Companies switching auditors after just missing earnings forecasts exhibit lower levels of earnings quality

Earnings management has long been a concern in the corporate world, with companies striving to meet or beat analysts‘ earnings forecasts through various accounting tactics. External auditors play a critical role in curbing opportunistic earnings management behavior and providing financial statement reliability. However, recent research by Eric Lohwasser and Yaou Zhou explores how companies that just miss earnings expectations may be more likely to change their auditor as a result of their opportunistic behavior.

The researchers examine the link between companies‘ earnings performance and their decisions to change the accounting firm that audits their financial statements. They find that companies reporting earnings per share (EPS) just below analysts‘ forecasts are more likely to switch auditors in the subsequent year. This suggests that these „just missing firms“ may view their current auditor as a constraint on their earnings management practices and seek to replace them with one more amenable to their objectives.

To support their argument, the researchers conduct several additional tests. They explore the ex-post effects of these opportunistic auditor changes and find that companies switching auditors after just missing earnings forecasts exhibit lower levels of earnings quality with their new auditors. The evidence shows a correlation between opportunistic auditor changes and reduced financial statement reliability.

Moreover, the study finds that these effects are more pronounced in firms with greater incentive or ability to achieve financial targets through earnings management. Companies with negative market reactions to earnings, higher levels of accruals flexibility, and weaker corporate governance are more likely to engage in opportunistic auditor changes.

The implications of this research raise concerns about auditor independence and objectivity. Auditors, as the primary defense against earnings management, may face increased pressure when their clients seek to manage earnings opportunistically. Such pressures can compromise auditors‘ ability to provide objective and unbiased audit procedures, potentially undermining the quality and reliability of financial statements.

The findings of this study have several practical implications. Regulators may need to revisit standards regarding auditor-change-related disclosure requirements. More transparent disclosure after an auditor change, especially for privately held reasons, can help protect auditor independence and provide capital markets with critical information.

The study also highlights the importance of considering investors‘ needs and interests in assessing the materiality of accounting misstatements. Regulators may utilize risk-based approaches in audit inspections to focus on potentially suspect audit engagements and address concerns related to MET behavior.

In conclusion, this research provides valuable insights into the complex interplay between earnings management, auditor changes, and ethics. Understanding the factors driving opportunistic auditor changes can help regulators, standard-setters, and the professional community address challenges related to auditor independence and financial statement reliability. By addressing these concerns, the accounting profession can uphold its fundamental principles of integrity and trust in serving the public interest.

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