Auditor switching, lowballing and conditional conservatism: evidence from selected Asian countries

Abstract

Purpose This paper aims to investigate the effect of auditor switching and lowballing on conditional conservatism, particularly how different types of auditor switching, namely, upward, downward and lateral switching to/from Big 4 and industry specialists, affect earnings quality in the following selected Asian countries: Indonesia, Malaysia, the Philippines, South Korea and Thailand. Design/methodology/approach Using conditional conservatism as a proxy for earnings quality, this study hypothesises that upward switching from non-Big 4 to Big 4 auditors, or from non-specialist to specialist auditors, would result in high conditional conservatism, while downward switching would lead to low conditional conservatism. The study further tests whether lowballing provides a viable explanation for reduced earnings conservatism in firms that switch from Big 4 to non-Big 4 auditors, or from specialist to non-specialist auditors. Findings The analysis, on a sample of 28,073 firm-year observations from 2007 to 2016, shows that the decision to downgrade auditors leads to lower conditional conservatism in the year of switching, compared with other firms and the pre-switching year. The evidence further shows that, when firms downgrade their auditors, lowballing contributes to a decrease in conditional conservatism in the first year of audit switching. Further, this research finds that switching to specialist auditors will result in increased conditional conservatism, while switching from specialist auditors to non-specialist auditors will result in reduced conditional conservatism. Practical implications The findings of this study are useful to investors who are looking to diversify their investment portfolio in developing markets, as evidence about auditor switching and quality of financial reporting may be an important factor in their investment decisions. Downward auditor switches and lowballing could act as red flags to investors in the sense that these events could signal a decrease in conditional conservatism and, hence, quality of earnings. Originality/value This research offers new evidence to support the view that management decisions to switch to lower-quality auditors will force newly appointed auditors to acquiesce to clients’ demands for reporting low-quality earnings.