Amsterdam Business School
The effect of audit partner tenure on audit
quality in a setting with mandatory audit partner
rotation
Evidence from the United Kingdom
Name: Nassira Chnioune Student number: 10186808 Date: 23 May 2014
Supervisor: Dr. J.J.F. van Raak
MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam
Abstract
Mandatory audit partner rotation is one of the main policy initiatives that have been adopted by many countries to deal with the concerns about audit quality. This study examines the effect of audit partner tenure on audit quality in a setting with mandatory audit partner rotation, using data from the largest public companies listed on the London Stock Exchange (FTSE 350), where the audit partner can be identified. Using the estimated level of signed and absolute value of discretionary accruals (DA) as a measure of earnings management, I found that audit partner tenure has a significant positive effect on negative discretionary accruals, which suggests that auditor oversight of management decisions is generally balanced in that auditors appear to constrain extreme income decreasing accruals. I found also evidence for signed DA, which suggests that firms that hire a BIG4 auditor oversight of management decisions, is generally balanced in that auditors appear to constrain extreme income increasing and income decreasing accruals. For signed income decreasing DA, I found evidence that BIG4 audit partners gain learning experience and build client-specific assets more quickly than non-BIG4 audit partners. The difference in audit quality between BIG4 and non-BIG4 audit partners diminishes with the passage of time. In examining going concern modified opinions, I found no supported evidence.
Keywords: audit partner tenure, audit quality, earnings management, going concern opinion, BIG 4,
Table of contents
1
Introduction ... 4
2
Literature review and development of hypotheses ... 7
2.1
Auditors’ independence and audit quality ... 7
2.2
The proponents of mandatory audit partner rotation ... 8
2.3
The opponents of mandatory audit partner rotation ... 10
2.4
The expertise of an auditor and audit quality ... 12
3
Methodology ... 15
3.1
Sample selection ... 15
3.2
Research design ... 16
3.2.1
Earnings management ... 16
3.2.2
Going-concern opinion ... 18
4
Results ... 20
4.1
Descriptive statistics ... 20
4.2
Correlation... 21
4.3
Empirical results Earnings management ... 22
4.4
Empirical results Going Concern model ... 25
4.5
Sensitivity analyses ... 27
4.5.1
Robustness audit partner tenure ... 27
4.5.2
Abnormal and signed working capital accruals ... 28
5
Conclusion ... 31
1 Introduction
Accounting scandals across the world, from Enron and WorldCom in the United States to Parmalat in Europe, have raised public concerns about the independence of the auditor (Chen et al. 2008). This resulted in a debate about audit quality and the factors that might influence the quality of an audit (Cullinan, 2004). Regulators are concerned that as the length of the auditor-client relationship (audit partner tenure) gets longer, auditors are more likely to compromise on their client’s accounting and reporting choices in order to retain the client (Chen et al. 2008).
These concerns have resulted in rules and regulation of financial reporting and the auditing profession. The first policy emerged in the United States (U.S.) in the 1970s. The American Institute of Certified Public Accountants (AICPA) mandated periodic auditor rotation after seven years of tenure. This became a requirement for U.S. Securities and Exchange Commission registered clients. Corporate scandals led to a revision of this policy with the signing of the Sarbanes-Oxley (SOX) Act of 2002. The SOX Act goes further, requiring auditor rotation at least once every five years. Specifically, in section 203 of the SOX Act (2002) states that “It shall be unlawful for a registered public accounting firm to provide audit services to an issuer if the lead (or coordinating) audit partner (having primary responsibility for the audit), or the audit partner responsible for reviewing the audit, has performed audit services for that issuer in each of the five previous fiscal years of that issuer”.
Lack of confidence in the independence of the auditor was not just an issue in the United States. Many changes to the regulatory regime for auditors were also made in Europe including the United Kingdom (UK). The European Parliament and the Council of the European Union signed into the 8th EU directive 2006/43/EC (European Union, 2006). This Directive aims at high-level
harmonization of statutory audit requirements and improves the level of audit quality in Europe. As part of this objective, auditor independence is addressed by implementing mandatory audit partner rotation within a maximum period of seven years. In addition to existing duties of setting auditing standards, the Auditing Practices Board took responsibility for setting ethical standards for auditors. One of the key provisions of the ethical standards is mandatory audit partner rotation of UK listed companies, with the audit engagement partner in the UK rotating every five years of tenure (APB, 2004).
Most of the literature is written as response to a long history of discussion on whether mandatory auditor rotation should be imposed (e.g. Mautz and Sharaf, 1961; AICPA, 1978; SEC, 1994; Barnier, 2010). The main argument used is that an increase in audit partner tenure leads to a personal relationship between the auditor and client. This suggests that auditors lose their independence when they become too familiar with the clients. This in turn can impair the judgment
of the auditor and may compromise the auditors’ independence (Geiger and Raghunandan, 2002; Myers et al. 2003; Gates et al. 2007). The proponents of mandatory audit partner rotation argue that setting a limit on the number of years that an auditor may audit the same company will safeguard auditor independence. On the other hand, the opponents of mandatory audit partner rotation argue that new auditors’ lack of client-specific knowledge and industry expertise arising from periodic rotation impairs audit quality (Geiger and Raghunandan, 2002; Chen et al. 2008).
In this study, I test the effect of audit partner tenure on audit quality in a setting with mandatory audit partner rotation. The focus of this study is the United Kingdom given the fact that both audit firm and audit partner names are publicly disclosed on the audit report of UK listed companies (Carcello and Li, 2013). Since Avril 2009, the audit partner of UK listed companies are required to sign the audit report in their own name and the name of the audit firm (PWC, 2010). The disclosure of audit partner information on the audit report makes it possible to undertake an empirical evaluation of whether mandatory audit partner rotation enhances audit quality. In the most countries the name of the audit partner is not mentioned in the audit reports and therefore the data of audit partner tenure are not available from public sources.
For answering my research question, I use data on financial statements from COMPUSTAT Global to examine the audit quality in the context of audit partner tenure for firms in the United Kingdom. I expect that there is a positive association between audit partner tenure and audit quality. I assume that in a setting of mandatory audit partner rotation the audit quality will be weaker in the early years of an audit engagement than in the last years before a switch, because a new audit partner is not able to recognize all of the potential issues of the clients business effectively. Furthermore, I expect that the audit quality will be higher for a partner of a BIG-4, than a non-BIG4 partner. However, I expect that there is a weaker association between audit partner tenure and audit quality, if the auditor is a partner of a BIG4 company than when the auditor is a non-BIG-4. The audit quality will I measure by two different proxies, namely: earnings management and the propensity to issue a going-concern audit opinion for distressed companies in the same setting.
This empirical research contributes to the literature on audit partner tenure and audit quality by providing evidence at the mandatory audit partner level. This thesis provides useful evidence for regulators and other professional bodies regarding the effectiveness of mandatory audit partner rotation after a fixed period of audit partner tenure as a means of improving the independence of the auditor. Most prior research has examined the association between auditor tenure and audit quality at the audit firm level. In addition, prior studies examine the relation between audit quality and audit firm/partner tenure in a period before audit partner rotation was
mandatory. In contrast to those studies, I examine the effect of audit partner tenure on audit quality in a mandatory setting. The results of this study are relevant to expand the knowledge on audit partner rotation. Furthermore, this study will give a clear overview of the effect of mandatory audit partner rotation on audit quality by using multiple proxies for audit quality.
The results from the audit quality model shows that audit partner tenure has a significant positive effect on negative discretionary accruals, which suggests that auditor oversight of management decisions is generally balanced in that auditors appear to constrain extreme income decreasing accruals. I found no evidence on absolute and income increasing discretionary accruals. I found also no effect of a BIG4 audit partner on absolute discretionary accruals. This indicates that hiring a BIG4 audit partner has no effect on audit quality. However, I found significant evidence on signed discretionary accruals, which indicates that firms that hire a BIG4 audit partner oversight of management decisions, is generally balanced in that auditors appear to constrain extreme income increasing and income decreasing accruals. The assumption that there is a weaker association between audit partner tenure and audit quality, if the auditor is a partner of a BIG4 is improved by signed negative discretionary accruals. This indicates that BIG4 audit partners gain learning experience and build client-specific assets more quickly than non-BIG4 audit partners. Furthermore, the difference in audit quality between BIG4 and non-BIG4 audit partners diminishes with the passage of time. In examining going concern modified opinions, I found no supported evidence for my hypothesis.
The remainder of this thesis is organized as follows. In Section 2, I review the relevant literature and develop my research hypotheses. Section 3 describes the research method and sample selection. Results are discussed in Section 4, and the conclusion is contained in Section 5.
2 Literature review and development of hypotheses
This section will give a definition of audit quality and the factors that might influence the audit quality. The relation between the independence of the auditor and audit quality will be also discussed. This chapter will elaborate on audit partner rotation and the hypotheses concerning the effect of audit partner tenure on audit quality.
2.1 Auditors’ independence and audit quality
The basis for the policy of mandatory audit partner rotation is the assumption that long audit partner tenure, which indicates the length of the auditor - client relationship, reduces audit quality (Carey and Simnett, 2006). DeAngelo (1981) defined audit quality as the joint probability that a given auditor will both (a) discover a breach in the client's accounting system, and (b) report the breach. The probability that a given auditor will discover a breach depends on the auditor's competence (knowledge and expertise). The conditional probability of reporting a discovered breach is a measure of an auditors’ independence from a given client (DeAngelo, 1981). In this study, I focus on those two components which are regarded as factors that might affect audit quality.
Auditors’ independence consists of two aspects, independence in fact versus independence in appearance. Independence in fact is a state of mind and exists when the auditor is actually able to maintain an unbiased attitude throughout the audit. Independence in appearance is an external assessment and can be defined as the result of others’ interpretations of the independence of the auditor (Arens et al. 2013). Independent auditors should not only be independent in fact; they should avoid situations that may lead outsiders to doubt their independence (AICPA, 1972).
The value of an audit depends on public confidence in the competence and independence of the auditor. The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements (International Standard on Auditing, 2000). International Standard on Auditing (ISA) requires the auditor to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error (ISA 200). Furthermore, the auditor must approach each audit with professional skepticism. The ISA define professional skepticism as “an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.” They explicitly require the professional to plan and perform an audit with professional skepticism recognizing that circumstances may exist that cause the financial statements to be materially misstated. The auditor’s independence enhances the auditor’s ability to act with integrity, be objective and maintain an attitude of professional skepticism.
Watts and Zimmerman (1990) argue that it is unlikely that auditors are perfectly independent from their client. Mautz and Sharaf (1961), also note that long associations with the client, although not of themselves detrimental, can lead to decreasing of the independence of an auditor. While they did not advocate mandatory auditor rotation, Mautz and Sharaf (1961, p. 208) suggested that “the greatest threat to his independence is a slow, gradual, almost casual erosion of his honest disinterestedness.”
Auditor independence is suggested to be negatively affected by audit partner tenure. Long audit partner tenure may lead to rise the concerns about familiarity and self-interest treats (e.g. Carey and Simnett, 2006; Chi and Hyang, 2005), which in turn decrease the independence and profession skepticism of the auditor. The Code of Ethics for Professional Accountants (IFAC, 2013), defines familiarity threat as: “the threat that due to a long or close relationship with a client or employer, a professional accountant will be too sympathetic to their interests or too accepting of their work.” Self-interest threat is defined as: “the threat that a financial or other interest will inappropriately influence the professional accountant’s judgment or behavior.” So, a relationship between the client and its auditor may lead to the development of personal relationships to the extent of developing bonds of loyalty, which impact the independence and the objectivity of the auditor (IFAC, 2013).
Mandatory audit partner rotation limits audit partner tenure, thereby maintaining the independence of the auditor. Brody and Moscove (1998) assert that auditor rotation enhances independence and improves audit quality through a reduction of clients’ inadequate influence on auditors. Results of the article of Arel et al. (2006) suggest that auditors in the rotation condition are more likely to modify their audit report as contrasted to those in a situation in which a continuing relationship is expected.
2.2 The proponents of mandatory audit partner rotation
The reason for mandatory audit partner rotation is that the auditor becomes too familiar with the client and losing objectivity. A new incoming audit partner could have a fresh perspective. Audit partner tenure is defined as the number of years an auditor is retained by the firm (Myers et al. 2003). The two (related) primary arguments supporting a negative association between long audit partner tenure and audit quality are (1) erosion of independence that may arise with the development of personal relationships between an auditor and their client, and (2) deterioration in the audit partner’s capacity to effect critical appraisal (Carey and Simnett, 2006).
The major expected benefit is that mandatory audit partner rotation will improve audit quality because inappropriate accounting practices are more likely identified when a new, and hence
independent, engagement partner assumes responsibility for the audit (Carey and Simnett 2006; Gold, 2012). Dopuch et al. (2001) indicate that mandatory rotation can increase auditors' independence, and thus audit quality. Chung (2004) contributes to the current stream of research on the implications of mandatory audit firm rotation and informs policy makers in the current debate on improving auditor independence. This study examines the impact of the limited auditor tenure on earnings, and thus audit, quality by taking advantage of the unique audit regulations that govern the listed firms in Korea. The evidence indicates that under an audit regime similar to mandatory auditor rotation, audit quality does appear to improve when the duration of the auditor-client relationship is truncated. This suggests that mandating auditor rotation could enhance auditor independence and provide auditors greater incentives to resist management pressures. Church and Zhang (2006) found also that the independence of the auditor can be improved with mandatory rotation, depending on the rotation period, start-up costs, the cost associated with biased reports, auditors' learning, and the time span of managers' incentives.
Archival empirical research has considered the question of the effectiveness of mandatory rotation at the audit partner level. The mandatory availability of partner signatures on audit reports in some countries, such as Australian and Taiwan, facilitated such endeavors. Carey and Simnett (2006) used Australia data, where the audit partner can be identified and for a period where audit partner rotation was not mandatory. They examine three measures of audit quality regard to audit partner tenure; the auditor’s propensity to issue a going concern audit opinion for distressed companies, an examination of the signed and absolute amount of abnormal working capital accruals and an analysis of the extent to which key earnings targets are just beaten (missed). For long audit partner tenure observations Carey and Simnett (2006) found that there is a lower propensity to issue a going concern opinion. There is no evidence of an association between long audit partner tenure with either the signed or absolute amount of abnormal working capital accruals. For the third measure they found some evidence of just beating (missing) earnings benchmarks for long audit partner tenure observations. The findings with regard the auditor’s propensity to issue a going concern audit opinion and the extent to which key earnings targets are just beaten are consistent with deterioration in audit quality associated with long auditor tenure.
The other published archival studies largely suggest a negative effect of audit partner tenure on audit quality. For instance, using Taiwanese data, Chi and Huang (2005) found that discretionary accruals are initially negative associated with the audit partner tenure and audit firm tenure, but the associations become positive when tenure exceeds five years. Chen et al. (2008) found that the absolute and positive values of discretionary accruals decrease with audit partner tenure, hence leading to an increase in audit quality. Chi et al. (2009) investigated the effects on audit quality of
the mandatory audit partner rotation implemented in Taiwan in 2004. Using absolute and signed abnormal accruals and abnormal working capital accruals as proxies for audit quality, they found that in 2004, audit quality was higher for companies subject to the mandatory rotation regime than for firms not subject to rotation. Those studies support the arguments of the proponents of mandatory audit partner rotation.
Davis et al. (2009) examine the relation between auditor tenure and a firm's ability to use discretionary accruals to meet or beat analysts' earnings forecasts. They found evidence that there is a positive relation between tenure and the use of discretionary accruals to meet or beat earnings in the pre-Sarbanes-Oxley (SOX, 1988-2001) period, but do not observe such a relation in the post-SOX period. This finding is consistent with regulatory reforms and heightened scrutiny of financial reporting in the post-SOX period resulting in less aggressive efforts at managing earnings by client firms and/or increased diligence on the part of auditors.
In addition, Firth et al. (2012) investigate how various forms of auditor rotation, like partner rotation, firm rotation, mandatory rotation and voluntary rotation, affect audit quality. They use for the study the propensity to issue a modified audit opinion as a proxy for audit quality. They found that firms with mandatory audit partner rotations are associated with a significantly higher likelihood of a modified audit opinion. Those results suggest that mandatory rotation leads to an increase of professional skepticism and the independence of the auditor.
2.3 The opponents of mandatory audit partner rotation
Prior studies have indicated that short auditor tenure is associated with financial reporting problems due to a lack of competence and/or a lack of auditors’ independence (e.g., Geiger and Raghunandan, 2002; Johnson et al. 2002; Myers et al. 2003; Carcello and Nagy, 2004; Ghosh and Moon, 2005). Geiger and Raghunandan (2002) examine an association between audit firm tenure and audit quality by using a sample of bankrupt companies and looking at going-concern opinion reports. If there was no going-concern opinion the year before the bankruptcy, this was treated as a reporting failure and that impairs audit quality. Their results indicated that there were significantly more audit reporting failures in the earlier years of the auditor/client relationship than when auditors served these clients for longer tenures. The results do not support the arguments of those who propose mandatory auditor rotation and suggest that, contrary to the concerns expressed by the SEC and AICPA, there is an inverse relationship between auditor tenure and audit reporting failures.
Johnson et al. (2002), document higher unexpected accruals when audit partner tenure is short (2–3 years) than when it is medium (4–8 years). Using medium tenure as a benchmark. Moreover, they find no evidence that a longer auditor–client relationship (9 years or more) is
associated with lower unexpected accruals compared to the medium auditor–client relationship. Myers et al. (2003), Carcello and Nag (2004), Ghosh and Moon (2005) and Jenkins and Velury (2008) found a positive relation between the length of auditor-client relationship and audit (earnings) quality, which means that the audit quality increases as auditor tenure increases. This suggests that mandating auditor rotation may have an adverse effect on the audit quality. The evidence of those studies confirmed also the results of Johnson et al. (2002).
The study of Knechel and Vanstraelen (2007) examine the effect of auditor tenure on audit quality for private companies in Belgium, an environment where they believe auditor tenure is more likely to have a negative effect on audit quality. They use the likelihood of an auditor issuing a going concern opinion as an indicator of audit quality. Using a sample of stressed bankrupt companies, and stressed non-bankrupt companies, the results indicate that auditors do not become less independent over time nor do they become better at predicting bankruptcy. The same applies to the article of Jackson et al. (2008), which investigate the effect that a regime of mandatory audit firm rotation would have on audit quality in Australia, proxied by the propensity to issue a going-concern opinion report. They found that audit quality increases with audit firm tenure. While Carey and Simnett (2006) found that long audit partner tenure is associated with lower propensity to issue a going-concern opinion using Australia data.
The independence hypothesis predicts that auditor tenure is negatively associated with audit quality, while audit partner rotation would have positive outcomes. In contrast, Ruiz – Barbadillo et al. (2009) show the impact of mandatory rotation of audit firms on auditor independence. The results of this study do not support the suggestion that a mandatory rotation requirement is associated with a higher likelihood of issuing going-concern opinions. Overall, the results of this study provide empirical support for the arguments put forward by opponents of mandatory rotation.
In addition, Blouin et al. (2007) take advantage of the unique setting created by the collapse of Arthur Andersen to examine the costs firms face in the selection of a new auditor. Those companies had the choice to either follow their old audit team to a new audit firm or to start with a completely new audit team at another audit firm. Blouin et al. (2007) conclude that mandatory auditor rotation regime would not necessarily improve earnings (audit) quality. The results of this study should be of interest to regulators, standard setters and academics who are debating the efficacy of mandatory audit partner tenure.
Given the above, I expect that in a setting of mandatory audit partner rotation the audit quality will be weaker in the early years of an audit engagement than in the last years before a
switch, because a new audit partner is not able to recognize all of the potential issues of the clients business effectively. This expectation leads to the following hypotheses:
H 1: There is a positive relationship between audit partner tenure and audit quality
2.4 The expertise of an auditor and audit quality
Several studies document an association between measures of higher quality auditors (such as auditor size, client knowledge or industry expertise) and higher quality of financial reporting (e.g. Becker et al. 1998; Johnson et al. 2002; Krishnan, 2003; Balsam et al. 2003; Myers et al. 2003; Ghosh and Moon, 2005). A report on the U.S. audit market issued by the U.S. Government Accountability Office (GAO) in 2008 also acknowledges the importance of industry expertise, noting that ‘a firm with industry expertise may exploit its specialization by developing and marketing audit services which are specific to clients in the industry and provide a higher level of assurance’ (GAO, 2008). Similarly, PWC (2002) argue that audit quality depends on numerous factors including an auditor's ‘knowledge and understanding of the company being audited and the industry in which it operates’. These arguments suggest that auditors with industry expertise are more likely to detect misstatements and irregularities than auditors without knowledge and expertise. Becker et al. (1998) examine the relation between audit quality and earnings management, whereby earnings management is proxied by discretionary accruals. Becker et al. (1998) conclude that the absolute values of discretionary accruals are higher for clients of non-BIG 6 auditors.
The importance of client knowledge and expertise has led academic researchers to extensively study its impact on audit quality. The findings of prior literature suggest that the auditor’s knowledge of the industry increases audit quality, improving the accuracy of error detection (Solomon et al. 1999; Owhoso et al. 2002). Solomon et al. (1999) shows that industry experts have a deeper knowledge than non-experts due to the greater experience in the industry which enables experts to make more accurate audit judgments. In particular, Johnson et al. (2002) argue that lack of adequate client-specific knowledge during the early years of an engagement decreases the likelihood of detecting material errors and misstatements.
The literature on auditor tenure suggests deterioration in audit quality in the early years of the tenure due to a loss of client-specific knowledge and expertise. In addition, DeAngelo (1981) identifies a ‘learning curve’ that gives incumbent auditors a comparative quality advantage. As the age of an engagement increases, auditors become more knowledgeable about the operations, business risks, and audit risks of the firm. This argument suggests that it takes time for auditors to develop client-specific knowledge to perform an effective and efficient audit. New auditors may
have less client-specific knowledge and expertise in the early years of an engagement which could result in a lower likelihood of detecting material misstatements, thereby giving auditors a comparative advantage in detecting errors over time as they obtain a deeper understanding of the client’s business (e.g., Johnson et al. 2002; Geiger and Raghunandan, 2002; Myers et al. 2003). In contrast to this view, the opponents of mandatory audit partner rotation believe that a long tenure allows audit quality to increase, because the auditors’ client-specific knowledge and expertise increases (Geiger and Raghunandan, 2002; Chen et al. 2008).
Asserting the benefits of auditor industry specialization is relevant for public companies choosing among auditors, and to audit firms aiming to perform high quality audits while maintaining their competitive position in each industry (Minutti-Meza, 2013). The literature provides evidence of a positive relation between auditors’ industry expertise and financial reporting quality. For example, Krishnan (2003) examines the association between auditor industry expertise (BIG-6 auditors), measured in terms of both auditor market share in an industry and an industry’s share in the auditor’s portfolio of client industries, and a client’s level of absolute discretionary accruals, a common proxy for earnings management. Clients of non-specialist auditors report absolute discretionary accruals that are higher than the discretionary accruals reported by clients of specialist auditors. This finding is consistent with the notion that specialist auditors mitigate accruals-based earnings management more than non-specialist auditors and, therefore, influence the quality of audit. Overall, these results reinforce the importance of the client-specific knowledge and expertise, which larger audit firms have. Furthermore, Balsam et al. (2003) compare the absolute level of discretionary accruals and earnings response coefficients of firms audited by industry specialists (BIG-5) with firms not audited by industry specialists. They found that clients of industry specialist auditors have lower discretionary accruals and higher earnings response coefficients than clients of non-specialist auditors. This suggests that larger offices of Big 4 auditors are predicted to have higher quality audits due to greater in-house experience in administering such audits. Dunn and Mayhew (2004) found also a positive relation between audit firm industry specialization and financial reporting quality. Carcello and Navy (2004) found a negative association between industry expertise and client financial fraud disclosed in SEC Accounting and Auditing Enforcements releases.
Myers et al. (2005) found that clients are more likely to make income increasing misstatements and to misstate core earnings the longer the auditor-client relationship. However, further analyses reveal that misstatements of quarterly, rather than annual, financial statements drive these results. To better understand the relationship between tenure and misstatements, they explore the role of auditor industry specialization and found that the results on the association between tenure and misstatements hold for non-specialist auditors but not for specialist auditors.
The linkage between auditor tenure, specialization and audit quality is based on the assumption that auditors’ ability to perform an audit effectively and efficiently will depend on their expertise in the client's industry as well as on their client-specific knowledge. Expertise in the client's industry is therefore likely to be beneficial to a new auditor (Gul et al. 2009). Gul et al. (2009) provides evidence that auditors’ industry specialization affects the relationship between auditor tenure and earnings quality. Gul et al. (2009) show that the association between shorter auditor tenure and lower quality of reported earnings is weaker for firms audited by industry specialists. An explanation for this result might be that auditors with expertise in client industry are more likely to detect irregularities and misrepresentations and provide higher audit quality, even if auditors lack client specific knowledge as a result of short auditor client relationships.
Almutairi et al. (2009) tested the association between the auditor tenure and their expertise with information asymmetry. They show that information asymmetry is negatively related to the employment of an industry specialist auditor and positively related to audit firm tenure. Furthermore, they conclude that those firms audited by specialized auditors disclose more information and consequently have higher audit qualities.
I assume that BIG4 auditors have more auditing and industrial expertise. So, I expect that BIG4 partners will be able to acquire client-specific knowledge more quickly than non-BIG4 partners. This leads to the following hypothesis:
H 2: Audit quality is higher for a BIG4 auditor
However, I expect that the association between the audit partner tenure and audit quality will be weaker, if the partner is a BIG4 auditor. A BIG4 auditor has already expertise in client industry. A non-Big 4 auditor creates knowledge and expertise in the age of an engagement increase, the auditor become more knowledgeable as the tenure increases. The difference in audit quality between BIG4 and non-BIG4 audit partners diminishes with the passage of time. Figure 1 presents my assumption.
H3: There is a weaker association between audit partner tenure and audit quality, if the auditor is a partner of a BIG4 company.
3 Methodology
In this section, the sample selection and research design will be discussed. To identify the effect of audit partner tenure on audit quality an archival research approach is followed.
3.1 Sample selection
This study concentrates on listed companies in the United Kingdom since audit partner rotation is mandatory only for publicly listed companies. The data collection for this study involves the review and analysis of available data of financial statements of the largest public companies listed on the London Stock Exchange (FTSE 350) from 2009 till 2013. This research starts from 2009, after the policy that the auditor of United Kingdom listed companies is required to sign the audit report in their own name and the name of the audit firm (PWC, 2010). The disclosure of audit partner information on the audit report makes it possible to undertake an empirical evaluation.
All the required data for this study are obtained from COMPUSTAT Global combined with hand-collected data on audit partner names from annual reports and documents, which are available on the firms’ homepages. I also hand-collected missing net income data for the fiscal year 2013, from the financial statements. Subsequently financial institutions (two-digit SIC codes 60-67 finance, insurance and real state) have been excluded from the main sample, as they operate different compared to other companies and would possibly have too much influence on the outcomes from this examination. Further, I also excluded firms with missing data or firms where the partner name is not named in the annual report of 2009. After this process the sample resulted in 740 firm-year observations (unique companies = 148). Table 1 provides a summary of the observations. The data is winsorized at the 1st and 99th percentiles.
Table 1 Summary of the observations
Selection Firm-year Unique observations companies
Listed UK companies from 2009 till 2013 1.750 350
Companies in finance, insurance and real state (575) (115)
Missing financial information/missing partner name (435) (87)
3.2 Research design
The literature operationalizes audit quality in several ways. Audit quality is a concept that is not easily observable but can be measured through a range of different proxies. For this research I use two common measures of audit quality; signed and absolute value of discretionary accruals as a measure of earnings management and the auditor’s propensity to issue a going-concern opinion for distressed companies. The examination of those two measures of audit quality allows me to create greater confidence in any observed relation between audit partner tenure and audit quality.
3.2.1 Earnings management
The most widely used way to measure audit quality is earnings management (EM). Prior literature posits that higher audit quality mitigates extreme management reporting decisions (e.g. Becker et al. 1998; Carey and Simnett, 2006). Accruals are commonly used to identify these extreme reporting decisions (Becker et al. 1998; Myers et al. 2003; Carey and Simnett, 2006).
The correlation between performance and accruals is problematic in tests of earnings management because commonly used discretionary accrual models (e.g., modified - Jones models) are severely mis-specified when applied to samples experiencing non-random performance (see Dechow, et al. 1995). In this study, I use the Modified Jones Model (Dechow et al. 1995) specified by Kothari et al. (2005). Kothari et al. (2005) recommend and develop accrual models as a function of performance. According to Kothari et al. (2005), the performance adjustment is done by augmenting the Modified Jones Model with Return on Assets (ROA). Thereby, I make a distinction between absolute and signed discretionary accruals to analyze firms with income increasing as well as firms with income decreasing discretionary accruals. Analysis of discretionary accruals occurs in two steps in which the residuals values is equal to the amount of discretionary accruals. The first equation is as follow:
TAᵼ = Ф₁ (1/ASSET ᵼ - ₁) + Ф₂ (ΔSALES ᵼ - ΔARᵼ) + Ф₃ PPEᵼ + Ф₄ ROA ᵼ - ₁ + ɛ (1) Where:
TAᵼ total accruals (earnings before extraordinary items minus net cash flow from
operations),
ΔSALES ᵼ change in net sales,
ΔARᵼ change in net accounts receivable, PPEᵼ net property, plant and equipment, ROA the rate of return on assets, and
ᵼ - ₁ Prior year.
In order to examine whether there is a positive relationship between audit partner tenure and audit quality and if the audit quality is higher for a BIG4 audit partner (hypotheses 1 and 2), the following model is suggested:
DAᵼ = β₀ + β₁ APTENURE + β₂ BIG4 + β₃ SIZE + β₄ LEV + β₅ LOSS + β₆ GROWTH + β₇ CFO +
β₈ PERFORM + ε (2)
Where:
DA performance adjusted discretionary accruals,
APTENURE length of the auditor-client relationship as of the fiscal year-end; 1, 2, 3, 4 and 5; BIG4 dummy variable equal to 1 if the company is audited by a partner of BIG4, and
0 otherwise;
SIZE natural logarithm of total assets at fiscal year-end; LEV total liabilities divided by total assets;
LOSS an indicator set to ‘1’ if net income is negative and otherwise ‘0’;
GROWTH sales growth rate calculated as (sales in year ᵼ -/- sales in year ᵼ - ₁) / sales in year ᵼ₁; CFO operating cash flow in year t divided by total assets;
PERFORM earnings before tax over total assets at the end of the fiscal year.
The variable of primary interest in this model is APTENURE. APTENURE indicates the number of years that the company has retained the audit partner and can have values set between 1 and 5. If the audit quality increases in the later years of limited audit partner tenure, then the DA are expected to be lower in these years. The coefficient on APTENURE will be negative. I also expect that a company audited by a partner of a BIG4 company has a higher audit quality, coefficient will be negative. To examine if there is a weaker association between audit partner tenure and audit quality, if the auditor is a partner of a BIG4 company (hypotheses 3), I estimate the following equation:
DAᵼ = β₀ + β₁ APTENURE + β₂ BIG4 + β₃ SIZE + β₄ LEV + β₅ LOSS + β₆ GROWTH + β₇ CFO +
β₈ PERFORM +β₉ (APTENURE x BIG4) + ε (3)
Where, APTENURE x BIG4 is included to measure the association between audit partner tenure and audit quality, if the auditor is a partner of a BIG4 company. I expect the coefficient of (APTENURExBIG4) to be negative.
The six control variables have been identified that are correlated with discretionary accruals (Dechow et al. 1995; Becker at al. 1998; Krishan, 2003). I use SIZE to control for the differences in the accrual behavior of managers of large and small firms. SIZE is included because larger firms have the tendency to record larger, more stable discretionary accruals (Dechow and Dechev, 2002). Abnormal accruals for larger firms are expected to be less extreme. Therefore, the coefficient on SIZE is expected to be negative. The variable LEV representing the debt ratio and is also known to be significantly negatively related to discretionary accruals because high leverage might be a sign of bad financial condition, which in turn can increase management’s incentives to manage earnings (DeFond and Jiambalvo, 1994; Johnson et al. 2002). Firms with continued losses are more likely to fail and therefore LOSS is included. The coefficient on LOSS is expected to be positive. GROWTH is included because firm growth is positively related to the accruals (DeFond and Jiambalvo, 1994). In addition, I include CFO in the model to take into account the negative association between accruals and cash flows as documented in prior studies (e.g. Dechow, 1994). PERFORM is included in the model as a measure of performance to control for the nondiscretionary component (Carey and Simnett, 2006).
3.2.2 Going-concern opinion
As a second audit quality proxy, this study uses the auditor’s propensity to issue a going-concern opinion. The audit report communicates the auditor’s findings to market participants and plays a crucial role in warning financial statement users of impending going concern problems. Issuing a going concern opinion, however, means that the auditor must be able to objectively evaluate firm performance and withstand client pressure to issue a clean opinion. This suggests that, ceteris
paribus, the auditor’s propensity to issue a going concern opinion is positively correlated with the
auditor’s level of independence (DeFond et al. 2002).
Since the majority of prior research suggests that long auditor tenure may not reduce audit quality, for stressed companies I expect that an auditor will not be less likely to issue a going concern opinion when tenure is longer (Knechel and Vanstraelen, 2007). A finding that audit partners have a lower propensity to issue going-concern opinions with increased tenure would provide convincing evidence in favour of mandatory audit partner rotation, i.e. if there is lower propensity to issue going-concern opinions with increased tenure, then auditor independence becomes impaired (Jackson et al. 2008).
The variable for going-concern opinion (GCO) is hand-collected by reviewing the independent auditor reports of distressed companies.1 The variable for GCO is coded by ‘1’ if the
auditor gave a going-concern opinion to a client in the fiscal year and ‘0’ otherwise. The sample resulted in 86 firm-year observations. The logistic regression model is as follow:
GCO = β0 + β1 APTENURE + β2 BIG4 + β3 (APTENURE x BIG4) + β4 BANKRUPT + β5 LEV +
β6 LOSS + β7 SIZE + β8 ZFC + ε (4)
Where,
BANKRUPT is the probability of bankruptcy as measured by adjusted Zmijewski financial condition (ZFC) score2. The classifications are based on the estimated probabilities of each estimation sample
for a given technique using a 0,5 probability cutoff, that is, firms with probabilities greater than or equal to (less than) 0,5 are classified as bankrupt (non-bankrupt) (Zmijewski, 1984). The variable BANKRUPT is a dummy variable equal to ‘1’ if the firm is classified as bankrupt, otherwise ‘0’.
1The measure of financial distress employed is negative cash flows operations and/or negative earnings (Defond et al. 2002; Carey and
Simnett, 2006; Jackson et al. (2008).
2 The measure is used in many studies (e.g. Carcello et al. 1995) and incorporates the financial variables found to be significant in
bankruptcy prediction studies (Carey and Simnett, 2006; Jackson et al. 2008). B* = -4.803 – 3.6 (net income/total assets) + 5.4 (total liabilities/total assets) – 0.1 (current assets/current liabilities).
4 Results
This section presents the empirical results from the different hypotheses. First, I will introduce the descriptive statistics. Second, I will show the correlation coefficients between the dependent variable, independent variables and control variables. Thirdly, the results on the hypotheses will be explained. Finally, I will include the robustness tests.
4.1 Descriptive statistics
Table 2 presents descriptive statistics on the absolute and signed (positive and negative) discretionary accruals, independent variables and control variables. The final sample consists of 740 firm-year observations. I make a distinction between absolute and signed discretionary accruals to analyze firms with income increasing as well as firms with income decreasing discretionary accruals. I separate the full sample because, of the asymmetric relationship between the independent variables and positive and negative abnormal accruals (Carey and Simnett, 2006; Myers et al. 2003).
Table 2 Descriptive statistics
Variable Observations Means Std. Dev. Min Max
Absolute DA 740 0,042 0,038 0,001 0,198 Signed positive DA 376 0,041 0,033 0,000 0,152 Signed negative DA 364 -0,043 0,044 -0,232 -0,001 BIG 4 740 0,968 0,177 0 1 APTENURE 740 2,924 1,447 1 5 APTENURE*BIG4 740 2,820 1,515 0 5 LEV 740 0,559 0,200 0,094 1,056 GROWTH 740 0,093 0,231 -0,419 1,367 PERFORM 740 0,113 0,072 -0,010 0,341 CFO 740 0,118 0,071 -0,025 0,337 LOSS 740 0,091 0,287 0 1 SIZE 740 7,664 1,576 4,760 12,585 Variable definitions Dependent variable:
Absolute DA the amount of absolute discretionary accruals as proxy for audit quality; Signed Positive DA the amount of signed positive discretionary accruals as proxy for audit quality; Signed Negative DA the amount of signed negative discretionary accruals as proxy for audit quality; Independent variables:
BIG 4 dummy variable equal to 1 if the company is audited by a partner of BIG4, and 0 otherwise; APTENURE length of the auditor-client relationship as of the fiscal year-end; 1, 2, 3, 4 and 5.
APTENURE*BIG4 included to measure the association between audit partner tenure and audit quality Control variables:
LEV total liabilities divided by total assets;
GROWTH sales growth rate calculated as (sales in year ᵼ -/- sales in year ᵼ - ₁) / sales in year ᵼ₁; PERFORM earnings before tax over total assets at the end of the fiscal year.
CFO operating cash flow in year t divided by total assets;
LOSS an indicator set to ‘1’ if net income is negative and otherwise ‘0’; SIZE natural logarithm of total assets at fiscal year-end;
This resulted in 376 observations with income increasing (with a mean of 0,041) and 364 observations show income decreasing discretionary accruals (with a mean of - 0,043). These mean values are generally in line with prior study (DeFond and Subramanyam, 1998). As shown, the absolute value of discretionary accruals is positive (0,042). The larger the absolute value of discretionary accruals, the lower the quality of earnings (Dechow et al. 1995).
The audit partner rotates on average after a period of 3 years. The BIG4 audit firms audit 96,8 percent of these clients and 3,2 percent are audit by non-BIG4 audit firms. This is consistent with the argument of Francis (2004), who suggests that large companies are more likely to select BIG4 auditors. The mean of the control variable LEV is 0,559, which indicate that more than 50 percent of the firms have debt ratio. Furthermore, 9,1 percent of the 740 firm-year observations represent a year in which the company was loss making. The mean of control variable SIZE (7,66) is very high with respect to the other control variables.
4.2 Correlation
Table 3 shows correlations between discretionary accruals (DA), BIG4, aptenure, lev, growth, perform, cfo, loss and size. Those variables discussed previously in chapter 3. The correlation numbers summarize the strength of the relationship between the variables.
Table 3 Pearsons' correlation coefficients
Variable definitions
(1) Signed DA the amount of signed discretionary accruals as proxy for audit quality; (2) Absolute DA the amount of absolute discretionary accruals as proxy for audit quality;
(3) BIG 4 dummy variable equal to 1 if the company is audited by a partner of BIG4, and 0 otherwise; (4) APTENURE length of the auditor-client relationship as of the fiscal year-end; 1, 2, 3, 4 and 5;
(5) APTENURE*BIG4 included to measure the association between audit partner tenure and audit quality; (6) LEV total liabilities divided by total assets;
(7) GROWTH sales growth rate calculated as (sales in year ᵼ -/- sales in year ᵼ - ₁) / sales in year ᵼ₁; (8) PERFORM earnings before tax over total assets at the end of the fiscal year;
(9) CFO operating cash flow in year t divided by total assets;
(10) LOSS an indicator set to ‘1’ if net income is negative and otherwise ‘0’; (11) SIZE natural logarithm of total assets at fiscal year-end.
variable (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (1) 1 (2) -0,139 1 (3) 0,027 -0,061 1 (4) 0,028 -0,003 -0,036 1 (5) 0,032 -0,016 0,341 0,912 1 (6) -0,144 -0,024 0,167 -0,005 0,026 1 (7) -0,021 0,050 -0,171 0,014 -0,061 -0,212 1 (8) 0,001 -0,046 0,049 -0,050 -0,031 -0,081 0,186 1 (9) -0,446 0,051 -0,001 -0,027 -0,024 -0,082 0,181 0,754 1 (10) -0,323 0,200 0,005 0,007 0,013 0,093 -0,138 -0,326 -0,223 1 (11) 0,038 -0,076 0,158 -0,020 0,039 0,159 -0,111 -0,226 -0,239 0,069 1
As shown, the independent variable APTENURE is positively correlated (0,028) with the value of signed discretionary accruals and negatively correlated (-0,003) with the absolute value of discretionary accruals. The independent variable BIG4 is positively (0,027) correlated with signed discretionary accruals, and negatively (-0,061) correlated with the absolute value of discretionary accruals. APTENURE is negatively (-0,036) correlated with BIG4 audit partners.
The correlation coefficients matrix between independent variables reveals that the firm size is positively (0,158) correlated with BIG4 audit partners. Hence, large firms are more likely to use BIG4 audit partners (Francis, 2004). The control variable LEV is negatively correlated with discretionary accruals. High leverage might be a sign of bad financial condition, which in turn can increase management’s incentives to manage earnings (DeFond and Jiambalvo, 1994; Johnson et al. 2002). The control variables PERFORM and CFO are positively correlated (0,754).
4.3 Empirical results Earnings management
The first measure of audit quality examined in this study is earnings management. Table 4 presents the results of estimating model examining the relationship between audit partner tenure and BIG 4 auditors on audit quality.
The third column shows the regression results when the dependent variable is the absolute value of discretionary accruals. The adjusted R-Square of this model is 0.058, indicating that 5,8 percent of the total variation in absolute value of discretionary accruals is explained by the independent variables and control variables. The remaining is unexplained. The F-statistic of this model is 6,01 and the p-value <0.000, which suggesting that the main effects of the model are significant.
The coefficient on APTENURE is equal to -0,007 (p-value= 0,165), which suggests that an additional year of audit partner tenure have no effect on absolute discretionary accruals. For absolute discretionary accruals, I find no significant effect of audit partner tenure (p-value > 0,10). So, there is no evidence to conclude that discretionary accruals and audit partner tenure are linearly related. This is consistent with the study of Manrey et al. (2008), who found no significant relationship between audit partner tenure and audit quality for large low-risk or high-risk companies or for smaller companies with shorter tenure. In this study, I investigate only short tenure, because the partners included in the sample do not have long tenure (>5) because of mandatory rotation policy. The third and fourth column in table 4 shows the regression results when the dependent variable is positive or negative discretionary accruals. For the regression of positive discretionary accruals, the coefficient on audit partner tenure equals -0,008 (p-value= 0,121). This means that audit partner tenure is not associated with positive discretionary accruals. For the regression of
negative discretionary accruals, the coefficient on audit partner tenure equals 0,013 (p-value= 0,051). This result suggests that audit partner tenure have a positively significant (p-value<0,10) effect on negative discretionary accruals. This indicates that extended audit partner tenure constrains income decreasing accruals. The coefficient for APTENURE is positive and significant, which suggests that auditor oversight of management decisions is generally balanced in that auditors appear to constrain extreme income decreasing accruals. However, Myers et al. (2003) found for both models (absolute and signed discretionary accruals) a significant association between auditor tenure and earnings management. This is not consistent with the results of this study.
The relationship between the independent variable BIG4 and discretionary accruals is also shown in table 4. The coefficient on BIG4 equals -0,031 (p-value= 0,107), which suggests that a BIG4 audit partner have no effect on discretionary accruals. For absolute discretionary accruals, I find no significant association between audit quality and BIG4 audit partner (p-value > 0,10). So, there is no evidence to infer that absolute discretionary accruals are associated with a BIG4 partner. The results indicates that hiring a BIG4 audit partner has no effect on audit quality, which is not consistent with Becker et al. 1998, Francis, 2004, Krishnan, 2003 and Gul et al. 2009.
The third and fourth column in table 4 shows the regression of signed (positive/negative) discretionary accruals. For the regression of positive discretionary accruals, the coefficient on BIG4 equals -0,035 (p-value= 0,064). This result suggests that there is a negatively significant (p-value <0,10) effect on positive discretionary accruals. For the regression of negative discretionary accruals, the coefficient on BIG4 equals 0,055 (p-value= 0,031). This result suggests that there is a positive significant (p-value<0,05) effect on negative discretionary accruals. Collectively, the results from the regression indicate that BIG4 audit partner is not associated with the absolute discretionary accruals. However, there is a significant and positive association between BIG4 audit partner and the amount of income decreasing accruals and a significant and negative association with the amount of income increasing accruals. Indicating that firms that hire a BIG4 audit partner oversight of management decisions is generally balanced in that auditors appear to constrain extreme income increasing and income decreasing accruals.
Table 4 also reports the results for hypothesis 3. For absolute and positive signed discretionary accruals (β=0,007, p-value= 0,173; β=0,009, p-value=0,119), I find no significant association at a 10 percent level. For the regression of negative discretionary accruals, the coefficient of the cross term of APTENURE and BIG4 equals -0,012 (p-value= 0,095). This result suggests that there is a negative significant (p-value<0,10) effect on negative discretionary accruals. This indicates that BIG4 audit partners gain learning experience and build client-specific assets more
quickly than non-BIG4 audit partners. Furthermore, the difference in audit quality between BIG4 and non-BIG4 audit partners diminishes with the passage of time.
Table 4 Regression results for absolute and signed discretionary accruals
Variables Expected
sign Absolute DA Signed Positive DA Signed Negative DA
_cons Coef, 0,080 0,0784 0,0061 T-value 3,97 5,32 0,39 P-value 0,000 0,000 0,693 BIG4 - Coef, -0,031 -0,035 0,055 T-value -1,61 -1,86 2,17 P-value 0,107 0,064 0,031 APTENURE Coef, -0,007 -0,008 0,013 - T-value -1,39 -1,55 1,95 P-value 0,165 0,121 0,051 APTENURE*BIG4 - Coef, 0,007 0,009 -0,012 T-value 1,36 1,56 -1,67 P-value 0,173 0,119 0,095 LEV + Coef, -0,002 -0,026 -0,025 T-value -0,29 -3,40 -2,91 P-value 0,769 0,001 0,004 GROWTH - Coef, 0,010 0,003 -0,015 T-value 1,59 0,53 -2,00 P-value 0,111 0,596 0,046 PERFORM ? Coef, -0,068 0,393 0,411 T-value -2,23 10,15 10,52 P-value 0,026 0,000 0,000 CFO - Coef, 0,088 -0,588 -0,659 T-value 2,98 -13,36 -16,26 P-value 0,003 0,000 0,000 LOSS + Coef, 0,028 -0,022 -0,056 T-value 5,48 -2,22 -10,94 P-value 0,0000 0,027 0,000 SIZE - Coef, -0,002 -0,001 -0,002 T-value -1,76 -0,87 -1,37 P-value 0,079 0,383 0,170 F-Statistic 6,01 22,03 43,66 Ajd, R2 0,058 0,335 0,489
Note: Significant at 5% and 10% level Note: See table 2 for variable definitions
Table 4 also provides the coefficients of the control variables. The coefficients describe the relationship between each control variables and the dependent variable (DA) in the sample. There is sufficient evidence at the 5 percent level to infer that control variables are linearly related to the absolute value of discretionary accruals. The control variable LEV has a negative coefficient (
β
=0,002), but is not significant at p> 0.05. This indicates that leverage has no effect on earnings management. However, for the regression of signed (positive/negative) discretionary accruals, the coefficient is negatively (β
=-0,026, β=-0,025) and significantly (p-values < 0,05). High leverage might be a sign of bad financial condition, which in turn can increase management’s incentives to manage earnings. The coefficient for Growth equals 0,010, indicating that in the sample for each additional effect of 100 percent change in growth the absolute discretionary accruals increases on average by 1,0 percent assuming the constancy of the other control variables. The p-value is greater than 0,05, which specifies that there is no significant relationship between audit quality and growth. Thereby, the coefficient for CFO equals 0,088, specifies that in the sample for each additional year of cash flow the absolute discretionary accruals decreases on average by 8,8 percent assuming the constancy of the other control variables. The p-value is less than 0,05, indicating that there is a significant relationship between audit quality and CFO. The coefficient of the control variable Loss is positive (0,028). Companies with a prior year loss have higher absolute level of discretionary accruals, which is consistent with Carey and Simnett (2006). Size shows a negative coefficient (-0,002), which means that for each additional year of size, the absolute value of discretionary accruals decreases on average by 0,2 percent. The p-value of 0,079 (p-value<0,10), indicating that there is a negative significant association between audit quality and size.4.4 Empirical results Going Concern model
The restriction of the analysis to situations where the client reports negative earnings and/or operating cash flows from 2009 till 2013 results in the identification of 86 firm-year observations. I reviewed the independent auditor reports of distressed companies and observe 5 (5,8 percent) going concern modified audit opinions. The data for the going concern model is also winsorized at the 1st and 99th percentiles to remove the effect of outliers.
Table 5 presents the results from the logistic regression model using the propensity to issue a going-concern audit opinion as a proxy for audit quality. The main effects of the model is significant (Chi-square= 13.52, p<0,060). The going concern model has an adjusted R-Square of 0.354, indicating that 35,4 percent of the total variation of the outcome is explained by the model.
Table 5 logistic regression propensity to issue a going concern
opinion for financially distressed companies (n = 86)
Variables Expected Coefficient
sign (P-value) Cons_ 2,544 (0,999) BIG4 + 8,631 (0,995) APTENURE + -0,143 (0,565) LEV + -19,661 (0,026) LOSS + 3,730 (0,995) SIZE - 0,168 (0,435) BANKRUPT + 0,022 (0,987) ZFC + 3,843 (0,021) Pseudo R² 0,354 Model Chi-square = 13,52, p < 0,060
Note: Significant at 5% and 10% level Variable definitions
BIG 4 dummy variable equal to 1 if the company is audited by a partner of BIG4, and 0 otherwise;
APTENURE length of the auditor-client relationship as of the fiscal year-end; 1, 2, 3, 4 and 5; LEV total liabilities divided by total assets;
LOSS an indicator set to ‘1’ if net income is negative and otherwise ‘0’; SIZE natural logarithm of total assets at fiscal year-end;
BANKRUPT a dummy variable equal to ‘1’ if the firm is classified as bankrupt, otherwise ‘0’;
ZFC adjusted Zmijewski financial condition (ZFC) score.
The results from this table indicate that audit-client relationship is negatively affected by the likelihood of issuing a going-concern opinion. The coefficient of APTENURE variable is negative (β= -0,143), but not significant (p-value = 0,565 > 0,10). The result indicates that APTENURE does not influence audit quality. This is not consistent with the article of DeFond et al. (2002) and Jackson et al. (2008). They found a positive significant association between audit quality and auditor tenure, proxied by the likelihood of issuing a going concern opinion. There is no support for hypothesis 1.
The results in table 5 indicate that a BIG4 audit partner has a positively effect on the likelihood of issuing a going-concern opinion. The coefficient of BIG4 variable is positive (β=8,631), but not significant (p-value = 0,995 > 0,10). The result indicates that a BIG4 audit partner does influence audit quality. So, there is no clear support for either of the hypotheses.
As expected, the Zmijewski’s financial condition index (ZFC) is positively (β=3,843, p-value=0,021) associated with the propensity to issue a going concern opinion, indicating that firms with a higher probability of bankruptcy are more likely to receive a going concern opinion. I do not found significance in the predicted direction of the coefficient for LEV and SIZE. The estimated coefficient for LOSS is positive (β=3,730), but is also not significant (p-value=0,995).
4.5 Sensitivity analyses
For additional support of my findings, I test the robustness of my results by taken only the firm-year observations where the audit partner tenure is certain for the measurement by the proxy abnormal and signed discretionary accruals. Furthermore, I test the robustness by using an alternative measure of accruals, by adopting abnormal working capital accruals.
4.5.1 Robustness audit partner tenure
The sample for the robustness test on certain audit partner tenure variable, results in 448 firm-year observations. The regression results can be found in table 6.
First, as shown in panel A of table 6, for absolute discretionary accruals I find a significant effect of APTENURE (p-value<0,05), which suggests that an additional year of audit partner tenure have negatively (β= -0,020) significant effect on absolute discretionary accruals. Panel B of table 6 shows the regression result when the dependent variable is positive discretionary accruals and negative discretionary accruals, respectively. For the regression of positive discretionary accruals, the coefficient on APTENURE equals -0,001 (p-value= 0,864). This means that APTENURE have no effect on firms with positive discretionary accruals. For the regression of negative discretionary accruals, the coefficient on APTENURE equals 0,059 (p-value<0,05). This means that APTENURE have a positively significant effect on firms with negative discretionary accruals. This is consistent with my primary results on signed discretionary accruals.
Second, panel A of table 6 shows that the independent variable BIG4 is negatively associated (β= -0,057, p-value=0,011) with absolute discretionary accruals. This is not consistent with the results in table 4. Another key exception is that after splitting the sample into firms with positive and negative discretionary accruals, I find no significant effect of BIG4 for the positive discretionary accruals. This is also not consistent with the results of table 4.
Thirdly, as shown in panel A of table 6, APTENURExBIG4 is positively associated (β= 0,021, p-value=0,015) with the absolute measure of discretionary accruals. For the regression of positive discretionary accruals, the coefficient on APTENURExBIG4 equals 0,002 (p-value= 0,780). This means that APTENURExBIG4 have no effect on firms with positive discretionary accruals. For the regression
of negative discretionary accruals, the coefficient on APTENURExBIG4 equals -0,059 (p-value<0,05). This means that APTENURExBIG4 have a negatively significant effect on firms with negative discretionary accruals. This is also consistent with my primary results on signed discretionary accruals.
Table 6 Robustness test absolute and signed discretionary accruals
Panel A: Absolute accruals BIG4 APTENURE APTENURE x BIG4
Absolute discretionary accruals β -.057 -.020 .021
Sig. .011 .019 .015
Panel B: Signed accruals positive negative
BIG4 APTENURE APTENURExBIG4 BIG4 APTENURE APTENURExBIG4 discretionary accruals β -.016 -.001 .002 .143 .059 -.059 Sig. .457 .864 .780 .000 .000 .000
Note: Significant at 5% and 10% level Note: See table 2 for variable definitions
4.5.2 Abnormal and signed working capital accruals
For the proxy earnings management, I do also a sensitivity analyze by estimating the abnormal working capital accrual model of DeFond and Park 2001. Abnormal working capital accrual (AWCA) is the difference between realized working capital and an expected level of working capital needed to support a current sales level. In order to capture expected working capital needed to support a current sales level, a historic relation of working capital to sales is used. DeFond and Park (2001) found their measure to be more powerful test. Furthermore, the focus on AWCA is supported by prior research that suggests that management can exert the most discretion over abnormal working capital accruals (Ashbaugh et al. 2003; Becker et al. 1998). DeFond and Jiambalvo (1994) explains that working capital accruals are more exposed to earnings management than non-working capital accruals.
The measure of AWCA is as follow:
AWCA ᵼ = WC ᵼ - {(WC ᵼ - ₁ / S ᵼ - ₁) x S ᵼ} (5)
Where:
t year, t – 1 refers to the prior year;
WCᵼ non-cash working capital in the current year computed as (current assets – cash and short-term investments) – (current liabilities - short-term debt);
WCᵼ - ₁ non- cash working capital in the prior year; Sᵼ - ₁ sales prior year; and
Sᵼ sales in current year.
All variables are scaled by average total assets (Myers et al. 2003; Carey and Simnett, 2006).
The absolute value of AWCA indicates the degree to which management exercises discretion in reporting decisions.
The abnormal working capital accruals data were obtained from COMPUSTAT. With accruals estimated using the abnormal working capital accrual as additional measure, I re-estimate models (2) and (3). Table 7 represents the results.
Table 7 Abnormal working capital (WC) accruals (448 firm-year observations)
Panel A: working capital accruals BIG4 APTENURE APTENURE x BIG4
Abnormal WC accruals β -.014 -.027 .028
Sig. .849 .354 .341
Panel B: Signed accruals positive negative
BIG4 APTENURE APTENURExBIG4 BIG4 APTENURE APTENURExBIG4 Abnormal WC accruals β .291 .091 -.094 .063 .022 -.023 Sig. .045 .225 .213 .353 .357 .334
Note: Significant at 5% and 10% level Note: See table 2 for variable definitions
The dependent variable absolute discretionary accruals in the primary results (see table 4) is not significant with the independent variables. But, the robustness tests in paragraph 4.5.1 shows us the opposite, by indicating absolute discretionary accruals are significant affected by the dependent variables. The results on the model of abnormal working capital accruals show no significance, with one exception on the relation between BIG4 and positive abnormal working capital accruals.
Panel A of table 7, shows that absolute abnormal working capital accruals (AWCA), is not associated with the independent variables. This is consistent with the results in table 4. For the
regression of positive AWCA, the coefficient on BIG4 equals 0,291 (p<0,05). This means that a firm that audited by a BIG4 partner has higher income increasing abnormal working capital accruals.
As shown in Panel B of table 7, the negative AWCA is not significant with the independent variables. This is not consistent with the primary results. However, the predicted direction of those variables is consistent.
