1
Audit Quality and Auditor Switching:
Some Lessons for Policy Makers
CLIVE S. LENNOX
Economics Department, Bristol University.
Address for Correspondence
University of Bristol
Department of Economics
8 Woodland Road
Bristol BS8 1TN
England
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Audit Quality and Auditor Switching:
Some Lessons for Policy Makers
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1. Introduction.
This paper reviews the literature on audit quality and auditor switching to assess different
countries’ policy regimes. It argues that policy-makers should limit managerial influence over
auditor switching rather than reduce auditors’ economic dependency on clients. In particular,
the paper advocates proper communication between shareholders and auditors, and a policy of
mandatory auditor retention. In contrast, some countries have adopted policies of mandatory
rotation, and have banned non-audit services and introductory fee discounts. It is argued that
such policies are less desirable on both theoretical and empirical grounds.
A lack of audit quality is most often alleged when it is believed that auditors should
have warned investors about impending corporate failures (these are often termed “audit
failures”).
1
The next section argues that audit failure is a significant cause for concern. Section
3 explains how auditor switching can affect audit quality. Section 4 describes regulatory
regimes aimed at increasing audit quality. Sections 5 and 6 discuss the theoretical and
empirical literature on auditor switching and audit quality. Section 7 concludes with policy

3
Table 1
The correlation between financial health and audit reporting.
Q
it
= 0 Q
it
= 1 GQ
it
= 0 GQ
it
= 1
FAILS
it
= 0 6804 177 6878 103
FAILS
it
= 1 97 26 102 21
Type I error (%) 78.86 82.93
Type II error (%) 2.54 1.48
FAILS
it
= 1 if company i received its final audit report in year t prior to entering bankruptcy; = 0
otherwise.
Q
it
= 1 if company i received a qualified report in year t; = 0 otherwise.
In addition, to going concern qualifications, qualified reports were given for non-compliance with
Statements of Standard Accounting Practice, and due to uncertainty regarding provisions for bad debts,
slow-moving stocks and litigation.

Secondly, the number and scale of successful litigation cases suggest that auditors sometimes
fail in their responsibilities towards shareholders (Palmrose, 1988). Finally, regulatory
investigations (by the Department of Trade and Industry (DTI) in the UK, and the Stock
Exchange Commission (SEC) in the US) have often been critical of auditors (Firth, 1990;
Wilson and Grimlund, 1990; Davis and Simon, 1992). Therefore, audit failure is a significant
and important problem - the following section discusses how auditor switching affects the
quality of audit reporting.

4
In the US, Carcello et al. (1995) report that type I error rates were approximately 48% between 1972-92 (evidence for type II error
rates was not given).
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3. The relationship between auditor switching and audit quality
It has been argued that companies use auditor switching to avoid receiving qualified reports.
This argument assumes that managers dislike qualified reports and that managers influence the
auditor appointment decision.
The first assumption is relatively uncontroversial - a qualified report may signal to
investors that managers are poor stewards of the company’s affairs, or that managers have
attempted to present an over-favourable view of the company’s performance. In addition,
qualified reports cause share prices to fall - this reduces managerial utility if managers own
shares or if their compensation is related to market value (Firth, 1978; Banks and Kinney,
1982; Fleak and Wilson, 1994; Chen and Church, 1996; Jones, 1996). Therefore, there are
strong grounds for believing that managers dislike receiving qualified reports.
The second assumption is more controversial because, de jure, auditors are appointed
by shareholders. However, de facto, managers exert considerable influence over auditor
appointments. For example, managers often dismiss incumbent auditors without consulting
shareholders - shareholders merely vote on whether to accept their recommendation regarding
the appointment of a new auditor or the re-appointment of the incumbent auditor. Thus, the
right to dismiss an auditor lies mainly with managers. Secondly, managers have some influence
over the appointment of a new auditor or the re-appointment of the incumbent auditor. They set

and auditors (for example SEC, 1988 and 1989). More recently, the US Public Oversight
Board (1994) recommended that auditors express judgements to boards of directors and audit

5
In the UK, a dismissed auditor has the right to make written representations to shareholders or to speak against the resolution for his
removal at the company’s Annual General Meeting (AGM). In the UK, an auditor’s notice of resignation is not effective unless it
contains either: (a) a statement to the effect that there are no circumstances connected with the resignation which should be brought to
the notice of the members or creditors of the company, or (b) a statement of any such circumstances. In Denmark, Ireland, the
Netherlands, Spain and Sweden, auditors are required to disclose the reason for a change of auditor. In all EU countries with the
exception of Spain, auditors have the right to defend their positions if threatened with dismissal.
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committees about the appropriateness of the financial statements, and that auditors meet with
boards of directors and audit committees at least once a year.
However, in many countries outgoing auditors rarely communicate with shareholders
even when there is a genuine cause for concern.
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For example, the DTI’s investigation of
Ramor Investments (1983) concluded, “We are critical of the auditors’ work . . . and of the fact
that when Price Waterhouse did resign they went too quietly.”
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One problem may be that
auditors do not wish to gain reputations as trouble-makers amongst the managers of other
companies.
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In addition, auditors may be concerned that communication would reveal previous
audit errors and increase the likelihood of litigation.
4.1.2 Communication between outgoing and incoming auditors

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A problem in the UK is that the auditor’s statement must first be sent to the company’s managers, who are then required to send

hotline has been set up for UK auditors to act as whistle-blowers to the pensions regulator. The fact that the regulator believed the
hotline needed to be anonymous suggests that auditors do not have an incentive to gain a reputation for being whistle-blowers. This is
consistent with the argument that managers rather than shareholders have most influence over auditor appointment.
9
In most countries, outgoing auditors are required to inform incoming auditors if there are
worrying circumstances that prompted the change in auditor.
9
The aim of this requirement is to
prevent a manager concealing unfavourable information by switching to a less well-informed
new auditor.
However, communication between incoming and outgoing auditors does not occur very
frequently. For example, the DTI’s investigation of Ramor Investments found that Price
Waterhouse had resigned because of matters relating to fraud. However, Price Waterhouse did
not reveal this to the incoming auditors Norton Keen - rather they were told that the resignation
decision was based on commercial grounds. These facts led the inspectors to conclude that
Price Waterhouse’s conduct with regard to the incoming auditors was “indefensible”.
More systematic evidence has been provided by Dunn et al. (1994) who found that UK
auditors only disclosed why resignations occurred in 19 out of 793 (2.4%) cases - this was
despite a high incidence of audit qualifications before and after the resignations.
10
Scope for
communication between incoming and outgoing auditors appears to be greater in the US. In
1975, the SEC introduced Accounting Series Release No. 165 requiring auditor changes to be
disclosed when the incumbent auditor’s appointment was terminated rather than when a new
auditor was appointed. Smith (1988) found that the increased timeliness of information about
auditor changes provided more useful information to investors. This suggests that policies
aimed at improving disclosure about auditor changes can be effective. More recently, the
American Institute of Certified Public Accountants (AICPA) issued SAS 84 (1997) which
increased incoming auditors’ rights of access to outgoing auditors’ working papers.
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because incumbent auditors have greater knowledge of clients (AICPA, 1978; Ryan
Commission, 1992). Consistent with this, studies have shown that it takes time for newly
appointed auditors to become familiar with clients and shorter periods of incumbency reduce
auditors’ incentives to invest in learning-by-doing (St. Pierre and Andersen, 1994; Arrunada
and Paz-Ares, 1997). In a survey of European auditors, Ridyard and Bolle (1991) found that 1-
2 years were needed to gain client familiarity in industries where the auditor had no previous
experience; 2 years were needed for industries in which the auditor had experience.

12
There is little systematic evidence for the view that long auditor-client relationships reduce auditors’ incentives to maintain
independence, although there is some anecdotal evidence. In the DTI’s investigation of Rotaprint (1991), the fact that Joselyne
Layton-Bennet had been Rotaprint’s auditor for thirty years was identified as being a potential problem (although the reason why this
was perceived to be a problem was not revealed).
13
In the UK, the rate of auditor switching is 4% per year with more than half of companies having the same auditor for more than 20
years (Ridyard and De Bolle, 1992; Lennox, 1998b).
14
Mandatory rotation of audit firms every 12 years was proposed by the Fifth EU Directive (1989). In the UK, the Cadbury
Committee (1992) recommended rotation of individual audit partners but not the rotation of audit firms. The Australian Society of
Certified Public Accountants (1993) recommended partner rotation every seven years, but this was subsequently rejected by the
Australian Joint Standing Committee (1996) because of the belief that second partner review would overcome problems of lengthy
partner tenure. In the US, audit members of the SEC Practice Section are required to rotate partners every seven years.
11
The US Quality Control Inquiry Committee found that audit failure was three times
more frequent in the first two years of auditor tenure (AICPA, 1992). Unfortunately, the
Committee did not clarify whether this correlation arose because shorter tenure increased the
probability of audit failure, or because companies prone to audit failure were more likely to
change auditor. In addressing this causality problem, Lennox (1998b) controlled for the effects
of opinion-shopping and financial health on auditor switching and showed that short tenure
increases the likelihood of audit failure. This supports the argument that mandatory rotation is

17
In the US, Accounting Series Release No. 250 required public disclosure of the type and
quantity of non-audit services as a percentage of the total audit fee - however, this requirement
was only in force between 1978-81. More recently, the US General Accounting Office (1996)
has argued that non-audit services do not reduce audit quality, and there are currently no plans
to require disclosure.
4.2.2 Low balling
Low balling occurs when an auditor wins a new client by offering an initial fee below cost, in
the hope of offsetting the initial loss by earning rents in subsequent periods. Concerns have
been expressed that these rents may increase the potency of the company’s switch threat. In
addition, low balling may give an auditor less incentive to qualify if the auditor believes that a
qualification would precipitate bankruptcy and the loss of future rents.
With respect to low balling, AICPA (1978) has stated, “An ethics ruling indicates that
when the preceding year’s audit fee remains unpaid, independence is impaired . . . accepting an
audit engagement with the expectation of offsetting early losses or lower revenues with fees to
be charged in future audits represents the same threat to independence.” These concerns are
also highlighted in an EU Green Paper (1996), “The growing intensity of competition for audit
‘business’, and especially for the audit of large ‘prestige’ companies, is a cause of concern.
There is no doubt that competition sometimes results in low-cost and perhaps even below-cost
tenders. The procedure of calls for tenders . . . should not have as a consequence that auditors
quote an audit fee which does not allow them to carry out their work in accordance with

and the UK. Legal services are allowed in all EU countries except Belgium Denmark, France, Greece, Italy and Portugal. Corporate
recovery services are allowed in all EU countries except Belgium, France, Italy and Portugal (Buijink et al., 1996).
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The UK’s disclosure requirement was proposed during the second reading of the Companies Bill. At its introduction, Lord Young
(for the government) stated: “The large accountancy firms have increasingly offered their audit clients a range of other services . . . I
think that we need to recognise the concern some people feel about possible conflicts of interest on the part of the auditors. I believe
that the appropriate antidote is disclosure, and I therefore propose to take a power to require the fees paid to auditors, or their
associates, for other services to be disclosed in company accounts, as audit fees are now. That will give shareholders a fuller basis on

receiving unfavourable reports. In Dye (1991), managers strategically use the switch decision
in an attempt to alter investors’ perceptions of the company’s financial health. In equilibrium,
managers successfully avoid receiving unfavourable audit reports, but on average such
behaviour does not alter investors’ beliefs. This is because investors’ expectations about
financial health take into account managers’ incentives to obtain more favourable reports.
Similarly, Teoh (1992) assumed that rational investors take account of information signalled by
a company’s switch decision when forming beliefs about the company’s financial health. Teoh
showed that a switch can signal either good or bad news depending on the information available
to the manager and the auditor. If the manager switches when he has favourable private
information that is not available to the incumbent auditor, the switch signals good news. If the
manager switches to conceal unfavourable information held by the incumbent auditor, the
switch signals bad news.
In both these models investors are not fooled on average (they form unbiased
expectations), but this does not imply that opinion-shopping is unimportant for investment
decisions. For example, opinion-shopping could increase uncertainty about the company’s
future and this may reduce the incentive of risk-averse investors to finance projects. Moreover,
Altman’s (1977) finding that type I errors are much more costly than type II errors, means that
opinion-shopping is socially undesirable. This is because opinion-shopping reduces the
frequency of audit qualifications and therefore increases the ratio of type I to type II errors.
The next section evaluates whether companies do successfully engage in opinion-shopping.
5.2 Empirical evidence
Evidence from Australia and Korea indicates that companies receive qualified reports less
frequently after switching - this is consistent with the view that companies engage in opinion-
shopping (Craswell, 1988; Park, 1990). In contrast, US and UK studies show that companies
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receive qualified reports at least as frequently after switching (Chow and Rice, 1982; Krishnan
and Stephens, 1995; Lennox, 1998b). This has led some to conclude that companies do not
successfully engage in opinion-shopping.
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However, there are two major problems with this

Theory and evidence strongly support the view that companies successfully engage in opinion-
shopping. Therefore, policies aimed at reducing managerial influence over auditor switching
appear to be desirable.
6. The switch threat
6.1 Theory
Auditor independence has long been regarded as crucial for maintaining audit quality.
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In
contrast, recent theoretical research has argued that a lack of independence need not be a cause
for concern. Instead, allowing companies to reward auditors for favourable reporting can
increase auditors’ incentives to exert effort and thereby increase audit quality (Thoman, 1996).
Thoman’s model assumes that an auditor faces a litigation threat when a clean audit
opinion is given to a company that subsequently fails (‘audit risk’), and a threat to income from
issuing an unfavourable opinion (‘business risk’). The assumption of business risk reflects
evidence that audit qualifications trigger switching and loss of rents for auditors (Chow and
Rice, 1982; Citron and Taffler, 1992; Krishnan, 1994; Krishnan and Krishnan, 1996). In
Thoman’s model, an absence of business risk (auditor independence) is sub-optimal because if
companies cannot reward (punish) auditors for issuing favourable (unfavourable) reports,
auditors would always shirk and give unfavourable reports. Therefore, the reports of
independent auditors have no information value in Thoman’s model. The model implies that
making auditors independent by removing business risk could reduce auditors’ incentives to
exert effort.
Even if it were desirable to reduce auditor dependence, it is theoretically ambiguous
whether this would be achieved by restricting the provision of non-audit services. On the one
hand, non-audit services provide auditors with client-specific rents and may increase auditor

20
For example, upon the creation of the US Independence Standards Board, Arthur Levitt (Chairman of the SEC) stated,
“Independence is the soul of the public accounting profession . . . By having the Independence Standards Board take the initiative in
preserving auditor independence, we harness the resources and expertise of the private sector to address a difficult challenge” (Press

the same information sets, auditors’ rents do not present a threat to independence because the company’s threat to switch is not
credible.
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qualification rates.
22
Barkess and Simnett (1994) and Craswell (1998) found no significant
relationship between non-audit fees and audit reporting for Australia - similar results have also
been found for the UK (Lennox, 1998c). Therefore, the evidence does not strongly support the
view that non-audit fees increase auditor dependence.
There is much evidence that audit firms engage in low balling (Simon and Francis,
1988; Turpen, 1990; Ettredge and Greenberg, 1990; Butterworth and Houghton, 1995). In
contrast, there is very little empirical evidence on the relationship between low balling and audit
quality. One exception is an experimental study by Dopuch and King (1996) which indicated
that low balling does not significantly reduce audit quality. This is perhaps unsurprising, given
that the theoretical relationship between low balling and audit quality is ambiguous.
6.3 Summary
Theory suggests that auditor independence is socially undesirable as some degree of
dependence is required to prevent auditors from shirking and issuing overly conservative
reports. Therefore, policies aimed at reducing auditor dependence may be socially undesirable.
Even if a reduction in auditor dependence were desirable, it is not clear that this would
be achieved by banning non-audit services or low balling. Theory predicts an ambiguous
relationship between the provision of non-audit services and auditor dependence, and there is
little convincing evidence that non-audit fees significantly affect auditor dependence. Therefore,
a ban on non-audit services does not appear to be justified. Similarly, theory predicts an
ambiguous relationship between low balling and audit quality, and there is no evidence linking
low balling with audit failure. Therefore, a ban on low balling also appears unwarranted.
7. Policy conclusions

22
Wines (1994) found a significant negative relationship between non-audit fees and audit qualifications for Australia, and

strengthened when one considers the economies of scope that can accrue from the provision of
20
non-audit services. Theory also predicts an ambiguous relationship between low balling and
audit quality and there is no evidence that low balling reduces quality. Therefore, a ban on low
balling also appears to be unwarranted - this conclusion is strengthened when one considers the
efficiency gains that can accrue from a competitive audit market.
To summarise, policies of improved communication between shareholders, incoming
and outgoing auditors appear to be desirable. In addition, mandatory retention is preferable to
mandatory rotation as a way to reduce managerial influence over auditor switching. Finally,
there is not yet a convincing case for banning low balling or restricting the provision of non-
audit services.
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