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...auditor rotation," which are based on concerns that longer auditor tenure reduces earnings quality. Multivariate results, controlling for firm age, size, industry growth, cash flows, auditor type (Big N versus non-Big N), industry, and year, generally suggest higher earnings quality with longer auditor tenure. We interpret our results as suggesting that, in the current environment, longer auditor tenure, on average, results in auditors placing greater constraints on extreme management decisions in the reporting of financial performance.
Keywords: auditor tenure; earnings quality; audit quality; mandatory rotation.
Data Availability: All data used in this study is publicly available.
I. INTRODUCTION
The issue of earnings quality and the quality of financial statements in general has been the focus of recent Congressional, regulatory, and financial statement user discussions. Recent events have focused the public's eye on earnings quality and on audit quality in general. Numerous legislative proposals at federal and state levels would place limits on the maximum length of a given auditor-client relationship. The proposed limits are based on the notion that extended auditor tenure results in auditor complacency about and possibly complicity in the decisions that management makes regarding the presentation of financial results. While the Sarbanes-Oxley Act of 2002 does not impose mandatory rotation on audit firms, it mandates a study of mandatory rotation by the Comptroller General of the United States to be completed within one year of the passage of the Act.
In this study, we document the relation between earnings quality (using absolute, signed, and raw [unsigned] accruals measures as proxies for earnings quality) and auditor tenure. We assert that earnings quality can be used to draw inferences about audit quality. We do not purport to comment on audit quality in the traditional sense--compliance with Generally Accepted Auditing Standards (GAAS). Rather, we claim that when audit quality is high, auditors constrain the extreme (and presumably self-serving) choices that management would like to make in presenting the financial position of the firm. When audit quality is low, we posit that auditors do not constrain these extreme choices and that in some cases, auditors may even aid management in "pushing the boundaries" of Generally Accepted Accounting Principles (GAAP). (1)
Proponents of mandatory rotation express the belief that poor-quality earnings are associated with extended auditor tenure. Poor-quality earnings are problematic because they can mislead investors, resulting in misallocated resources. In its defense, the accounting profession has argued that mandatory rotation increases audit start-up costs and increases the risk of audit failure because the incoming auditor places increased reliance on the client's estimates and representations in the initial years of an engagement. Over time, auditors can gain firm-specific expertise, which helps them to understand the business and allows them to rely less on management estimates. (2) Managers of firms being audited are also opposed to mandatory rotation because changing auditors is costly. These managers believe that auditors better understand their particular business with experience and managers have concerns about whether a new auditor will have the requisite industry expertise and/or will be able to put forth the additional effort required to audit a new client (Dunham 2002).
In this paper, we provide evidence on the claim made by proponents of mandatory auditor rotation that the current voluntary rotation system is flawed. Because the push for mandatory rotation stems from the belief that extended auditor tenure impairs auditor independence, we assert that understanding the relation between auditor tenure and earnings quality is central to the debate. That is, the veracity of claims made by proponents about the current system should be central to decisions made by regulators, and of interest to auditors and financial statement users. To our knowledge, this is the first broad cross-sectional study to explicitly consider the relation between auditor tenure and earnings quality as proxied for by measures of accounting accruals. We assume that producing higher-quality earnings is the goal of recent legislative proposals and claim that the extent to which auditor tenure either enhances or inhibits earnings quality should be addressed before legislative or regulatory changes impose limits on auditor tenure. Borrowing extensively from previous research that uses accounting accruals as a proxy for earnings quality, we test for an association between auditor tenure and earnings quality for those auditor-client combinations where the auditor-client relationship lasts for at least five years. We do this by examining the relation between absolute, signed, and raw values of both Discretionary and Current Accruals and auditor tenure after controlling for other factors expected to affect the distribution of accruals.
Although we cannot comment on whether mandatory auditor rotation would improve earnings quality, we do provide evidence inconsistent with the claim that earnings quality deteriorates with extended auditor tenure under the current voluntary rotation system. After controlling for firm age, size, industry growth, cash flows, auditor type (Big N versus non-Big N), industry, and year, we find that the magnitude of both Discretionary and Current Accruals decline with longer auditor tenure. Further, we find some evidence that longer auditor tenure is associated with less extreme income-increasing accruals. (3) This suggests that as the relationship lengthens, auditors limit management's ability to use accruals to increase current period earnings. We also find evidence that longer auditor tenure is associated with less extreme income-decreasing accruals. This suggests that as the relationship lengthens, auditors limit management's ability to create reserves to manage future earnings. We find this result particularly interesting because income-decreasing earnings management has received a great deal of attention from regulators and the popular press as of late. (4)
The remainder of the paper is organized as follows. In Section II, we summarize the arguments supporting and opposing mandatory auditor rotation and develop our hypotheses. We discuss our data and empirical results in Section III, and in Section IV we present our conclusions and the implications of our study.
II. HYPOTHESIS DEVELOPMENT
Arguments Supporting Mandatory Auditor Rotation
Whether auditor rotation should be made mandatory is an issue that has been debated for more than 40 years in the U.S. Proponents of mandatory auditor rotation are generally concerned that auditor independence, and thus audit quality, will decrease with increased auditor tenure. Mautz and Sharaf (1961) suggest that extended auditor-client relationships could have a detrimental affect on auditor independence because an auditor's objectivity about a client is reduced with the passage of time. Further, the Metcalf Committee states that "mandatory auditor rotation is a way to bolster auditor independence" (U.S. Senate 1976, 21). More recently, regulators suggest a link between auditor tenure and reductions in earnings quality, and allude to mandatory auditor rotation as a possible solution (U.S. Senate 1977; AICPA 1978; Berton 1991; SEC 1994). It has been suggested that decreased auditor independence could lead to auditors' support for more aggressive accounting choices that "push the boundaries" of GAAP and could ultimately result in a failure to detect material fraud and/or misstatements. Mandatory rotation proponents argue that limiting auditor tenure reduces concerns about deteriorating independence and audit quality. (5) In response to the recent Enron/Anderson audit failure, several bills containing provisions limiting auditor tenure and mandating auditor rotation were proposed in the House and Senate as part of an effort to improve financial reporting and protect investors. (6)
Arguments Opposing Mandatory Rotation
Opponents of mandatory rotation suggest that along with higher audit costs, an increased likelihood of audit failures would result from mandated rotation. New auditors, they argue, lack sufficient knowledge regarding firm-specific risks and, as a consequence, audit failures would likely increase. This argument is consistent with research indicating that a greater proportion of audit failures occur on newly acquired clients (Berton 1991; Petty and Cuganesan 1996) and that auditors' litigation risk is greater in the early years of an engagement (Palmrose 1986b, 1991). Further evidence on auditor tenure and audit quality is provided by the AICPA's Quality Control Inquiry Committee of the SEC Practice Section. The Committee analyzed 406 cases of alleged audit failure between 1979 and 1991 and concluded that allegations of audit failure occur almost three times as often when an audit firm is performing its first or second audit of a given client (AICPA 1992). Finally, the accounting profession argues that uncertainty regarding characteristics of the client increases the potential for audit failures early in the auditor-client relationship (PricewaterhouseCoopers 2002). (7)
Accounting Accruals and Audit Quality
Absent from public discussion and prior research is a cogent...
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