African Journal of Business Management Vol. 5 (19), pp. 7864-7875,9 September, 2011 Available online at http://www.academicjournals.org/AJBM DOI: 10.5897/AJBM10.1439 ISSN 1993-8233 ©2011 Academic Journals

Full Length Research Paper

Auditor switch, analysts forecasts and executives stock options

Chin-Fang Chao1*, Yi-Mien Lin2, Chu-Shiu Li3 and Sheng-Jung Fang4

1Ling Tung University, Feng Chia University, Taiwan

2Department of Accounting, National Chung Hsing University, Taiwan.

3Department of Economics, Feng Chia University, Taiwan.

4Jih Sun Securities Co., LTD, Taiwan.

Accepted 3 February, 2011

This paper shows that companies tend to switch auditors when audit opinions are inconsistent with those in the previous period, financial performances are worse, and both stock and option values fall. We find no evidence that, during the switching year, option values and firm performance affect the exercise of executives’ stock options, possibly because the exercise of stock options often occurs before switching auditors in order to prevent the SEC from investigating insider trading in the switching year. The changes in holdings of executives’ stock options are positively correlated with the degree to which analysts’ earnings forecasts deviate from previous periods; the announcements of analysts’ earnings forecast errors have no influence on the value of executives’ options, since that signaling effect has already reflected on the stock price. Furthermore, accruals are unrelated to the changes in holdings of executive stock options, possibly because investors often have negative beliefs about auditor switches, so executives do not tend to take advantage of this opportunity to manipulate earnings. Key word: Auditor switch, analyst forecast, executive stock option, earnings management.

INTRODUCTION Under the separation of the rights of management from that of ownership, the manager often pursues maximize-tion of his or her own interest at the expense of share-holders’ wealth as a result of asymmetric information. Managers may exploit shareholders’ assets for their own benefit, causing a reduction in the firm’s value. Compen-sation and performance evaluation systems are adopted to solve such agency problems and to increase incen-tives and supervisory mechanisms to protect shareholder value. Meanwhile, outsiders and the board of directors use the financial reports to evaluate the managers’ performance and decide on salaries and rewards, so managers may take advantage of private information and the discretionary right given by the Generally Accepted Accounting Principles (GAAP) to manipulate earnings

*Corresponding author. E-mail:fang3642@gmail.com. Tel: 886-422580068.

for the maximization of their wealth. This situation may be even worse when compensation

is based on accounting performance indices. Managers are likely to inflate the earnings of their companies through discretionary accruals in order to increase their bonuses. Cornett et al. (2008) suggest that earnings management through the use of discretionary accruals responds dramatically to management incentives.

Besides, the volatility of stock price of one company is closely related to the value of executives’ granted options. When a company’s stock price increases, the payoff of executives’ option may be times the size of stock return. As a result, managers have a tendency to engage in earnings manipulation to increase stock price volatility and, in turn, options value. Bergstresser and Philippon (2006) provides evidence that the use of discretionary accruals to manipulate reported earnings is more pronounced at firms where the CEO’s potential total compensation is more closely tied to the value of stock and option holdings. Kuang (2008) also proves that

managers are more likely to engage in earnings manage-ment when they hold a larger proportion of their compensation in performance-vested stock options.

Generally, switching an auditor is a double-edged sword. There would be several kinds of potential costs that the client companies undertake, including switching cost, agency cost and implicit insurance cost. Hackenbrack and Hogan (2002) classify the reasons of auditor switches into four categories: 1. Service-related reasons. 2. Disagreement-related reasons. 3. Audit fee-related reasons. 4. Uninformative reasons. And, they suggest that market response to earnings surprise is lower subsequent to an auditor change for companies that switched for disagreement-related or fee-related reasons and higher for those that switched for service-related reasons. Therefore, while the auditor will not provide an unqualified opinion for financial statement of the company, the managers maybe switch the auditor for fear of the company’s stock price collapsing and causing financial distress. Accordingly, management may choose acquiescent auditors to complete audit work, especially if the company is experiencing financial difficulties. Schwartz and Menon (1985) strongly support that failing (bankrupt) firms have a greater tendency to switch auditors than do healthier firms. Even Sikka (2009) also posits that auditing firms’ fee dependency lets companies has the capacity to silence auditors.

On the other hand, the stock price may drop not only when companies switch their auditor, but also when actual earnings fail to meet market expectations. The latter scenario will impair investors’ confidence and in-crease financing costs, and the executives of companies that fail to communicate bad news to investors in time will have high litigation risk. Thus, earnings management may be undertaken to avoid the negative effects caused by a decrease in abnormal earnings. Robb (1998) find that managers would have incentive to make use of discretio-nary accruals to manipulate earnings to meet earnings forecasts when the analysts are in consensus in their earnings predictions. Cormier and Martinez (2006) also document that earnings -forecast deviation influences a firm's accruals behavior.

Following the aforementioned discussions, we would like to examine whether share prices and option values drop when financial performance deteriorates, whether a company switches its auditor when the audited opinion is inconsistent with that of the previous period, and whether executives exercise their options early to prevent losses of personal wealth in the event of an auditor switch. We also investigate whether managers exercise stock op-tions early when actual earnings fail to meet the analysts’ forecasts and whether the value of stock options falls after switching an auditor. We attempt to establish

Chao et al. 7865 whether, when audit switches are based on weaker operating performance and inconsistent audit opinions from period to period, executives exploit earnings management to increase their holdings of stock options and the value of stock options.

Prior literature includes many studies of the relationship between executive stock options and earnings manage-ment and between options and stock prices. However, there are quite few studies concerning the relationship between auditor switching and the value and holdings of executives’ stock options. Therefore, the contribution of our study is to provide insight to the effect of auditor rotations. LITERATURE REVIEW AND HYPOTHESES Prior literature provides evidence on timing of executive stock option grants (Aboody and Kasznik, 2000), Yermack, 1997) and repricings (Callaghan et al., 2004). Many researchers indicated the run-up in stock price immediately following these events as evidence of opportunistic managerial behavior rather than positive incentive effects. Ittner et al. (2003) also argue that when return on assets and share price performance becomes worse, the numbers of stock options executives hold are less than expected. Therefore, managers are likely to look for other self-interest ways if their companies experienced bad performance and managerial pay-for- performance, in turn, is impaired. There may produce internal control problems. Once auditors are unable to acquiesce to a firm’s aggressive accounting policies or in-ternal control weakness, they will voluntarily or passively resign from engaged auditors. For example, Beneish et al. (2005) indicate that auditor switches attributed to a disagreement over accounting treatment or over the adequacy of internal controls are associated with negative abnormal returns.

Ashbaugh-Skaife et al. (2007) also mention that an auditor switch may indicate unacceptable audit engage-ment risk due to weak operating performance and financial distress that reflects inadequate investment in internal control. Even without receiving unqualified audit opinions, firms may dismiss auditors by reason of lacking performance, especially when the firms discover material internal control weaknesses (Zhang et al., 2007). As a result, this study predicts that a company is unlikely to switch auditors if business performance is better and that when performance is worse, managers are likely to switch to auditors who acquiesce with the client’s accounting reporting. Accordingly, we set up the following hypotheses. H1: After falling option value and inconsistent audit opinions, a company is apt to switch auditors. Insiders often have the advantage of private information

7866 Afr. J. Bus. Manage. regarding a company’s future prospects, enabling them to estimate financial performance and economic trends more accurately than outsiders and time the purchase or sale of their shares to their benefit. When financial performance does not meet expectations, insiders would be inclined to sell their shareholdings before the infor-mation is made public to avoid loss and gain higher returns. Aboody and Kasznik (2000) indicate that such insider trading can gain more returns than outsider trading because insiders have private information to perfectly predict share price trends. Beneish and Vargus (2002) show that insiders often buy stocks before prices increase and sell shareholdings before prices fall. Bergstresser and Philippon (2006) also documents that CEOs of firms that use discretionary accruals to increase reported earnings exercise abnormally large amounts of stock options and sell unusually large quantities of shares.

Nevertheless, auditor switch may intrigue investors to question a firm’s earnings quality and that its stock price and option’s value may drop. To avoid large loss of options granted for past performance, managers will exercise early stock options as soon as they are aware of the high possibility of switching auditors. Ke et al. (2003) stated that when insiders hear about negative private information, they will sell shareholdings before the announcement is made to the public. And, Callaghan et al. (2004) focus on executive stock options and obtain the consistent findings. These findings lead us to the following hypothesis:

H2: Executives are apt to exercise stock options when a company switches an auditor.

The analysts’ forecast is an important indicator from which investors make investing decisions. If reported earnings diverge negatively from forecasts, investors are likely to dump their shares and management will suffer losses; the probability of financial distress will increase and share prices will drop. Therefore, management tends to manipulate earnings to meet market expectations and to overstate earnings. Imhoff and Lobo (1984) show that analysts’ composite forecast revisions have information content, and upward revisions in average predicted earnings are accompanied by positive unsystematic returns and downward revisions by negative unsyste-matic returns. Pownall et al. (1993) indicate that revisions in managerial earnings forecasts have an effect on stock prices. Although Elgers et al.(2003) mention that analysts’ earnings forecasts are less biased than the market’s earnings expectation in interpreting accruals, Kang and Yoo (2007) argue that analysts’ earnings forecasts are more biased than stock prices in interpreting accruals. Thus, meeting analysts’ earnings forecasts to smooth stock price is still an unsolved question.

On the other hand, Kasznik (1999) find that managers may adjust reported earnings upward through

discretionary accruals when actual reported earnings are lower than analysts’ earnings forecasts; meanwhile, lawsuit cost has a positive correlation with the degree of earnings management by the manager as a result of forecast errors. Aboody and Kasznik (2000) find that managers can revise previous financial forecasts to make reported earnings close to earnings predictions. Burgstahler and Eames (2002) indicate that managers can manipulate earnings to make the earnings consistent with analysts’ forecasts; when reported earnings fail to meet analysts’ predictions, management will use discre-tionary accruals to make them consistent with the prediction. Beyer (2008) also documents that investors anticipate the manager’s reporting behavior and hence react more strongly to negative earnings surprises than to positive earnings surprises, in particular if the manager’s cost of manipulating earnings is low. Moreover, Matsunaga and Park (2001) indicate that managers have economic incentives to manipulate earnings when reported earnings fail to reach analysts’ earnings fore-casts or the earnings of the corresponding period in the previous year, which causes a reduction in the managers’ cash bonuses.

Based on these findings, a company may switch auditors as a result of deteriorating business perfor-mance. After switching their auditors, once the returns of the companies fail to meet analysts’ earnings forecast, their managers have incentive to exercise stock options earlier than the bad news is announced. Consequently, we derive the following hypothesis:

H3a: Executives early exercise their stock option when they know the actual reported earnings are lower than the analyst forecasts after the company switches its auditor. H3b: Executives’ option value will decline when actual reported earnings diverge from the analyst forecasts after the company switches its auditor.

The manager has a discretionary right to adjust accruals so he can take advantage of discretionary accruals to manipulate reported earnings. Managers tend to manipu-late earnings consistent with, or slightly above, analysts’ predictions, and it is supposed that a high-quality audit can detect this kind of action. DeFond and Subramanyam (1998) find that discretionary accruals are clearly reduced in the last year before the auditor switch, and that the manager tends to manipulate high negative earnings when the company faces the risk of large lawsuits. Davis et al. (2000) indicate that discretionary accruals are positively correlated to auditor tenure. Dee et al. (2001) argue that successive auditors prefer to employ a policy of reducing earnings in order to avoid litigation risk. Lin and Liu (2009) suggests that when benefits from lowering capital raising costs via hiring top 10 auditors are trivial, firms with weaker internal corporate governance mecha-nism are inclined to choose a low-quality auditor so as to capture and sustain their opaqueness gains. Due to high litigation costs, it is unlikely that executives

will engage in earnings management just before and just after the companies switch their auditors. This effect may result from the fact that successive auditors tend to exercise a conservative accounting policy or the execu-tives want to avoid the attention of the Securities Exchange Commission (SEC) at this sensitive time. Therefore, we develop the following hypothesis. H4: When a company switches auditors, executives are unlikely to engage in earnings management. RESEARCH DESIGN Sample and data

Our data are collected from several databases: (1) The data on managers’ compensation are from the ExecuComp database. (2) The relevant information on audit switches, such as switch year, CAP firm switch, auditor name switch, and the like, are from the Audit Analytics database. (3) The analyst earnings forecasts are from the I/B/E/S database. (4) The financial data, including company financial ratios, financial performance, and the like, are from the Compustat database. The sample examined here consists of firms included in the S and P 500 Index, the MidCap Index, and the S and P SmallCap Index as of the start of 2001. Except that data concerning volatility of stock returns based on the average of three-year stock returns is from 1999 to 2006, our sample period runs from 2001 to 2006. We further divided the samplings into pre-switch and post-switch in order to facilitate discussion of the influence of auditor switch on stock options, financial performance, and stock price. Companies for which the required data is omitted are companies that do not adopt the calendar year as an audit year, and companies in finan-cial or insurance industries are eliminated. The total number of pre-switch companies in the sample is 3,528 firm/year and those of post-switch companies in the sample is 812 firm/year. Variables

Our definitions and measurements of variables in the empirical model are described as follows:

Dependent variables 1. Auditor switch (CpachD): An indicator variable equals one if the company switches the auditor in the current period, and zero if otherwise. 2. Exercise of stock options (Opex): An indicator variable equals one if the executives exercise stock options in the current period, and zero if otherwise. 3. Stock price fall (StoprD): An indicator variable equals one if the stock prices fell more than ten percent for the year in which the auditor was switched, and zero if otherwise. 4. Options’ fall in value (OptVD): An indicator variable equals one if the value of executives’ stock option fell over ten percents for the year of the auditor switch, and 0 if otherwise. 5. Stock options value (Optval): The values of executives’ stock options are evaluated by the Black-Scholes model and by taking the log value. Changes in the holdings of executives’ stock options (Optch) are measured by stock options granted to executives plus the number of stock options executives bought from the public

Chao et al. 7867 market, minus the number of stock options the executives sold, minus the number of stock options exercised by the executives.

The changes should take a natural logarithm. Independent variables 1. Change in return on stockholder’s equity (ROED): An indicator variable that equals one if the firm’s return on stockholder’s equity in the current year is less than the triennium average of the same industry, and zero otherwise. It is used to measure the company’s operation performance. 2. Return on total assets (ROA): The ratio of net income after tax to total assets, representing the company’s business performance. 3. Changes in audit opinions (AOPD): An indicator variable equals one if audit opinions from the previous auditor are inconsistent over the three years, and zero if otherwise. 4. Stock price fall (StoprD): An indicator variable equals one if the firm’s stock prices fell over 10%, and zero if otherwise. 5. The value of stock options (Optval): Measured by the log of the value of executives’ stock options, as evaluated by the Black-Scholes model. 6. Analysts’ earnings forecast errors (ForeErr): The difference between reported earnings and analysts’ forecasts for the year of auditor switch:

where itanalystForeEa, = analysts’ earnings forecasts and

itactualForeEa

, = actual reported earnings. 7. Accruals (Accrual): According to the Myers et al. (2003) method, and taking absolute value:

where = current accruals, = the change in

current assets, = the change in cash and cash

equivalents, = the change in current liabilities, and

= the changes in short-term notes and current portion of long-term debt.

Control variables

1. Volatility of stock returns (Stova): Calculated as the standard deviations of the three-year returns, that is, the year compensation are acquired and the previous two years. 2. Options sensitivity (Opsen): Hemmer et al. (2000) suggest that individual wealth is an important factor influencing the incentive effect of compensation plans based on stock options. Our study also examines whether executives consider risk aversion when they exercise stock options, so options sensitivity is regarded as a control variable and is calculated as the executives’ stock options value times one percent of the stock price of the company. 3. Executives’ compensations (Com p): Finkelstein and Hambrick

itForeErr =

( )analystititactualitanalyst ForeEaForeEaForeEa ,,, −

, , , ,( ) ( )

i t i t i t i tAccruals CA Cash CL STD= ∆ − ∆ − ∆ − ∆

Accruals ,i tCA∆

,i tCash∆

,i tCL∆

,i tSTD∆

7868 Afr. J. Bus. Manage. (1989) indicate that firm size would influence executives’ compen-sation, so the compensation should be deflated by total assets to eliminate the size effect. 4. Firm size (size): Becker et al. (1998) show that firm size is one of the factors that influences whether management manipulates financial reports. The larger the firm, the greater the effect of earnings decline on stock price and the greater the likelihood that executives will manipulate earnings. Thus, this study includes as one of the control variables the firm size as a log of total assets. 5. Financial leverage (Lev): Calculated as the ratio of total long-term liability divided by total stockholder’s equity. The company’s bankers and bondholders scrutinize whether the company borrows too much and demand that it keep its debt within limits. Thus, the executives are likely to manipulate earnings to meet debt contracts. 6. Growth (Grow): The ratio of market value of equity to book value of equity, which is the proxy for future growth opportunity. Net cash

flow from operations (OCF): Net cash flow from operations in the current year divided by total assets at the end of the year. 7. Dummy variable of CPA firms (BiD): A dichotomous variable Empirical model

Regression models are used to test the hypotheses.

Model 1

We utilize Models 1a and 1b to analyze whether the company will switch auditors in the next period as a result of the inconsistent audit opinions in previous periods when company stock prices or options values fall (H1a, H1b, respectively).

(1a)

(1b)

where = dummy variable for average stock price decrease, OptVD = dummy variable for options value decrease, ROA= return on total assets, ROED= dummy variable for return on equity, AOPD = changes in audit opinions, Opsen = options sensitivity, Grow=

growth opportunity of the company, Size= firm size, = financial leverage, Comp= executives’ compensations, and CpachD = dummy variable of auditor switch. Model 2 One of the purposes of this study is to establish whether an executive whose company switches auditors will exercise stock options in advance (in all likelihood, to avoid personal loss). The logistic model is as follows:

(2) Where, Opex = dummy variable for exercise of stock options, Optval = the value of executives’ stock options, and Stova = volatility of stock returns. All other variables specified in this model are as defined earlier. Model 3 Models 3a and 3b examine respectively whether managers are apt

to exercise stock options earlier (H3a), or executives’ stock options will drop (H3b) when the deviation between actual reported earnings

of the company and analysts earnings forecasts increases after companies switch auditors.

(3a)

(3b)

where ForeErr= analysts’ earnings forecast errors, BiD = dummy

variable for CPA firms, OCF = net cash flow from operations, and Optch = changes in the executives’ holdings of stock options. All other variables specified in this model are as previously defined.

Model 4

Companies may switch auditors as a result of deteriorating business performance or inconsistent audit opinions.

In these situations, executives will not take advantage of earnings management to raise the stock price and further increase their stock options (in all likelihood, because they have to avoid the attention of the administrative authority).

Model 4 tests this argument: CPA firms, and zero otherwise .

(4)

tiCpachD , =

titititititi

titititi

CompaSizeaLevaGrowaOpsena

AOPDaROAaROEDaStoprDaa

,1,91,81,71,61,5

1,41,31,21,10

ε++++++

++++=

−−−−−

−−−−

tiCpachD

,=

titititititi

titititi

CompaSizeaLevaGrowaOpsena

AOPDaROAaROEDaOptVDaa

,1,91,81,71,61,5

1,41,31,21,10

ε++++++

++++=

−−−−−

−−−−

StoprD

Lev

tiCpex , =

tititititi

titititi

CompcSizecLevcOpsenc

StovacROAcROEDcOptvalcc

,,8,7,6,5

,4,3,2,10

ε+++++

++++

Optchi,t = d0 + d1ForeErrit + d2 ForeErri,t-1 + d3Stovait + d4Opseni,t

+d5BiDi,t +d6Sizei,t+d7OCFi,t+d8Levi,t +εi,t

Optvali,t = d0 + d1ForeErri,t + d2 ForeErri,t-1 + d3Stovai,t + d4Opseni,t

+d5BiDi,t +d6Sizei,t+d7OCFi,t+d8Levi,t +εi,t

titi

tititititi

titititi

Comph

ROEDhSizehLevhBiDhOCFh

OpsenhStovahAccrualhAccrualhh

,,10

,9,8,7,6,5

,4,3,21,10

ε++

+++++

++++− tiCptch

,=

Chao et al. 7869

Table 1. Industry distribution of samples.

Industry Pre-switch Post-switch

N Percent N Percent

Agriculture 286 8 59 7

Mining 272 8 79 10

Construction 434 12 105 13

Manufacturing 543 15 122 15

Telecommunication, Information, technology 727 21 147 18

Wholesale 527 15 113 14

Retailing 432 12 96 12

Service 307 9 91 11

Total 3,528 100 812 100 where Accrual= accruals item, which is measured earnings

management; all other variables specified in this model are as previously defined.

EMPIRICAL RESULTS Preliminary analysis The industrial analysis of pre-switch and post-switch companies is shown in Table 1. In the pre-switch com-panies, telecommunication and information technology companies have the largest proportion (21%) of this sample, whereas both agriculture and mining companies have the lowest proportion (8%) among the sample. As to post-switch sample firms, the distribution of industries is approximate to that of the pre-switch sample firms. The descriptive statistics in the pre-switch and post-switch samples are shown in Table 2. In Panel A, the change in the CPA dummy variables is 0.3894, which shows that, in the total samples, the percentage of companies in which auditors have been switched is less; the average of dummy variables for stock decline is 0.4975, representing that about half of the samples experience the drop of stock prices in the same year; natural logarithms of stock options values are from 0 to 8.8890, with an average of 5.3564, so there exists a wide range of option value; the average of dummy variables for the less-than-industry performance of return on equity is 0.4848, indicating that the proportion of that companies which their returns on stockholders’ equity are less than industry average is around 48% ; the average of dummy variables for incon-sistent audit opinions is 0.1543, which means nearly 16% of sample companies ever received the inconsistent audit opinions during the sample period.

Panel B of Table 2 shows that the average of dummy variables for decline in option value is 0.2438 after an auditor switch. However, switching firms that experienced the drop of stock price (0.5714) are more than those that dropped in the value of stock options in the same year. And, that the average of dummy variables for a fall in share price before and after an auditor switch is 0.4975

and 0.5714 respectively implies switching an auditor for a company would stir its market value. As to errors in analysts’ earnings forecasts, its mean is -0.8784, but the standard deviation is about 1.59. This means there is some divergence between analyst forecasts and actual performance. The mathematical logarithms of changes in options are from 0 to 6.5678, with an average of 4.6952. This shows that the managers do not exercise many share options after the company switches auditors.

The value of the manager’s share options (5.7514) after an auditor switch is less than that (5.3564) before an auditor switch; the average of business performance after a switch is better than that before; and the average of total management compensation (0.0042) before a switch is less than that (0.0054) after. It can be inferred that business performance of a company may be improved after an auditor switch since the managers have incentive to reverse the negative public response to the switch.The Pearson correlation coefficients of Models 1a and 1b are listed in Tables 3 and 4 The OptVD and StoprD are negatively correlated with ROA, which means a fall in the value of executives’ stock options is related to business performance. Decreases in stock options and stock prices are positively correlated with CpachD, indicating that an auditor switch may be associated with the company’s negative information. In addition, Optch has no obvious relationship to Fore Err, possibly because analysts are not insiders and their knowledge of actual business performance is not as great as the manager’s.

An auditor switch may not cause the managers to exercise stock options in advance; on the con-trary, the manager will make more efforts to improve business performance and avoid an investigation of insider trading by the SEC. Furthermore, the change in holdings of exe-cutives’ stock options is positively correlated with Accrualt-1 but is unrelated to Accrualt

The effect of audit opinion, stock price, and option value on an auditor switch

Under controlling stock options sensitivity, share

7870 Afr. J. Bus. Manage. Table 2. Descriptive statistics.

Variable Min. Max. Mean S.D

Panel A：：：：Pre-switch sample （N=3,528））））

CpachD 0.0000 1.0000 0.3894 0.2876

StoprD 0.0000 1.0000 0.4975 0.1389

Optval (log) 0.0000 8.8890 5.3564 1.2253

ROED 0.0000 1.0000 0.4848 0.0998

ROA (%) -0.3210 0.5927 0.0616 0.0094

AOPD 0.0000 1.0000 0.1543 0.0457

Opsen 0.0000 125761.8724 4869.9455 549.2642

Grow -2.0564 32.5005 6.3356 2.4325

Lev (%) 0.0001 9.8593 2.5667 0.5614

Size 5.6193 10.9991 8.8226 0.6725

Com (%) 0.0003 0.0175 0.0042 0.0001

Panel B: Post-switch sample (N = 812)

OptVD 0.0000 1.0000 0.2438 0.2786

StoprD 0.0000 1.0000 0.5714 0.4975

ForeErr (%) -5.2951 4.7607 -0.8784 1.5890

Accrual (thousand) 4.8609 10543.2265 81.0223 76.5501

Opex

0.0000 1.0000 0.5976 0.2388

Optch (log)

0.0000 6.5678 4.6952 3.7186

Optval (log) 0.0000 8.2329 5.7514 2.9856

ROA (%) -0.3708 0.4557 0.0998 0.0828

ROED 0.0000 1.0000 0.3847 0.1493

Opsen 0.0000 100286.0959 5139.8025 425.7081

Stova 0.0017 2.5422 0.2790 0.3841

Comp (%) 0.0001 0.0093 0.0054 0.0038

Grow (%) -1.7910 24.9100 4.9630 3.2724

Size 5.9025 10.1175 7.9982 0.4443

Lev (%) 0.0001 7.8963 3.8016 0.2428

OCF (%) -1.7148 8.8748 4.3166 1.5222

BiD 0.0000 1.0000 0.4064 0.1853

AOPD 0.0000 1.0000 0.5367 0.2957

Note: CpachD=A dummy variable that equals 1 if the firm switched auditor. Opex=A dummy variable that equals 1 if managers exercise the stock options. StoprD=A dummy variable that equals 1 if stock prices fell more than 10%. OptVD= A dummy variable that equals 1 if the value of executives’ stock option fell more than 10%ForeErr=Analysts’ earnings forecast errors measured by differences between the reported earnings and

analysts’ forecasts in switch auditor year. Accrual=Total current accruals. Optval= The values of executives’ stock option measured by the Black-Scholes model. ROED=A dummy variable that equals 1 if the return on equity less than the average three-year’s

industry level. ROA=Return on assets. Optch=The changes in the holdings of executives’ stock options. AOPD=A dummy variable that equals 1 if opinions from previous auditor are inconsistent for three years. Opsen=Option sensitivity measured by the value of executives’ stock option times 1% of stock prices. Grow=Growth opportunities. Lev=Leverage. Size=Firm size. Comp=Total executives’ compensation divided by total assets. Stova=The volatility of stock returns. OCF= Firm’s cash flow from operations scaled by total assets. BiD=An indicator variable that equals 1 if successor auditor is one of the Big 4.

Chao et al. 7871 Table 3. Pearson Correlations between Variables for Pre-switch Samples.

Variable CpachD StoprD OptVD ROED ROA AOPD Opsen

Grow Lev Size Comp

CpachD 1 StoprD 0.040***(0.005) 1 OptVD 0.179***<(0.001) 0.156***(0.009) 1 ROED 0.102***<(0.001) 0.024(0.372) 0.088***<(0.001) 1 ROA 0.013(0.368) -0.028***<(0.055) -0.053***<(0.001) 0.816***<(0.000) 1 AOPD 0.053***<(0.001) 0.050***<(0.001) 0.010(0.788) -0.027*(0.060) -0.019(0.197) 1 Opsen

0.017(0.244) 0.233***<(0.001) -0.054(0.140) 0.101***<(0.001) 0.388***<(0.001) -0.027*(0.057) 1

Grow -0.009(0.527) -0.085*(0.015) -0.009(0.520) 0.060(0.114) 0.067*(0.076) 0.002(0.917) 0.046***(0.002) 1 Lev -0.046***<(0.001) 0.064*(0.046) 0.027*(0.056) -0.176(0.000) 0.122***(0.000) 0.005(0.748) -0.026*(0.069) 0.099***(0.009) 1 Size -0.003(0.815) -0.056(0.143) -0.034(0.019) 0.154***(0.000) 0.122***(0.001) -0.023(0.110) 0.355***(0.000) -0.066*(0.085) -0.041(0.278) 1 Comp 0.072***<(0.001) 0.223***<(0.001) 0.253**<(0.011) 0.087***<(0.001) 0.213***<(0.01) -0.002(0.903) 0.674***<(0.01) 0.017(0.248) -0.020(0.158) 0.375***<(0.01) 1

Note:1. P-value in parentheses; *, **, ***significant at the 10, 5, and 1 percent levels, respectively. 2. Total samples are 3,528.3. Variable definitions refer to Table 2.

Table 4. Pearson correlations between variables for post-switch samples.

Variable Optch Optval tForeErr 1tForeErr− Stova

Opsen

Bid Size OCF Lev

Optch 1

Optval 0.069***(0.010) 1

ForeErrt

-0.002(0.948) 0.215***<(0.001) 1

ForeErrt-1

-0.051(0.142) 0.099***(0.008) -0.053(0.122) 1

Stova

0.012(0.728) -0.060(0.115) -0.046(0.180) 0.429***<(0.001) 1

Opsen

-0.196***<(0.001) -0.061(0.115) -0.041(0.237) 0.923***<(0.001) 0.433***<(0.001) 1

Bid -0.129***<(0.001) -0.061(0.103) -0.018(0.597) 0.478***<(0.001) 0.553***<(0.001) 0.488***(0.000) 1

Size -0.525***<(0.001) 0.043(0.260) 0.018(0.603) 0.177***<(0.001) 0.096***(0.005) 0.355***(0.000) 0.191***(0.000) 1

OCF -0.210***<(0.001) -0.060(0.108) -0.005(0.878) 0.626***<(0.001) 0.507***<(0.001) 0.725***(0.000) 0.669***(0.000) 0.281***(0.000) 1

Lev -0.036(0.292) 0.045(0.229) -0.025(0.475) 0.095***(0.006) 0.192***<(0.001) 0.074**(0.031) 0.221***(0.000) 0.091***(0.008) 0.102***(0.003) 1

Note:1. P-value in parentheses; *, **, ***significant at the 10, 5, and 1% levels, respectively. 2. Total samples are 812.3. Variable definitions refer to Table 2.

price or share options value would drop if business performance is worse. According to Table 5, the company is apt to switch auditors when audit opinions are inconsistent with previous periods.

Furthermore, the larger Lev is, the higher the possibility of financial risk and violating loan

contracts, so audit opinions may be so conser-vative that they are inconsistent with the com-pany’s expectations. That is, the larger Lev is, the likely there will be an auditor switch.

These results support H1: When there is bad performance, a decline in the stock prices and option values, and inconsistent audit opinions in

previous periods, a company is likely to switch auditors.

The effect of an auditor switch on the exercise of stock options

Table 6 reports results related to whether

7872 Afr. J. Bus. Manage. Table 5. Effect of audit opinion, stock price and option value on auditor switch.

variable Audit opinion and stock price, model (1a) Audit opinion and option value, model (1b)

coefficient P-value coefficient P-value

constant 0.753** 0.025 -0.227*** 0.006

StoprD; OptVD 0.002** 0.040 0.001*** 0.001

ROED 0.267*** 0.000 -0.022* 0.097

ROA -0.317 0.109 0.380*** 0.001

AOPD 0.144** 0.034 0.238* 0.089

Opsen 0.014*** 0.002 0.001*** 0.010

Grow 0.000 0.338 0.001 0.341

Lev 0.138* 0.061 -0.149* 0.056

Size -0.002 0.970 0.076 0.979

Com p 0.001*** 0.000 0.000*** 0.000

Observations 3528 3528

Cox & Snell R2 0.016 0.024

Nagelkerke R2 0.018 0.033

MODEL 2χ

25.632 27.524

P-value 0.042 0.023

Note: 1. P-value in parentheses; *, **, ***significant at the 10, 5, and 1 percent levels, respectively. 2. Variable definitions refer to Table 2.

titititititi

tititititi

CompaSizeaLevaGrowaOpsena

AOPDaROAaROEDaStoprDaaCpachD

,1,91,81,71,61,5

1,41,31,21,10,

ε++++++

++++=

−−−−−

−−−−

(1a)

titititititi

tititititi

CompaSizeaLevaGrowaOpsena

AOPDaROAaROEDaOptVDaaCpachD

,1,91,81,71,61,5

1,41,31,21,10,

ε++++++

++++=

−−−−−

−−−−

(1b)

Table 6. Effect of auditor switch on exercise of stock options (Equation 2).

Variable Coefficient P-value

constant 0.487** 0.019

Optval 0.012 0.264

ROED 0.132 0.131

ROA 0.026 0.253

Stova 0.293** 0.021

Opsen 0.002* 0.072

Lev 0.020** 0.045

Size 0.054 0.769

Com p 0.009 0.347

Observations 812

Cox and Snell R2 0.162

Nagelkerke R2 0.214

Model 21.025

P-value 0.043

Note:1. P-value in parentheses; *, **, ***significant at the 10, 5, and 1 percent levels, respectively. 2. Variable definitions refer to Table 2.

2χ

Chao et al. 7873

Table 7. Effect of deviation of earnings forecasts on value and holdings of executives stock options (Equations 3a and b).

Holdings of executive stock options,

model (3a)

Value of executives stock options,

model (3b)

Variable Coefficient P-value Coefficient P-value

Constants -3.148** 0.026 -3.521* 0.061

ForeErrt 0.496* 0.073 0.081 0.192

ForeErrt-1 1.053 0.256 1.963 0.205

Stova 0.195** 0.023 0.036* 0.069

Opsen 0.733* 0.059 0.026* 0.082

BiD 1.285 0.517 2.269 0.563

Size 0.335*** 0.002 0.209* 0.067

OCF -0.656*** 0.000 -0.657*** 0.000

Lev -0.032** 0.036 -0.034** 0.049

Observations 812 812

R2 0.113 0.289

Adjusted R2 0.085 0.278

F-value 25.204 27.865

D-W 1.960 1.894

Note:1. P-value in parentheses; *, **, ***significant at the 10, 5, and 1 percent levels, respectively. 2. Variable definitions refer to Table 2.

managers exercise stock options early after an auditor switch. The results show that the values of stock options and business performance have no influence on the exercise of executives’ stock options in the current period. This result may occur because managers have already exercised some options before the year in which the auditor switch is disclosed, or because they would like to avoid an SEC investigation into insider trading (if the managers exercise too many stock options in the switch year). We also find that exercise of executives’ stock options is positively correlation with the fluctuation of stock returns and financial leverage. The effect of earnings forecasts on the value and holdings of executive stock options Table 7 presents the regression results of the effect of earnings forecast errors on the value and holdings of executives’ stock options. The changes in holdings of executives’ stock options are unrelated to ForeErrt-1 , but are positively related to ForeErrt, perhaps because of the asymmetric information between analysts and managers. The managers know the actual performance clearly, so they can dispose of stock options in the current period and would not wait to sell or buy stock options in the next period. As shown in Table 8, financial risks and business performance are key factors that influence the holdings and value of executive stock options. The better the business performance, the more grants of share options received from the company, and sold or exercised

stock options are worth relatively less. In addition, a larger deviation in the analyst forecast may not influence the value of executives’ stock options’ value when the information is disclosed. This finding maybe the result of the time interval between the disclosure of the earnings forecast and the year-end value of stock options. Thus, the signaling effect may be reflected in the stock price. In addition, the value of stock options is relatively lower when financial risk is greater and business performance is worse. Accruals and the change in holdings of executives’ stock options Table 8 shows that the accruals in the previous and current period have no impact on the changes in holdingsof executives’ stock options. Possible reasons for an auditor switch are that the previous auditors did not acquiesce to the aggressive accounting policies of the client, or that the company is searching for higher audit quality and switches to an audit firm with a name-brand reputation. The subsequent auditors are also more likely to pursue a conservative accounting path in order to avoid litigation risk. In addition, the managers dare not engage in earnings management at the initial stage of an auditor switch because the switch usually creates negative impressions among investors and attracts the attention of supervisory authorities. Therefore, the change in the accruals has no significant impact on executive holdings of stock options.

7874 Afr. J. Bus. Manage.

Table 8. Effect of accruals on change in holdings of executives stock options (Equation 4).

Variable Coefficient P-value

Constant -1.148** 0.026

Accrualt-1 0.081 0.192

Accrualt 1.963 0.205

Stova 0.036 0.139

Opsen 0.026* 0.082

OCF -0.657*** 0.000

BiD 2.269 0.563

Lev -0.034** 0.049

Size 0.209* 0.067

ROED -0.657*** 0.000

Com p -0.034** 0.049

Observations 812

R2 0.091

Adjusted R2 0.084

F-value 60.256

D-W 1.954

Note: Variable definitions refer to Table 2.

Conclusions This paper uses samples of pre-switch companies and post-switch companies to examine the influence of incon-sistent audit opinions on auditor switch when the value of share prices and stock options fall. We also analyze the main factors that influence the exercise of stock options and the effect of a higher deviation of analyst earnings forecast on options value and the holdings of executives’ stock options after the switch. We further investigate whether managers manipulate earnings to gain more from their stock options.

We find that managers are more likely to switch audi-tors when business performance deteriorates and audit opinions are inconsistent in previous periods. However, operating performance has no influence on the holdings of stock options of executives in the switch year perhaps because the managers would have hedged their risk earlier to avoid investigation of insider trading by the SEC. We also find that the managers tend to exercise some stock options earlier when the deviation between the analyst earnings forecast of the current period and actual reported earnings is large, but this deviation has no influence on the value of stock options because there are time intervals between earnings forecasts and the year-end stock option value, and the signaling effect has already influenced the stock price before the analysts forecasts are disclosed. We also show that accruals in the current and previous period have no influence on changes in holdings of executives’ stock options, so an auditor switch would make it more difficult for executives to benefit their own interest. We find that an auditor switch may be unable to prevent managers from

engaging in earnings manipulation, but it has a warning function.

The implications of these findings for regulators and practitioners is to consider switching auditors as a warning signal of earnings quality and managers may opportunistically hedge their risk of shrinking incentives when firms’ performance actually become worse. In addition, managers with the private information of earnings negatively far from analysts’ forecasts will exercise more options than those whose firms’ earnings almost meet analysts’ forecasts. When companies design their pay-for-performance for executives, it should take this condition into account. Thus, the regulators should devise some approaches to enhance auditor indepen-dence, for example, elevating litigation cost of collusion. Auditor firms will avoid aggressive policies in an effort to protect their accumulated reputation capital. Through auditor‘s expertise, it helps not only to protect the shareholders’ wealth, but managerial performance also may be more fairly evaluated. While we endeavor to collect more data about switching auditor, the Audit Analytics database offers material only beginning from 2000. Management non-audit services provided implicitly by auditors have not been considered and the results may be different if this kind factor is included in the analysis. Future research may develop more proper option valuation to examine the subtle relation between compensation and true performance. REFERENCES Aboody D, Kasznik R (2000). CEO stock option and the timing of

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