Audit firm rotation and earnings quality Dutch companies

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Audit firm rotation and earnings quality

Dutch companies

Name: Gul Ucurum

Studentnumber: 10278834 Supervisor: Bo Qin

Date: 23th June 2015 Master Accountancy

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The European Commission adopted on 14th April 2014 audit legislation to improve the audit quality across the European Union. This legislation stems from the European Commission Green Paper: ‘’Audit Policy’’, Lessons from the Crisis, which was issued in October 2010. One of the rules among this legislation is mandatory audit firm rotation. The financial crisis in 2008 raised some questions about the work of the auditors. Some inspection reports by the national

supervisors showed major shortcomings in the European audit sector. Auditors have made mistakes and are accused for not being independent and provinding low quality audits.

In a free market it is important that the investors, stakeholders and other parties are provided with credible financial information. Auditors play important societal roles by providing the investors and shareholders with company’s financial statements free of material

misstatements, which gives a true and accurate view of the company accounts. The key measures to provide this service is audit quality, transparency, accountability and high quality audit

requires that the auditor is competent, objective and independent.

After decades of debate and research The current discussion both in the European Union and the US.

Many studies suggest that auditor independence and earnings quality impair when the auditor-client relationship lasts longer. Governments and regulators claim that they found the solution by implementing mandatory audit firm rotation. They argue that mandatory firm rotation will increase auditor independence and thus the earnings quality.

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This study examines the effect of audit firm rotation on earnings quality for the Dutch publicly listed companies in pre-mandatory period. On 1 January 2016 the legislation on mandatory audit firm rotation will be implemented in the Netherlands. The motivation behind this amendment is that long firm tenure impairs the auditor independence and thus the audit quality. As I am going to analyze the pre-manadatory period if long firm tenure increase/decreases the earnings quality. And after the implementation of the legislation on January 2016 the results can show if long firm tenure is the cause for the impairment of auditor independence. Because a lot of studies have been performed, which showed different opinions on this topic. Some studies could not find a relation between firm tenure and auditor independence and on the other hand other studies and the accounting profession claim that long firm tenure has a positive association with auditor independence.

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5 2. Theory

Due to accounting scandals like Enron and WorldCom and the financial crisis in 2008 was the beginning of the discussion about auditor independence and auditor quality. This impaired the confidence of the public, the shareholders and investors, government and requlatory institutions in the accounting profession. Auditors lacked critical view, professional skepticism and auditor independence.

The Autoriteit Financiele Markten (AFM), responsible for supervising the operation of the financial markets in the Netherlands, published a report (AFM, 2011) to improve the audit quality in the Netherlands. In this report the AFM suggests that the audit incidents during the financial crisis were caused by some main issues. For example they suggest that because of the fact that external auditors are paid by their audit clients, this puts pressure on external auditor

independence and that audit firms who performs audit for the client is not allowed to provide other services as this results in threats to independence.

2.1 Auditor independence

Because auditor independence is a critical factor for the auditing profession, many studies have been performed on this topic. One of the studies is of DeAngelo (1981a) who shows that audit quality is defined as the probability that, first the auditor will uncover a breach and second to report the breach. He suggest that if the auditors are not independent, they will be less likely to report the irregularities and this will impair the audit quality.

Based on the study of Tepalagul and Lin (2015) the main four threats to auditor

independence are determined by client importance, non-audit services, auditor tenure and client affiliation with audit firms. Because the external auditors are paid by the clients, they have incentives to retain their clients and provide more non-audit services and this can put pressure on the auditor independance. Long auditor-client tenure can develop a close relationship with the client and this can result in acting in favor of the management. In the next section I will give a short description of these determinants.

Client importance

Tepalagul and Lin (2015) claim that larger clients, who are economically important to audit firms can create a potential for an independence problem. Also if the client portfolio of the audit firm consist of one or two major clients, can put pressure on the auditor independence. However audit firms also consider expected costs of audit failures like litigation and reputation risk. It is argued

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that costs related to the loss of reputationa and litigation reduce the incentives for auditors to compromise their independence

(Khurana and Raman 2004). They show that audit quality is linked to litigation risk and the level of damages facing the auditor. If the auditor damages their reputation, they will also lose fees from other and future clients. So there is still mixed evidence about auditor independence and client importance

Non-audit services

The SOX Act of 2002 prohibits auditors to provide non-audit services to their audit client. The motivation behind this Act is that the economic bond between auditor and client would impair auditor independence. Another study of Mishra, Raghunandan, and Rama (2005) shows that non-audit services has an impact on the shareholders perception, because information about non- audit-related fees are viewed favorably by shareholders and NAS like tax and other services are viewed unfavorably. Also the report of AFM (2011) set out some services that auditors are prohibited to provide, as it is a threat for the auditor indepence. Examples of prohibited services are valuation services, certain legal- and corporate finance services etc. However the opponents argue that NAS result in a more efficient and effective audit, because the auditor has a good knowledge of the client's business. The members of the Institute of Chartered Accountant in

England and Wales (ICAEW) also state that restricting NAS would have an unintended adverse affect on the underlying quality of audit through restrictions in knowledge and skills. Clients of the auditors do have incentives to purchase NAS because of cost savings and higher quality service (Public Oversight Board, 1979).

So different studies have various views on NAS. Some proponents argue the benefits of

providing NAS, but the opponents like financial statement users and for example the AFM and SOX Act of 2002 prohibited some NAS because the reducing effect o audit quality.

Auditor tenure

There are a lot of studies about the effects of auditor tenure on audit quality and the findings are mixed. Some studies suggest that there is a relation between audit tenure and audit independence. Regulators have argued that social bonding from long tenure impairs professional skepticism and audit quality, while on the other hand the auditing profession argued that there is no decline in audit quality as the audit tenure increases and say that restrictions on audit tenure may impair audit quality, because new coming auditor would not posses the same client-specific knowledge

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and experience about the client than a continuing audit firm. Beside this the literatur on audit firm tenure suggest that during initial years of the audit firm rotation it is more likely that audit quality declines, because a lack of client familiarity and information asymmetry would be increased (Litt, Sharma, and Tanyi 2014). Gosh and Moon (2005) analyzed the audit tenure and audit quality from the perspective of the investors and found evidence that support the conlusions of the auditing sector. In their analysis they found a positive association between the investor

perceptions of earnings quality and auditor tenure. So they claim that investors and information intermediaries perceive auditor tenure as improving quality. Contrary Carey and Simnett (2006) report that for long tenure observations they found a lower trend to issue a going-concern opinion (going-concern used as a proxy for audit quality). Another proxy they used for audit quality was to which extent key earnings benchmarks are beaten and missed. Also for this proxy they found evidence that long tenure is associated with beating earnings benchmarks and this suggest the increase in the ability to manage earings in order to report a profit during later years of audit tenure. This findings provides evidence that a long tenure is associated with reduction in audit quality.

Most studies find no association between audit tenure and auditor independence and even suggest that long audit tenure improves audit quality as the auditor gains more client-specifiec knowledge and experience about the client. Also investors do not perceive long tenure with reducing audit quality.

Client affiliation with audit firms

In the study of Imhoff (1978) the author highlights three factors of auditor-client relationship that may influence the auditor indepence, which are a) the auditor may view the client as a employer; b) the closeness of the auditor with the management can create a distance between the auditor and the shareholders and the final factor is that the auditor can have difficulty in maintaining

independence in front of their former colleagues.

In the AFM report in section 4.2.2 business relationships with audit clients is explained. In this section is set out business relationships are acceptable as long as there is not an insignificant threat to independence.

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8 2.2 Measuring auditor independence

Auditor independence is difficult to measure. The previous section showed the results of prior research that tried to determine the factors that influence the auditor independence.

2.3 Earnings quality

Earnings quality is a broad concept. Earnings quality is defined by Dechow et al. (2010) as follows: “Higher quality earnings provide more information about the features of a firm’s

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2.4 Mandatory audit firm rotation in the Netherlands

On 11 December 2012, the Dutch Senate approved two amendments to the Audit Firms Supervision Act. The amendments are a) a mandatory audit firm rotation as of 1 January 2016 and b) segregation of audit and non-audit services (NAS) as of January 2013. In this study we analyze the earnings quality and the firm tenure. Auditor independence is a difficult concept to judge objectively and this was an incentive for the Dutch government to legislate this aspect. By introducing mandatory audit firm rotation the legislator wants to prevent that the external audior develops a familiarity with the audit client. And the second amendment, non-audit services prevents the auditor from ''checking his own work''. So the aim for implementing mandatory firm rotation is to increase earnings quality and auditor independance. Thus shorter firm tenure may increase earnings quality. Also the study of Leuz (2003) examined the differences in earnings management across 33 countries. Leuz suggest that earnings management is expected to decrease in investor protection, because strong protection limits the insiders ability to acquire private control benefits. In his study the findings for Netherlands suggests that the institutional setting of the Netherlands consists of less-developed stock markets, weak investor rights and strong legal enforcement. So Leuz found in his study that there is more earnings management in the

Netherlands than in the United States (where institutional setting consists of large stock markets, strong investor rights and strong legal enforcement). Because earnings management is higher in the Netherlands, we can suggest that the manadatory audit firm rotation (shorter tenure) will have a positive effect on the auditor independence and will increase the audit quality. Subsequently this will result in lower earnings management.

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10 3. Hypothesis

The audit firm rotation period is eight years in the Netherlands. H 1: Does long audit firm tenure change the earnings quality?

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11 4. Research methodology

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12 5. Results

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13 6. Conclusion

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14 References

 AFM report (2011) Incentives for audit quality

file:///C:/Users/Gebruiker/Downloads/report-incentives-audit-quality.pdf.

 Nopmanee Tepalagul1 and Ling Lin (2015) Auditor Independence and Audit Quality

Journal of Accounting, Auditing & Finance.

 Inder K. Khurana and K. K. Raman, Litigation Risk and the Financial Reporting Credibility of Big 4 versus Non-Big 4 Audits: Evidence from Anglo-American Countries, The Accounting Review Vol. 79, No. 2 (Apr., 2004).

 Leuz, C., Nanda, D., Wysocki, P. D. (2003). Earnings management and investor protection: an international comparison.

 Mishra, Suchismita, Raghunandan, K. and Rama, Dasaratha V.

Do Investors' Perceptions Vary with Types of Nonaudit Fees? Evidence from Auditor

Ratification Voting.

 Litt, B., D.S. Sharma, T. Simpson, and P.N. Tanyi. 2014. Audit Partner Rotation and Financial Reporting Quality. Auditing: A Journal of Practice & Theory 33(3):59–86.

 Peter Carey and Roger Simnett, Audit Partner Tenure and Audit Quality. The Accounting

Review, Vol. 81, No. 3 2006 pp. 653–676.

 Aloke Ghosh and Doocheol Moon , Auditor Tenure and Perceptions of Audit Quality, The

Accounting Review, Vol. 80, No. 2 2005 pp. 585–612.

 Eugene A. Imhoff (1978), Employment effects on auditor independence, The Accounting

Audit firm rotation and earnings quality Dutch companies

Audit firm rotation and earnings quality

Dutch companies

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