The change of auditors in businesses and earnings conservatism

This paper investigates the level of earnings conservatism during the first year of auditor change. We hypothesize that newly-appointed auditors demand more conservative accounting compared to established auditors due to lack of specific knowledge about the new client and higher litigation risks. We measure earnings conservatism based on the asymmetric recognition speed of good news and bad news on earnings, using Basu's reverse regression. The sample includes 3,054 firm-year observations from 2003-2008. Our results indicate that firms with a newly-appointed auditor experienced significantly higher earnings conservatism than other firms. We also find that the level of earnings conservatism required by newly-appointed auditors depends on the size of the former auditor and that of the successor. Specifically, we find that firms that change from a small audit firm to one of the Big 4 exhibit significantly higher earnings conservatism than firms that change from one of the Big 4 to a small audit firm. This evidence is consistent with the argument that auditors require more conservative accounting when the risk of litigation is higher.