Key.2010.CAR.LIM.CHEE-YEOW.TAN.HUN-TONG.Does Auditor Tenure Improve Audit Quality moderating effects

Does Auditor Tenure Improve Audit Quality? Moderating Effects of Industry Specialization and

Fee Dependence*

CHEE-YEOW LIM,Singapore Management University

HUN-TONG TAN,Nanyang Technological University

1.Introduction

In this study,we investigate whether the relation between auditor tenure and audit quality is conditional on auditor specialization and fee depen-dence(in terms of economic contribution to the public accounting?rm’s income).We argue that auditor tenure is associated with two related con-structs:auditor expertise and economic incentives.First,auditor tenure is associated with greater acquired expertise in that,with extended auditor tenure,the auditor can gain a better understanding of the client’s business processes and risks(Bell,Marrs,Solomon,and Thomas1997).Longer audi-tor tenure may be associated with reduced vigilance through overfamiliarity with the client(Mautz and Sharaf1961),an effect that may be remedied by greater auditor expertise(Smith and Kida1990;Libby and Luft1993;Solo-mon,Shields,and Whittington1999).Second,extended auditor tenure (without the prospect of mandatory rotation)may create economic incen-tives for auditors to be less independent,in that auditors may acquiesce to the client’s demands in order to continue to secure a stream of future audit fees(Hoyle1978;Conference Board2005).Also,a corollary of the earlier expertise argument is that,to the extent that the auditor develops,through extended tenure,expertise and a reputation for performing audits in the cli-ent’s industry,the auditor also develops incentives to improve audit quality in order to protect this reputational capital and loss of future revenue streams(DeAngelo1981;Krishnan2003).The effects operate in opposite directions.These offsetting effects suggest that,in assessing the effects of auditor tenure on audit quality,it is important to consider the joint consid-eration of the effects of auditor expertise and incentives and not either the effects of expertise or incentives alone.

Prior research generally shows that auditor tenure is associated with higher audit quality(Geiger and Raghunandan2002;Johnson,Khurana, and Reynolds2002;Myers,Myers,and Omer2003;Mansi,Maxwell,and Miller2004;Ghosh and Moon2005;Chen,Lin,and Lin2008).However, *Accepted by Michel Magnan.We thank the editor(Michel Magnan),two anonymous referees,and Sanjay Kallapur for helpful comments.

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doi:10.1111/j.1911-3846.2010.01031.x

924Contemporary Accounting Research

recent research shows some con?icting results.For instance,there is evi-dence that extended tenure is associated with both positive and negative effects on audit quality(Davis,Soo,and Trompeter2009).Also,Carey and Simnett(2006)?nd no relation between audit partner tenure and accruals. Instead,they?nd that audit quality(as proxied by the incidence of going concern opinions and the proclivity to beat earnings benchmarks)is associ-ated with lower audit quality when audit partner tenure increases.

Studies on the moderating effect of incentives effects on auditor tenure have found con?icting results on whether audit?nonaudit fees(common proxies for auditor incentives to please the client)are associated with poorer or superior audit quality with auditor tenure(cf.Gul,Jaggi,and Krishnan 2007;Stanley and Dezoort2007).Similarly,studies that assess the empirical relation between auditor tenure and auditor specialization(a common proxy for auditor expertise)have found con?icting results and document either no moderating effect of auditor specialization(Myers et al.2003)or an inter-action(Stanley and Dezoort2007;Gul,Fung,and Jaggi2009).None of these studies examines the effect of both expertise and incentives on the auditor tenure–audit quality relation.1

These opposite and con?icting predictions and?ndings in prior litera-ture may be attributable to failure to jointly examine expertise and incentive constructs,differences in empirical proxies,differences in sample or sample periods used,or a combination of these reasons.In this study,we develop predictions about the effect of auditor tenure on audit quality based on a more complete consideration of the moderating effects of auditor expertise and incentives,and test our predictions across a common set of empirical proxies used in prior studies and over a common sample period.

The issue of whether longer auditor tenure impairs auditor independence and audit quality has a controversial history(e.g.,see Mautz and Sharaf 1961;U.S.Senate Metcalf Committee1976).Recent?nancial scandals have also precipitated concerns over whether auditor tenure impairs auditor inde-pendence and audit quality and have led to regulatory interest in the use of mandatory rotation to enhance auditor independence and reduce the likeli-hood of audit failures(Public Oversight Board2002;U.S.Congress2002; International Organization of Securities Commissions[IOSCO]2005).

Mandatory rotation of auditors has taken two forms:at the audit?rm level and at the audit partner level.In this study,we examine auditor rota-tion at the?rm level,which has continued to attract debate over its ef?cacy.

1.Gunny,Krishnan,and Zhang(2007)also examine the effect of auditor tenure,auditor

specialization,and fees on audit quality.However,they only examine two-way interac-tions among these variables,not a three-way interaction.For instance,they?nd some evidence that tenure and specialization are jointly associated with higher audit quality, while tenure and abnormal total fees are jointly associated with lower audit quality.

Note that their sample only includes?rms audited by non–Big4?rms,and hence their results may not be generalizable because a large proportion of the?rms in the United States are audited by Big4auditors.

CAR Vol.27No.3(Fall2010)

Does Auditor Tenure Improve Audit Quality?925 Mandatory rotation of audit?rms has been implemented in various parts of the world(such as Brazil,Italy,and Singapore),while mandatory rota-tion of audit partners was implemented in Canada and the United Stats.In the United States,mandatory audit?rm rotation was part of reforms con-sidered by the U.S.General Accounting Of?ce(GAO).While the GAO concluded that it would be more prudent to take time to assess the effec-tiveness of the Sarbanes-Oxley Act(SOX)reforms before mandating audit ?rm rotation,it was left as an option for the future(GAO2003).Even where mandatory audit partner rotation has been implemented,pressures for audit?rm rotation continue(Economist2004)and audit?rm rotation is an issue of continued interest by standard setters(IOSCO2005).More recently,the Commission on Public Trust and Private Enterprise appointed by the Conference Board endorsed the use of audit?rm rotation,even in the presence of audit partner rotation,to improve auditor independence (Conference Board2005).Audit?rm rotation is also a recurrent and cur-rent concern of public accounting?rms(PricewaterhouseCoopers2007).2 Arguments on the costs and bene?ts of extended auditor tenure invari-ably involve issues related to auditor expertise and incentives.Arguments in favor of extended auditor–client relations rest primarily on an expertise argument(although,as we explain below,an incentive argument can also apply).Speci?cally,auditors climb a steep learning curve to understand the client’s industry and the business it operates,along with the associated risks(Knapp1991;PricewaterhouseCoopers2002).This suggests that audi-tors are less likely to detect errors when they?rst engage in the audit of the client.There is empirical evidence that alleged audit failures(American Institute of Certi?ed Public Accountants[AICPA]1992;Geiger and Rag-hunandan2002;Carcello and Nagy2004a)and the likelihood of litigation (Palmrose1991)are higher during the early years of an auditor–client relation.With longer tenure,auditors develop a better understanding,both of the client and the industry.One implication is that,with extended ten-ure,to the extent that the auditor develops a reputation for performing audits in the client’s industry and grows his client base in that industry, the auditor also develops incentives to improve audit quality in order to protect this reputation and loss of clients from inappropriately acquiescing to any single client’s demands(DeAngelo1981;Krishnan2003).

Arguments against extended auditor–client relationships and in favor of mandatory rotation are based on both cognitive(expertise-related) and incentive arguments.For example,one reason cited by the Cohen 2.It is also not practically feasible to investigate audit partner rotation effects using Cana-

dian and U.S.data because the name of the engagement audit partner is not disclosed in the audit report.Audit?rm rotation can be seen as a more extreme form of auditor rotation in that,when audit?rms rotate,the engagement audit partner necessarily changes too.

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926Contemporary Accounting Research

Commission(AICPA1978)for mandatory rotation is that the new auditor brings a fresh perspective to the audit.Allegedly,an auditor who has audited the client over time can become overfamiliar with the client,become complacent,and develop blind spots.These are cognitive limitations inde-pendent of an incentive argument,and may be mitigated by auditors with expertise(Smith and Kida1990).

The second reason is an incentive argument.For instance,it has been alleged that‘‘long association between a corporation and an accounting ?rm may lead to close identi?cation of the accounting?rm with the inter-ests of its client’s management...’’(U.S.Senate Metcalf Committee1976, 21).Similarly,the report of the Commission on Auditors’Responsibilities (AICPA1978,108)highlights that,with mandatory rotation,‘‘the audi-tor’s incentive for resisting pressure from management would be increased’’.Speci?cally,over time,the auditor may become less indepen-dent,less skeptical,and more complacent,motivated by concerns about maintaining the client relation so as to pro?t from it.This argument sug-gests that an auditor’s incentives to be less independent increase with extended tenure,particularly for important clients that the auditor earns signi?cant audit fees from.

In summary,increased auditor tenure is associated with both increased expertise factors and associated incentives to protect reputational capital (which increases audit quality),as well as increased incentives to please the client(which reduces audit quality).In our study,we proxy auditor expertise by whether auditors are industry specialists.We use this proxy because a client’s business operations and risks vary by industry,and prior research documents industry-speci?c variation in the nature and inci-dence of?nancial statement errors(Maletta and Wright1996).Hence, industry specialist auditors’greater expertise in the speci?c industry domain enables them to better acquire knowledge concerning the client’s business and risks(Bell,Peecher,and Solomon2005).Specialization also proxies for incentives for auditors to protect their reputational capital and avoid costly litigation(Krishnan2003).Hence,specialization can be con-sidered to be proxying jointly both for expertise and the incentive to pro-tect this expertise.We consider the dependence of an auditor on fees received from a particular client to be associated with greater auditors’incentives to side the client and be less objective in their judgments.We assess how auditor specialization and fee dependence interact with auditor tenure in determining audit quality.

Empirical measures for audit quality can be noisy and there is little con-sensus on what is the most appropriate proxy.Hence,we conduct our empirical tests using multiple proxies of audit quality that have been used in prior studies.We use,as our main proxy for audit quality,the accrual quality measure developed by Dechow and Dichev2002,with modi?cations suggested by McNichols2002.We proxy auditor industry specialization based on the industry market share of the Big N auditors.We use the CAR Vol.27No.3(Fall2010)

Does Auditor Tenure Improve Audit Quality?927 measure of client importance by Chung and Kallapur2003at the city level to proxy auditors’economic bond with the client.3

Our results indicate that audit quality is higher for?rms audited by spe-cialists relative to nonspecialists when auditor tenure increases.Further,the improvement in audit quality with extended auditor tenure is greater when auditors have lower fee dependence on clients.These results are generally robust to various sensitivity analyses and other proxies for audit quality such as higher propensity for auditors to issue going-concern opinion to ?nancially distressed?rms and stronger market’s response to quarterly earn-ings surprises(i.e.,earnings-returns coef?cients).

Our paper contributes to the literature on the audit quality effects of audit tenure.From a theoretical perspective,our paper contributes to the audit tenure literature by posting and demonstrating that the tenure–audit quality effect is conditional on both auditor specialization and fee depen-dence.Prior studies have examined only a subset of these independent vari-ables,and theoretical arguments made in these studies on conditions under which auditor tenure improves or impairs audit quality are less complete. Our results also provide useful evidence to regulators and policy makers on the impact of audit tenure on audit quality.Regulators in various countries have mandated auditor rotation,presumably on the premise that extended auditor tenure is detrimental to audit quality.We show that extended audi-tor tenure does not necessarily decrease audit quality;in fact,audit quality is improved with extended tenure when two conditions are met—the audi-tor is a specialist and has low fee dependence.These results should be help-ful to the GAO in its assessment of whether to mandate audit?rm rotation (GAO2003),and also to other standard setters that are deliberating on this issue(IOSCO2005).The?ndings should also be of interest to public accounting?rms in their efforts to improve audit quality.Our results sug-gest that,in developing longer-term ties with a client,public accounting ?rms should consider investing in resources to further develop expertise in the client’s industry and to avoid overly high fee dependence on any client. In turn,this has broader implications on public accounting?rms’strate-gies?policies to position themselves as industry specialists and on their client acceptance?retention decisions.

The remainder of this paper is organized as follows.We discuss prior literature and develop our hypotheses in section2.Section3describes our sample and variable measurement.We present the empirical results in sec-tion4,while section5discusses the sensitivity analyses performed.We offer some concluding remarks in section6.

3.The individual practice of?ce in a particular city is generally the locus of contracting

between the client and the audit?rm.Therefore,the variable of interest is the impor-tance of the client to the practice of?ce at the city level rather than across the entire audit?rm.

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928Contemporary Accounting Research

2.Background and hypothesis development

Effects of auditor tenure

Arising from regulatory interest in the issue of mandatory auditor rotation, several recent studies investigate the relation between auditor tenure and various measures of audit quality.The dominant?nding is that audit qual-ity improves with auditor tenure(Geiger and Raghunandan2002;Johnson et al.2002;Myers et al.2003;Mansi et al.2004;Ghosh and Moon2005). There are some exceptions,with recent evidence showing that audit quality deteriorates either with increased auditor tenure(Carey and Simnett2006) or both at the earlier or later part of auditor tenure(Davis et al.2009).A recent study by Manry,Mock,and Turner2008?nds that audit quality is improved only for small clients with partner tenure of greater than seven years.

Some recent studies examine the interaction between auditor tenure and either fees or auditor specialization.However,seemingly opposite conclu-sions are reached.One set of studies examines the interaction between audi-tor tenure and audit fees.Gul et al.(2007)?nd that nonaudit fees(but not audit fees)are associated with poorer audit quality in terms of higher dis-cretionary current accruals for?rms with short auditor tenure.In contrast, Stanley and DeZoort(2007)document that audit fees(but not nonaudit fees)are associated with improved audit quality in terms of lower likelihood of restatement for?rms with short auditor tenure.Another set of studies examines the interaction between auditor tenure and auditor specialization, but results differ depending on the proxy for audit quality.Myers et al. (2003)?nd no such interaction with discretionary accruals.In contrast, using discretionary accruals and restatements as proxies for audit quality, other studies document this interaction(Stanley and Dezoort2007;Gul et al.2009).

Effects of industry specialization

Audit?rms that are industry specialists invest time and?nancial resources in developing personnel and technology in speci?c industries to improve audit quality.Thus,auditors working in audit?rms that are industry spe-cialists have more opportunities to develop expertise than those working in nonspecialist?rms.Because clients’operations and business risks vary by industry and research indicates that the nature and incidence of?nancial statement errors vary by industry(Maletta and Wright1996),industry-specialist auditors’greater expertise in the speci?c industry allows them to better acquire knowledge concerning the client’s business,operations,and risks(Bell et al.2005)compared to nonspecialists.Consequently,they are also less likely to be misled by management representations(Solomon et al. 1999).

Auditors who are industry specialists also likely have incentives to pro-tect their reputational capital and avoid reputation damage.Inasmuch as CAR Vol.27No.3(Fall2010)

Does Auditor Tenure Improve Audit Quality?929 auditors have been posited to be more independent when they have a larger client base to lose(DeAngelo1981),4industry specialists have more to lose from poor audit quality in terms of losing future revenue streams and fee premiums.Thus,they have greater incentives than nonspecialists to main-tain high-quality audits(be more independent)to avoid jeopardizing this reputation(Watts and Zimmerman1983)through litigation exposure(Shu 2000).Prior research shows that specialist auditors’clients are less likely to be associated with Securities and Exchange Commission enforcement actions(Carcello and Nagy2004b)and are more likely to comply with auditing standards(O’Keefe,Kin,and Gaver1994).

Effects of fee dependence

Economic theory indicates that,when an auditor derives a high proportion of revenue from a particular client,this creates economic bonds on the auditor and causes the auditor to be?nancially reliant on the client,which can cause the auditor to lose objectivity(DeAngelo1981).Psychology research suggests the same outcome,but the mechanism by which the audi-tor loses objectivity with fee dependence is said to be unconscious(Kunda 1990;Bazerman,Morgan,and Lowenstein1997).

We posit that greater clarity on the auditor tenure–performance rela-tionship requires the joint consideration of the auditor’s industry specializa-tion and fee dependence.Two interaction patterns are possible,and we discuss each of these in the next two subsections.

Auditor tenure and industry specialization relation and the moderating effect of fee dependence

The?rst interaction pattern focuses on the relation between auditor tenure and industry specialization and how their effect on audit quality is contin-gent on fee dependence.

In terms of the relation between auditor tenure and industry special-ization,one of the arguments for extended auditor tenure(and against mandatory rotation)is that auditors take time to acquire speci?c knowl-edge about the industry and business of their clients.Auditors who are industry specialists begin the audit of a new client with superior knowl-edge of the industry,which facilitates their understanding of the client rel-ative to nonspecialists.One possibility is that,particularly in a relatively static industry and client environment,nonspecialists can catch up with the specialists in their knowledge of the client with increased tenure,which suggests no effect of industry specialization with an extended auditor–client relationship.

4.Auditor specialization is typically measured in terms of market share(e.g.,Chung and

Kallapur2003;Lim and Tan2008),which further reinforces the point that specialists have more incentives to be independent as they have more market share to lose from poor audit quality.

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930Contemporary Accounting Research

However,the environment is more likely to be dynamic(Bell et al. 2005).In a dynamic and changing environment,specialists are more likely to be able to adapt,update their knowledge,and keep abreast of changes. Indeed,psychology research indicates that people who start off with higher domain knowledge are better able to acquire more high-quality knowledge over time and at a faster rate than those with lower domain knowledge (e.g.,see Chiesi,Spilich,and Voss1979;Bonner2007).5This notion of adaptation over time is implicit in a common argument made against extended tenure—that is,as auditor tenure increases,auditors develop more blind spots in terms of detecting problems in the client’s business pro-cess and controls and errors in the?nancial statements.Presumably,this can arise because the auditor becomes overfamiliar with the client and com-placent(e.g.,in assuming that things that had worked in the past will con-tinue to do so)or because the auditor has not suf?ciently kept abreast with changes in the client and in the industry.However,the greater resources invested by audit?rms specializing in particular industries in their personnel and technology likely enable their staff to be more adaptive in their audit approaches in response to business or industry changes.To the extent that the environment is dynamic over time,these arguments suggest that audit quality is more likely to increase with tenure(i.e.,over time)for specialist auditors than nonspecialist auditors.In addition,as we mentioned earlier, specialist auditors have greater incentives than nonspecialists to maintain high-quality audits to protect their reputational capital.

However,a competing incentive to reduce audit quality arising from fee dependence is likely to reduce the bene?cial effect of auditor specialization on extended auditor tenure.We predict that the specialization by tenure interaction described above is contingent on fee dependence.With extended auditor tenure,audit quality correspondingly increases with industry spe-cialization but is more likely so when fee dependence is low.The reason is that,although specialist auditors are likely associated with higher audit quality with longer auditor tenure,incentives to align with the interest of an important client(in terms of fees earned)may somewhat cloud their profes-sional judgment and increase their proclivity to take the side of the client on controversial accounting issues.This premise is consistent with the argu-ment by Bazerman et al.(1997,93–94)that,with fee dependence,‘‘indepen-dence becomes a problem even for the most moral,honest auditor.Despite the auditors’best effort to place the external users’interests above the client’s and to maintain objectivity,they may be unable to completely 5.Like the other theories we use(e.g.,auditor expertise,bias from fee dependence),this

theory of learning is at the individual level,as it is the audit partner who interacts with the client and forms audit judgments.These effects likely generalize at the?rm level to the extent that the public accounting?rm is essentially a collection of individual audi-tors.Note that the nonavailability of empirical proxies for tenure,fee dependence,and specialization at the individual partner level necessitates that we use?rm-level proxies for these constructs.

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Does Auditor Tenure Improve Audit Quality?931 overcome cognitive or psychological biases that make them arrive at mar-ginal decisions in the client’s favor.’’This suggests the following directional hypothesis:

H YPOTHESIS1a.As auditor tenure increases,audit quality increases with

auditors’industry specialization but is more likely so when fee depen-

dence is low.

Auditor tenure and fee dependence relation and the moderating effect of industry specialization

The second possible interaction pattern focuses on the relation between auditor tenure and fee dependence and how their effect on audit quality is contingent on the auditor’s industry specialization.

In terms of the relation between auditor tenure and fee dependence, one argument against extended auditor tenure(and for auditor rotation) is that,over time,the auditor becomes less independent and audit quality goes down,arising from economic bonds by way of fee dependence formed between auditor and client.The reasoning is that,with mandatory rotation(i.e.,without extended tenure),‘‘in disagreeing with management, auditors would no longer be risking a stream of revenues that they believed would continue in‘perpetuity,’since the audit engagement would no longer be perceived as permanent’’(Conference Board2005,39).This argument suggests lower audit quality with longer auditor tenure,with the effect magni?ed in the presence of high fee dependence,because an auditor would be loath to lose a client that contributes signi?cantly to the income earned by the public accounting?rm.6Interestingly,economic bonding from high fee dependence also argues against short auditor ten-ure.Following DeAngelo1981,to the extent that auditors lowball audit fees,auditors are more likely to acquiesce to clients’demands in the ini-tial years for fear of threats of dismissal and loss of future quasi-rents (Geiger and Raghunandan2002),this effect should be greater for higher fee dependence as the magnitude of these quasi-rents is clearly higher for clients whose fees form a signi?cant proportion of the public accounting ?rm’s revenue.Thus,the joint consideration of fee dependence and audi-tor tenure does not indicate a clear directional effect on audit quality; with greater economic incentives to side the client with higher fee depen-dence,audit quality may suffer either with extended tenure or short ten-ure.However,any dysfunctional effect is less likely for industry specialists than nonspecialists.The reason is that specialist auditors are more likely 6.Studies on the relation between the provision of nonaudit services(which contributes to

total fee income of the public accounting?rm)and audit quality has yielded mixed results,with some?nding negative effects(e.g.,Frankel,Johnson,and Nelson2002;

Khurana and Raman2006)and others?nding no effect(e.g.,Ashbaugh,LaFond,and Mayhew2003;Chung and Kallapur2003;Li2009).

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932Contemporary Accounting Research

to resist such incentives,arising from their relatively stronger incentives to preserve their reputational asset.Because the directional nature of the fee dependence by tenure relation is unclear,we make a general prediction below:

H YPOTHESIS1b.The joint effect of auditor tenure and fee dependence on

audit quality is moderated by auditors’industry specialization.

3.Data and variables measurement

Data

Our initial sample consists of40,881?rm-years with fee information from the Audit Analytics database and?nancial information in COMPUSTAT for?scal years2000–2005.7We restrict our study to clients of Big N auditors to control for brand name(Johnson et al.2002;Chung and Kallapur2003).Accordingly,we remove11,436?rm-years that are not audited by Big N auditors.Given the fundamentally different operating characteristics associated with?nancial institutions,we exclude3,764?nancial companies from the analyses(SIC codes6000–6999).We drop 4,356?rm-year observations due to missing data needed to compute fee dependence at the city level.We remove3,352?rm-years without suf?-cient data to compute accrual quality.Finally,we delete the top and bottom1percent of each of the continuous control variables used in the regression to remove extreme values,and the?nal sample usable for the study is12,783?rm-years,with complete information on the control variables.Panels A and B in Table1report the distribution of sample ?rms by year and industry,respectively,for the data used for the accrual quality test.

Auditor tenure

Following prior studies(Myers et al.2003;Ghosh and Moon2005),we measure tenure as the cumulative number of years the auditor has been employed by the?rm.We do not employ a continuous measure for auditor tenure because the relation between auditor tenure and audit quality may not be linear.Instead,we use dummy variables to capture the effect of ten-ure on audit quality in two ways.First,we use the median tenure as a cutoff to indicate long versus short tenure(DTENU).Second,following prior studies(e.g.,Johnson et al.2002;Carcello and Nagy2004a),we use two indicator variables,one for short tenure(SHORT,equals one when the length of the auditor–client relationship is three years or less,and zero 027e6705f18583d049645958PUSTAT covers full information for the?rms up to the year2006.Our sample

ends at2005because we require one-year-ahead cash?ow from operating activities to compute our proxy for audit quality and accrual quality.Our sample begins in year 2000because it is the?rst year where fee data is available.

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otherwise),and another for long tenure (LONG ,equals one when the length of the auditor–client relationship is nine years or longer,and zero other-wise).The comparison group relates to ?rms with medium auditor tenure (four to eight years).

TABLE 1

Sample size and industry description Panel A:Distribution of sample ?rms by year Year N Percent 20001,89614.8320012,52919.7820022,51119.6420032,33218.2420041,99515.6120051,52011.89Total

12,783

100.00

Panel B:Distribution of sample ?rms by industry SIC

Industry

N Percent 73Business services,including software 2,00115.6536Electronic ?other electric equipment 1,29910.1628Chemical and allied products 1,29010.0938Instruments and related products 1,1288.8235Industrial machinery ?equipment 9117.1349Electric,Gas,Sanitary services 552 4.3213Oil and Gas Extraction 452 3.5450Durable Goods–Wholesale 350 2.7448Communications

322 2.5287Engr,Acc,Resh,Mgmt,Rel Svcs 320 2.5080Health Services

283 2.2159Miscellaneous Retail

280 2.1937Transportation equipment 270 2.1120Food and Kindred Products

263 2.06Others

(32industries)3,06223.95Total 12,783

100.00

Note:

The sample period is ?scal years 2000–2005,and the sample consists of 12,783

non?nancial ?rms audited by Big N public accounting ?rms,with all information on control variables.

Does Auditor Tenure Improve Audit Quality?

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934Contemporary Accounting Research

Auditor industry specialization

Previous studies(e.g.,Chung and Kallapur2003;Lim and Tan2008)typi-cally use the market share of the Big N public accounting?rms to proxy for auditor specialization.We de?ne auditors with a large industry market share(de?ned as two-digit SIC code)as the specialist(SPEC).We consider an auditor to have a large market share in the industry if the auditor has at least24percent for the2000–2001period and30percent for the2002–2005 period.8We also test the sensitivity of our results using other operational-izations of auditor industry specialization.

Fee dependence

We use client importance,which captures the relative signi?cance of a cli-ent’s total fees to the fee revenue received by the auditor in the same city,9 as a measure to capture economic bonding between the auditor and the cli-ents(Chung and Kallapur2003).10This measure better captures the speci?c economic bonding unique to each auditor,relative to the auditor’s total fee revenue.A total fees measure does not take into consideration the size of the auditor,in that the same total fees may be economically signi?cant for one auditor but not for another,depending on its total fee revenue. Empirical model

The conventional linear discretionary accruals models introduced by Jones 1991have been widely used in accounting literature to estimate discretion-ary accruals(e.g.,Myers et al.2003;Ashbaugh et al.2003;Johnson et al. 2002).There is little evidence documenting which discretionary accruals model is superior or more appropriate.In a recent study,Jones,Krishnan, and Melendrez(2008)evaluate a comprehensive set of proxies for earnings management used in the prior studies and report that McNichols’s2002 modi?cation of the Dechow and Dichev2002model is better able to detect earnings management.Hence,our main tests are based on the modi?ed 8.Following Neal and Riley2004,we employ a cutoff for‘‘large’’market shares of

(1?N)*1.2,where N is the number of big audit?rms.The largest?rms are the Big5 after the merger between Coopers and Lybrand and Price Waterhouse in1998,and Big 4after the demise of Arthur Andersen in2002.This measure includes all?rms that cross the24percent and30percent thresholds.

9.Consistent with Francis,Reichelt,and Wang2005,we de?ne cities using the U.S.Cen-

sus Bureau de?nition of metropolitan statistical areas to identify metropolitan areas based on state and county codes.

10.We do not solely use nonaudit fees for two reasons.First,high audit fees(and not

nonaudit fees per se)can also create similar incentives for auditors to compromise audit quality in their reporting decisions with respect to a speci?c client.Second,the SOX passed in2002effectively bans auditors from performing many types of nonaudit ser-vices,leading to a corresponding decline in nonaudit services revenue.However,total fees is likely to be stable as the decline in revenues from nonaudit services are likely to be offset by substantial increases in audit fees due to,for example,the cost of complying with Section404implementation costs under SOX.

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Does Auditor Tenure Improve Audit Quality?935 accrual quality measure by McNichols2002.The same model has also been used in recent studies(e.g.,Srinidhi and Gul2007;Francis,LaFond, Olsson,and Schipper2005).We use an alternative discretionary accruals model in our sensitivity tests.

Following McNichols2002,we measure accrual quality by using the following regression model:

CA i;t?a0ta1OCF i;tà1ta2OCF i;tta3OCF i;tt1ta4D REV i;tta5PPE i;ttv i;t

e1T; where

CA=current accruals measured by net income before extraordinary items plus depreciation and amortization minis operating cash?ow;

OCF=operating cash?ow at year t)1,t,and t+1;

D REV=change in revenues;and

PPE=gross value of property,plant,and equipment.

All variables are scaled by average total assets.The regression is run for each industry-year with a minimum of20observations in each two-digit SIC industry.The coef?cients a1to a3measure the associations of current accruals with the cash?ows in the previous,current,and subsequent years, respectively.We expect a1and a3to be positive and a2to be negative.11 The residual from the regression is denoted as DD.The absolute value of the DD is our measure of accrual quality(denoted as|DD|).12Higher values of|DD|indicate lower accrual quality.

We run the following regression to test the association between auditor tenure,auditor specialization,and fee dependence on accrual quality:

j DD j?/0t/1TENUt/2MVt/3INGRt/4OCFt/5LITIGt/6ZSCORE t/7MBt/8AGEt/9SPECt/10FEEt/11TENU?SPEC

t/12TENU?FEEt/13SPEC?FEEt/14TENU?SPEC?FEE

tYear Dummiestee2T;

11.Accruals represent intertemporal shifting of cash?ows.Other things being constant,if

more of current cash?ows are shifted to either the previous or the next period,the cur-rent accruals will be higher,and the current cash?ows will be lower.Hence a2is expected to be negative.Dechow and Dichev(2002)argue that the current accruals anticipate future cash?ows;hence a3is expected to be positive.Dechow and Dichev also argue that some accruals defer the recognition of some past cash?ows into current earnings and that,once current cash?ow is controlled for,the association between cur-rent accruals and past cash?ows should be positive.Hence a1is expected to be positive.

12.Dechow and Dichev(2002)use the standard deviation of the residuals for each?rm as

the accrual quality measure.They suggest that an alternative measure for the accrual quality at the?rm-year level is the absolute value of the residual for that year(note6).

Both Srinidhi and Gul(2007)and Jones et al.(2008)use the absolute values as their proxy for earnings management.

CAR Vol.27No.3(Fall2010)

936Contemporary Accounting Research

where:

|DD|=accrual quality measure which is the absolute value of the residual estimated from(1);

TENU=auditor tenure measured as follows;

DTENU=indicator variable equals one if the tenure is greater than the sample median,and zero otherwise;

SHORT=indicator variable,equals one when the length of the auditor–client relationship is three years or less,and zero otherwise;

LONG=indicator variable,equals one when the length of the auditor–client relationship is nine years or longer,and zero otherwise;

MV=natural log of market capitalization at?scal year end;

INGR=industry sales growth over the year(by two-digit SIC code);

OCF=operating cash?ows divided by total assets at?scal year end;

LITIG=one if the?rm operates in a high-litigation industry and zero otherwise.

High-litigation industries are industries with SIC codes2833–2836,

3570–3577,3600–3674,5200–5961,and7370–7374(as used by

Frankel et al.2002and Ashbaugh et al.2003);

ZSCORE=Zmijewski’s(1984)bankruptcy scores;

MB=market-to-book value of equity;

AGE=natural logarithm of the number of years since the company was listed on a stock exchange;

SPEC=one if the auditor is the specialist in the industry,and zero otherwise; FEE=fee dependence measured by the ratio of a particular client’s

total fees given all total fees received by the audit?rm in the same

city.

We include various control variables that may potentially affect accruals.Small?rms,those in industries with high sales growth,and ?rms with low cash?ow from operations tend to record higher accruals (Myers et al.2003),while?rms with high litigation risk are more likely to manage earnings(Frankel et al.2002).We control for?rms’?nancial conditions(as proxied by Zmijewski’s1984bankruptcy scores)and growth opportunities,because?nancially distressed?rms and high-growth?rms are more likely to manage earnings(DeFond and Jiambalvo 1994).

The interaction term,TENU*SPEC,is used when we test Hypothesis 1a.The coef?cient for TENU*SPEC shows the incremental effect of TENU on|DD|when a?rm is audited by specialist auditors than when it is audited by nonspecialist auditors.To the extent that the improvement in audit quality with extended auditor tenure is higher for specialists compared to nonspecialists,we expect the coef?cient for TENU*SPEC to be negative. However,Hypothesis1a predicts that the negative association between TENU*SPEC and|DD|to be moderated(reduced)by fee dependence; hence,we expect the coef?cient for TENU*SPEC*FEE to be positive.The CAR Vol.27No.3(Fall2010)

Does Auditor Tenure Improve Audit Quality?937 interaction term,TENU*FEE,is used to test Hypothesis1b.The coef?cient for TENU*FEE shows the incremental effect of TENU on|DD|when a?rm’s fee revenue is more important to an auditor.The extent that TENU*FEE is moderated by auditor specialization is captured by TENU*SPEC*FEE.

Because the accrual quality for a particular?rm may not be fully inde-pendent over consecutive years,residuals obtained in regression analyses may be serially correlated.Hence,we use ordinary least squares regressions with clustered robust errors(Rogers1993;Petersen2009).13

4.Results

In Table2,we report the mean coef?cients of the industry-year cross-sectional regressions from estimating(1).Adj.R2is the average of the adjusted R2from the286industry-year regressions.The t-statistics are based on the mean of the coef?cients from the industry-year regres-sions.

As expected,a1and a3,the coef?cients of previous-and subsequent-period cash?ows,are positive and signi?cant at the1percent level.a2,the coef?cient of the current cash?ow,is negative and signi?cant at the1per-cent level.Consistent with our expectation,we?nd that increases in sales are associated signi?cantly with higher current accruals.However,we do not?nd a signi?cant association between PPE and current accruals.The average adjusted R2is39.3percent,similar to that reported in Dechow and Dichev2002.

In Table3,we report the descriptive statistics in panel A and the corre-lation coef?cients for the variables used in(2)in panel B.The mean(med-ian)auditor tenure in years is10.51(8).On average,21percent of the?rms have auditor–client relation of three years or less,while46percent of the ?rms have auditor–client relation of nine years or more.The mean(median) value of DD is0.0111(0.0005)while the mean(median)value of|DD|is 0.0565(0.0412).

Panel B shows the correlations between the variables used in the regres-sion model.The correlations between|DD|and DTENU and between|DD| and LONG are both)0.05(signi?cant at the1percent level),consistent with the notion that long auditor tenure is associated with higher audit quality.The correlation between|DD|and SHORT is0.04(also signi?cant at the1percent level),suggesting that short auditor tenure is detrimental to audit quality.Consistent with prior studies(e.g.,Krishnan2003),|DD|is negatively and signi?cantly associated with SPEC(correlation=)0.09).

13.We detected the presence of heteroskedasticity using the White1980speci?cation.

Hence,the t-values reported are based on robust standard errors.

CAR Vol.27No.3(Fall2010)

938Contemporary Accounting Research

TABLE2

Coef?cient estimates in estimating accrual quality

Variable Coef?cient t-stats

Intercept a00.000)0.01 OCF i,t)1a10.135 5.46*** OCF i,t a2)0.272)8.78*** OCF i,t+1a30.1127.29*** D REV a40.062 5.56*** PPE i,t a5)0.003)0.56 Average Adj.R20.393 N286 Notes:

The table shows mean coef?cients from annual cross-sectional regressions of the following model:

CA i;t?a0ta1OCF i;tà1ta2OCF i;tta3OCF i;tt1ta4D REV i;tta5PPE i;ttv i;t

The above model is based on Dechow and Dichev2002,as modi?ed by McNichols 2002.CA is current accruals measured by net income before extraordinary

items plus deprecation and amortization minus operating cash?ow;OCF is

operating cash?ow at year t)1,t,and t+1;D REV is change in revenues;

PPE is gross value of property,plant,and equipment.All variables are

scaled by average total assets.The regression is run for each industry-year

with a minimum of20observations in each two-digit SIC industry.Adj.R2

is the average of the adjusted R2from the286industry-year regressions.The t-statistics are based on the mean of the coef?cients from the industry-year

regressions.*,**,***denote signi?cance at the10percent,5percent,and1 percent levels(two-tailed),respectively.

We do not?nd evidence that fee dependence alone erodes audit quality. The association between|DD|and FEE is)0.03and signi?cant.14 We report the regression results for the accrual quality test in Table4. Panel A shows the results when auditor tenure is proxied by DTENU. Model1reports the results of auditor tenure,auditor specialization,and fee dependence on|DD|.DTENU is negatively associated with|DD|at the10 percent level.Both SPEC and FEE are signi?cantly and negatively associ-ated with|DD|at the5percent level.For the set of control variables,our results indicate that large?rms,?rms with higher cash?ow,and?rms in 14.Frankel et al.(2002)report a similar negative correlation between ABSDACC and rank

of total fees()0.03,signi?cant at10percent),while Khurana and Raman(2006)also report a signi?cant negative relation()0.06)between TFEE?OFFICEREV and their proxy of audit quality,cost of equity.

CAR Vol.27No.3(Fall2010)

T A B L E 3D e s c r i p t i v e s t a t i s t i c s a n d c o r r e l a t i o n s b e t w e e n v a r i a b l e s u s e d i n t h e a c c r u a l q u a l i t y m o d e l

P a n e l A :D e s c r i p t i v e s t a t i s t i c s

M e a n

M e d i a n

1s t Q u a r t i l e 3r d Q u a r t i l e S t d D e v .

T e s t v a r i a b l e s D D 0.01110.0005)0.05650.05620.5048|D D |0.05650.04120.01740.08440.0488T E N U (i n y e a r s )10.518.004.0014.008.62D T E N U 0.460.000.001.000.50S H O R T 0.210.000.000.000.41L O N G 0.460.000.001.000.50S P E C 0.280.000.001.000.45F E E (%)1.410.21

0.060.89

3.29

C o n t r o l v a r i a b l e s M V 5.895.934.497.242.08I N G R 0.080.070.030.120.10O C F 0.030.070.010.130.21L I T I G 0.400.000.001.000.49Z S C O R E )3.63)3.81)4.66)2.941.48M B 2.732.061.272.062.20A G E

2.29

2.301.61

3.09

0.97

(T h e t a b l e i s c o n t i n u e d o n t h e n e x t p a g e .)

Does Auditor Tenure Improve Audit Quality?

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CAR Vol.27No.3(Fall 2010)

T A B L E 3(C o n t i n u e d )

P a n e l B :P e a r s o n c o r r e l a t i o n m a t r i x

|D D |D T E N U S H O R T

L O N G M V I N G R O C F L I T I G Z S C O R E M B A G E S P E C F E E

|D D |1.00D T E N U )0.05*1.00S H O R T 0.04*)0.49*1.00L O N G )0.05*1.00*)0.49*1.00M V )0.17*0.18*)0.07*0.18*1.00I N G R )0.03*0.01)0.020.010.12*1.00O C F )0.12*0.16*)0.010.16*0.37*0.011.00L I T I G 0.08*)0.07*)0.03*)0.07*)0.06*)0.05*)0.14*1.00Z S C O R E 0.08*0.06*)0.03*0.06*0.11*0.09*0.38*0.12*1.00M B 0.06*0.01)0.010.010.45*0.17*0.18*0.14*0.16*1.00A G E )0.11*0.47*)0.04*0.47*0.26*0.020.24*)0.22*0.01)0.021.00S P E C )0.09*0.07*)0.06*0.07*0.07*)0.010.04*)0.09*)0.05*)0.020.06*1.00F E E )0.03*

0.14*

)0.04*

0.14*0.44*0.06*0.24*)0.17*)0.08*0.04*0.25*0.011.00

N o t e s :

T h e s a m p l e f o r t h e a c c r u a l q u a l i t y t e s t c o n s i s t s o f 12,783?r m -y e a r o b s e r v a t i o n s f o r t h e p e r i o d 2000–2005t h a t h a v e c o m p l e t e ?n a n c i a l i n f o r m a t i o n i n C O M P U S T A T .T h e t a b l e r e p o r t s t h e d e s c r i p t i v e s t a t i s t i c s a n d t h e c o r r e l a t i o n s b e t w e e n v a r i a b l e s u s e d i n t h e r e g r e s s i o n m o d e l .|D D |i s t h e a b s o l u t e v a l u e o f t h e r e s i d u a l s f r o m t h e D e c h o w a n d D i c h e v 2002m o d e l ,a s m o d i ?e d b y M c N i c h o l s 2002.T h e s p e c i ?c a t i o n o f t h e m o d e l i s s h o w n i n f o o t -n o t e s o f T a b l e 2.D T E N U i s a n i n d i c a t o r v a r i a b l e t h a t e q u a l s o n e i f t h e a u d i t o r t e n u r e i s g r e a t e r t h a n t h e s a m p l e m e d i a n ,a n d z e r o o t h e r w i s e .S H O R T i s a n i n d i c a t o r v a r i a b l e t h a t e q u a l s o n e w h e n t h e l e n g t h o f t h e a u d i t o r -c l i e n t r e l a t i o n s h i p i s t h r e e y e a r s o r l e s s ,a n d z e r o o t h e r w i s e .L O N G i s a n i n d i c a t o r v a r i a b l e t h a t e q u a l s o n e w h e n t h e l e n g t h o f t h e a u d i t o r -c l i e n t r e l a t i o n s h i p i s n i n e y e a r s o r l o n g e r ,a n d z e r o o t h e r w i s e .M V i s n a t u -r a l l o g o f m a r k e t v a l u e .I N G R i s i n d u s t r y s a l e s g r o w t h o v e r t h e y e a r (b y t w o -d i g i t S I C c o d e ).O C F i s c a s h ?o w f r o m o p e r a t i o n s s c a l e d b y t o t a l a s s e t s a t t h e b e g i n n i n g o f t h e ?s c a l y e a r .L I T I G i s c o d e d o n e i f t h e ?r m o p e r a t e s i n a h i g h -l i t i g a t i o n i n d u s t r y ,a n d z e r o o t h e r w i s e .H i g h -l i t i g a t i o n i n d u s t r i e s a r e i n d u s t r i e s w i t h S I C c o d e s 2833–2836,3570–3577,3600–3674,5200–5961,a n d 7370–7374.Z S C O R E i s Z m i j e w s k i ’s 1984b a n k r u p t c y s c o r e s .M B i s t h e m a r k e t -t o -b o o k r a t i o .A G E i s l o g o f ?r m a g e .S P E C ,a n i n d i c a t o r v a r i a b l e ,e q u a l s o n e i f t h e a u d i t o r h a s a t l e a s t 24p e r c e n t i n d u s t r y m a r k e t s h a r e f o r t h e 2000–2001p e r i o d ,a n d 30p e r c e n t f o r t h e 2002–2005p e r i o d ,a n d z e r o o t h e r w i s e .F E E i s m e a s u r e d b y t h e r a t i o o f a p a r t i c u l a r c l i e n t ’s t o t a l f e e s g i v e n a l l t o t a l f e e s r e c e i v e d b y t h e a u d i t ?r m i n a c i t y .

*d e n o t e s s i g n i ?c a n c e a t t h e 1%l e v e l (t w o -t a i l e d ).

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Contemporary Accounting Research

CAR Vol.27No.3(Fall 2010)

T A B L E 4A u d i t o r t e n u r e ,a u d i t o r s p e c i a l i z a t i o n ,a n d c l i e n t i m p o r t a n c e o n a c c r u a l q u a l i t y

P a n e l A :T e n u r e m e a s u r e d b y D T E N U

M o d e l 1

M o d e l 2M o d e l 3M o d e l 4

I n t e r c e p t u 0

0.226(9.89)***0.221(9.69)***0.225(9.91)***0.217(9.52)***D T E N U u 1

)0.006()1.71)*0.016(1.22)0.008(0.62)0.021(1.56)M V u 2

)0.016()6.64)***)0.016()6.64)***)0.016()6.61)***)0.016()6.60)***I N G R u 3

)0.396()8.06)***)0.397()8.06)***)0.396()8.06)***)0.397()8.06)***O C F u 4

)0.166()5.09)***)0.167()5.11)***)0.167()5.11)***)0.167()5.13)***L I T I G u 5

0.053(6.19)***0.053(6.21)***0.053(6.17)***0.053(6.18)***Z S C O R E u 6

0.013(3.22)***0.013(3.22)***0.013(3.22)***0.013(3.22)***M B u 7

0.012(6.53)***0.012(6.52)***0.012(6.53)***0.012(6.52)***A G E u 8

0.008(1.25)0.008(1.30)0.007(1.22)0.008(1.32)S P E C u 9

)0.020()2.17)**)0.002()0.14))0.020()2.16)**0.006(0.38)F E E u 10

)0.212

()2.24)**

)0.211()2.62)***)0.124()1.02)0.061(0.41)D T E N U *S P E C u 11

)0.037()1.99)**)0.050()2.35)**D T E N U *F E E u 12

)0.170()1.05)

)0.044()1.21)S P E C *F E E u 13

)0.658()2.56)***D T E N U *S P E C *F E E u 14

0.939(2.83)***

N 12,78312,78312,78312,783A d j R 2(%)

11.91

11.93

11.90

11.93

(T h e t a b l e i s c o n t i n u e d o n t h e n e x t p a g e .)

Does Auditor Tenure Improve Audit Quality?

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CAR Vol.27No.3(Fall 2010)

T A B L E 4(C o n t i n u e d )

M o d e l 1

M o d e l 2M o d e l 3M o d e l 4

P a n e l B :T e n u r e m e a s u r e d b y S H O R T a n d L O N G I n t e r c e p t u 00.225(9.71)***0.215(9.28)***0.223(9.66)***0.211(9.10)***S H O R T u 1a 0.004(2.31)**0.015(1.04)0.005(0.40)0.016(1.09)L O N G u 1b 0.0076(0.48)0.022(1.38)0.010(0.66)0.028(1.73)*M V u 2)0.016()6.62)***)0.016()6.63)***)0.016()6.58)***)0.016()6.59)***I N G R u 3)0.397()8.02)***)0.396()8.01)***)0.396()8.01)***)0.397()8.02)***O C F u 4)0.167()5.10)***)0.167()5.11)***)0.167()5.12)***)0.167()5.14)***L I T I G u 50.053(6.12)***0.053(6.13)***0.053(6.10)***0.053(6.10)***Z S C O R E u 60.013(3.23)***0.013(3.20)***0.013(3.23)***0.013(3.20)***M B u 70.012(6.52)***0.012(6.50)***0.012(6.53)***0.012(6.50)***A G E u 80.007(1.11)0.008(1.14)0.007(1.08)0.008(1.16)S P E C u 9)0.020()2.16)**0.014(0.68))0.020()2.16)**0.021(0.92)F E E u 10)0.212()2.64)***)0.210()2.62)***)0.070()0.42)

0.110(0.50)S H O R T *S P E C u 11a

)0.042()1.56))0.039()1.31)L O N G *S P E C u 11b

)0.053

()2.22)**)0.065()2.43)**S H O R T *F E E u 12a

)0.121()0.51))0.118()0.38)L O N G *F E E u 12b

)0.222()1.11)

)0.493()1.60)S P E C *F E E u 13

)0.600()1.68)*S H O R T *S P E C *F E E u 14a

)0.105()0.23)L O N G *S P E C *F E E u 14b

0.880(2.12)**

N 12,78312,78312,78312,783A d j R 2(%)11.90

11.93

11.89

11.92

(T h e t a b l e i s c o n t i n u e d o n t h e n e x t p a g e .)

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Contemporary Accounting Research

CAR Vol.27No.3(Fall 2010)

T A B L E 4(C o

n t i n u e d )N o t e s :T h e r

e

g

r e

s s

i o

n

m

o

d

e l

i s :

j D D j ?/0t/1T E N U t/2M V t/3I N G R t/4O C F t/5L I T I G t/6Z S C O R E t/7M B t/8A G E t/9S P E C t/10F E E t/11T E N U ?S P E C t/12T E N U ?F E E t/13S P E C ?F E E t/14T E N U ?S P E C ?F E E tY e a r D u m m i e s te T

h

e s a m p l e c o n s i s t s o

f 12,783?r m y e a r o b s e r v a t i o n s f o r t h e p e r i o d 2000–2005.T h e v a r i a b l e s u s e d i n t h e r e

g r e s s i o n m o d e l a r e a s d e ?n e d i n t

h e n o t e s o f T a b l e 3.W e r u n t h e o r d

i n a r y l e a s t s q u a r e s c l u s t e r e d b y ?r m ,a n d w i t h y e a r d u m m i e s .T o c o n s e r v e s p a c e ,w e d o n o t r e p o r t t h e c o e f ?c i e n t e s t i m a t e s f o r t h e y e a r d u m m i e s .F o r e a c h v a r i a b l e ,w e r e p o r t t h e r e g r e s s i o n c o e f ?c i e n t ,f o l l o w e d b y t h e t -s t a t i s t i c i n p a r e n t h e s e s .*,**,a n d ***d e n o t e s i g n i ?c a n c e a t 10p e r c e n t ,5p e r c e n t ,a n d 1p e r c e n t l e v e l s (t w o -t a i l e d ),r e s p e c t i v e l y .Does Auditor Tenure Improve Audit Quality?943

CAR Vol.27No.3(Fall 2010)

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