Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127 Contents lists available at ScienceDirect Advances in Accounting, incorporating Advances in International Accounting j o u r n a l h o m e p a g e : w w w e l s ev i e r c o m / l o c a t e / a d i a c The determinants of auditor switching from the perspective of corporate governance in China Z Jun Lin a,⁎, Ming Liu b a b Department of Accountancy and Law, Hong Kong Baptist University, Kowloon Tong, Kowloon, Hong Kong Department of Accounting and Information management, The University of Macau, Macau a b s t r a c t This paper reports the association between firms' internal corporate governance mechanisms and their auditor switch decisions in the Chinese context We identify two types of auditor switch, namely switching to a larger auditor and switching to a smaller auditor Three variables are used to proxy for firms' internal corporate governance mechanism, including the ownership concentration (shareholding by the largest owner), the effectiveness of supervisory board (SB), and the duality of chairman of board of directors (CBoD) and CEO We regressed the internal corporate governance variables over firms' audit switching types during a specific period of 2001–2004 when a bear market continued in China The empirical results demonstrate that firms with larger controlling owners or in which CBoD and CEO are held by the same person are more likely to switch to a smaller auditor rather than to a larger one However, the effect of the SB variable does not have a significant impact on auditor switching decisions In general, the study findings suggest that firms with weak internal corporate governance mechanism tend to switch to smaller or more pliable auditors in order to sustain the opaqueness gains derived from weak corporate governance On the other hand, with the improvement of corporate government, firms should be more likely to choose large (high-quality) auditors in making auditor switching decisions © 2010 Published by Elsevier Ltd Introduction The purpose of this study is to investigate the association between firms' internal corporate governance mechanisms and their auditor switching decisions in the Chinese context Shortly after the founding of the People's Republic of China in 1949, the auditing profession in China diminished completely under the public (the state) ownership of all production means The independent auditing function was virtually nonexistent in the planned economy before the 1980s, when the state both owned and ran enterprises directly The mushrooming Sino-foreign joint ventures brought about by the government's adoption of the “open-door” policy in the early 1980s, led to the emergence of independent auditing Owing to the involvement of non-state equity interest in the joint-ventures, it became necessary to have independent professionals, or the certified public accountants (CPAs), to verify capital contributions and audit the annual financial statements and income tax returns (Lin et al., 2003) Thus the Chinese Institute of Certified Public Accountants (CICPA), a quasi-governmental organization in charge of national administration of CPAs and auditing firms, was established in the early 1980s Following the business restructuring campaign, shareholding (stock) companies ⁎ Corresponding author Tel.: +852 3411 7537; fax: +852 3411 5581 E-mail address: linzj@hkbu.edu.hk (Z.J Lin) 0882-6110/$ – see front matter © 2010 Published by Elsevier Ltd doi:10.1016/j.adiac.2010.03.001 reappeared in the Chinese economy at the turn of 1990s, which further resulted in a sharp increase in the demand for external audits The establishment of the Shanghai and Shenzhen stock exchanges and the promulgation of new accounting and auditing standards have played an important role in this process The China Securities Regulatory Commission (CSRC) has therefore required that all listed firms have their annual reports audited by registered Chinese CPAs The separation of ownership and management in the listed firms came with opportunistic management behavior and agency problems (Jensen and Meckling, 1976) This, in turn, created a market for independent auditors who should check on firms' management performance with the resources entrusted to them by the owners (Dye, 1993; Francis and Wilson, 1988; Imhoff, 2003) The auditors would attest the fairness of the management's financial reports to various stakeholders and detect serious deviations from generally accepted accounting principles (GAAP) in their audit engagements in accordance with the Generally Accepted Auditing Standards (GAAS) Firms can employ reputable auditors to assure outside investors of the credibility of financial disclosures and hence mitigate the agency problems (Anderson et al., 2004; Willenborg, 1999) Thus auditors serve a corporate governance role in monitoring a firm's financial reporting process (Ashbaugh and Warfield, 2003; Cohen et al., 2002; Fan and Wong, 2005) Independent audits reduce agency costs by verifying the truthfulness and completeness of the financial statements, thereby allowing more precise and efficient contracts to be 118 Z.J Lin, M Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127 based on the financial statements (Cohen et al., 2002; Maniam et al., 2006; Watts and Zimmerman, 1986) Nonetheless, firm-specific corporate governance mechanisms may also determine a firm's decision on auditor selection or switching Several factors motivated this study First, corporate governance has a positive impact on corporate financial reporting and auditing processes A study of auditor switching with respect to internal corporate governance mechanisms may assist in the analysis of audit quality and the auditor's role in ensuring the credibility of corporate financial disclosures Second, for the controlling owners, there is always a tradeoff between hiring or switching to a high-quality auditor to signal good corporate governance to lower the costs of capital raising and hiring or switching to a low-quality auditor to maintain the gains from the opacity of corporate governance (such as the benefits through earnings manipulation by the management or “tunneling” behaviors to transfer resources to its controlling shareholder) Usually it is difficult to disentangle the effects of these two motivations However, the continuous bear market in China during 2001–2004 provides a good opportunity to study the association between firms' internal corporate governance mechanisms and their auditor switching decisions since the incentive for the benefits from lowering capital raising costs was trivial during the period Third, the CICPA has begun to rank auditors in China since the early 2000s in order to improve transparency in the Chinese auditing market, which presents a possibility of identifying high-quality auditors in the Chinese market An investigation of the determinants of auditor switching with respect to the relationship between corporate governance and audit quality should assist the understanding of the necessity and utility of independent audits in China The Independent auditing function can detect or disclose earnings management and other misconducts committed by business managers or the controlling shareholders Thus a firm's management would like to influence auditor choice decisions and have a motivation of switching auditor in order to pursue their own self-interests In particular, when the existing auditor is going to issue an “unclean” (non-standard) audit report, the firm's management or the controlling shareholders may search for a more pliable auditor for the purpose of “opinion shopping” in order to mitigate the negative impact of the unclean audit report on the firm's stock price in the market, and on the self-interests of the management or the controlling shareholders Auditor switching decisions are subject to the constraints of the corporate governance structure in place In general, there are effective monitoring devices over operating activities and management performance if a firm has set up sound corporate governance mechanisms Thus the firm's management or its controlling shareholder may not have a free-hand in making the decision regarding auditor choice or auditor switching Nonetheless the management or controlling shareholder may be able to manipulate auditor choice or auditor switching in terms of their own intension if the firm's corporate governance mechanisms are relatively weak in operation As a result, the risk of aggressive earnings management or “tunneling” behaviors will increase while the credibility of financial statements will decrease Therefore, there should be an association between a firm's corporate governance and its auditor choice or switching decision Hence, this study empirically investigated the relationship between firms' internal corporate governance mechanisms (proxied by ownership concentration, effectiveness of the Supervisory Board (SB) monitoring, and duality of CBoD and CEO) and their auditor switching decisions contextual to the corporate governance practices in the Chinese listed firms Literature review 2.1 Role of auditing function In contemporary market economies, business incorporation led to the separation of ownership and management Firms' owners (shareholders) are not to be directly involved in business administration and professional managers are hired to run daily business operations Due to varied self-interests and information asymmetry, business managers may pursue their self-welfare even at the expense of the owners and other stakeholders, which result in agency costs that must be eventually borne by the management (Jensen and Meckling, 1976) Thus, a series of mechanisms or measures are imposed to bind the managers and to induce them to act in the best interest of the owners One of the binding mechanisms is the auditing function performed by independent professionals over the operations and information disclosures provided by the management (Watts and Zimmerman, 1986; Willenborg, 1999) Independent auditing can reduce the agency costs associated with the contractual relationships between the owners (the principal) and the management (the agent) or among various groups of stakeholders An auditor should not only attest to and verify the fairness and completeness of the financial statements produced by the management, but also monitor the management's financial performance in terms of the stewardship responsibilities (Francis and Wilson, 1988; Imhoff, 2003; Singh and Davidson, 2003) Thus, auditors are able to detect or discover the management's manipulation of accounting numbers (e.g., earnings management) and other misconducts that have violated the established rules or regulations (Beattie et al., 2000; Francis and Krishnan, 1999; Lee et al., 2003) As a result, an audit should be able to ensure the credibility of the financial statements and enhance the usefulness of accounting numbers for investors' decision making (Anderson et al., 2004; Ashbaugh and Warfield, 2003; Johnson and Lys, 1990) In fact, as suggested by Willenborg (1999), an independent audit should serve two roles in corporate financial reporting process; the assurance provider and the information intermediater Nonetheless, the utility of the auditing function depends upon audit quality which is determined by the independence of auditors and the industrial expertise possessed by the auditors (Beattie et al., 2000; Dye, 1993; Francis, 2004; Teoh, 1992) A high-quality auditor should have independence (relationship based), enough expertise (technique based), and good integrity (honesty and forthrightness) In a broad sense, auditor independence includes expertise and integrity Normally, audit quality is considered to be commensurate with the size of the auditing firm, i.e., large audit firms should have a higher degree of independence and possess more industrial expertise and resources so they can provide better quality of auditing services For instance, DeAngelo (1981) contends that audit quality is positively associated with the size and market shares of auditing firms Other studies found that large or brandname auditors should have to bear higher reputation costs and they would be more prudent in audit engagement and more likely to issue qualified or other unclean audit reports to their clients, thus provide audit services with higher quality (Francis and Krishnan, 1999; Lee et al., 2004; Lennox, 2005; Menom, 2003) Some empirical studies have demonstrated that high quality auditors (Big 6/Big 5) can more effectively detect management's earnings management through the use of accounting accruals and thus better ensure the truthfulness and usefulness of accounting information (Balsam et al., 2003; Francis and Krishnan, 1999; Watkins et al., 2004) Relatively, due to the constraints of industrial knowledge and resources, the audit services provided by small auditing firms may be of lower quality (Becker et al., 1998; Ghosh and Moon, 2005; Krishnan, 2003; Teoh and Wong, 1993) Several prior studies demonstrate that investors will attach greater market value to the accounting numbers (e.g., earnings and book values) reported by the clients of large auditing firm, or the market participants will perceive the accounting numbers disclosed by the clients of large auditing firms to have greater “information content” to the market (Francis, 2004; Knechel et al., 2007; Krishnan, 2003; Lennox, 2005; Watkins et al., 2004) DeFond and Subramanyam (1998) argue that there are incentives for firms' managers or controlling shareholders to seek self-welfare by Z.J Lin, M Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127 manipulating accounting numbers or transferring resources through “tunneling” behaviors Thus, they will weigh their self-interests in making auditor choice or switching decisions (Johnson et al., 2000; La Porta et al., 2002) On the one hand, selecting or switching to a large auditing firm will signal to the market that the financial statements should be more reliable under more effective auditing monitoring proved by high quality (large) auditing firms, thus the firms may benefit from lower costs in capital raising from the equity or debt market or from the reduction of agency costs in the enforcement of contractual obligations On the other hand, the managers or controlling shareholders may also consider the capacity of large auditing firms in detecting earning management activities or “tunneling” behaviors and they may prefer to choose or switch to a small auditing firm with relatively lower quality of audit monitoring (Imhoff, 2003; Johnson and Lys, 1990; Lee et al., 2003) In particular, when firms received a “qualified” or other type of unclean audit report, they might initiate auditor switching by searching for more pliable auditing firms with relatively lower quality for the purpose of “opinion shopping” (Chow and Rice, 1982; Geiger et al., 1998; Krishnan, 1994; Lee et al., 2004; Schauer, 2002) This is because receiving an unclean audit reports would depress the prices of a firm's securities and impair its ability to raise funds in future However, the empirical studies on whether firms can be successful in “opinion shopping” have yielded inconsistent results in industrialized countries (Johnson and Lys, 1990; Klock, 1994; Rosner, 2003; Watkins et al., 2004) Nonetheless, many researchers agree that investors and other market participants will normally perceive auditor switching as a negative signal as they believe that firms with auditor switching may become more aggressive in financial reporting which should lead to more “noise” in the accounting numbers being reported, thus, reducing the credibility and usefulness of the financial statements As a result, the market will react negatively to the announcement of auditor switching, such as depressing the firms' stock prices or increasing the firm's cost of capital Thus, there are high costs for a listed firm to switch its auditor For example, the firm should incur negotiation costs, the new auditor needs times to get familiar with the firm's operation and internal control systems, and investors may respond negatively to auditor switching (Anderson et al., 2004; Chaney and Philipich, 2002; Ghosh and Moon, 2005; Klock, 1994; Knechel et al., 2007; Reed et al., 2000; Teoh, 1992) In theory, auditor switching may take different forms, i.e., switching to a smaller auditing firm or switching to a larger auditing firm Many studies confirmed that switching to a smaller or lower quality auditing firm would result in negative responses from investors and other market participants However, in the case of the latter form of auditor switching, since the successor auditing firm is larger than the predecessor auditing firm, the audit quality should improve while the possibility of earnings management or “tunneling” behaviors should reduce As a result, the credibility and usefulness of accounting numbers should increase Nonetheless there is a general lack of research on this regard in the extant literature 2.2 Corporate governance and the auditing function Corporate governance also came with the separation of ownership and management underlying the modern corporate system (Singh and Davidson, 2003) Since many interested parties are associated with business firms there have varied kinds of principal– agent relations, i.e., between owners and the management, controlling (large) shareholders and minority shareholders, creditors and owners/management, regulatory bodies and business firms, etc A primary objective of corporate governance is thus to monitor the behaviors of different interested parties and to reduce the agency costs underlying various principal-agent relationships (Karpoff et al., 1996; Lashgari, 2004; Maniam et al., 2006) Thus, corporate 119 governance can be defined as “a set of mechanisms, both industrial and market-based, that induce the self-interested controllers of a company to make decisions that maximize the value of the company to its owners” (Denis and McConnell, 2003) More specifically speaking, corporate governance is a set of external and internal rules, regulations, procedures and measures to govern the behaviors of various interest parties within a firm A sound corporate governance mechanism should be able to balance the powers and obligations of different interested parties in order to reduce potential conflicts of interest and other agency costs through a series of binding devices to implement the contractual responsibilities and obligations among the shareholder (owners), the Board of Directors (BoD), the management, and the employees, in order to promote goal congruence among the related parties and maximize the values for the firm as a whole (Dewing and Russell, 2003; Singh and Davidson, 2003) Several empirical studies have found that corporate governance is positively associated with a firm's operating efficiency and effectiveness (Anderson et al 2004; Bushman and Smith, 2001; La Porta et al., 2002) Investors are willing to pay a higher premium for firms with sound corporate governance (Bai et al., 2004; Gompers et al., 2003; Lemmon and Lins, 2003; McKinsey & Company, 1999–2002; Steen, 2005) In particular, after the notorious corporate scandals in the early 2000s, such as Enron and WorldCom, more and more market regulators, researchers and practitioners in developed and developing countries have devoted great efforts in corporate governance studies and proposed various procedures to raise the standards of corporate governance in recent years (Bai et al., 2004; Denis and McConnell, 2003; Jiraporn et al., 2005) Market regulators and public investors have all paid great attention to the important role of corporate governance in improving corporate financial reporting and the auditing process (Ashbaugh and Warfield, 2003; Pergola, 2005; Steven, 2006; Ugeux, 2004) Generally speaking, the independent auditing function can be treated as a device of corporate governance, i.e., an audit will provide external monitoring over a firm's financial reporting by independent professionals (auditors) In fact, an audit provides an independent check on the work of the firm's management (agents) and of the information provided by the management, and therefore, serves a fundamental role in reinforcing the confidence in corporate financial reporting Auditor can and should also investigate and evaluate a firm's internal control procedures and measures to ensure rule compliance and reliable information disclosures Thus, the independent audit can enhance the roles of corporate governance (Beasley et al., 2000; La Porta, 2002; Fan and Wong, 2005) The more audits contribute to corporate governance, the more valuable audits are to the firms As high quality auditing firms are more professional and more independent, they are more likely to discover and report irregularities in financial reporting and therefore better serve as a monitoring device Empirical research further indicates that the demand for independent audits as a corporate governance mechanism by firms in UK and US is a function of audit quality and the assurance provided by audit firms (Chaney and Philipich, 2002; Cohen et al., 2002; Ghosh and Moon, 2005; Willenborg, 1999) Nonetheless, corporate governance should also have a positive impact on the quality and effectiveness of external auditing (Abbott et al., 2007; Ashbaugh and Warfield, 2003; Francis et al., 2005) A sound corporate governance mechanism should ensure the firms appoint qualified auditors and ensure that auditors should exercise independent and effective monitoring over the firm's financial reporting process and attest that the financial statements are fairly presented in conformity with GAAP Thus, corporate governance should play a role in enhancing the credibility and usefulness of the financial statements to all stakeholders (Bushman and Smith, 2001; Dewing and Russell, 2003; Fan and Wong, 2005; Maniam et al., 2006) On the other hand, when there is a lack of sound corporate governance, it would be difficult to prevent the firm's managers or 120 Z.J Lin, M Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127 controlling shareholders from infringing upon the interests of the firm and other stakeholders while the audit function may be unable to play its monitoring and assurance roles effectively (Marnet, 2005; Rosner, 2003) Certainly the association between corporate governance and external auditing (including auditor choice and switching) is an important issue worthy of serious study In particular, the business administrative system and corporate governance practices in China differ substantially from those in the developed countries, which may have different impacts on the utility of the auditing function as well as the consequences of auditor switching in the Chinese context To study the determinants of auditor switching from the perspective of corporate governance contextual to the Chinese market environment should not only promote the development of corporate governance and independent auditing in emerging economies like China but also enrich the extant auditing literature on the related issues Hypotheses development Since the establishment of the Shanghai Stock Exchange and Shenzhen Stock Exchange, Chinese listed firms have achieved an accumulated financing amount of RMB 1.16 trillion (RMB 7.5 = US $1) between 1992 and 2004, and the total market capitalization once hit RMB 1.61 trillion in 2000 However, the five years' bear market since 2000 has seen the market value slump by RMB 0.44 trillion to RMB 1.17 trillion in 2004 (CSRC 2005) Because of the weak market, listed firms were less enthusiastic to offer new equity securities to the public from 2001 to 2004 The CSRC even stopped the listed firms from issuing new equity securities to the public in June 2002 In such a market, we posit that the benefits of lowering capital raising costs are insignificant because the listed firms have little intention or possibility of offering new equity securities to the public Therefore, the opaqueness gains from weak corporate governance are supposed to outweigh the benefits of lowering capital raising costs in the bear market period Hence, lower-quality auditing firms may be preferred by the listed firms, and especially by firms with weak internal corporate governance mechanisms, because they have more opaqueness gains to protect (Beasley et al., 2000; Felo et al., 2001) To address the research question empirically, we intended to test the relationship between firms' internal corporate governance mechanisms and their auditor switching decisions In other words, we wanted to find out whether the firms with weak internal corporate governance mechanisms were more likely to switch to auditing firms of lower quality We used three proxies to measure a firm's internal corporate governance mechanisms: the degree of ownership concentration (shareholding of the largest owner), the effectiveness of SB monitoring (SB size), and the duality of CBoD and CEO (BoD oversight over management performance) There are other variables appropriate for measuring internal corporate governance mechanisms, such as the function of the independent (non-executive) directors and the audit committees However, the latter internal monitoring variables are not included in our study because they were introduced to the Chinese listed firms only after 2002 and their full adoption is beyond the test period.1 In the western literature, independent non-executive directors and audit committee are emphasized as important components of internal corporate governance Although some Chinese listed firms might have voluntarily adopted the independent director or audit committee system before the introduction of the new guidelines on good corporate governance practices issued by CSRC in 2002, most Chinese listed firms have not appointed sufficient numbers of independent directors until 2004 or 2005 Furthermore the data for independent directors or audit committees were generally not available during our test period Hence, we assume that the SB, instead of the independent directors or audit committee system, as a significant component of internal corporate governance for the Chinese listed firms during 2001–2004 High ownership concentration is a distinct feature of listed firms in China A Chinese listed firm usually has a large controlling owner.2 The largest controlling owner is usually the government or the parent SOE.3 Nonetheless, ownership structures affect corporate governance and corporate value in many complex ways Johnson et al (2000) argue that more narrowly held firms may face greater agency costs because the controlling shareholders will have a dominant influence on corporate affairs and it is easier for them to bypass the monitoring of other shareholders La Porta et al (1999, 2002) showed that in emerging transitional economies, the controlling shareholders may expropriate the minority shareholders through aggressive “tunneling” behaviors They further argue that “the central agency problem in large corporations around the world is that of restricting expropriation of minority shareholders by controlling shareholders” (La Porta et al., 1999) This is particularly true for Chinese listed firms where the controlling shareholders, on average, hold a very large proportion of the equity In China, the controlling shareholders have frequently intervened in the operations of listed firms to benefit parent companies, using listed firms to guarantee loans for related entities, and exposing listed firms to unnecessary financial and operating risks In fact, the controlling shareholders of many listed firms are keen only to raise funds from the stock market They frequently engage in benefit transfers through misappropriation of funds or related-party transactions to expropriate listed firms and infringe upon the interests of other shareholders (Lin et al., 2007) Extracting private control benefits, if detected, is likely to invite external intervention by minority shareholders, analysts, stock exchanges, or regulators (Haw et al., 2004) The desire to maximize self interests through ‘tunneling’ or benefit transfer leads listed firms to avoid being monitored by highquality auditing firms The higher the degree of ownership concentration (e.g., with large controlling owner), the weaker the internal corporate governance mechanisms and the more opacity gains there will be Therefore, firms with large controlling owners may be more likely to switch to a pliable auditing firm to protect or realize the private benefits gained through earnings management, tunneling behaviors or other misconducts Hence, our first hypothesis can be stated as the following: Hypothesis (H1): ceteris paribus, a firm with a high percentage of total shares held by its controlling owner is more likely to switch to a smaller auditing firm Pursuant to the Chinese Company Law, all Chinese firms have adopted the German-style dual-board system of governance, thus each listed firm has to set up both a BoD and a supervisory board (SB) The SB is composed of shareholders' representatives (including Party officials) and an appropriate proportion of employee representatives who are nominated by the employee union of the firm The Company Law specifically defines the SB as a monitoring mechanism to carry out a series of responsibilities, including the following: monitoring the performance of directors and senior managers, to ensure the compliance with laws, regulations, and the articles of incorporation; reviewing the financial affairs of the firm; According to an investigation report that the share interest of the first large shareholder (mainly the parent SOEs) accounts for, on average, around 50% of the total equity of the Chinese listed companies in 2000 Most of Chinese listed firms were restructured from the former state-owned enterprises (SOEs) Thus there are normally three types of equity holding for a Chinese listed firm, i.e., the state-owned shares (representing the state's interest in the firm), the social-legal-entity shares (mainly the interest of the parent SOEs or other social agencies), and the public shares held by institutional and individual investors, with a major part of the total equity shares in the firm are controlled by the state (government agencies) and/or parent SOEs Z.J Lin, M Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127 requesting directors and senior managers to alter and/or rectify their personal actions if they are in conflict with the firm's objectives; proposing specific shareholder meetings whenever they deem necessary; fulfilling any other duties that are stipulated in the articles of incorporation of the firm; and submitting a SB report to the shareholders' annual general meeting (The Company Law 1993, 1999, 2005) The Standard Codes of Corporate Governance for Listed Companies in China issued by the CSRC and State Economic and Trade Commission in 2002 further requires that SB members should have some professional knowledge or work experience in such areas as law and accounting Under the requirements of Company Law, the SB shall independently and effectively conduct its supervision over the activities carried out by the directors and the management as well as monitor or examine the financial affairs of the firm Such German-styled two-tier board system with co-existence of the BoD and the SB, in fact has become the backbone of corporate governance in most Chinese listed firms since the mid 1990s Using an events study, Dahya et al (2003) suggest that investors consider the SB as an important device of corporate governance in China Chen (2005) found that there was a positive association between the size of the SB and the level of corporate governance More members in a SB will enhance its monitoring role This suggests that a SB of a large size should be more effective in carrying out its legitimate monitoring responsibilities Hence, we adopt the number of SB members as a proxy for the monitoring strength of the SB The fewer SB members a listed firm has, the weaker the internal corporate governance is, vice verse Therefore the second hypothesis can be stated as below: Hypothesis (H2): ceteris paribus, a firm with fewer SB members is more likely to switch to a smaller auditing firm Within a sound corporate governance structure, the BoD must ensure that the management acts in the best interests of the shareholders The BoD is responsible for the execution of the resolutions passed by the shareholders' meetings; for appointing, removing and remunerating the senior managers However, many directors are concurrently the executives of the firm (including the CEO) As a result, they are less likely to be impartial in supervising and evaluating the performance of the management For the BoD to effectively perform an oversight function, the separation of the positions of CEO and CBoD is essential with respect to effective internal corporate governance mechanisms (Claessens et al., 2002; Jiraporn et al., 2005; La Porta et al., 1999) Thus, the CEO's performance can be impartially monitored and evaluated by the BoD Traditionally the duality of the CBoD and the CEO was common in American businesses However, in most European, British, and Canadian businesses, these two positions are usually split, in an effort to ensure better governance of the company Combining the two positions does have its advantages, giving a CEO multiple perspectives on the firm as a result of his/her multiple roles, and empowering him/ her to act with determination Nonetheless, this allows for little transparency in the CEO's acts, and as such his/her actions can go unmonitored, which may pave the way for serious scandals and corruption An effectively independent board is a shareholder's best protection Separating the two important positions allows the CBoD, on behalf of the stockholders, to impartially oversee the work of the CEO and the management's overall performance Ultimately, when CBoD does not occupy the position of CEO, the firm is governed in a more impartial manner (La Porta et al., 2002; Steven, 2006) Investors, researchers, and government officials gradually accept the view that the best practices of corporate governance require the separation of the roles of CBoD and CEO Such a corporate governance 121 device has received a boost since 2003 after recent corporate scandals It is now widely considered as a bad corporate governance practice if the positions of a firm's CBoD and CEO are held by the same person, which will lead to less transparency and ineffective BoD oversight function in the firm In practice, market regulators and professional bodies in many developed countries have all imposed the requirement for the separation of the two important positions as good corporate governance (Jiraporn et al., 2005) The CSRC has also adopted this measure in its Standard Codes of Corporate Governance for the Listed Companies in China since 2002 Consistent with the association between internal corporate governance and the audit function, we'll have the third hypothesis being stated as the following; Hypothesis (H3): ceteris paribus, a firm with CBoD and CEO positions occupied by the same person is more likely to switch to a smaller auditing firm Research methodology 4.1 Model specification We examine the determinants of audit switching from the perspective of the internal corporate governance mechanisms in Chinese listed firms Thus, our sample includes firms that conducted auditor switching in 2001 to 2004 We classified all firms that switched their auditors only once during the 4-year test period into two types: those switching to a larger auditing firm (switching upwards, or SU firms) and those switching to a smaller auditing firms (switching downwards, or SD firms) according to the ranking order of the auditors in China, which was compiled in terms of their annual audit revenues by the CICPA (see Appendix) As elaborated earlier, the size of an auditing firm is regarded as an effective surrogate for the independence and monitoring strength of auditors (DeAngelo, 1981; Willenborg, 1999; Copley and Douthett, 2002; Farbar 2005) Switching to a smaller auditing firm may facilitate listed firms to elude more stringent monitoring from their predecessor auditor Visa verse, switching to a large auditing firm should have opposite effect Thus, we construct a model to test whether a firm's internal corporate governance mechanisms (proxied by ownership concentration, SB monitoring strength and duality of the CBoD and the CEO) is associated with the different types of auditor switching (namely switching to a larger auditing firm or a smaller one) as stated by the three hypotheses We run logit regression on the following auditor switching model to test Hypotheses 1–3 AS = β0 + β1 LSH + β2 SB + β3 CEOCHR + β4 GOV ð1Þ + β5 OPI + β6 LNASSET + β7 LEV + β8 MB + β9 LOSS + β10 Yr02 + β11 Yr03 + β12 Yr04 + ε where: if the firm switches to a smaller auditor; otherwise largest owner's shareholding as a percentage of total shares number of members of the supervisory board if the CEO also holds the position of Chairman of the Board of Directors; otherwise GOV if the largest shareholder is a government agency; otherwise OPI if the firm receives an unclean auditor's opinion for the previous year; otherwise LNASSET log of total assets at the end of the previous year LEV long-term liabilities divided by total assets at the end of the previous year MB market to book ratio at the end of the previous year, AS LSH SB CEOCHR 122 Z.J Lin, M Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127 calculated as the market value of stocks divided by the book value LOSS if the firm experiences a loss for the previous year; otherwise Yr02 if the auditor switching occurs in Year 2002; otherwise Yr03 if the auditor switching occurs in Year 2003; otherwise Yr04 if the auditor switching occurs in Year 2004; otherwise In the regression, the dependent variable is defined by the types of auditor switching Thus, it is coded if a firm switched to a smaller auditing firm, comparing to its preceding auditor For the independent variables, we expect β1 (for ownership concentration) and β3 (for duality of CBoD and CEO) should have positive sign as firms with high ownership concentration and combination of CBoD and CEO positions may be more likely to switching to a smaller auditing firm But β2 (for SB size or monitoring strength) should be negative as a large or stronger SB may discourage the firm to switching to a smaller auditing firm Some studies argue that ownership concentration may not be equal to government control of the listed firms as some nongovernment owned or controlled firms were listed in China in recent years in the course of China's transition towards a market-based economy Thus, government controlled and non-government controlled (privately owned or controlled) firms may have different corporate governance structures and their auditor switching decisions may have varied considerations In general, government agencies have stronger influence over the government-controlled firms, and it is easier for them to get a firm's financial information for their policy needs (Chan et al 2006) So government-controlled firms may have less demand for high quality independent audits and they may have greater propensity to switching to smaller auditing firms compared to non-government controlled firms Therefore, we add another variable of GOV to capture the effect of government controlled ownership on a firm's auditor switching decisions This variable is coded if the largest owner of the firm is a government agency, while nongovernment owned firms are coded It is expected that this variable should be positively associated with downward switching of auditors We also controlled for the effects of some firm-specific factors that have been shown or are likely to affect firms' audit switching decisions; e.g., auditor's opinion, firm size, growth potential, profitability, and financial leverage (risk) There are some studies on auditor switching in the literature, but they focus mainly on the development of auditing markets in western countries (Beattie and Fearnley, 1995; Chaney et al., 2004; Craswell, 1988; DeFond, 1992) Nonetheless, the basic theories and findings in prior research on auditor switching should be applicable to this study as the Chinese auditing profession has gradually adopted international accounting and auditing standards in pace with rapid progress of China's transition towards a market-based economy in recent years One very common reason cited for auditor switching is the qualification of auditor opinions Prior research found that clients receiving an unclean audit report were likely to switch auditors (Chow and Rice, 1982; Geiger et al., 1998; Vanstraelen, 2003), perhaps because the management or the controlling shareholders believed that once an incumbent auditor was dismissed, the firm could find a more pliable auditor whose opinion would be more in line with the management's views (Chow and Rice, 1982; Craswell, 1988;DeFond and Subramanyam, 1998; Vanstraelen, 2003) Alternatively, the management or controlling owners might dismiss an auditor solely as a punishment for the auditor for issuing a goingconcern report, or due to irreparable damages when management was in conflict with the auditor The auditor's opinion is likely to be related to the firm's auditor switching decision and it is controlled in the regression model We expected the variable (receiving an unclean auditor opinion in prior year = 1) should be positively related to downward switching of auditors Large firms have less incentive to switch to a smaller auditing firm, since financial analysts and the financial press will scrutinize their auditor switches more closely Beatty (1993) reports that audit efforts and fees are found to increase with the size and complexity of the clients (Copley & Douthett, 2002) Willenborg (1999) suggest that large firms will be forced to hire or switch to large auditing firms as large firms were usually more complicated in operation, and therefore, needed to hire auditors with more expertise which is usually possessed by large auditing firms Economies of scale also increase the probability that large firms select high-quality auditors, as the high-quality auditing firms (usually of large size) are able to audit large firms at low average costs (Chaney and Philipich, 2002) Following Friedlan (1994) and Lennox (1999), we use the log of total assets to control for the size effect of the firms The sign of firm size variable is thus expected to be negative in the regression Anderson et al (2004) report that firms with a high asset turnover ratio or greater growing potential are inclined to choose high-quality auditors as firms prefer to benefit from the signaling effect of better reputation or quality of large auditing firms We also include marketto-book ratio to control for the propensity of growing firms to switch to less conservative auditors (DeFond and Subramanyam, 1998) In addition, several studies document that firm performance (profitability) or stock returns may affect the selection of auditors (Sainty et al., 2002) Willenborg (1999) documented that firms audited by large auditing firms were more profitable, ceteris paribus More profitable firms may be more eager to switch to a high-quality auditor to testify to their good performance to the market In addition, more profitable firms usually can better afford to switch to a large or a higher-quality auditor Nonetheless, firms that incurred a loss in prior year may have the propensity of switching to a small (lower-quality) auditing firms (DeFond et al., 2000) Hence, both growth and profitability factors are controlled for in the regression model We expect the loss variable should be positively associated with downward switching of auditors Reed et al (2000) found that firms selecting Big auditors tended to be highly leveraged They argue that more leveraged firms have stronger incentives to hire a high-quality auditor to mitigate the market's suspicion on their performance and to lower their costs of capital In contrast, Titman and Trueman (1986) predicted that entrepreneurs of highly-leveraged firms were more likely to choose low-quality auditors Their prediction follows the argument that agency costs tend to be higher in highly leveraged clients so they would be less likely to hire a high-quality auditor Thus, a firm with bad information (e.g., higher financial leverage) may obtain less benefit in switching to a high-quality auditor (Copley and Douthett, 2002; Friedlan, 1994) However, some researchers argue that the signaling value associated with the utility of a high-quality auditing firm will increase if firm-specific risk rises In general, the incentive to switch to a high-quality (large) auditor increases with firm risk (Datar et al., 1991; Hogon, 1997) Willenborg (1999) argues that high-quality auditors can provide better “assurance” to investors: if the audited financial information turns out to be misleading, investors can sue the auditors for a damage award The value of such assurance is increasing with respect to the degree of firmspecific risk However, empirical results are not generally consistent with this prediction (Feltham et al., 1991; Simunic and Stein, 1987) Copley and Douthett (2002) confirmed that the demand for large auditing firms increased with the extent of firmspecific risk (financial leverage) Hence, highly leveraged or more risky firms may benefit from switching to a high-quality auditor because their information uncertainty can be reduced to a greater extent than less leveraged ones Due to opposing arguments associated with auditor switching in the literature for highly- Z.J Lin, M Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127 Table Description of data 123 Table Descriptive statistics of variables Panel A: Sample selection Variable Firms that switched auditors during 2001–04 Less: Firms with missing data Financial, transportation, and utility firms Firms switching auditors more than once during 2001–04 Final sample 316 47 11 25 233 Panel B: Sample distribution by sector and year Sector 2001 2002 2003 2004 Total Industry Commerce Property Conglomerate Total 49 10 13 79 42 10 65 32 6 53 17 10 36 140 29 22 42 233 N Mean Median MIN MAX STD AS LSH (%) SB (#) CEOCHR GOV OPI LNASSET LEV MB LOSS Yr02 Yr03 Yr04 233 233 233 233 233 233 233 233 233 233 233 233 233 0.42 48.94 4.21 0.06 0.79 0.16 21.04 0.08 5.88 0.12 0.28 0.23 0.15 48.38 20.94 0.06 3.88 0 0 0.43 0 19.03 0.00 1.27 0 0 89.51 12 1 24.60 0.51 230.39 1 1 0.50 18.11 1.73 0.25 0.41 0.37 0.89 0.09 15.65 0.33 0.45 0.42 0.36 leveraged firms, we did not predict the sign of this firm-specific risk variable As mentioned earlier, independent non-executive director and audit committee practices were introduced to Chinese listed firms by the CSRC in 2002 with the issuance of the Standard Codes of Corporate Governance for the Listed Companies in China The new Standard Codes require that each listed firm appoint at least one-third independent non-executive directors for the BoD and that the audit committee should be set up under the BoD Because most firms did not fulfill the new requirement until 2004 or 2005, this new internal corporate governance device could not be directly included in our test model Nonetheless, the announcement and implementation of the new Standard Codes may have some impact on the improvement of corporate governance mechanisms for the listed firms in China Thus, we add a dummy variable for the years 2002 to 2004 to capture the potential impact of this new corporate governance device on firms' auditor switching decisions during the test period At the end of 2004, there were 1387 A-share firms listed in the two stock exchanges in China, among which 316 firms (22.7%) switched their auditors during the four year period of 2001–2004 This implies that generally firms are not willing to switch auditors because of the potential high costs associated with auditor switching such as the costs for searching for and renegotiating with a new auditing firm and the potentially unfavorable market/investor responses to auditor switching, etc (Abbott et al., 2007; Anderson et al., 2004; Ghosh and Moon, 2005; Teoh, 1992) Panel A of Table presents the sample size for this study Financial, transportation, and utility firms are excluded in this study because their operations are very different from other types of firms in nature We also delete firms that switched auditors more than once during the four year period Firms switching auditors frequently may indicate some serious underlying reasons which are beyond the scope of this study Also, firms switching twice or more may switch to a larger auditing firm once and to a smaller auditing firm another time, making it difficult to categorize its switching type The final sample consists of 233 firms 4.2 Sampling Empirical results Our sample covers A-share firms that switched auditors during the period from the beginning of 2001 to the end of 2004.4 There are two main reasons to limit the sample firms that made auditor switches in this time period The first one is the availability of the ranking of Chinese auditors, which has been compiled by the CICPA since 2002 Thus it provides a possibility of identifying or classifying the different types of auditor switching (i.e., switching to a larger or a smaller auditing firm) The second reason is that during this time period, firms have only trivial intentions to offer equity issuing to the public, therefore the opaqueness gains from weak corporate governance significantly outweigh the benefits from lowering the costs of capital raising The bear market period from 2001 to 2004 is hence appropriate to test the association of firms' internal corporate governance mechanisms with their auditor switching decisions Data are collected from China Stock Market and Accounting Research (CSMAR) Database, TEJ database (carrying the financial information and stock market data compiled by Taiwan Economic Journal), and the authoritative national newspapers or magazines designated by the CSRC to publish the financial reports of the Chinese listed firms, such as China Security Daily, Shenzhen Security Times, and Shanghai Security News The collected data of the sample firms were cross checked or verified by different data sources to ensure their reliability Description of the data is provided in Table Table presents the basic statistics of the testing variables Among the 233 sample firms, 134 firms switched to larger auditing firms, while 99 firms switched to smaller auditing firms according to the ranking of Chinese auditors The largest controlling owners, on average, held 48.94% of the total shares of the sample firms, indicating high ownership concentration in the Chinese listed firms About 79% of our sample firms are directly owned by the government or governmental agencies, which reflect the fact that the majority of Chinese listed firms were originally carved out from the state owned enterprises (SOEs) and various government agencies remain the largest owners of the listed firms In the sample, 15.9% (37/233) of the firms received unclean auditor opinions before their auditor switches This high percentage may support the assertion that there is an association between unclean auditor opinions being received and auditor switching being made among the Chinese listed firms The average size of SB is about 4.41 with a minimum of persons in a SB and the maximum of 12 persons In 9% of the sample firms (21/233), their CEOs also hold the position of CBoD Table presents the correlation coefficient matrix for the variables used in the regression model Firms' switching to a smaller auditing firm are significantly and positively correlated with the largest owner's shareholding, the same as the size of the SB, CEO holding the position of CBoD and the growth (market-to-book ratio); and significantly and negatively related to firm size (log of total assets) Correlation coefficients among independent variables are moderate with no value exceeding 0.5 (the largest one is only 0.441), so the multicollinearity problem is not serious and won't distort the relationship between the dependent and independent variables in the regression model The stock market in China is segregated The A-share firms are for domestic investors while a small numbers of B-share firms are for overseas investors According to the existing regulations, the financial statements of B-share firms must be audited by international auditing firms (the Big 5/4) Thus, auditor switch for B-share firms was very few because of limited availability of alternative auditors Therefore, those Chinese listed firms issuing both A-shares and B-shares are excluded from our test 124 Z.J Lin, M Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127 Table Correlation coefficient matrix of variables Variable AS LSH SB CEOCHR LNASSET LEV MB LOSS OPI GC Yr02 Yr03 Yr04 AS LSH SB CEOCHR LNASSET LEV MB LOSS OPI GOV Yr02 Yr03 Yr04 1.000 0.105* 0.087* 0.128** − 174*** 0.037 0.128** 0.070 0.054 − 0.004 0.046 − 0.156*** 0.113** 1.000 − 0.045 0.073 0.201*** − 0.161*** − 0.040 0.044 − 0.041 0.211*** 0.021 − 0.092* − 0.011 1.000 0.009 − 0.071 0.045 − 0.016 − 0.031 0.049 0− 029 0.063 0.011 − 0.004 1.000 − 0.148** − 0.155*** − 0.028 − 0.046 − 0.066 − 0.079 0.032 0.025 − 0112** 1.000 0.251*** − 0.095* − 0.209*** − 0.139** 0.086* 0.035 0.099* − 0.013 1.000 − 0.013 − 0.076 0.059 0.021 − 0.001 − 0.019 0.045 1.000 0.011 0.188*** − 0.006 − 0.048 − 0.078 − 0.042 1.000 0.441*** 0.003 0.026 0.044 0.091* 1.000 − 0.122** − 0.035 − 0.040 0.009 1.000 − 0.008 − 0.047 0.017 1.000 − 0.338*** − 0.266*** 1.000 − 0.232*** 1.000 ***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively Table provides empirical results from the regression which tests whether, among the switching firms, firms with weak internal corporate governance mechanisms are inclined to switch to a smaller auditing firm Since there are only two values for the dependent variable (1 for switching to a smaller auditing firms, and for switching to a larger auditing firms), OLS regression does not work for the model Instead, we use logit regression With a Chi-square of 34.641, p b 0.01, and a pseudo R-squared of 0.186, the regression model is satisfactory in differentiating firms switching to smaller auditing firms from those switching to larger ones at the acceptable significance level The coefficient for the largest owner's shareholding is positively significant at the 5% level of significance, which supports H1 It suggests that firms with a higher degree of ownership concentration (i.e., higher percentage of equity shares held by the largest controlling owners) are more likely to switch to a smaller auditing firm Since a higher degree of ownership concentration normally represents weak corporate governance, the result confirms that firms with weak corporate governance would be inclined to switch to smaller auditing firms to avoid more effective monitoring by the larger auditing firms The coefficient for the size of the SB is insignificant, therefore, H2 is not supported, indicating that the SB monitoring effectiveness is not related to whether firms switch to a larger or a smaller auditing firm This finding may suggest that the monitoring role of the SB is in doubt in practice and the SB has no impact on firms' auditor switching decisions at present Since members of the SB are mainly from inside the firm, the question of whether the SB can effectively play a monitoring role is controversial The coefficient for the SB remaining insignificant may indicate that the SB could not effectively play a corporate governance role in the Chinese listed firms Some researchers contend that the SB is mainly decorative in the Chinese firms at present (Dahya et al 2003; Xiao et al 2004) Our study findings confirm such an assertion Consistent with H3, the coefficient for the duality of CBoD and CEO is positive and significant at the 10% level of significance Thus, a firm is more likely to switch to a smaller auditing firm if its CEO also holds the position of CBoD It is interesting to note that the coefficient of the GOV variable is positive but not significant Thus, it is not convincing that the government owned and controlled firms will more likely switch to smaller (low quality) auditing firms in comparison with non government controlled firms Mainly, the ownership concentration is an influential factor underlying a firm's auditor switching decisions in China In addition, the coefficient for the auditor opinion (OPI) variable is positively related to switching to small auditing firms but not at the conventional significance level Therefore, we obtained no sufficient evidence to explain whether firms receiving unclean audit reports would be inclined to switch to smaller auditing firms for the purpose of “opinion shopping” among the Chinese listed firms Nonetheless, this finding is consistent with some studies in the US (Craswell, 1988; Watkins et al., 2004) or in China (Chan et al., 2006) Consistent with our predictions, firm size is negatively related to switching to a smaller auditing firm at the significance level of 0.05 This finding confirms that large firms are less likely to switch to a smaller auditing firm when they make auditor switching decisions An explanation may be that the operations of large firms are more complicated and they may be more concerned about their image in the market, so they would prefer to switch to larger (higher quality) auditing firms when necessary In addition, both variables of growth (market-to-book ratio) and risk (financial leverage) have positive and significant coefficients Hence, firms with great growth potential and high financial leverage ratio were inclined to switch to smaller auditing firms among the Chinese listed firms Normally, fast growing firms have a relatively higher degree of risk in business expansion and they would prefer to switch to smaller auditing firms to have a relatively lower degree of audit monitoring Finally, the profitability of firms (proxied by loss incurred in the prior year) does not have a Table Internal corporate governance mechanisms and switching to a smaller auditing firm test of H1 to H3 (main test) AS = β0 + β1LSH + β2SB + β3CEOCHR + β4GOV + β5OPI + β6 LNASSET + β7 LEV + β8 MB + β9 LOSS + β10Yr02 + β11Yr03 + β12Yr04 + ε Intercept LSH SB CEOCHR GOV OPI LNASSET LEV MB LOSS Yr02 Yr03 Yr04 β0 β1 β2 β3 Β4 Β5 Β6 Β7 Β8 Β9 β10 β11 β12 + 0.021 5.669** − 0.093 1.165 + 1.249 4.089** + 0.022 004 + − 0.123 074 − − 0.408 4.386** + 3.473 3.897** + 0.127 3.876** + 0.209 0.169 ? 0.323 0.760 ? − 0.235 310 ? 0.859 3.757* Predictions ? Coeff 5.644 Wald 1.901 N = 233 Chi-square = 34.641 Pseudo R-square = 0.186 The Wald-Wolfowitz test examines whether the mean (median) of each variable for Top 10 clients equals to that of non Top-10 clients ***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively Z.J Lin, M Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127 125 Table Internal corporate governance mechanisms and switching to a smaller auditing firm test of H1 to H3 (Sensitivity: Top 10 to Non-Top 10) AS = β0 + β1LSH + β2SB + β3CEOCHR + β4GOV + β5OPI + β6 LNASSET + β7 LEV + β8 MB + β9 LOSS + β10Yr02 + β11Yr03 + β12Yr04 + ε Intercept LSH SB CEOCHR GOV OPI LNASSET LEV MB LOSS Yr02 Yr03 Yr04 β0 β1 β2 β3 Β4 Β5 Β6 Β7 Β8 Β9 β10 β11 β12 + 0.053 4.405** − 0.201 0.984 + 3.070 5.082** + − 0.514 0.296 + − 3.013 2.841* − − 0.992 4.043** + 2.789 0.794 + 0.149 0.494 + 0.380 0.051 ? 2.583 4.622** ? 1.292 1.539 ? 2.014 3.063* Predictions ? Coeff 15.221 Wald 2.205 N = 62 Chi-square = 26.005 Pseudo R-square = 0.461 In this sensitivity test we use a more strict measure to proxy for AS Here AS = if switching from a Top 10 auditor to a non-Top 10 auditors and AS = if switching from a non-Top 10 auditor to a Top 10 auditor will be coded as The Wald-Wolfowitz test examines whether the mean (median) of each variable for Top 10 clients equals to that of non Top-10 clients ***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively significant effect on auditor switching decisions among the Chinese listed firms at present In other words, profitability is not a significant concern when a firm decides to switch its auditor As indicated by Table 4, the coefficients for year dummy variables are not significant except for 2004 which is marginally significant at the 10% level This suggests even the Chinese listed firms had been required to adopt the independent non-executive director and auditing committee practices in their corporate governance since 2002 The auditor switches incurred during the test period were not affected by the new corporate governance practices being introduced One explanation may be because most listed firms had not adopted the new practices until 2004, or the new practices did not function well in the test period, even though they were specified by the new corporate governance standard codes being effective since 2002 In summary, the empirical results support that there is an association between a firm's internal corporate governance mechanisms and their auditor switching decisions Namely, firms with weaker internal corporate governance (proxied by higher degree of ownership concentration and duality of CBoD and CEO) would be more likely to switch to a smaller auditing firm rather than to larger auditing firm to avoid more effective audit monitoring provided by large or higher-quality auditors The result implies that the opaqueness gains derived from weak corporate governance (such as earnings management and tunneling behavior) might be a major consideration when firms decided to switch their auditors in China Sensitivity tests To examine the robustness of the regression model and the empirical results, we tried different sensitivity tests First, we use a more strict measure to proxy for the dependent variable of auditor switching (AS), which is defined as switching from a Top 10 auditor to a non-Top 10 auditor The empirical results remain unchanged (see Table 5) In order to make sure that the largest shareholder does control the listed firm, we limit the sample to firms in which the largest owners own a significant percentage of total shares After deleting observations in which the largest owners held less than 10% of total shares, the empirical results remain qualitatively the same (see Table 6) We also adopt alternative proxies to measure the control variables We use the log of revenues to proxy for firm size, the total debt to asset ratio to proxy for financial leverage, and the increase in assets for growth After adopting different measures for these control variables, the empirical results still reveal a significantly positive relationship between auditor switching (AS) and ownership concentration (LSH) and duality of CBoD and CEO (CEOCHR) Again, the coefficient for SB is insignificant We also reran the regression after deleting cases that were more than three standard deviations from the mean and the results remained qualitatively the same Therefore, H1 and H3 are robustly supported, while H2 is not supported in the tests Summary and conclusions The purpose of this paper is to investigate the determinants of firms' auditor switching from the perspective of their internal corporate governance mechanism in China Three measures are used to proxy for internal corporate governance mechanism, including the concentration of ownership (shareholding of the controlling owner), the role of supervisory board (proxied by SB size), and the duality of CEO and CBoD We divided all auditor switches during the period of 2001–2004 into two types: switching to a larger auditor or switching to a smaller auditor, and empirically examined the effects of corporate governance variables on firms' auditor switching decisions Three hypotheses are used to test the association between firms' internal corporate governance mechanism and their auditor switching decisions H1 and H3 are supported, but there is insufficient evidence for H2 Hence firms with larger controlling owners (regardless of direct government ownership) and in which the CBoD and CEO positions are held by the same person are more likely Table Internal corporate governance mechanism and switching to a smaller auditing firm test of H1 to H3 (Sensitivity: Ten Percent Cutoff) AS = β0 + β1LSH + β2SB + β3CEOCHR + β4GOV + β5OPI + β6 LNASSET + β7 LEV + β8 MB + β9 LOSS + β10Yr02 + β11Yr03 + β12Yr04 + ε Intercept LSH SB CEOCHR GOV OPI LNASSET LEV MB LOSS Yr02 Yr03 Yr04 β0 β1 β2 β3 Β4 Β5 Β6 Β7 Β8 Β9 β10 β11 β12 + 0.018 4.003** − 0.082 0.886 + 1.244 4.062** + 0.061 0.027 + − 0.136 0.091 − − 0.415 4.531** + 3.404 3.737* + 0.130 3.958** + 0.178 0.123 ? 0.354 0.907 ? − 0.221 0.276 ? 0.916 4.189** Predictions ? Coeff 5.962 Wald* 2.105 N = 230 Chi-square = 33.746 Pseudo R-square = 0.183 To ensure effective control, this sensitivity test excludes observations in which the largest shareholders hold less than 10% of total shares The Wald-Wolfowitz test examines whether the mean (median) of each variable for Top 10 clients equals to that of non Top-10 clients ***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively 126 Z.J Lin, M Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127 to switch to smaller auditors However, whether firms with smaller or less effective supervisory boards will opt to switch to smaller auditors is not conclusive Generally, we conclude that firms with relatively weak internal corporate governance mechanism are more likely to switch to smaller auditors in order to protect or realize the opaqueness gains associated with weak corporate governance mechanism That the coefficient for SB variable is not significant may imply that the SB does not play an effective monitoring role in the Chinese listed firms at present, possibly because the SB members are mainly from inside the firms and they not have enough expertise in corporate governance and independent auditing Our regression results show that firms with larger controlling owners (higher degree of ownership concentration), or in which the positions of CBoD and CEO are held by the same person are more likely to switch to a smaller auditor rather than to a larger auditor However, the SB monitoring strength is not a significant factor underlying auditor switching decisions The findings generally suggest that firms with weak internal corporate governance mechanism tend to switching to smaller or more pliable auditors to sustain the opaqueness gains derived from weak corporate governance The finding that SB function (proxied by its size to represent its monitoring effectiveness) does not have a significant influence on auditor switching decisions may imply that the monitoring role of SB is not consistently effective in practice This study should contribute to the literature on auditing research As we carefully choose a time period to minimize the incentives for lowering capital raising costs, the association between firms' internal corporate governance mechanism and their auditor switching decisions can be more appropriately pinpointed Although some prior studies have examined whether there is an association between firms' auditor switching decisions and their firm-specific characteristics, those studies did not consider the different types of auditor switching However, the varied types of auditor switching may be driven by different motivations In this study, we classified two major types of auditor switching, namely switching to a larger auditor and switching to a smaller auditor The empirical results demonstrate that the two different types of auditor switching would have varied implications on corporate governance or the firm-specific corporate governance devices will affect a firm's decision of auditor switching in varied manners The findings of this study should update the knowledge on the determinants of auditor switching with respect to the influences of internal corporate governance mechanism In addition, this study should not only assist readers to understand the recent development of audit function and corporate governance in the context of Chinese environment but also facilitate market regulators and participants to keep a close monitoring of the independent auditing process as well as the credibility of financial reporting in the emerging markets like China This paper has several limitations First, more rigorous results could be derived from simultaneous equation methods Simultaneous equation methods can be used to control both the demand and supply sides of independent auditing function However, as many Chinese listed firms not disclose audit fee information, controlling for supply side effects is difficult to perform at present Second, the SB may not be a proper independent variable to proxy for corporate governance as the SB could not play a good monitoring role in the listed firms in China Thus the independent (non-executive) director system or the auditing committee function may be used as alternative corporate governance variables in the future studies when those data become available In addition, we adopted the size of auditing firms to differentiate high- or low-quality auditors There are other variables being employed as alternative indicators of auditor quality in the literature, which could also be used to examine the determinants of auditor choice decisions Appendix A Ranking of auditors in China Ranking 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 Auditor Ranking Auditor PwC Zhongtian KPMG Huazhen Deloitte Huayong EY Huaming Lixin Changjiang Yuehua Xinyongzhonghe Beijing Jingdu Jiangsu Gongzheng EY Dahua Zhongshen Zhongruihua Tianzhizixin Shanghai Zhonghua Lianda Zhejiang Tianjian Tianjian Guangzhou Yangcheng Zhongtianhuazheng Shenzhen Pengcheng Shanghai Donghua Tianyi Hubei Daxin Shanghai Gongxin Jiangsu Suya Zhongxi Zhongxingcai Wuhan Zhonghuan Zhejiang Dongfang Beijing Zhongluhua Shanghai Shangkuai Tianjin Wuzhou Shandong Zhengyuan Shenzhen Nanfang Shenzhen Dahua Guangdong Zhengzhong Hu'nan Kaiyuan Beijing Yongtuo Yunnan Yatai Zhonglei Jiangsu Tianheng Guangdong Tianhua Beijing Tianhua 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 Jiangsu Tianhua Huayan Gansu Wulian Zhejiang Wanbang Beijing Zhongzhou Huazheng Guangdong Hengxin Nanjing Yonghua Shandong Wanlu Chongqing Tianjian Xi'an Sigma Jiangsu Tianye Anhui Huapu Xiamen Tianjian Sichuan Huaxin Shandong Huide Beijing Zhongxingyu Beijing Zhongwei Shenzhen Tianjian Fujian Huaxing Beijing Zhongxing Shanghai Wanlong Shandong Tianghengxin Yatai Group Zhongtianyin Huajian Guangdong Kangyuan Shanghai Tongcheng Zhonghengxin Beijing Zhongzheng Shanghai Shangshen Liaoning Tianjian Beijing Xinghua Beijing Zhongtianheng Shandong Qianju Sichuan Hongri Zhongqin Wanxin Hebei Hua' Beijing Zhongpingjian Sichuan Junhe Shanghai Jiahua Guangxi Xianghao Note: The rankings are based on average audit revenues of Year 2002–04 as compiled by CICPA.2) Auditors must be ranked among the top 100 based on revenues for all three years of 2002–04 References Abbott, L J., Parker, S., Peters, G F., & Rama, D V (2007) Corporate governance, audit quality, and the Sarbanes-Oxley Act: Evidence from Internal Audit Outsourcing The Accounting Review, 82(4), 803−835 Anderson, U., Kadous, K., & Koonce, L (2004) The role of incentives to manage earnings and quantification in auditors' evaluations of management-provided information Auditing: A Journal of Practice & Theory, 23(1), 11−27 Ashbaugh, H., & Warfield, T D (2003) Audits as a corporate governance mechanism: 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