Bankrupcy, Auditor Switching and Audit Failure: Evidence from the UK 1987-1994

Abstract

If a company's auditor believes that the company is likely to enter bankruptcy, the auditor is required to warn investors by giving a 'qualified' audit report. This paper investigates whether auditor switching can help explain why auditors frequently fail to warn about impending bankruptcy. The paper shows that managers use the switch decision to avoid receiving qualified reports and a switch exogenously reduces the accuracy of audit reports by replacing established incumbent auditors with less well informed new auditors. These results mean that the use of switching by managers is not necessarily contrary to investors' interests. Moreover, policies aimed at reducing managerial influence - for example, a recent EC policy proposal recommended the compulsory periodic switching of auditors - could reduce the accuracy of audit reports.