lin and liu - 2010 - the determinants of auditor switching from the perspective of corporate governance in china

The determinants of auditor switching from the perspective of corporate governance
in China
Z. Jun Lin
a,
⁎
, Ming Liu
b
a
Department of Accountancy and Law, Hong Kong Baptist University, Kowloon Tong, Kowloon, Hong Kong
b
Department of Accounting and Information management, The University of Macau, Macau
abstract
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 govern ance 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.
1. 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-governmen-
tal 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
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 state-
ments, thereby allowing more precise and efficient contracts to be
Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127
⁎ Corresponding author. Tel.: +852 3411 7537; fax: +852 3411 5581.
E-mail address: (Z.J. Lin).
0882-6110/$ – see front matter © 2010 Published by Elsevier Ltd.
doi:10.1016/j.adiac.2010.03.001
Contents lists available at ScienceDirect
Advances in Accounting, incorporating Advances in
International Accounting
journal homepage: www.elsevier.com/locate/adiac
based on the financial statements (Cohen et al., 2002; Maniam et al.,
2006; Watts an d 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 share-
holder). 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 r elationshi p between corpor ate
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 perfor-
mance if a firm has set up sound corporate governance mechanisms.
Thusthefirm's managementor 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 mechan-
isms (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 gover-
nance practices in the Chinese listed firms.
2. 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 adminis-
tration 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 stake-
holders. 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 perfor-
mance in terms of the stewardship responsibilities (Francis and
Wilson, 1988; Imhoff, 2003; Singh and David son, 2003). Thus,
auditors are able to detect or discover the management's manipula-
tion 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 d etermined by t he independence o f a uditors and t he
industrial expertise possessed by the auditors (Beattie et al., 2000; Dye,
1993; Francis, 2 004; Teoh, 1992). A high-quality auditor should have
independence (relationship based), enough expertise (technique b ased),
and good integrity (honesty and forthrightness). In a broad sense, auditor

independence inc ludes 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 q uality of auditing services. For instance, DeAngelo (1 981)
contends that audit quality is p ositively associated with the size and
market shares of auditing firms. Other s tudies found t hat large o r brand-
name auditors should have to bear higher reputation costs and they
would b e more p rudent in audit e ngagement and more likely t o issue
qualified or other unclean audit reports to their clients, thus provide audit
services with higher quality (F rancis and Krishnan, 1999; Lee et al., 2004;
Lennox, 2005; Menom, 200 3
).
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 demon-
strate 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 co ntent” 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

118 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. O n 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 yi elded inconsistent results in industr ialized
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 ac counting 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., switch-
ing 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
Cor porate governance also came with the separation of owner-
ship and management underlying the m odern 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, control-

ling (large) shareholders and minority shareholders, creditors and
owners/management, regulatory bodies and business firms, etc. A
primary objective of corporat e governance is thus to mon itor 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
governance can be define d 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 (Ander-
son et al. 2004; Bushman and Smith, 2001; La Porta et al., 2002).
Investors are willing to pay a higher premium for fi
rms w ith 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 indepen-
dent 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 mecha-
nism 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 an d 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
119Z.J. Lin, M. Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127
controlling shareholders f rom infringing u pon 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 bet ween 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 diff er 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 environmen t should not only
promot e the development of corporate governa nce and indepen-
dent auditing in emerging economies like China but also enrich the
extant auditing literature on the related issues.

3. 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 trillio n 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 t he listed firms
from iss uing 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 opa queness gains from weak corpor ate governance are sup-
posed to outweigh the benefits of lowering capital raising costs in
the bear market period. Hence, lower-q uality auditing firms may be
preferred by the listed fir ms, and especially by firms with weak
internal corporate governance mechanisms, bec ause they have more
opaque ness 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 governa nce
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 de gree of
ownership concentration (shareholding o f 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 mechani sms, such as the function of the independent
(non-exec utive) directors and the audit committees. However, the
latter internal monitoring varia bles are not included in our study
because they were i ntr oduce d to the Chinese listed firms only after
2002 and their full a doption is beyond the test period.
1
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 expro-
priation 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 fac t, 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 transac-
tions 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 high-
quality auditing firms. The higher the degree of ownership concen-
tration (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 1. (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 fi
rms 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:
1. monitoring the performance of directors and senior managers, to
ensure the compliance with laws, regulations, and the articles of
incorporation;
2. reviewing the financial affairs of the firm;
1
In the western literature, independent non-executive directors and audit
committee are emphasized as important components of internal corporate govern-
ance. 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.
2
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.
3
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.
120 Z.J. Lin, M. Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127

3. requesting directors and senior managers to alter and/or rectify
their personal actions if they are in conflict with the firm's
objectives;
4. proposing specific shareholder meetings whenever they deem
necessary;
5. fulfilling any other duties that are stipulated in the articles of
incorporation of the firm; and
6. 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 indepen-
dently 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 responsibi-
lities. 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 2. (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 exec ution 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
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 require-
ment 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 3. (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.
4. Research methodology
4.1. Model specification
We examine the determinants of a udit s witching 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). Switch-
ing 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 = β
0
+ β
1
LSH + β
2
SB + β
3
CEOCHR + β
4
GOV
+ β
5
OPI + β
6

LNASSET + β
7
LEV + β
8
MB + β
9
LOSS
+ β
10
Yr02 + β
11
Yr03 + β
12
Yr04 + ε
ð1Þ
where:
AS if the firm switches to a smaller auditor; 0 otherwise
LSH largest owner's shareholding as a percentage of total shares
SB number of members of the supervisory board
CEOCHR 1 if the CEO also holds the position of Chairman of the Board
of Directors; 0 otherwise
GOV 1 if the largest shareholder is a government agency; 0
otherwise.
OPI 1 if the firm receives an unclean auditor's opinion for the
previous year; 0 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,
121Z.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 1 if the firm experiences a loss for the previous year; 0
otherwise
Yr02 1 if the auditor switching occurs in Year 2002; 0 otherwise.
Yr03 1 if the auditor switching occurs in Year 2003; 0 otherwise.
Yr04 1 if the auditor switching occurs in Year 2004; 0 otherwise.
In the regression, the dependent variable is defined by the types of
auditor switching Thus, it is coded 1 if a firm switched to a smaller
auditing firm, comparing to its preceding auditor. For the independent
variables, we expect β
1
(for ownership concentration) and β
3
(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 β
2
(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 non-
government 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 con-
trolled (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 1 if the
largest owner of the firm is a government agency, while nongovern-
ment owned firms are coded 0. 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, profit-
ability, 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 stan-
dards 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 we re likely to switch auditors
(Chow and Rice, 1982; Geiger et al., 1998; Vanstraelen, 2003),
perhap s beca use the mana gement or th e controlling shar eholders
believed that once an incumbe nt 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). Alter-
natively, the management or controlling owners might dismiss an
auditor solely as a punishment for the auditor for issuing a going-
concern report, or due to irreparable damages when manageme nt
was in conflict with the auditor. The auditor's opinion is likely to be
related to the firm's auditor switchi ng decision and it is cont rolled in
the regression model. We expected the va riable (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 fi rms (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 fi rms. We also include market-

to-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 (profitabi-
lity) 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
fi
rms 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 6 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 t he 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 auditor s 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 firm-
specific risk. However, empirical results are not generally
consistent with this prediction ( Feltham et al., 1991; Simunic
and Stein, 1987). Cople y and Douthett (2002) confirmed that the
demand for large auditing firms increased with the extent of firm-
specificrisk(financial leverage). Hence, highly le veraged or more
risky firms may benefi
t from switching to a high-quality auditor
because their information uncertai nty can be reduced to a greater
extent than less leveraged ones. Due to opposing arguments
associated with auditor switching in the literature for highly-
122 Z.J. Lin, M. Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127
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.
4.2. Sampling
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 corpor ate
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 1.
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 1 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.
5. Empirical results
Table 2
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 3 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 3 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
multicollinea rity problem is not serious a nd won 't distort the
relationship between the dependent and independent variables in
the regression model.
4
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.
Table 1
Description of data.
Panel A: Sample selection

Firms that switched auditors during 2001–04 316
Less: Firms with missing data 47
Financial, transportation, and utility firms 11
Firms switching auditors more than once during 2001–04 25
Final sample 233
Panel B: Sample distribution by sector and year
Sector 2001 2002 2003 2004 Total
Industry 49 42 32 17 140
Commerce 10 8 6 5 29
Property 7 5 6 4 22
Conglomerate 13 10 9 10 42
Total 79 65 53 36 233
Table 2
Descriptive statistics of variables.
Variable N Mean Median MIN MAX STD
AS 233 0.42 0 0 1 0.50
LSH (%) 233 48.94 48.38 0.43 89.51 18.11
SB (#) 233 4.21 3 1 12 1.73
CEOCHR 233 0.06 0 0 1 0.25
GOV 233 0.79 1 0 1 0.41
OPI 233 0.16 0 0 1 0.37
LNASSET 233 21.04 20.94 19.03 24.60 0.89
LEV 233 0.08 0.06 0.00 0.51 0.09
MB 233 5.88 3.88 1.27 230.39 15.65
LOSS 233 0.12 0 0 1 0.33
Yr02 233 0.28 0 0 1 0.45
Yr03 233 0.23 0 0 1 0.42
Yr04 233 0.15 0 0 1 0.36
123Z.J. Lin, M. Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127
Table 4 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 0 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 gov ernance role in the Chinese list ed 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 qua lity ) auditi ng firmsincomparisonwithnon
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 3
Correlation coefficient matrix of variables.
Variable AS LSH SB CEOCHR LNASSET LEV MB LOSS OPI GC Yr02 Yr03 Yr04
AS 1.000
LSH 0.105* 1.000
SB 0.087* − 0.045 1.000
CEOCHR 0.128** 0.073 0.009 1.000
LNASSET − .174*** 0.201*** − 0.071 − 0.148** 1.000
LEV 0.037 − 0.161*** 0.045 − 0.155*** 0.251*** 1.000
MB 0.128** − 0.040 − 0.016 − 0.028 − 0.095* − 0.013 1.000
LOSS 0.070 0.044 − 0.031 − 0.046 − 0.209*** − 0.076 0.011 1.000
OPI 0.054 − 0.041 0.049 − 0.066 − 0.139** 0.059 0.188*** 0.441*** 1.000
GOV − 0.004 0.211*** 0− .029 − 0.079 0.086* 0.021 − 0.006 0.003 − 0.122** 1.000
Yr02 0.046 0.021 0.063 0.032 0.035 − 0.001 − 0.048 0.026 − 0.035 − 0.008 1.000
Yr03 − 0.156*** − 0.092* 0.011 0.025 0.099* − 0.019 − 0.078 0.044 − 0.040 − 0.047 − 0.338*** 1.000
Yr04 0.113** − 0.011 − 0.004 − .0112** − 0.013 0.045 − 0.042 0.091* 0.009 0.017 − 0.266*** − 0.232*** 1.000
***, **, and * denote significance at the 1%, 5%, and 10% levels, respectively.
Table 4
Internal corporate governance mechanisms and switching to a smaller auditing firm test of H1 to H3 (main test).
AS = β
0
+ β
1

LSH+ β
2
SB+ β
3
CEOCHR + β
4
GOV + β
5
OPI+ β
6
LNASSET+ β
7
LEV+ β
8
MB+ β
9
LOSS + β
10
Yr02+ β
11
Yr03 + β
12
Yr04+ ε
Intercept LSH SB CEOCHR GOV OPI LNASSET LEV MB LOSS Yr02 Yr03 Yr04
β
0
β
1
β
2

β
3
Β
4
Β
5
Β
6
Β
7
Β
8
Β
9
β
10
β
11
β
12
Predictions ? + − +++− +++?? ?
Coeff. 5.644 0.021 0.093 1.249 0.022 − 0.123 − 0.408 3.473 0.127 0.209 0.323 − 0.235 0.859
Wald 1.901 5.669** 1.165 4.089** .004 .074 4.386** 3.897** 3.876** 0.169 0.760 0 .310 3.757*
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.
124 Z.J. Lin, M. Liu / Advances in Accounting, incorporating Advances in International Accounting 26 (2010) 117–127
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
requ ired 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 s upport that there is an
association between a firm's internal corporate governance mecha-
nisms 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 opaque-
ness 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.
6. 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.
7. Summary and conclusions
The purpose of this paper is to investigate the determinants of
firms' auditor switching from the perspect ive of their internal
corporate governance mechanism in China. Three measures are
used to proxy for int ernal corporate gov ernance mechanism,
including the concentration of ownership (share holding 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 switch-
ing decisions. H1 and H3 are supported, but there i s insufficient
evidence for H2.Hencefirms with larger controlling owners
(regardless of direct gove rnment owne rship) and in which the
CBoD and CEO positions are held by the same person are more likely
Table 5
Internal corporate governance mechanisms and switching to a smaller auditing firm test of H1 to H3 (Sensitivity: Top 10 to Non-Top 10).
AS = β
0
+ β
1
LSH+ β
2
SB+ β
3
CEOCHR + β
4
GOV + β
5
OPI+ β
6
LNASSET+ β
7
LEV+ β
8
MB+ β
9
LOSS + β
10

Yr02+ β
11
Yr03 + β
12
Yr04+ ε
Intercept LSH SB CEOCHR GOV OPI LNASSET LEV MB LOSS Yr02 Yr03 Yr04
β
0
β
1
β
2
β
3
Β
4
Β
5
Β
6
Β
7
Β
8
Β
9
β
10
β
11

β
12
Predictions ? + − +++ − +++? ? ?
Coeff. 15.221 0.053 0.201 3.070 − 0.514 − 3.013 − 0.992 2.789 0.149 0.380 2.583 1.292 2.014
Wald 2.205 4.405** 0.984 5.082** 0.296 2.841* 4.043** 0.794 0.494 0.051 4.622** 1.539 3.063*
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=1 if switching from a Top 10 auditor to a non-Top 10 auditors and AS=0 if switching from a non-Top 10
auditor to a Top 10 auditor will be coded as 0.
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.
Table 6
Internal corporate governance mechanism and switching to a smaller auditing firm test of H1 to H3 (Sensitivity: Ten Percent Cutoff).
AS = β
0
+ β
1
LSH+ β
2
SB+ β
3
CEOCHR + β
4
GOV + β
5
OPI+ β
6
LNASSET+ β
7

LEV+ β
8
MB+ β
9
LOSS + β
10
Yr02+ β
11
Yr03 + β
12
Yr04+ ε
Intercept LSH SB CEOCHR GOV OPI LNASSET LEV MB LOSS Yr02 Yr03 Yr04
β
0
β
1
β
2
β
3
Β
4
Β
5
Β
6
Β
7
Β
8

Β
9
β
10
β
11
β
12
Predictions ? + − +++− ++ +?? ?
Coeff. 5.962 0.018 0.082 1.244 0.061 − 0.136 − 0.415 3.404 0.130 0.178 0.354 − 0.221 0.916
Wald* 2.105 4.003** 0.886 4.062** 0.027 0.091 4.531** 3.737* 3.958** 0.123 0.907 0.276 4.189**
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.
125Z.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 o pt to switch to smaller
auditors is not conclusive. Generally, we conclude that firms with
relatively weak internal corp ora te govern ance 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 c oefficient f or SB variable is not significant
may imply t hat the SB does not play an ef fective monitoring role in
the Chinese listed firms at present, possibly because the SB
members are mainly from inside the firms and they do not have
enough expert ise in corporate governance and independent
auditing.

Our regression results show that firms wit h 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 str ength 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 findin g 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 consisten tly effective i n practice.
This study should contribute to the literature on auditing
research. As we carefully choose a time period to minimize the
incentives for lo wering capit al raisi ng 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 switchi ng may be driven by different motivations. In this
study, we classified two major types of auditor switching, na mely
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 develop-
ment of audit function and corporate govern ance 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 financi al repor ting 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 do 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 Auditor Ranking Auditor
1 PwC Zhongtian 44 Jiangsu Tianhua
2 KPMG Huazhen 45 Huayan
3 Deloitte Huayong 46 Gansu Wulian

4 EY Huaming 47 Zhejiang Wanbang
5 Lixin Changjiang 48 Beijing Zhongzhou
6 Yuehua 49 Huazheng
7 Xinyongzhonghe 50 Guangdong Hengxin
8 Beijing Jingdu 51 Nanjing Yonghua
9 Jiangsu Gongzheng 52 Shandong Wanlu
10 EY Dahua 53 Chongqing Tianjian
11 Zhongshen 54 Xi'an Sigma
12 Zhongruihua 55 Jiangsu Tianye
13 Tianzhizixin 56 Anhui Huapu
14 Shanghai Zhonghua 57 Xiamen Tianjian
15 Lianda 58 Sichuan Huaxin
16 Zhejiang Tianjian 59 Shandong Huide
17 Tianjian 60 Beijing Zhongxingyu
18 Guangzhou Yangcheng 61 Beijing Zhongwei
19 Zhongtianhuazheng 62 Shenzhen Tianjian
20 Shenzhen Pengcheng 63 Fujian Huaxing
21 Shanghai Donghua 64 Beijing Zhongxing
22 Tianyi 65 Shanghai Wanlong
23 Hubei Daxin 66 Shandong Tianghengxin
24 Shanghai Gongxin 67 Yatai Group
25 Jiangsu Suya 68 Zhongtianyin
26 Zhongxi 69 Huajian
27 Zhongxingcai 70 Guangdong Kangyuan
28 Wuhan Zhonghuan 71 Shanghai Tongcheng
29 Zhejiang Dongfang 72 Zhonghengxin
30 Beijing Zhongluhua 73 Beijing Zhongzheng
31 Shanghai Shangkuai 74 Shanghai Shangshen
32 Tianjin Wuzhou 75 Liaoning Tianjian
33 Shandong Zhengyuan 76 Beijing Xinghua

34 Shenzhen Nanfang 77 Beijing Zhongtianheng
35 Shenzhen Dahua 78 Shandong Qianju
36 Guangdong Zhengzhong 79 Sichuan Hongri
37 Hu'nan Kaiyuan 80 Zhongqin Wanxin
38 Beijing Yongtuo 81 Hebei Hua'
39 Yunnan Yatai 82 Beijing Zhongpingjian
40 Zhonglei 83 Sichuan Junhe
41 Jiangsu Tianheng 84 Shanghai Jiahua
42 Guangdong Tianhua 85 Guangxi Xianghao
43 Beijing Tianhua
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.
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