DOI: 10.1111/j.1475-679X.2006.00211.x Journal of Accounting Research Vol. 44 No. 3 June 2006 Printed in U.S.A. Does Opinion Shopping Impair Auditor Independence and Audit Quality? TONG LU ∗ Received 7 October 2004; accepted 22 October 2005 ABSTRACT This study investigates how companies’ threats to dismiss auditors and their engagement in opinion shopping influence auditor independence and au- dit quality, which in turn affect misstatements in financial statements. It also examines how outsiders’ reactions to auditor switching influence opinion shopping. The results indicate that neither the predecessor auditor’s nor the successor auditor’s independence is compromised by dismissal threats and opinion shopping. Further, the successor auditor’s audit quality exceeds the predecessor auditor’s audit quality. In addition, auditor switching decreases potential understatements and increases potential overstatements in finan- cial statements, and the capital market’s and the successor auditor’s reac- tions to auditor switching reduce the benefits of opinion shopping to com- panies. Additionally, the study sheds some light on the potential effects of both the Sarbanes-Oxley’s restriction on non-audit services and mandatory auditor rotation or retention. The paper also derives a rich set of empirical implications. ∗ University of Houston. This paper is based on my dissertation at the University of Minnesota. I am very grateful to my advisor, Chandra Kanodia, for his guidance. I also thank the members of my dissertation committee, Regina Anctil, Andrea Moro, and especially Frank Gigler, for their advice. I gratefully appreciate the constructive comments by the anonymous referee. Thispaper hasalso benefitedfrom thecomments ofPhilip Berger(the editor),Haresh Sapra, Raghu Venugopalan, and workshop participants at the University of Minnesota. 561 Copyright C  , University of Chicago on behalf of the Institute of Professional Accounting, 2006 562 T. LU 1. Introduction The recentexplosivegrowth inauditor switching isexemplified by thefact that in 2004, more than 1,600 companies changed their outside account- ing firm, an increase of 78% over 2003. Moreover, 61 companies changed auditors at least twice in 2004, and the 2,514 changes during 2003 and 2004 represents more than one-fourth of all U.S. publicly traded companies (Taub [2005]). Whereas some auditor switches occur for legitimate reasons like client firm growth, others are driven by opinion shopping, which “is generally understood to involve the search for an auditor willing to sup- port a proposed accounting treatment designed to help a company achieve its reporting objectives even though that treatment might frustrate reli- able reporting” (SEC [1988]). To date, debate continues in the financial community, academic literature, and popular press as to the most effective way of curbing opinion shopping. Whereas the Sarbanes-Oxley Act of 2002 required the General Accounting Office to study the potential effects of mandatory auditor rotation in strengthening auditors’ resistance to opin- ion shopping threats, some scholars advocate a policy of mandatory auditor retention to mitigate companies’ opinion shopping opportunities (Lennox [1998]). Legislators’ and regulators’ attention to auditor switches apparently re- sults from two concerns: (1) impairment of the reliability of reported ac- counting numbers because of auditors’ failure to detect misstatements in financial statements (an issue of “audit quality”) and (2) expansion of op- portunities for earnings management by unscrupulous managers because of auditors’ failure to deal appropriately with detected misstatements (an is- sue of “auditor independence”). Audit quality refers to the probability that the auditor will detect misstatements, while auditor independence refers to the probability that the auditor will refuse to support detected misstatements. The concern is that companies’ threats to dismiss auditors and their engage- ment in opinion shopping might damage auditor independence and audit quality, thereby precipitating materially misstated financial statements and ultimately harming capital market investors. Most debate over opinion shopping has so far revolved around manda- tory auditor rotation versus mandatory auditor retention. However, before answering the questions of whether and how the government should inter- vene, the status quo free market setting in which companies can voluntarily switch auditors should be investigated first. Therefore, several more prim- itive economic questions must precede the issue of public policy: Are the predecessor auditor’s and the successor auditor’s independence impaired by dismissal threats and opinion shopping? Is the successor auditor’s audit quality lowerthan the predecessorauditor’saudit quality?Are misstatements in financial statements increased by opinion shopping? Can companies fool the capital market and the successor auditor and reap the full benefits of opinion shopping? This paper contributes to the research stream by ad- dressing these crucial questions. OPINION SHOPPING 563 Dye [1991] and Teoh [1992] are important forerunners of this paper in that they too investigate auditor switches resulting from auditor-client dis- agreements ina capital market setting. However, thereare two important dif- ferences between those studies and this study. Whereas Dye [1991] presents what might be termed a “vindication seeking” view of auditor switches in which auditor replacement is done by “good” firms, my theory integrates both “vindication seeking” and “opinion shopping.” Similarly, whereas Teoh [1992] focuses on auditor switching after public disclosure of audit opinions, my investigation concentrates on firms’ shopping for opinions before their public release. My model introduces two opposing forces that influence auditors’ de- cisions: auditor fee and legal liability. Auditor fees are potential auditor benefits from repeat audit business and non-audit services, while legal li- abilities are those that may be imposed on auditors when the rosiness of a client’s portrayal turns out to be gloomy. Auditors are assumed to choose their audit quality and attestation so as to maximize the differ- ence between the expected auditor fee and legal liability, less the audit cost. The firm is assumed to maximize its price in the capital market, less the auditor fee, by choosing the proposed accounting report, the audi- tor fee, and the auditor switching strategy, thereby influencing its audi- tor’s audit quality and attestation, and thus misstatements in audited ac- counting reports. The price in the capital market depends on inferences that traders make from audited accounting reports; the beliefs of traders are consistent with the firm’s and the auditor’s equilibrium choices. Infor- mational differences in reports induce a change in the behavior of mar- ket prices, which in turn induces changes in the firm’s and the auditor’s decisions. The results in my paper depend on informational differences in audited accounting reports caused by different directions and degrees of misstatements, which are affected by auditor independence and audit quality. The study’s primary findings are as follows. First, neither the predeces- sor auditor’s nor the successor auditor’s independence is compromised by dismissal threats and opinion shopping. Second, the successor auditor’s audit quality exceeds the predecessor auditor’s audit quality. Third, auditor switching decreases potential understatements and increases potential over- statements in financial statements. Fourth, both the capital market’s and the successor auditor’s reactions to auditor switching reduce the benefits of opin- ion shopping to companies. The first twofindings contrast starkly with the popular beliefthat dismissal threats and opinion shopping impair auditor independence and audit qual- ity, which implies that a policy of mandatory auditor rotation or retention is called for. Rather, my analysis suggests that proponents of such public policies fail to recognize the corporate governance role of capital market prices in disciplining excessive client pressure. Nevertheless, the results on auditor independence and audit quality do not necessarily imply that opinion shopping is innocuous. Rather, 564 T. LU as the third finding asserts, auditor switching may decrease one type of misstatement (understatements) but increase the other (overstatements). On the other hand, a policy of mandatory auditor retention, which forbids auditor switching for a fixed duration, may prevent correction of under- statements. Furthermore, I show that, when auditor switching is feasible, in the preswitching period, firms prefer auditor conservatism; however, as a result of mandatory retention, firms with better prospects would prefer audi- tor aggressiveness instead. Thus, in evaluating alternative policy proposals, legislators and regulators must carefully investigate the trade-off between understatements and overstatements. The fourth finding extends the points made earlier and implies that mandatory auditor rotation may take away valuable information from out- siders. In a free market, auditor switching is voluntary and so is itself in- formative to outsiders: the capital market and the successor auditor extract useful information from auditor switching to assess the firm’s financial con- dition. This finding shows that outsiders’ assessments and consequent re- actions reduce the benefits of opinion shopping to companies; in some cases, they even preclude opinion shopping. In contrast, mandatory rota- tion, which forces all types of firms to switch auditors after a fixed duration, suppresses the information content of auditor switching, thereby possibly providing a cover for opinion shopping and encouraging overstatements. Thus, my analysis suggests that requiring mandatory auditor rotation may be dysfunctional. The analysis also sheds some light on the potential effects of banning most auditor-provided non-audit services, which is required by the Sarbanes- Oxley Act of 2002. I show that, (1) given auditor conservatism, the ban im- pairs audit quality; (2) given auditor aggressiveness, the ban improves audit quality; and (3) a severe restriction on non-audit services makes attestations conservative. In addition to the above main results, the analysis provides a framework to both explain systematically many extant empirical findings and derive a rich set of new empirical predictions. These empirical implications in- clude (1) the likelihood, behavior, and consequences of auditor switching; (2) the properties of and the asymmetric price responses to audited ac- counting reports; (3) the determinants and consequences of auditor con- servatism and audit quality; and (4) comparisons of the predecessor and successor auditor’s fees and their impacts on auditor conservatism and audit quality. The remainder of the paper is organized as follows. Section 2 de- scribes the model. Section 3 characterizes equilibrium reporting, attes- tation, and capital market price, and section 4 characterizes audit qual- ity in the absence of auditor switching. Section 5 outlines both the equilibrium in the presence of auditor switching and the firm’s equi- librium auditor switching strategy. Section 6 investigates auditor fees before and after auditor switching. Finally, section 7 presents possible extensions of the model. Proofs of propositions are contained in the appendix. OPINION SHOPPING 565 2. The Model I studya financial accounting and auditingsetting inwhich a firmprovides the capital market audited financial statements on its profitability. The firm hasa decreasingreturnsto scaletechnologythat producesstochastic returns. Specifically, by investing k in the firm’s technology, capital market investors receive a positive return of 2 √ k with probability p and a zero return with probability 1 − p. The profitability parameter p takes the value p G with probability 1 −x and the value p B with probability x, where 1 ≥ p G > p B ≥ 0 and 1 >x > 0. Because the value of p is unobservable to investors, the firm is required to publish report G or B to indicate whether p is p G or p B . Based on the report and other available information, the capital market prices the firm at m. To ensure its consistency with the firm’s underlying financial condi- tion, the accounting report must be audited by an auditor before its re- lease. The auditor’s audit technology produces audit evidence on the firm’s profitability parameter p. The audit evidence can be either con- clusive or uninformative. Uninformative evidence, denoted by p 0 , where p 0 = Pr(p G )p G + Pr(p B )p B , provides no incremental information, and it can also be interpreted as two pieces of conflicting evidence. In contrast, conclusive evidence, either p G or p B , unmistakenly identifies the value of p and so can be used to check for misstatements in the client’s proposed report. In the real world, the audit technology is not always able to pro- duce conclusive evidence, a feature that the model captures by assuming that the conclusive evidence is produced with probability q and the unin- formative evidence is produced with probability 1 − q. The probability of obtaining conclusive evidence—or equivalently, the probability of detecting misstatements, q—is referred to as “audit quality.” This audit quality q can be increased by devoting more resources to the audit technology. Letting C(q) denote the audit cost required to achieve a certain level of q, C(q)is increasing and convex in q with C(0) = 0, C  (0) = 0, and C  (1) =∞. Audit evidence helps auditors make informed attestations. The auditor must give either an unmodified audit opinion, U , in support of the client’s report or a modified audit opinion, M, stating disapproval of it. The prob- ability that the auditor refuses to support detected misstatements is here termed “auditor independence.” Thus, auditor independence would be com- promised if an auditor with the audit evidence p B supported the report G. However, no issue of auditor independence exists when the audit evidence is uninformative because such evidence cannot reveal any misstatement. To induce an unmodified opinion on its preferred report, the firm lures the auditor with future audit and non-audit services. The total auditor fee from these businessopportunities isdenoted byF . 1 If the auditoris unwilling 1 F does not include the fee for the current audit engagement. The current period audit fee is required to be noncontingent on the current period audit opinion and so it is not modeled here. Results from a setting in which the current period audit fee is formally modeled are available upon request. 566 T. LU to support its report, the firm may threaten to take away the business oppor- tunities and appoint a new auditor. As a countervailing force against client pressure, a legal liability, L, is imposed on any auditor giving an unmodified opinion, U, on the firm’s report G when the subsequently realized return to investment turns out to be zero. The sequence of events is as follows: 1) The firm chooses an auditor fee, F . 2) The firm’s profitability parameter, p, is realized. 3) The auditor chooses an audit quality, q, and then receives the audit evidence. 4) The firm and the auditor decide on the accounting report, G or B, and the audit opinion, U or M. 5) The firm decides whether to switch auditors. If the firm switches auditors, it chooses an auditor fee, F , for the new auditor and the sequence of events goes back to stage 3 and continues onward; if the firm does not switch auditors, the accounting report and the audit opinion are released. 6) Capital market investors price the firm at m and make an investment of k. 7) The return to investment is realized, and legal liability, if any, is imposed on the auditor. Regarding observability of information, the profitability parameter, p,is private to the firm; the audit quality, q, and the audit evidence are private to the auditor; and all else are public information. In terms of the decision-makers’ objectives, the firm maximizes its expec- tation of themarket price less theauditor fee by choosing the report, the fee, and whether to switch auditors; the auditor chooses his or her audit quality and attestation to maximize the expected auditor fee less the expected legal liability, net of the audit cost; and the capital market investors choose their investments to maximize their expected return on investments. 3. Reporting, Attestation, and Capital Market Price The characterization of equilibrium in the absence of auditor switching begins with an outline of the firm’s reporting strategy, the auditor’s attesta- tion decision, and the capital market’s pricing rule. Letting ˆ p denote theinvestors’assessment ofthe firm’sprofitabilityparam- eter, p,on thebasis oftheaccounting reportand otheravailable information, an investment of k will produce a positive return of 2 √ k with probability ˆ p and a zero return otherwise. Therefore, the investors’ objective function— their expected return on investments—is 2 √ k ˆ p − k. The first-order condi- tion with respect to k implies that the optimal level of investment is ˆ p 2 . Inserting this value of k into the objective function yields ˆ p 2 , which equals the equilibrium price in a competitive capital market: m = ˆ p 2 . (1) OPINION SHOPPING 567 Equation (1) expresses the market price as a function of the market belief. How the market forms its belief, ˆ p, depends on its understanding of the auditor-client interactions that produce audited accounting reports, which the following text elaborates. Recall that the auditor is torn between auditor fee and legal liability when facing the client’s favorite report, G: disapproving G jeopardizes the auditor fee, F , whereas supporting G risks legal liability, L. Thus, the auditor assesses the litigation risk on the basis of the audit evidence. When the evidence is conclusive (p G or p B ), the auditor’s expected legal liability when supporting G is (1 − p G )L or (1 − p B )L. When the evidence is uninformative, the auditor uses the prior expectation of p, p 0 , to assess the expected legal liability, which is (1 − p 0 )L. Comparing the expected legal liability with the expected auditor fee, the auditor decides whether to support the client firm’s preferred report, G. Because (1 − p G )L < (1 − p 0 )L < (1 − p B )L, only four cases need be considered: (1) F ≤ (1 − p G )L, (2) (1 − p G )L ≤ F ≤ (1 − p 0 )L, (3) (1 − p 0 )L ≤ F ≤ (1 − p B )L, and (4) (1 − p B )L ≤ F . Case (1): F ≤(1 −p G )L. In this extreme case, the auditor fee is too small to cover even the smallest expected legal liability; so the auditor refuses to approve report G regardless of audit evidence. Therefore, the firm is forced to issue report B no matter what its profitability. Yet such a report B contains no information whatsoever about p and is thus ignored by the capital market, which then uses its prior belief about p, p 0 , to price the firm according to equation (1): m = p 2 0 . Case (4): (1 − p B )L ≤ F . In this other extreme case, the auditor fee is so large that it can cover even the largest expected legal liability; therefore, the auditor approves whatever report the client prefers regardless of audit evidence. However, once again, such a report, either G or B, contains abso- lutely no information about p and is therefore ignored by the market. Thus, as in case (1), the market uses its prior belief, p 0 , to price the firm: m = p 2 0 . Cases (1) and (4) indicate that excessive legal liability or excessive auditor fee leads to “uninformative accounting,” in which accounting reports pro- vide no incremental information on the firm’s financial condition.Thus, the market’s belief given uninformative accounting is the same as the market’s belief prior to the release of accounting reports: p 0 = (1 − x)p G + xp B . (2) Additionally, by equation (1), the market price prior to the release of ac- counting reports is m 0 = [(1 − x)p G + xp B ] 2 . (3) Because reports from uninformative accounting make no impression on the capital market, the firm will not choose a fee, F , to induce uninformative accounting. Thatis, uninformative accountingis not an equilibrium. Rather, if informative reports are to be produced, the tension between auditor fee and legal liability must not be lopsided, as shown in the two remaining 568 T. LU G p q 1 – q q 1 – q 0 p 0 p B p firm type audit evidence G p B p GG G G B B BB conservative accounting aggressive accounting 1 – x x F IG. 1.—Conservative and aggressive accounting. cases. Case (2): (1 − p G )L ≤ F ≤(1 − p 0 )L. In this case, audit evidence matters to theauditor. Recall that the favorableevidence, p G , impliesthat theclient is a high-profitability firm, whereas the unfavorable evidence, p B , implies that the client is a low-profitability firm; while the uninformative evidence, p 0 , may correspond toeither ahigh- or low-profitabilityfirm. Whenthe evidence is favorable (p G ), the auditor fee exceeds the legal liability ((1 − p G )L ≤ F ), so the auditor approves report G. When the evidence is unfavorable (p B ) or uninformative (p 0 ), the legal liability exceeds the auditor fee (F ≤ (1 − p 0 )L < (1 − p B )L), so the auditor disapproves G and the firm has to issue B. Clearly, in case (2), a high-profitability firm’s financial condition (p G ) might be understated (reported as B), whereas a low-profitability firm’s financialcondition wouldnot.This typeofaccounting, withsuch asymmetric understatements—here termed “conservative accounting”—is illustrated in figure 1. Based on its understanding of the auditor-client interaction, the market makes its rational inferences. If report G is issued, the market believes that the auditor has identified the firm as a high-profitability type, p G , so its belief given G is ˆ p G = p G . If report B is issued, the market believes that either the firm is a high-profitability type, p G (the probability of which is 1 −x), not so identifiedby theauditor(the probabilityofwhich is1−q) or thefirm is alow- profitability type, p B (the probability of which is x). Therefore, the market’s belief given B is, by Bayes’ Theorem, ˆ p B = (1 −x)(1−q)p G +xp B 1 −(1 −x)q . 2 Inserting the expressions for the market’s beliefs, ˆ p G and ˆ p B , into equation (1) yields the 2 Section 4 provides an explanation of how the market rationally infers audit quality, q,on the basis of observable information. OPINION SHOPPING 569 market prices given G and B, denoted by m c G and m c B , respectively. (The superscript c denotes conservative accounting.) Case (3): (1 − p 0 )L ≤ F ≤ (1 − p B )L. The analysis for this case is similar to that for case (2). The auditor’s attestations in case (3) differ from those in case(2) only when the evidence is uninformative (p 0 )—because auditor fee exceeds legal liability ((1 − p 0 )L ≤ F ), the auditor approves G. Clearly, in case (3), a low-profitability firm’s financial condition (p B ) might be over- stated (reportedas G),whereas ahigh-profitability firm’sfinancial condition would not. This type of accounting with such asymmetric overstatements, here referred to as “aggressive accounting,” is illustrated in figure 1. From figure 1, given aggressive accounting, the market’s rational belief given B is ˆ p B = p B , and its belief given G is ˆ p G = (1 −x)p G +x(1 −q )p B 1 −xq . Inserting the expressions for ˆ p G and ˆ p B into equation (1) yields the market prices given G and B, denoted by m a G and m a B , respectively. (The superscript a denotes aggressive accounting.) The above results are summarized in the following proposition. P ROPOSITION 1. a) (Conservative accounting). When (1 −p G )L ≤ F ≤ (1 − p 0 )L, a high-profitability firm p G publishes report G if it is detected by the auditor but B otherwise, a low-profitability firm, p B , publishes B, and the market prices given G and B, respectively, are m c G = p 2 G and m c B =  (1 − x)(1 −q)p G + xp B 1 − (1 − x)q  2 . (4) b) (Aggressive accounting). When (1 − p 0 )L ≤ F ≤ (1 − p B )L , a low-profitability firm, p B , publishes report B if it is detected by the auditor but G otherwise, a high- profitability firm, p G , publishes G, and the market prices given G and B, respectively, are m a G =  (1 − x)p G + x(1 −q)p B 1 − xq  2 and m a B = p 2 B . (5) c) Regardless of the accounting type, the auditor approves G when the audit evidence is p G and disapproves G when the audit evidence is p B ; when the audit evidence is p 0 , the auditor disapproves G given conservative accounting and approves G given aggressive accounting. Proposition 1 and figure 1 directly imply the following results: C OROLLARY 1. a) Auditor independence is not compromised. b) A lower (higher) F relative to L results in auditor conservatism (aggressiveness). c) Pr (misstatements) is decreasing in q. d) Pr (misstatements |conservative accounting) < Pr (misstatements |aggressive ac- counting) if and only if Pr(p G ) is sufficiently low. e) The report G produced from conservative accounting ismore informative than G pro- duced from aggressive accounting; the report B produced from aggressive accounting 570 T. LU is more informative than B produced from conservative accounting. f) Pr (G |conservative accounting) < Pr (G |aggressive accounting). Corollary (1a) states that auditor independence is maintained in equi- librium: the auditor approves G when the audit evidence is favorable and disapproves G when the audit evidence is unfavorable. That is, the audi- tor refuses to support detected misstatements. This important conclusion results from the corporate governance role of market prices. Supposing that a low-profitability firm is identified by the auditor, to induce the au- ditor’s attestation to its favored report—that is, to compromise auditor independence—the low-profitability firm must offer a huge auditor fee to allay its auditor’s legal liability concern (F ≥ (1 − p B )L). However, such a huge fee destroys the financial report’s credibility in the eyes of the capi- tal market, which then ignores these rosy reports in its pricing of the firm. Consequently, anticipating the market’s rational pricing, the firm does not find it worthwhile to offer its auditor a huge fee in return for nothing ex- tra from the market. Thus, the market’s pricing regulates excessive client pressure on the auditor, and auditor independence is maintained in equilib- rium. In equilibrium, misstatements in financial statements may only survive when the auditor receives uninformative evidence; however, as discussed in section 2, this issue is not one of auditor independence but of audit quality. A poorer audit quality implies a greater likelihood of uninformative evi- dence and consequently a greater likelihood of errors in attestations. When the auditor fee is small relative to the legal liability, litigation risk concerns provide incentives for auditors to err on the side of conservatism. Specif- ically, when in doubt, the auditor disapproves the client’s more favorable report and may unknowingly force a high-profitability firm to issue a less favorable report. Thus, auditor conservatism may result in understatements in financial statements, leading to conservative accounting. On the other hand, when the auditor fee is large relative to the legal liability, lucrative business opportunities provide incentives for auditors to err on the side of aggressiveness. That is, when in doubt, the auditor approves the client’s more favorable report and may unknowingly allow a low-profitability firm to issue a more favorable report. Thus, auditor aggressiveness may lead to overstatements, causing aggressive accounting. Overall, as Corollary (1b) shows, the tension between the auditor fee and legal liability determines auditor conservatism/aggressiveness and in turn leads to accounting con- servatism/aggressiveness. 3 Clearly, conservative accounting may hurt “good” firms and aggressive accounting may hide “bad” firms. Thus, the less likely the firm is to be a 3 Even though many factors contribute to accounting conservatism/aggressiveness, this study focuses on one factor: auditor conservatism/aggressiveness. Whereas Gigler and Hem- mer [2001] and Venugopalan [2004] study cases in which these two types of accounting are exogenous systems, this paper addresses a case in which they are endogenous outcomes. [...]... successor OPINION SHOPPING 581 auditor s choice of a higher audit quality than that of the predecessor auditor (Proposition (7c)) makes opinion shopping less likely to succeed 7 Conclusion My results contradict the conventional wisdom that opinion shopping impairs auditor independence and audit quality I study a plausible capital market setting in which (1) firms have information superior to the market and auditors... x[(1 − p B )L − F ], and dq 1 dF (9) < 0 Figure 2 illustrates the auditor s optimal audit quality as a function of the auditor fee Clearly, depending on the type of accounting, a larger auditor fee may cause a higher or lower audit quality, which implies that the popular belief that auditor fee depresses audit quality is not always correct The relation between audit quality and auditor fee is driven... of audit quality) Therefore, having established that auditor independence is maintained in equilibrium, the discussion now turns to audit quality 4 Audit Quality A higher audit quality increases the chances of informative audit evidence and helps the auditor make more informed attestations Nevertheless, a higher audit quality necessarily comes at a higher audit cost In view of this trade-off, the auditor. .. the successor auditor and stimulates audit quality A mandatory rotation, on the other hand, forces all types of firms to switch auditors and therefore eliminates the information content of auditor switching As a result, it may not enhance audit quality but may encourage overstatements by providing a good cover for opinion shopping Therefore, my theory questions the wisdom of mandatory auditor rotation... conditions, and (2) firms are concerned about how they are priced in the capital market I show that neither auditor independence nor audit quality is impaired by dismissal threats and opinion shopping In addition, auditor switching decreases potential understatements and increases potential overstatements in financial statements, and because of the capital market’s and the successor auditor s reactions to auditor. .. successor auditor s fee and the predecessor auditor s fee As evidenced by figure 2, the auditor fee affects both the auditor s attestation (conservative or aggressive) and the audit quality (q) Thus, when choosing the auditor fee, the firm takes into account both effects of the fee 6.1 DETERMINATION OF THE SUCCESSOR AUDITOR S FEE, F2 By Proposition 5, the switching firm induces aggressive accounting after auditor. .. spectrum of auditor- provided non -audit services It is clear from figure 2 that such restrictions on auditor fees have 574 T LU three impacts: (1) given conservative accounting, a restriction on auditor fees will impair audit quality; (2) given aggressive accounting, a restriction will improve audit quality, but with a higher audit cost; and (3) a severe restriction might eliminate aggressive accounting and. .. Sections 3 and 4 have addressed a situation in which auditor turnover is absent; however, when auditor switching is introduced, significant changes occur 5 Auditor Switching This section begins with outsiders’ (the capital market’s and nonincumbent auditors’) perceptions of and reactions to auditor switching and then characterizes the firm’s auditor switching strategy given these perceptions and reactions... x)q 1 1 − (1 − x)q 1 (10) OPINION SHOPPING 575 Hence, outsiders’ prior expectation of p given auditor switching is p0 = (1 − x)(1 − q 1 ) p G + xp B 1 − (1 − x)q 1 (11) Outsiders’ skepticism about auditor switching considerably affects the successor auditor s audit quality and capital market prices Like that of the predecessor auditor, the successor auditor s independence is unimpaired in equilibrium... the incentive for the auditor to raise the audit quality, q Therefore, given aggressive accounting, a larger auditor fee causes a lower audit quality Overall, the tension between auditor fee and legal liability not only affects auditor independence but also affects audit quality It might seem that if this tension were just right, either kind of attestation error would be precluded, meaning that neutral . the predecessor auditor s and the successor auditor s independence impaired by dismissal threats and opinion shopping? Is the successor auditor s audit quality lowerthan the predecessorauditor’saudit quality? Are. successor auditor s independence is compromised by dismissal threats and opinion shopping. Second, the successor auditor s audit quality exceeds the predecessor auditor s audit quality. Third, auditor switching. that influence auditors’ de- cisions: auditor fee and legal liability. Auditor fees are potential auditor benefits from repeat audit business and non -audit services, while legal li- abilities are