there were 156 sole practitioners and the number in partnerships had increased to 395 The number of licensed auditors employed by the IAO was relatively flat, changing from 207 in 2001 to 237 in 2003, but the modest growth suggests the private sector growth was not merely a transfer of auditors from government employment to private practice We observe a corresponding change in market shares between government and private sector auditors, based on the number of clients in our sample; the private sector auditors’ market share rose from 33% in 2001 to 62% in 2003 Although the statutory requirements for an audit identify shareholders as the intended recipients of reports, the law does not establish a recognizable duty of care or direct liability to shareholders and Iranian law does not provide for civil action against auditors to recover damages The primary legal exposure for auditors in Iran is prosecution under criminal provisions in the Iranian Trade Law; however, we are not aware of any such prosecutions to date Iranian audit firms are not affiliated with major international audit firms (they are prohibited by law) and there are no obvious domestic substitutes as market leaders The market shares of Iranian audit firms were dynamic during our study period, with many audit firm entries, restructurings and mergers Using client revenues or the number of clients as measures of auditor size, no firm was consistently ranked in the Big N across our sample period Although data limitations preclude direct assessment of the economic significance of audits in Iran, several domestic studies indicate that financial statement users regard the independent audit as important (Salehi et al., 2009; Moradi et al., 2011a,b) Consistent with experiences in other jurisdictions, these studies also indicate that the traditional audit expectations gaps and issues regarding self-interested agents are prevalent in Iran Auditor switching and alignment We argue that the institutional changes described above created incentives for companies to switch auditors to achieve preferred auditor–controlling shareholder alignment or auditor–managerial alignment, and changes in the audit market provided increasing opportunities to switch, but did not necessarily abate government influence in the decisions of partially privatized companies Exploiting the dynamics of the Iranian market, we develop hypotheses concerning government influence, auditor–controlling shareholder misalignment and auditor–managerial misalignment Auditor– client alignment and managerial interests have received prior attention in the audit choice/switching literature The literature identifies a variety of potential incentives for audit switching We revisit these switching incentives to assess whether they apply in our novel setting and for our new measure of auditor–controlling shareholder misalignment, and to evaluate the extent to which government influence prevails over private incentives for switching induced by auditor–managerial misalignment However, several of these incentives (litigation risk, audit fees and auditor size) not apply to the Iranian context or cannot be tested with available data Iranian Trade Law requires listed companies to appoint a licensed auditor, who is approved by shareholders at the annual general meeting Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx The absence of civil litigation risk for Iranian auditors eliminates the insurance hypothesis for auditor selection (see Wallace, 1987), but it has other implications for auditor switching The absence of litigation risk may increase the propensity for Iranian corporations to switch auditors to gain other advantages, because the costs of switching are lower Kallunki et al (2007) argue that the importance of reliable auditing services and the resources a client has to devote to familiarizing the new auditor with the client are lower in countries where the severity of the legal environment is lower, compared to countries where it is higher Consequently, switching costs are lower in countries with less strict legal environments The absence of litigation risk for managers and auditors in Iran implies lower switching costs for clients and auditors, which should increase the willingness of auditors to compete for clients and the likelihood of switching Therefore, we expect the Iranian market to exhibit a larger number of switches due to managers seeking improved auditor–controlling shareholder alignment or auditor–managerial alignment This expectation is confirmed by our data set We had a sample-based switching rate of 9.8% during 1999–2003, with a maximum annual rate of 18.7% in 2003 (as discussed in Section 5).5 Prior studies indicate that audit fees can motivate switching decisions While audit fee data are not generally available for Iranian corporations, we obtained voluntarily disclosed audit fees for 74 listed corporations for 2003 The average audit fee as a percentage of sales for these 74 corporations was 0.31%; and their average audit fee as a percentage of assets was 0.15%.6 On this basis, while Iranian audit fees appear less material than fees in developed markets (Gul et al (2009) report average audit fees as a percentage of assets for non-lowballing US firms for 2003–2004 of 0.34%), they appear non-trivial for Iranian corporations Therefore, audit fees may be a significant switching incentive, but we cannot test this effect While this is a potential limitation of our study, the alignment switching incentives we examine are not likely to be correlated with audit fees; we argue that the unavailability of audit fee data biases our study against finding significant alignment switching factors Research in mature audit markets has long used auditor size (Big N or market share) as an indicator of audit quality (following DeAngelo, 1981; Francis, 2004) While switching to signal audit quality to investors may be an incentive, we cannot proxy this traditional aspect of auditor quality in the Iranian market Major international audit firms are excluded from the Iranian market and, using client revenues or the number of clients as measures of auditor size, no firm is consistently ranked in the Big N across our sample period because of the audit firm entries, growth and mergers If a positive reputation is built over a long period (Fombrun and Shanley, 1990), then firm name reputational effects are likely to be weak in a market with only five years of development Bedard et al (2010) indicate that, despite considerable research interest, there is little understanding of investors’ and managers’ perceptions of audit quality in mature markets and it is beyond the scope of this study to resolve how investors or managers assess audit quality in Iran The absence of international or large, established Iranian audit firms implies reputational or quality aspects not rely on simple brand name effects, with auditor switching being motivated by other criteria The following sections discuss other incentives identified in the extant literature that may be applicable to the Iranian context, as well as incentives that we argue are specific to the Iranian market 3.1 Government influence In a competitive market, companies or management tend to select or retain auditors that best meet their needs (Burton and Roberts, 1967; Shockley, 1981; Addams and Davis, 1994; Beattie and Fearnley, 1998), resulting in a market characterized by a high level of auditor–client alignment Auditor Our maximum switching rate is around double the switching rates reported for the Chinese market for a similar period Chan et al (2006) report a sample-based switching rate of 9% in China during 1996–2002 (with a maximum annual rate of 11% in 2000 and 2001) Despite the substantial legal, cultural and economic differences between the Iranian and Chinese markets, we suggest this comparison indicates a particularly rapid increase in the propensity for switching in the Iranian market While not sufficient for modeling, these cases are reasonably consistent with the average size of firms in our sample, as described in Section The mean natural log of revenues for the 74 firms for which we obtained 2003 fee data is 11.49, compared to 11.62 for our full sample; the standard deviations are 1.12 and 1.29 respectively Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx switching is more likely to occur when an auditor and client are not well aligned Changes in either client or auditor characteristics may result in a misalignment, which can be corrected by switching auditors (Landsman et al., 2009) The government-owned audit firm initially audited corporations that became listed as a consequence of Iran’s privatization policy There are multiple arguments as to why (partially) privatized corporations might retain or switch auditors We argue that the incentives for privatized firms to switch auditors are conditioned by the extent of continuing government influence Privatizations in emerging markets have prompted concerns regarding potential agency conflicts between minority investors and politically connected managers or continuing government ownership Government influence through ownership may render corporations more likely to pursue social or political goals such as infrastructure development, employment or other social agendas In particular, government owners may have strong motives to obscure firm performance information (Bushman et al., 2004), which may be facilitated by stock exchanges that are illiquid and opaque during privatization programs (Megginson and Netter, 2001; Guedhami et al., 2009) There is evidence that government ownership affects board member selection (Fan et al., 2007) and corporate structure (Fan et al., 2012) Although government-controlled listed corporations not have to be audited by the government-owned audit firm, managers of government-influenced companies may generally prefer the government auditor because of its experience with such entities or for political reasons Where there is significant government influence through retained ownership, managers are more likely to choose auditors that are more aligned with government interests (Wang et al., 2008; Guedhami et al., 2009) and it has been suggested that governments can influence government auditors (Wang et al., 2008) Political or social objectives may divert government-controlled firms from pursuing profits (e.g., Eckel and Vining, 1985; Shleifer and Vishny, 1994), making acquiescent managers less likely to switch to auditors more suited to private investor interests Consistent with these arguments, Chan et al (2007) report increased demand for higher-quality audits following decreased government share ownership in China Therefore, our government influence hypothesis is: H1 The likelihood of an auditor switch is negatively associated with significant government influence With respect to determining significant government influence, we focus on the percentage of shares retained by the government Consistent with the International Financial Accounting Standard 28 (IASB, 2011) on equity accounting, we use government ownership of 20% or more of the shares as indicative of significant government influence This follows previous influential studies (e.g., La Porta et al., 1999; Claessens et al., 2000, 2002) However, as argued by Chapelle and Szafarz (2005), the threshold of 20% is an empirical rule of thumb that has no specific formal justification Therefore, we examine other thresholds in our robustness tests There may be non-shareholding sources of government influence, such as government contracts, manager–government relationships and board members’ political connections, but we not have access to such data 3.2 Auditor–controlling shareholder misalignment In the absence of significant government influence, privatization relieves an Iranian company of responsibility for implementing government policy (Komijani, 2003) and Iranian government-controlled companies were known to be mismanaged and poor performers (EghtesadeIran, 2002) If government control or the pursuit of government objectives is costly to private sector shareholders, managers of privatized companies have incentives to signal increased emphasis on investors’ interests and reduced government involvement by switching to a private sector auditor Private sector auditors may have also developed different expertise in regulatory compliance and be perceived as having more affinity with the interests of investors, brokers and investment bankers Therefore, we expect private auditors’ experience and reputation to better match the needs of a privatized company Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx Consequently, where there is auditor–controlling shareholder misalignment, there is more incentive to switch auditors for alignment purposes We consider that an auditor–controlling shareholder misalignment occurs when a government-controlled company has a private sector auditor and where a private sector company has a government auditor.7 Therefore, our auditor–controlling shareholder misalignment hypothesis is: H2 The likelihood of an auditor switch is positively associated with auditor–controlling shareholder misalignment 3.3 The effect of managerial interests on auditor choice Managers’ preferences may motivate auditor selection and switching behavior Incoming managers may choose to switch auditors if they have a preferred relationship with a particular auditor (Williams, 1988; Seabright et al., 1992; Addams and Davis, 1994; Beattie and Fearnley, 1998; Hudaib and Cooke, 2005) Existing managers may also switch auditors if they are seeking accommodation of their choices and applications of accounting policies (Schwartz and Menon, 1985) Therefore, our auditor–managerial misalignment hypothesis is: H3 The likelihood of an auditor switch is positively associated with auditor–managerial misalignment We test this hypothesis by examining three indicators of potential misalignment of auditors and managerial preferences: changes in management, accounting choice preferences and disagreements between auditors and managers indicated by qualified opinions To test the proposition of incoming managers preferring particular auditors, we focus on changes in CEO and Chair of the Board We consider both CEO and Chair changes because we have no evidence of the relative power of each of these offices in Iranian companies We observe very high rates of change in CEOs (22%) and Chairs (25%) in our pooled sample of TSE-listed companies; the pooled rate of simultaneous change in CEO and Chair is 11%.8 These high rates of change suggest there might not be sufficient stability in the managerial labor market or managerial entrenchment for managers to influence auditor choice However, consistent with studies indicating that management changes are one of the main reasons for auditor switches (Burton and Roberts, 1967; Carpenter and Strawser, 1971; Beattie and Fearnley, 1995, 1998; Woo and Koh, 2001; Hudaib and Cooke, 2005), we expect the likelihood of an auditor switch is higher following a change in client management.9 With respect to managers seeking auditors who are more accommodating of their accounting choices, we examine evidence of accounting choice and auditor opinions that indicate auditor– manager disagreement over the choice and application of accounting policies If managers prefer auditors who are more accommodating with respect to their choice and application of accounting policies (Schwartz and Menon, 1985), then we expect accounting choices to be linked to auditor switches, irrespective of management changes We contend that auditors are not indifferent to accounting choices, and will prefer conservative accounting practices if this exposes them to less risk of punitive actions This contention is consistent with US evidence that auditors are more likely to be sued when there are earnings overstatements compared to when there are earnings understatements (St Pierre and Anderson, 1984) While Iranian auditors not face civil litiga7 A controlling shareholder is defined as one who holds 50% or more of the issued shares In our additional testing, we also test auditor–controlling shareholder misalignment when a government-controlled company has a private sector auditor While the same person could be CEO and Chair during the period of our study, we find no instances of this in our sample The simultaneous changes in both Chair and CEO in our sample also appear unrelated to privatization or other ownership changes The results of earlier studies of the association between management changes and auditor switches are inconsistent Some studies not find any significant association (e.g., Chow and Rice, 1982; Schwartz and Menon, 1985; Williams, 1988), while others find significant associations (e.g., Burton and Roberts, 1967; Carpenter and Strawser, 1971; Beattie and Fearnley, 1995, 1998) Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx tion risk, they can be jailed for issuing unqualified opinions on misleading financial reports (Iranian Trade Laws Article 267) or have their license suspended or cancelled by the IACPA If prosecutions or other adverse outcomes are more likely when there are earnings overstatements rather than earnings understatements, then Iranian auditors have incentives to prefer conservative accounting methods and choices If an incumbent auditor’s accounting preferences lead to income decreasing accounting choices, then there is a greater likelihood of an auditor switch, because it is more likely to be inconsistent with managers’ preferences (Defond and Subramanyam, 1998) This argument does not assume that managers are motivated to manipulate earnings – it argues that, if managers believe the incumbent auditor’s accounting choice preferences are more conservative than those expected from the average auditor, then management has an incentive to switch auditors in the hope of finding a more reasonable successor (Defond and Subramanyam, 1998, p 36) It follows that an auditor switch is more likely for a company with large negative discretionary accruals than for other companies Therefore, we expect the likelihood of an auditor switch increases following large negative discretionary accruals, as indicated by the lower quartile of discretionary accruals Qualified and adverse audit opinions reflect either disagreements with management or inherent uncertainties Qualified audit opinions may be viewed as negative signals of managements’ stewardship of the company (Williams, 1988) and have been linked to adverse effects on company value and management compensation (Chow and Rice, 1982) Some prior studies report an increased likelihood of auditor changes following a qualified audit opinion (e.g., Chow and Rice, 1982; Teoh, 1992; Lennox, 2000; Hudaib and Cooke, 2005) Others report a negative association (Woo and Koh, 2001) or no association (e.g., Schwartz and Menon, 1985; Haskins and Williams, 1990) Earlier studies mostly not distinguish between qualified audit opinions resulting from disagreements with management and qualified opinions resulting from environmental conditions such as inherent uncertainties or scope limitations not imposed by the client However, Hudaib and Cooke (2005) find that the severity of an audit opinion, in relation to disagreements, is positively associated with auditor switching We contend that management has more incentive to bring about an auditor switch if the audit opinion reflects adversely on management In Iran, qualified and adverse audit opinions are issued for scope limitations, inherent uncertainties and violations of GAAP (disagreements with management over the choice and application of accounting policies) We contend that qualified and adverse opinions that reflect directly on management (i.e., client-imposed scope limitations and violations of GAAP) are more likely to result in management seeking a change of auditor, compared to qualified opinions issued because of environmental conditions (i.e., inherent uncertainties or scope limitations not imposed by the client) Therefore, we expect the likelihood of an auditor switch is higher if a client receives a qualified audit opinion resulting from violations of GAAP or client-imposed limitations of scope Empirical model We specify the following logistic regression as our main model to test the hypothesized effects on auditor switching propensities To test the impact of significant government influence (H1), we use the indicator variable Government influence In relation to the auditor–controlling shareholder misalignment hypothesis (H2), we test auditor–controlling shareholder misalignment with the variable Misaligned We use the variables DManagement, NegativeDA and QualDisagree to test the auditor– managerial misalignment hypothesis (H3) The control variables in the model are described in Section 4.1 Auditor switcht ẳ b0 ỵ b1 Gov ernment influence ỵ b2 Misalignedt1 ỵ b3 DManagementt1 ỵ b4 QualDisagreet1 ỵ b5 Negativ eDAt1 ỵ b6 Gov ernment ownership ỵ b7 QualOthert1 ỵ b8 Positiv eDAt1 ỵ b9 Sizet1 ỵ b10 SalesGrowtht1 ỵ b11 Losst1 ỵ b12 Lev eraget1 ỵ b13 ROAt1 ỵ b14 Competition years ỵ Rbi Industryi 1ị Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 10 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx where: Dependent variable: Auditor switch If a corporation had a change of auditor in the current year, otherwise We identify switches from the audit firm names on the published audit reports in the relevant corporation’s annual report obtained from the TSE library Test variables: Government If government owns 20% or more of the issued shares and otherwise We influence use 20% to be consistent with the threshold used in equity accounting standards to determine significant influence We test other thresholds in our robustness tests Misaligned If a corporation is private sector controlled and had a government auditor in the previous year, otherwise Types of auditor and corporations were identified from the published annual reports obtained from the TSE library DManagement If there was a change in both the Chair of the Board and the Chief Executive Officer in the previous year, otherwise The Chair and the CEO are identified from notes in the annual report obtained from the TSE library QualDisagree If the audit opinion for the previous year was qualified because of a violation of GAAP or a client-imposed scope limitation, otherwise We identify the type of audit opinion from the auditor’s report in the annual report obtained from the TSE library NegativeDA If discretionary accruals for the previous year, estimated using the Dechow and Dichev (2002) approach, was in the bottom quartile (income decreasing), and otherwise We exclude the middle quartiles to reduce noise and control for the top quartile using PositiveDA Control variables: Government Percentage of issued shares held by government agencies ownership QualOther If the audit opinion for the previous year was qualified for reasons other than violations of GAAP or client-imposed scope limitations, otherwise We identify the type of audit opinion from the auditor’s report in the annual report obtained from the TSE library PositiveDA If discretionary accruals for the previous year, estimated using the Dechow and Dichev (2002) approach, was in the top quartile (income increasing), and otherwise Size Natural logarithm of total revenue for the previous year, as disclosed in the financial statements in the annual reports obtained from the TSE library SalesGrowth If sales growth during the previous year was greater than or equal to 30%, using sales as disclosed in the financial statements in the annual reports obtained from the TSE library Other thresholds are also tested Loss If a loss was reported in the previous year and otherwise, as disclosed in the financial statements in the annual reports obtained from the TSE library Leverage Long-term debt divided by total assets at the end of the previous year, as disclosed in the financial statements in the annual report obtained from the TSE library ROA Previous year net profit divided by total assets Competition For cases occurring during the years of increased competition in the audit years market following the introduction of the IACPA in 2001 (i.e., 2002–2003), otherwise Industry (0,1) Classification variables for industries based on the industry classifications published by the TSE Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 11 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx Table Sample by auditor changes Year 1999 2000 2001 2002 2003 Firm-years Companies (n) Significant government influence (%) Number of private sector audit firms Auditor changes Direction of auditor change Frequency % Public to private Private to private Private to public 106 134 151 149 117 657 52 52 51 43 39 47 18 17 18 28 37 21 23 62 6.6 6.7 1.3 14.1 19.7 9.4 16 20 40 20 0 0 4.1 Control variables for other switching effects We include the continuous variable Government ownership as a control variable, because prior research has found this to be significant in relation to auditor switching (Guedhami et al., 2009) and to control for any government ownership influence incremental to our significant influence threshold measure We include the variable QualOther to control for the possibility that audit qualifications, for reasons other than violations of GAAP and client-imposed scope limitations, impact on auditor switching We include the variable PositiveDA to control for two reasons Income increasing discretionary accruals may reflect the preferences of management and have been approved by the auditor, reducing the likelihood of switching However, if switching is management’s response to auditors limiting the capacity of managers to engage in earnings management, irrespective of direction, then the results should be the same for both income-increasing and income-decreasing discretionary accruals We control for Size and SalesGrowth, because client size and growth are known to be important determinants of auditor choice in developed markets (Francis and Wilson, 1988) and some emerging markets (Chan et al., 2007; Wang et al., 2008; Guedhami et al., 2009).10 Large clients are more likely to have selected a large auditor, so a market with few competing large auditors offers little opportunity for switching An auditor switch is much more likely when sales growth is relatively large Low to moderate sales growth is less likely to trigger an audit switch, because it is less likely to change the size of the client to the level where client size-auditor size becomes misaligned Therefore, in relation to client growth, we expect auditor switches are more likely to arise as a threshold effect rather than a linear relation.11 Prior studies suggest that auditor opinions and switching are influenced by profitability and financial distress (Schwartz and Menon, 1985; Geiger et al., 1998; Carey et al., 2008), which we control for using Loss, Leverage and ROA (Chan et al., 2007; Wang et al., 2008; Guedhami et al., 2009) Consistent with prior studies on auditor switching, we include industry control variables based on the industry classifications used by the TSE We control for the following: equipment; oil and petrochemical; investment; medical and pharmaceutical; alimentary and drinking; basic metals; packaging; rubber and plastic; electrical machinery; minerals; textile; and automotive Other industry groups have too few cases for separate controls.12 In our discussion of the institutional environment in Section 2, we indicate that the number of licensed auditors in private practice increased substantially following the establishment of the IACPA (also see Table in Section 5) Increased competition for audit clients increases the opportunities for 10 Expertise or specialization may also be an important factor in auditor selection However, some industries attracting specialization in developed markets are not prevalent in Iran; for example, there are no listed financial institutions Also, auditor expertise requires both strategic investment of resources and sufficient time for knowledge acquisition and reputation building We contend that the emergent firms in an immature market are highly constrained in this regard, and so Iranian audit firms had little opportunity to develop specializations in the two years post-2001 included in our study Therefore, we not construct an industry specialization hypothesis for auditor alignment switching, although we control for industry effects in our final model 11 In further tests, we test and report a range of thresholds for sales growth 12 While capital-raising might influence switching decisions in developed markets (Healy and Lys, 1986; Woo and Koh, 2001), data deficiencies prevent us controlling for this possible effect Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 12 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx companies to change auditors (Beattie and Fearnley, 1998) in order to select an auditor that better matches the company’s or manager’s needs We control for this effect with the Competition years indicator variable, and also control for individual year fixed effects, reducing the likelihood of our test variables proxying for omitted variables Sample statistics Our population is all companies listed on the TSE during 1999–2003, which is two years preceding and two years following the establishment of the IACPA in 2001 The numbers of listed companies in each of the five years were 296, 311, 323, 338 and 386, yielding a potential population of 1654 firmyears For our sample, the average government ownership declined from 31% (1999–2001) to 24% (2002–2003) Data were manually collected from the hardcopy financial statements held in the TSE library We excluded 15 companies where private shareholdings totaled less than 5% to avoid the potential bias of what were effectively pseudo-privatizations, where private interests are unlikely to influence managers Incomplete files and missing data resulted in our final sample of 657 firm-year observations.13 The increased competition in the supply of audit services following the establishment of the IACPA in 2001 is illustrated in Table 1, which indicates that the number of audit firms in our sample was flat at 17–18 through 1999–2001, but this increased to 28 in 2002 and 37 in 2003.14 The post-2001 growth coincides with the majority (71%) of the 62 auditor changes during our sample period These are presented by year and direction in Table Companies that have a change in audit firm as a result of an audit firm merger are not coded as switches Most switches (65%) were from the government auditor to a private sector auditor Only two switches were from a private sector auditor to the government auditor, which occurred in 1999, prior to the establishment of the IACPA The predominance of switches in the later years is consistent with switches being facilitated by the changes in government policy that increased auditor competition The variation in switching across the years also confirms the desirability of controlling for individual year fixed effects Descriptive statistics and frequencies for the other variables for each year are presented in Table There is a near even split between companies with significant government influence; 47% of our sample have government ownership P20% The percentage of companies in our sample with significant government influence declined from 52% in 1999 to 39% in 2003, which is consistent with the government’s privatization policies This variable is also used for split sample descriptions in Table The switching rate for the pooled sample is 9%, but the switching rate is significantly lower (p = 0.005) for the sub-sample with significant government influence, compared to the sub-sample with no significant government influence (6% vs 12%) Average government ownership in the pooled sample is 28%; with 54% and 4% for the significant and no significant government influence sub-samples respectively (significantly different at p < 0.001) 13 Many of the available TSE files were incomplete We did not detect any bias with respect to missing data, other than a greater proportion of missing cases for the first and last year of the series Our sample represents 36–51% of cases for each year Based on chi-square tests of differences in frequencies of valid and missing data for each variable grouped by auditor switch versus no switch, we not find any significant difference for included variables We did find substantial bias with respect to capital-raising (changes in equity or debt), for which there was a large amount of missing data, so we have not included capital-raising in our models Our reported models are estimated using list-wise deletion of cases with missing data However, as an additional missing data test we also estimate the main model using all possible cases, where missing values are replaced by mean values of nearby points, and we obtain substantially similar results These tests suggest the deletion of cases with missing data does not bias our results We also re-estimate our models with change in equity and change in debt as additional variables but these were unreliable and unstable, and are not tabulated Most corporate debt in Iran comes from government-owned banks and it is not obvious how this might relate to incentives for switching incentives This may be an interesting future study should the necessary data become available 14 The number and structure of private sector audit firms during our period of study is very dynamic Firm identities vary considerably from year to year; our sample contains over 50 private sector audit firms and many have only a small number of clients in any year Total yearly client numbers for private sector audit firms range from to 15, and this is highly fragmented if tabulated by client type or other demographics Our final sample has 657 cases from a population of 1654 firm-years; while we have no basis for assuming any sample bias in this regard, we cannot be sufficiently confident that the sample profile indicates the market shares of individual audit firms each year We are not able to identify any patterns in sample distributions by audit firm that allows us to identify clear market leaders Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 13 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx Table Descriptive statistics Pooled sample (n = 657) Significant government influence (n = 312) Mean/ Proportion Auditor switch (0,1) Government influence (0,1) Misaligned (0,1) DManagement (0,1) QualDisagree (0,1) NegativeDA (0,1) Government ownership QualOther (0,1) PositiveDA (0,1) Size SalesGrowth (0,1) Loss (0,1) Leverage ROA Competition years (0,1) No significant government influence (n = 345) Mean/ Proportion Mean/ Proportion Std deviation 0.09 0.47 0.40 0.11 0.79 0.25 0.28 0.09 0.25 11.37 0.29 0.16 0.11 0.11 0.40 Std deviation 0.12 – 0.30 1.20 0.13 0.17 0.06 – 0.48 0.10 0.82 0.26 0.04 0.10 0.23 11.23 0.29 0.15 0.12 0.10 0.45 0.32 0.12 0.77 0.24 0.54 0.09 0.27 11.50 0.29 0.17 0.11 0.11 0.35 Std deviation 0.06 1.08 0.16 0.23 1.30 0.13 0.18 Auditor switch = if a corporation had a change of auditor in the current year, otherwise Government influence = if the government owns 20% or more of the issued shares and otherwise Misaligned = if a corporation is private sector controlled and had a government auditor in the previous year, otherwise DManagement = if there was a change in both the Chair of the Board and the Chief Executive Officer in the previous year, otherwise QualDisagree = if the audit opinion for the previous year was qualified because of a violation of GAAP or a client-imposed scope limitation, otherwise NegativeDA = if discretionary accruals for the previous year, estimated using the Dechow and Dichev (2002) approach, was in the bottom quartile (income decreasing), and otherwise Government ownership is the percentage of issued shares held by government agencies QualOther = if the audit opinion for the previous year was qualified for reasons other than violations of GAAP or client-imposed scope limitations, otherwise PositiveDA = if income increasing discretionary accruals for the previous year, estimated using the Dechow and Dichev (2002) approach, was in the top quartile, and otherwise Size = natural logarithm of total revenue for the previous year SalesGrowth = if sales growth in the previous year P 30% Leverage = long-term debt divided by total assets at the end of the previous year Loss = if a loss was reported in the previous year and otherwise Leverage = long-term debt divided by total assets at the end of the previous year ROA = previous year net profit divided by total assets Competition years = if year is 2002 or 2003, otherwise Among our switching incentive measures, there are significant differences between the split samples for Misaligned (p < 0.001) and QualDisagree (p = 0.089) Unusually, most companies received a qualified audit opinion, and most of these are QualDisagree; these mostly arise because the auditor disagreed with management’s interpretations of tax laws and so was not satisfied with the adequacy of management’s provision for tax payable The remaining switching incentive indicators (SalesGrowth, DManagement, NegativeDA) have reasonably consistent proportions across the sub-samples Pearson and Spearman correlation coefficients were estimated between all test and control variables The only notable correlations involving test variables are between the mutually exclusive QualDisagree and QualOther (correlation is À0.63, p < 0.001) and Government ownership and Misaligned (correlation is À0.37, p < 0.001); therefore, we not report the matrices here Results As discussed below, all three hypotheses are supported by the results for the pooled sample reported in Panel A of Table 3.15 Our main variable of interest, Government influence, is negative and significant, indicating that the existence of significant government influence reduces the likelihood of an auditor switch, supporting H1 15 All regressions control for year and industry fixed effects and p-values are determined using robust standard errors clustered on firm Please cite this article in press as: Bagherpour, M.A., et al Government and managerial influence on auditor switching under partial privatization J Account Public Policy (2014), http://dx.doi.org/10.1016/ j.jaccpubpol.2014.04.004 14 M.A Bagherpour et al / J Account Public Policy xxx (2014) xxx–xxx Table Logistic regressions of auditor switches Variable Predicted sign Panel A Panel B (split sample) Pooled sample No significant government influence Significant government influence Coefficient p-Value onetail (two-tail) Coefficient Coefficient À1.098 0.047 – 1.135 0.610 1.637 0.553 0.003 0.057 0.003 0.059 1.180 0.912 1.641 0.862 0.008 0.029 0.035 0.024 0.530 0.479 2.321 À0.096 0.291 0.299 0.013 0.437 ? 1.436 (0.277) 1.436 (0.647) À0.102 (0.961) ? À À + ? ? ? + 0.688 À0.220 À0.250 0.285 0.718 0.247 2.527 1.841 (0.412) 0.287 0.009 0.200 (0.135) (0.816) (0.118) 0.002 1.150 0.324 À0.304 0.552 0.418 0.029 1.114 1.609 (0.316) 0.234 0.054 0.068 (0.509) (0.983) (0.535) (0.055) À1.372 À1.125 À0.280 À0.405 1.788 À0.139 8.256 3.062 (0.673) 0.047 0.061 0.269 (0.113) (0.941) (0.095) (0.011) À3.112 657 94.63 0.21 À162.80 (0.012) À3.058 345 88.7 0.19 À105.05 (0.122) À4.878 312 70.55 0.38 À44.61 (0.099) Government interests Government À influence Switching incentives Misaligned + DManagement + QualDisagree + NegativeDA + Controls: Government ownership QualOther PositiveDA Size SalesGrowth Loss Leverage ROA Competition years Constant n Wald chi2 Pseudo R2 Log pseudo likelihood (