chow and rice - 1982 - qualified audit opinions and auditor switching

Qualified Audit Opinions and Auditor Switching Author(s): Chee W. Chow and Steven J. Rice Source: The Accounting Review, Vol. 57, No. 2 (Apr., 1982), pp. 326-335 Published by: American Accounting Association Stable URL: http://www.jstor.org/stable/247018 . Accessed: 28/04/2014 23:50 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. . American Accounting Association is collaborating with JSTOR to digitize, preserve and extend access to The Accounting Review. http://www.jstor.org This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions THE ACCOUNTING REVIEW Vol. LVII, No. 2 April 1982 NOTES Qualified Audit Opinions and Auditor Switching Chee W. Chow and Steven J. Rice ABSTRACT: This study focuses on the influence of qualified opinions on auditor switches. Results from a random sample of SEC-registrants support the contention that firms switch auditors more frequently after receiving qualified opinions. However, it was not found that firms that have received qualified opinions switch systematically to audit firms with a history of rendering proportionally fewer qualified opinions. Also, limited results suggest that qualified firms which switch auditors do not tend subsequently to receive more clean opinions. I. INTRODUCTION LARGE-SCALE auditing scandals like Continental Vending, Equity Fund- ing, and National Student Market- ing have focused the public's attention on auditor "independence." Critics frequently charge that the asymmetry of power between auditors and managers may seriously weaken the auditor's ability to exercise freely his professional judgment. A statement by Sterling [1973, p. 66] is representative: The major problem facing public accounting today is its lack of power. First, in com- paring the power or authority to the responsibility, we find that the responsibility far outweighs the authority. The public accountant must act judicially but he has not been given the power to enforce his rulings. The authority is lessened further by the existence of competition among accounting firms. Resignation from an engagement might be an effective means of enforcement if it were not for the fact that other firms may take the engagement and issue an opinion. When one considers the fact that accountants must judge management, . . . [the imbalance between management's power and the accountant's power] is not only un- desirable, it is intolerable. The auditor-client relationship has also been a concern of accounting policy makers. The AICPA has promulgated voluminous guidelines for auditing and reporting procedures and commissioned a study of auditor responsibility. The SEC has been increasing its disclosure requirements for auditor-client relationships.' Even the U.S. Congress has voiced its concern for auditor "independence" 1 Examples include ASR 165 [SEC, 19741 and ASR 194 [SEC, 1976]. The authors gratefully acknowledge the assistance of Professors John Chiu, Jim Jiambalvo, Robert Bowen, and Jamie Pratt. Chee W. Chow is Lecturer in Account- ing and Steven J. Rice is Assistant Profes- sor of Accounting, both at the University of Washington. Manuscript received November 1980. Revision received April 1981. Accepted May 1981. 326 This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions Chow and Rice 327 in the Moss Committee Report [U.S. House of Representatives, 1976] and the Metcalf Committee Staff Report [U.S. Senate, 1976]. Policy makers attach importance to the ability of managers to "shop" for auditors. The concern is that managers can pressure auditors into giving clean opinions by threatening to switch to a new auditor. It is argued that managers wish to avoid qualified opinions because they may affect (a) the market price of the firm's common stock and (b) the manager's compensation. Moreover, the manager often holds some of the firm's shares in his personal portfolio either through open market purchases or through stock options granted as part of his compensation. Compensation may be tied to the reported earnings and the reliability of those reports comes into question when there is a qualification. If (a) qualified opinions are seen (by managers) to reduce security prices and/or manager compensation and (b) managers control the auditor selection decision, then we should be able to observe that qualified opinions are followed by auditor switches. The purpose of this paper is to present empirical evidence relating to the following four questions concerning auditor switching: 1. Do firms switch auditors more often after receiving qualified opinions than after receiving clean opinions? 2. Do auditors differ in their propen- sity to issue qualified opinions? 3. If auditors do differ in their pro- pensity to issue qualified opinions, do firms after receiving qualified opinions switch to auditors issuing proportionally fewer qualified opinions? 4. When firms switch auditors after receiving a qualified opinion, are they more likely to receive clean opinions the following year? Positive answers to these questions would imply that firm managements may use auditor switches to pressure auditors into issuing clean opinions. Such evidence could prompt the SEC and/or the FASB to further consider their policies regarding firms changing auditors. We present our analysis as follows: Section II reviews some prior research regarding auditor switching. Section III describes our data collection procedures and the tests per- formed. We draw some conclusions in Section IV and discuss the implications of our results for future research and public policy. II. SOME PREVIOUS PUBLISHED STUDIES ON AUDITOR SWITCHING A number of authors have discussed the role of accounting disputes in firms' choice of auditors.2 However, only one study has provided systematic evidence on this issue. Burton and Roberts [1967] examined 83 auditor switches made by Fortune 500 firms between 1952 and 1965. Using questionnaires as their primary tool, the authors determined that accounting standards disputes were the major causes for only six switches. The other switches were related to changes in management, the demand for additional services or needs arising out of new financing. This led Burton and Roberts to conclude that competition among auditors was not a cause of loose application of accounting standards. This conclusion is suspect because if firms switch auditors so as to gain more control over the con- tents of issued financial statements, it is not in the firms' own interest to reveal this action to outsiders. Further, if auditors were already forced by competition to apply loose accounting standards, firms would have no need to 2 Goldman and Barlev [1974], Nichols and Price [1976], Burton and Roberts [1967], and Fried and Schiff [1981 ]. This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions 328 The Accounting Review, April 1982 switch auditors due to accounting disputes. Even though the Burton and Roberts study fails to resolve whether accounting standards play a major role in auditor switching, it does identify other variables, such as management changes and new financing, which affect firms' choice of auditors. These findings are supported by Carpenter and Strawser [1971] and a study by an ad hoc committee of the AICPA [1971]. III. DATA COLLECTION AND TESTS A. The Association Between Qualified Au- dit Opinions and Auditor Switches One way of testing whether firms switch auditors after receiving qualified opinions would be to classify all of the firms reporting to the public over a given time period into four categories: 1. Received a qualified opinion and switched auditors subsequently,3 2. Received a qualified opinion and kept the same auditor, 3. Received a clean opinion and switched auditors subsequently, and 4. Received a clean opinion and kept the same auditor. Then a four-cell contingency table could be set up and tested using the Chi-square test for independence of classification. A significant value for Chi-square would mean that switching was not independent of receiving a qualified opinion. Our data were collected from the 1973 and 1974 volumes of the Leasco Disclo- sure Journal.4 All companies that had a qualified opinion (excluding consistency exceptions) in 1973 and all companies that changed auditors between the 1973 and 1974 fiscal year-ends were selected. This procedure yielded a count for the first three of the categories listed above. The count for the fourth category (clean opinion and did not switch) was arrived at indirectly by counting the total number TABLE 1 THE ASSOCIATION BETWEEN QUALIFIED AUDIT OPINIONS AND AUDITOR SWITCHING Qualified Unqualified Row totals (1) (3) Switched 141 277 418 (2) (4) Non switched 991 8,051 9,042 Column totals 1,132 8,328 9,460 Actual x2 (1 d.f.)= 196.81 Significant x2 (1 d.f.)=6.635 for o=0.0. of firms reporting and subtracting the total of the first three categories. Table 1 shows the contingency table with the count for each cell and the results of the Chi-square test for independence of While this overall test provides inter- esting information, it ignores the effect of classification. The test clearly supports the notion that changing auditors is not independent of receiving a qualified audit opinion.' other variables that might influence a firm to change auditors. In order to address this issue, we collected data for various subsets of the firms in Table 1. For each firm in a subset, we collected additional data from the Disclosure Jour- nal on several variables which had been identified in previous studies as related to changing auditors.6 The following variables were recorded simply as being 3 We assume that, in the absence of other causes, an auditor switch due to a qualified opinion will be made during the next fiscal year. If this is not true, the omission of subsequent switches will bias results against finding a significant relationship. 4 The Disclosure Journal includes all firms that file with the SEC. To allow for the possibility that some firms may switch auditors in anticipation of a qualified opinion, we reconstructed Table 1 by including in Cell 1 57 additional firms which switched auditors before their 1973 fiscal year-end rather than after. The results were not significantly altered. 6 Burton and Roberts [1967 ], Carpenter and Strawser [1971], and AICPA [1971]. This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions Chow and Rice 329 present or not present for each firm in fiscal 1974: a management change, some merger activity, new financing, an accounting dispute with the auditor, and any other item identified by management as the reason for changing auditors. Data on the name of the auditor, the name of the new auditor (if switched), the type of opinion, the industry (three- digit SIC code), and revenues earned in 1973 were also recorded. The approach to forming the subsets and testing them was to randomly select 141 firms from cell 4 in Table 1 (about 1.75 percent of the total cell 4 firms), and to randomly select the same percentage of firms from each of the other three cells.7 This sample size was considered to be small enough to enable us to gather the additional information needed in a reasonable amount of time. The same percentage in each cell was used in order to preserve the proportions that existed in the Leasco population. The relation of these variables to auditor switching was tested in an equation of the form :8 S = a + bjQ + b2Mg + b3Mr + b4N + b5X (1) where: S=switched auditors (1) or did not switch (0) Q = received a qualified opinion (1) or unqualified (0) Mg = management change took place (1) or did not take place (0) Mr = merger activity present (1) or not present (0) N=new financing arranged (1) or not mentioned (0) X= some reason (other than those above) was given for switching (1) or no other reason listed (0). It may appear that ordinary least squares (OLS) would be a reasonable tool to evaluate Equation (1). However, such is not the case. Theil [1972, sec. 12.5] points out that there are three major problems with OLS when the dependent variable is dichotomous. First, the esti- mating equation is unbounded and there is no guarantee that the predicted value of the dependent variable (a probability) will be in the (0, 1) interval. Second, the residuals will be heteroscedastic and OLS would yield inefficient estimators. Finally, because the dependent variable is dichotomous, the residuals cannot be assumed normal. This means that the typical F and t tests of significance cannot be used. We also rejected multivariate discriminant analysis (MDA) because of its dis- tributional requirements. Eisenbeis [1977] and Ohlson [1980] point out that MDA requires the variance-covariance matrices of the independent variables to be the same for both groups (switched and non-switched). We found that this does not hold for our sample. Also, MDA assumes normally distributed independent variables, which does not hold for our case. Theil [1971] and McFadden [1973] point out that conditional logit analysis essentially avoids all of the problems discussed above. This is a maximum- likelihood estimation procedure which applies a transformation to the dependent variable. McFadden [1973, p. 119] indicates that this method yields estimators that are asymptotically efficient and normally distributed. He also presents simulation results which suggest that the approximation is reasonably good even in quite small samples. This means that one can construct approximate large- sample confidence bounds and tests of 7 The 141 firms represented an arbitrary number cor- responding to the number of firms in cell 1. 8 We did not include "accounting dispute" as an independent variable. The SEC 8-K requirement of accounting-dispute disclosure applies only to firms that switched auditors. Our data source did not reveal whether some firms that did not switch auditors also had had accounting disputes. This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions 330 The Accounting Review, April 1982 TABLE 2 VARIABLES RELATED TO AUDITOR SWITCHING Asymptotic Variable Coefficient t-score* Qualified 1.5859 2.6589* Management Change -25.9250 -0.0006 Merger - 0.5236 -0.4872 New Financing 0.5078 0.6884 Other -26.7340 -0.0004 Intercept - 3.1911 -8.2712 Estimated R2 = .1042 X2 (5 d.f.) =9.242 t-score of 1.96 =significance level of .05 and t-score of 2.33 =significance level of .0 1. hypotheses for parameters. Because of this, we chose a conditional logit analysis for Equation (1).9 The results appear in Table 2. McKelvey and Zavoina [1975] show that the significance of the logit model can be tested by taking -2 times the log- likelihood ratio. The resulting statistic is distributed as a Chi-square with degrees of freedom equal to the number of independent variables. This statistic is 9.242 for our model and is significant at the .1 level. The t-scores in Table 2 show clearly that qualification is the only significant variable in explaining switching. How- ever, given the independent variables used, the coefficients may have been biased by multicollinearity. We did not conduct a formal test for this. Table 3 presents the correlations among the independent variables. Even though a few are statistically significant, none of the values seems high enough to cause concern)'0 B. Difference Among Auditors' Percent- ages of Qualified Opinions An incentive for switching auditors after receiving a qualified opinion can be TABLE 3 CORRELATIONS AMONG THE INDEPENDENT VARIABLES (Numbers in Parenthesis are significance levels.) Q Mg Mr N X Q 1.0 Mg .177 1.0 (.023) Mr 066 .030 1.0 (.373) (.602) N .190 .047 091 1.0 (.016) (.522) (.204) X .260 .246 043 .0 85 1.0 (.001) (.001) (.611) (.250) inferred if there is a different "tendency to qualify" across auditors. A proxy for this tendency may be the observed percentage of qualified opinions given by an auditor. However, a raw calculation of this percentage is not sufficient. There is much evidence that auditors specialize I Theil [19711 also suggests probit analysis as an ap- propriate tool. We conducted the same analysis with probit and obtained almost indistinguishable results from the logit analysis. 10 Farrar and Glauber [1967] provides a detailed explanation of tests for multicollinearity. Kmenta [1971] points out that some degree of multicollinearity almost always exists, but the point at which it becomes "harmful" has never been satisfactorily determined. According to one criterion, if the overall equation is significant, but none of the t statistics for the regression coefficients (other than the regression constant) is significant, then multicollinearity is regarded as harmful. According to this criterion, we do not have "harmful" multicollinearity. Further, several statisticians who examined our data unanimously declared that the numbers were so low that multicollinearity was not likely to be a problem. We tried to assess the potential significance of the multicollinearity problem by generating estimate Equation 1 three more times. Merger had a significant coefficient in one of the new regressions. Otherwise the results were unchanged. This suggests that multicollinearity is not a significant problem in our study. This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions Chow and Rice 331 by client size and industry. " If operating conditions, legal constraints, and firm characteristics were to differ across indus- tries, this could cause observed differences in the percentages of qualified opinions across auditors which really reflect industry differences. Indeed, War- ren [1975, 1980] reports a significant relationship between industry class, firm size, and the receipt of a qualified opinion. Warren [1980] also finds auditor identity to be significantly related to qualified opinions. However, he does not investigate which auditors are more likely to issue such opinions. More im- portant, Warren uses the parametric analysis of variance (ANOVA) to analyze his data. Unfortunately, the dependent variable in his studies is a dichotomous variable, which seriously violates the basic ANOVA assumption of normally distributed dependent variables, and casts doubt on his results.'2 Shank and Murdock [1978] also investigate the differences among auditors' percentages of qualified opinions. Unlike Warren, they do not find auditors to be significantly different after accounting for systematic risk. Also, they do not find either size or industry to have significant explanatory power for the incidence of qualified opinions. Shank and Murdock apparently also use ANOVA on a dichotomous dependent variable. If so, their results suffer from the same problems as Warren [1975, 1980]. In any case, the divergent results obtained by these researchers suggest the need for further investigation. To take into account the dichotomous nature of the dependent variable, the approach used for testing Question II was again a logit analysis, with qualification as the dependent variable and size, industry, and auditor as the independent variables in a linear equation. Size was measured by revenues earned in 1973. The industry was classified as one of seven, depending on the three-digit SIC code as follows :13 0-149 Mining 200-399 Manufacturing 400-499 Transportation and public utilities 500-519 Wholesale trade 520-599 Retail trade 600-699 Finance, insurance, real estate 700-899 Services The auditor was classified as one of nine: the Big Eight firms and all others. In order to have enough data points, 141 firms were randomly selected from cells 2, 3, and 4 to match the number of firms which comprise the whole population of cell 1 in Table 1. Thus, the analysis was run on 564 firms with 15 independent variables: size, six industry class dummy variables, and eight auditor dummy variables. The effect of the service industry and "other" auditors are included in the intercept. The results are reported in Table 4. The Chi-square for this model is significant at the .001 level. Of the independent variables, size is significantly and negatively related to qualifications. Also, significant industry effects exist for transportation/public utilities, retail, and perhaps also mining. Having taken into I IZeff and Fossum [1967] and Rhode, Whitsell, and Kelsey [1974] report such evidence. Another factor which may limit the usefulness of the "observed percentage qualified" proxy is potential auditor specializa- tion by auditor quality and self-selection by audit clients. Chow and Rice [1981 ] provide a discussion of this issue. 12 A detailed discussion of ANOVA and its assump- tions is available in Neter and Wasserman [1974]. 13 With the exception of the mining industry, these industry definitions are identical to Warren's [1975, 1980]. Our definition of the mining industry is more en- compassing than Warren's. However, only one firm's industry class was affected by this difference in definition. This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions 332 The Accounting Review, April 1982 TABLE 4 VARIABLES RELATED TO RECEIPT OF A QUALIFIED OPINION Asymptotic Variable Coefficient t-score* Size - .0032 - 3.0679* Mining .8792 1.8596 Manufacturing .2197 .7941 Transportation/public utilities -1.0571 -2.8288* Wholesale trade .6020 1.2078 Retail trade - .9179 -2.2356* Finance, insurance, real estate - .0886 - .3060 Arthur Andersen & Co. .0679 .2181 Arthur Young & Company 1.1487 2.5913* Coopers & Lybrand .7796 1.9567* Deloitte Haskins & Sells .1759 .4397 Ernst & Whinney .7068 1.8960 Peat, Marwick, Mitchell & Co. .4990 1.8299 Price Waterhouse & Co. .0357 .0899 Touche Ross & Co. 1.0897 2.4863* Intercept - .0908 - .3702 Estimated R2 =.1745 X2 (15 d.f.)=79.1398 * t-score of 1.96= significance level of .05 and t-score of 2.33 =significance level of .01. account size and industry, three auditors still have significantly positive coefficients: Arthur Young & Company, Coopers & Lybrand, and Touche Ross & Co. These auditors can be interpreted as having a higher tendency to qualify, ceteris paribus. Again, multicollinearity does not appear to be of major concern. Of the 105 pairwise correlations among the independent variables, one was slightly above .3 (significant beyond .00 1) and two were between .2 (significant beyond .001) and .3. The rest were all much smaller (and usually insignificant). Thus, Question II has been answered affirmatively; there may be some incentive to switch auditors in seeking clean opinions. C. The Direction of Auditor Switches by Qualified Firms Can it be shown that firms, after receiving qualified opinions, tend to switch more away from Arthur Young & Com- pany, Coopers & Lybrand, and Touche Ross & Co.? To test this question, a Chi- square analysis was run on the 141 firms which received qualified opinions and then switched- auditors. The three significant auditors in Table 4 were classed as High Tendency (HT) and the others were classed as Lower Tendency (LT). Table 5 shows the results. The numbers in paren- theses below the actual frequencies repre- sent the expected frequencies of those cells if there were no relationship between old and new auditor in terms of tendency to qualify. If the answer to Question III is positive, we would expect more than 120 firms to have switched from HT to LT (cell 2) and less than five to have switched from HT to HT (cell 4). Clearly, there is no significant relationship here, and the Chi-square value of .2561 (significance=.6128) bears this out.'4 D. Auditor Switches and Subsequent Audit Opinions The last question was whether a switch in auditors actually results in receiving a clean opinion. To answer this question properly, it would be necessary to hold other factors, such as the firm's financial condition, constant. We used the qualified-and-no-switch group as a control. As we discuss later, this may not provide 14 We repeated this analysis by including in the HT group auditors from Table 4 whose t-scores were close to significance, i.e., Ernst & Whinney and Peat, Marwick, Mitchell & Co. The results were quite similar. We also repeated this analysis by re-grouping the data into HT and LT groups based on "folklore" rather than on empirical data. "Folklore" might indicate that in the minds of management a certain group of auditors, say, non-Big Eight auditors, had a lower tendency to qualify. We investigated this using a Big Eight versus non-Big Eight dichotomy and again found no significant relationship. This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions Chow and Rice 333 TABLE 5 DIRECTION OF AUDITOR SWITCHING BY QUALIFIED FIRMS New Auditor LT HT Row totals (1) (3) LT 96 20 116 (95) (21) Old Auditor (2) (4) HT 19 6 25 (20) (5) Column totals 115 26 141 X2 (1 d.f.)= 2561 adequate control for other variables. Thus, our results can only be viewed as a preliminary look at this question. Recall that in testing Question II we drew a sample of 141 firms for each cell and looked up the auditor, size, industry, etc. for fiscal 1973. Now, for each firm in the qualified-and-switched and the qualified-and-no-switch cells, we collected data on the audit opinion for fiscal 1974. Using both the Disclosure Journal and microfiche copies of 10-K reports, we located the 1974 audit opinion for all 141 firms in the qualified-and-no-switch group and for 132 firms in the qualified- and-switched group. A Chi-square test was applied to these firms to determine if a relationship exists between auditor switching and the subsequent audit opinion. Table 6 reports these results. If switching helps reduce the incidence of qualifications, we would expect fewer than 98 firms in cell 1 and more than 34 firms in cell 3. Just the opposite is the case. Although the Chi-square value of 1.92 was not significant at the .1 level, the data suggest that those firms that did not switch tended to get more clean opinions TABLE 6 AUDITOR SWITCHES AND SUBSEQUENT AUDIT OPINIONS Type of Opinion in Year Following Qualification Not Qualified Qualified Row totals (1) (3) Switched 103 29 132 (98) (34) (2) (4) No switch 100 41 141 (105) (36) Column totals 203 70 273 Actual X2 (1 d.f.) = 1.924. Significant x2 (1 d.f.) = 2.71 for a = .10. in the following year than those firms that switched. 1 One possible reason for this tendency is the failure to control for the effects of extraneous variables like financial condition. But perhaps a more basic issue is involved: if a firm knew that the reason for the qualified opinion would not exist the following year, it would not have an incentive to switch auditors for this reason. Thus, the qualified-and-no-switch group might be expected to have a higher percentage of clean opinions in the following year. Another possible explanation relates to the type of qualification. If managers view certain types of qualified opinions as "benign," again there would be no incentive to switch auditors. We did not pursue this potential explanation with 15 We could not find 1974 audit opinions for nine of the firms in the qualified-and-switched group. In order to evaluate the potential impact of these nine firms on the Chi-square test, we did the test assuming that all nine firms received qualified opinions in 1974. The Chi- square value was 2.74 which was significant at the .10 level. We did the test again assuming that all nine firms received clean opinions in 1974. There was no significant relationship. This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions 334 The Accounting Review, April 1982 our data. Our preliminary results suggest, however, that further research is warranted. IV. CONCLUSIONS AND IMPLICATIONS Our results support the contention that firms tend to switch auditors after receiving a qualified opinion. The incentive for such switching may exist due to observed differences among auditors' percentages of qualified opinions issued. However, our analysis of switching firms does not indicate that qualified firms tend to switch to lower percentage-qualified auditors. We also find that firms that switched auditors after a qualified opinion, compared to the qualified firms that did not switch, are not more likely to receive a clean opinion the following year. The evidence tends to support the opposite. While our results are preliminary and based on a limited time span, they suggest that further work in this area may be fruitful. Even if our major results are replicated in more extensive studies, it does not necessarily imply that there is cause for concern over auditor lack of independence. Recently, Jensen and Meckling [1976], Watts [1977], Smith and Warner [1979], and others have explored the role of external auditing in business firms. They postulate that the manager can benefit from letting shareholders and bondholders monitor his allocation of the firm's resources. The choice of an external auditor is part of this monitoring contract, and it is in the manager's self- interest to select an auditor who has es- tablished a reputation for integrity. The implication of this analysis is that when a firm manager chooses (or switches) an auditor, he is guided by the expected reactions from shareholders and bondholders. Thus, auditor switching per se, regardless of whether it is associated with a qualified opinion, may not be contrary to investors' interests. We believe that future research should explore the roles played by management and external investors in the auditor selection decision. When such evidence is combined with findings on the extent of auditor switching, we will have a better basis to determine the need for regulatory intervention in this area of accounting. REFERENCES AICPA, Report of the Ad Hoc Committee on Auditor Displacement, summarized in C. Carpenter and R. Strawser, "Displacement of Auditors When Clients Go Public," Journal of Accountancy (June 1971), pp. 55-58. Burton, J. C., and W. Roberts, "A Study of Auditor Changes," Journal of Accountancy (April 1967), pp. 31-36. Carpenter, C. G., and R. H. Strawser, "Displacement of Auditors When Clients Go Public," Journal of Accountancy (June 1971), pp. 55-58. Chow, C., and S. Rice, "Qualified Audit Opinions and the Measurement of Auditing Standard Uni- formity," Unpublished manuscript, University of Washington (May 1981). Eisenbeis, R. A., "Pitfalls in the Application of Discriminant Analysis in Business, Finance, and Eco- nomics," Journal of Finance (June 1977), pp. 875-900. Farrar, D., and R. Glauber, "Multicollinearity in Regression Analysis: The Problem Revisited," Review of Economics and Statistics (February 1967), pp. 92-107. Fried, D., and A. Schiff, "CPA Switches and Associated Market Reactions," THE ACCOUNTING REVIEW (April 1981), pp. 326-341. Goldman, A., and B. Barlev, "The Auditor-Firm Conflict of Interests: Its Implications for Independence," THE ACCOUNTING REVIEW (October 1974), pp. 707-718. Jensen, M., and W. H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs and Owner- ship Structure," Journal of Financial Economics (October 1976), pp. 305-360. This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions [...]... 10 3-1 20 Neter, J., and W Wasserman, Applied Linear Statistical Models (Irwin, 1974) Nichols, D., and K Price, "The Auditor- Firm Conflict: An Analysis Using Concepts of Exchange Theory," THE ACCOUNTING REVIEW (April 1976), pp 33 5-3 46 Ohlson, J., "Financial Ratios and the Probabilistic Prediction of Bankruptcy," Journal of Accounting Research (Spring 1980), pp 10 9-1 31 Rhode, J., G Whitsell, and R Kelsey,... 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Journal of Management (April 1977), pp 5 3-7 5 Zeff, S., and R Fossum, "An Analysis of Large Audit Clients," THE ACCOUNTING REVIEW (April 1967), pp 29 8-3 20 This content downloaded from 128.252.88.241 on Mon, 28 Apr 2014 23:50:42 PM All use subject to JSTOR Terms and Conditions . April 1982 NOTES Qualified Audit Opinions and Auditor Switching Chee W. Chow and Steven J. Rice ABSTRACT: This study focuses on the influence of qualified opinions on auditor. the "observed percentage qualified& quot; proxy is potential auditor specializa- tion by auditor quality and self-selection by audit clients. Chow and Rice [1981 ] provide. for each cell and looked up the auditor, size, industry, etc. for fiscal 1973. Now, for each firm in the qualified -and- switched and the qualified -and- no-switch cells, we

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