Audit Tenure Partner

The effect of audit partnertenure on client managers’

accounting discretionNeil Fargher

Macquarie University, Sydney, Australia

Ho-Young LeeYonsei University, Seoul, South Korea, and

Vivek MandeCalifornia State University-Fullerton, Fullerton, California, USA

Abstract

Purpose – This paper aims to examine the effect of audit partner tenure (PARTEN) on clientmanagers’ accounting discretion.

Design/methodology/approach – The authors contend that, when a new audit partner is from thesame audit firm as the outgoing audit partner (audit partner rotation), audit quality increases becausethe new audit partner brings “fresh eyes” to the engagement.

Findings – The results confirm this conjecture. The authors find that, in the initial years of tenure ofa new audit partner, client managers’ accounting discretion decreases when the new partner is fromthe same audit firm as the outgoing partner. However, when the new audit partner is from a differentaudit firm as the outgoing partner (audit firm rotation), it is found that client managers’ accountingdiscretion increases in those initial years.

Originality/value – The results provide support for recent legislation in the US restricting auditPARTEN and should be of interest to other regulatory bodies contemplating mandatory audit partnerrotation.

Keywords Auditors, Financial reporting

Paper type General review

IntroductionThe purpose of this paper is to examine the effect of audit partner tenure (PARTEN) onclient managers’ accounting discretion. Following recent high-profile audit failuressuch as Enron and WorldCom, the effect of lengthy auditor tenure on audit quality hasbecome the subject of extensive public debate in the USA. As early as 1999, the USSecurities and Exchange Commission (SEC) had begun to express concerns about theeffects of long auditor tenure on auditor independence[1]. Then Chief Accountant of theSEC, Lynn Turner called on academics to investigate whether the quality of financialreporting deteriorated as client managers developed long-lasting relationship withtheir auditors (Turner, 1999). Arthur Levitt, the Chairman of the SEC in 2000, echoedthe anxiety of his Chief Accountant that auditor judgment was impaired when auditorsremained on an engagement for a lengthy period of time (Levitt, 2000). Later, Levitt(2002) testified before the Senate Committee on Governmental Affairs that:

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The data used are from public sources identified in the paper.

Effect of auditpartner tenure

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Managerial Auditing JournalVol. 23 No. 2, 2008

pp. 161-186q Emerald Group Publishing Limited

0268-6902DOI 10.1108/02686900810839857

. . . serious consideration be given to requiring companies to change their audit firm – not justthe partners – every 5-7 years to ensure that fresh and skeptical eyes are always looking atthe numbers.

However, these views expressed above are not universally accepted. Opposed to auditorrotation is the auditing profession which has argued that as auditor tenure increases, sodoes an auditor’s understanding of the client’s business, control risks and other factorsthat contribute to audit failures (AICPA, 1992; PricewaterhouseCoopers, 2002)[2].

Given the conflicting views on auditor tenure, Congress in 2002, decided not to requirethe mandatory rotation of audit firms. Instead, it directed the General Accounting Office(GAO)[3] to conduct research on the potential effects of mandatory audit firm rotation onaudit quality. The GAO’s (2003) study of the largest public accounting firms and theirFortune 1000 publicly traded client-companies concluded that “mandatory audit firmrotation may not be the most efficient way to strengthen auditor independence andimprove audit quality.”

In 2002, Congress also considered the issue of whether lengthy audit PARTENadversely affected audit quality. Contrary to the case of audit firm rotation,Congress decided that it was necessary to require mandatory partner rotation everyfive years to increase audit quality. Section 203 of the Sarbanes-Oxley Act (2002)provides that it is:

. . . unlawful for a registered public accounting firm to provide audit services to an issuer ifthe lead audit partner (having primary responsibility for the audit) or the audit partnerresponsible for reviewing the audit that is assigned to perform those audit services hasperformed audit services for that issuer in each of the five previous fiscal years of thatissuer[4].

Following Sarbanes-Oxley, the SEC (2003) issued its rules on audit partner rotationin 2003.

Several recent published US studies have examined the effect of audit firm tenure(AUDTEN) on audit quality (Ghosh and Moon, 2005; Carcello and Nagy, 2004; Myerset al., 2003; Johnson et al., 2002; Geiger and Raghunandan, 2002). The results of thesestudies are generally supportive of the GAO’s conclusions that as AUDTEN increases,audit quality also increases. They show that audit failures are most likely to occur in thefirst few years of tenure of an audit firm. However, there have only been a few studiesthat have examined whether audit partner rotation also adversely affects audit quality.As with audit firm rotation, rotation of audit partners can increase the risk of auditfailures during a partner’s initial years on an engagement if rotation creates a steeplearning curve about the client’s operations for the new partner[5].

Our study contributes to the literature by providing some of the first evidence on therelationship between audit PARTEN and audit quality. Specifically, our paper examinesthe effect of audit PARTEN on client managers’ accounting discretion. We test ourhypothesis using tenure data on Australian audit partners. Unlike US rules which onlyrequire the audit firm’s name to be disclosed underneath the auditor’s opinion,Australian law requires the auditor’s report to be signed by the partner-in-charge of theaudit engagement[6]. Two papers have examined the effect of audit PARTEN on auditquality in the Australian context. Carey and Simnett (2006) find a negative associationbetween Australian audit PARTEN and audit report qualifications which supports thecase for mandatory rotation. Concurrent research by Hamilton et al. (2005) find that audit

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partner changes are associated with lower unexpected accruals (ACC) consistent witharguments in support of audit partner rotation. Unlike our study their tests focus oncross-sectional comparison of firms with auditor partner changes to all firms. Theirresults are however generally consistent with results reported in this study.

The results of this study show that as audit PARTEN increases, managers’accounting discretion increases. We find that in the first years of an engagement, clientmanagers’ discretionary accruals (jDACCRj) are smaller than in the later years butonly if the new audit partner is from the same audit firm as the outgoing partner(audit partner rotation). In contrast, client managers’ accounting jDACCRj are larger inthe initial years when the new audit partner is from a different audit firm as theoutgoing audit partner (audit firm rotation). These findings suggest that new partnersfrom the same audit firm bring “fresh eyes” to an engagement increasing audit quality,while new partners from a different audit firm (although they also bring fresh eyes)face a very steep learning curve regarding the client’s operations as a result of whichaudit quality suffers. Our results support recent regulatory policy, for example in theUSA, requiring the rotation of audit partners but not audit firms.

The next section provides background on the Australian context, followed by asection on the development of our hypothesis. This is followed by a discussion of ourresearch design and data collection methods. Results are presented next, followed byour conclusion.

BackgroundThe International Federation of Accountants Code of Ethics (IFAC, 2003) recognizes thatprolonged use of the same lead engagement partner on an audit may create a “familiaritythreat” that by virtue of a close relationship with an assurance client, its directors,officers or employees, a member of the assurance team becomes too sympathetic to theclients’ interests. The code proposed that the lead engagement partner be rotated after apre-defined period, normally no more than seven years.

Countries that have adopted a mandatory rotation policy include: Austria,Australia, Brazil, Greece, India, Italy, Israel, Singapore, South Korea, Taiwan and theUSA (Catanach and Walker, 1999; Kim et al., 2004; Cameran et al., 2005; Chi and Huang,2005; Chi et al., 2005; Carey and Simnett, 2006). Spain adopted mandatory rotation andsince abandoned the policy (Cameran et al., 2005).

The Australian profession’s standard on independence was revised in line with theIFAC Code of Ethics during 2001. The first mandatory requirement for auditor rotationin Australia was issued in May 2002, Professional Statement F1 ProfessionalIndependence (Professional Statement F1) (Institute of Chartered Accountants inAustralia (ICAA, 2002)). The effective date was December 31, 2003 with the partnerrotation requirement impacting fiscal periods ending in 2004. Professional StatementF1 introduced the mandatory rotation of the lead engagement partner and the reviewpartner on an engagement for publicly listed companies. With limited exceptions, therequirement was for the lead engagement partner to be rotated after a pre-definedperiod, no longer than seven years for audits of listed public companies. A partnerrotating after a pre-defined period should not resume the lead engagement role until afurther period of time, no less than two years has elapsed.

Prior to the introduction of Professional Statement F1 there was no specificrequirement for audit partner rotation in Australia. Carey and Simnett (2006) note that


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between 1997 and 2001 Arthur Andersen had a policy of mandatory partner rotationafter seven years. The other Big 6 firms were aware of the issue and undertook partnerrotation but not on a mandatory basis. Subsequent to the period of this study furtherreforms were adopted in Australia: Corporate Law Economic Reform Program (AuditReform and Corporate Disclosure) Act 2004 (Cth) (CLERP 9). CLERP 9 requiresmandatory partner rotation every five years. The legislation became effective fromJuly 1, 2004 however the audit partner rotation requirements did not come into effectuntil after the period examined in this study.

Hypothesis developmentProponents of mandatory auditor rotation have argued that extended auditor tenureleads to low-quality audits. Low-quality audits can mislead investors and result inmisallocated resources. In several class-action lawsuits, institutional investors havecharged that a long relationship between the client and its auditor resulted in lowerscrutiny by the auditor over the company’s improper accounting practices (AccountingToday, 2004). As the regulator of US capital markets, the SEC has a keen interest inknowing whether the quality of financial reports deteriorates as client managersdevelop long-lasting relationships with their auditors (Turner, 1999). In 2002, followinga series of several high-profile audit failures, Congress passed the Sarbanes-Oxley Act.Congress considered the issue of the effect of auditor tenure on audit quality anddirected the GAO to study whether rotation of audit firms should be required.

Opponents of mandatory auditor changes include the public accounting firmswhich have argued that that mandatory auditor rotation increases audit start-up costsand the risk of audit failure in the initial years of an engagement because the incomingauditor is forced to place a higher level of reliance on the client’s estimates andrepresentations (PricewaterhouseCoopers, 2002). They have argued that as tenureincreases, an auditor is able to gain firm-specific expertise and a better understandingof the client’s business[7].

Several prior US studies have attempted to shed light on the debate about auditortenure. Deis and Giroux (1992) find that audit quality decreases as auditor tenureincreases[8]. In contrast, St Pierre and Andersen (1984) find that auditors of new clients(three years or less on the engagement) commit more errors and experience higher legalrisk than auditors with a tenure greater than three years. Based on audit committeemembers’ responses to a survey, Knapp (1991) also concludes that as auditors gainmore experience with individual clients, the likelihood of discovering material errorsincreases.

More recently, Geiger and Raghunandan (2002) find that long-tenured auditors aremore efficient in the collection and evaluation of evidence than short-tenured auditors.Their results are consistent with long-tenured auditors having a more in-depthknowledge of their clients’ financial status and operating systems than short-tenuredauditors. Carcello and Nagy (2004) find that fraudulent financial reporting is more likelyto occur in the first three years of an audit. In addition, they find no evidence of greaterfraudulent financial reporting by clients of long-tenured auditors. Finally, Myers et al.(2003) test for the association between auditor tenure and earnings quality where theauditor-client relationship lasted for at least five years. They find that the magnitude ofboth discretionary and current ACC declines with longer auditor tenure. They also findevidence that lengthier auditor tenure is associated with less extreme ACC. Their results

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suggest that as the relationship between the auditor and client lengthens, the auditor isable to limit management’s ability to use ACC to manage earnings.

However, the above research has only examined the effect of AUDTEN on auditquality. It has not examined how audit PARTEN on an engagement affects the quality ofan audit. To the extent that an audit partner’s knowledge of a client’s business increaseswith his/her tenure on the audit, audit partner rotation, like audit firm rotation, canarguably lead to a decrease in audit quality. Also, similar to audit firm rotation, auditpartner rotation can lead to the most qualified audit partner on an engagement beingreplaced by a partner who is less qualified. The SEC (2003) acknowledges that the qualityof the engagement audit team could, in fact, decrease as a result of its rules mandatingaudit partner rotation. This suggests that in some circumstances audit partner rotationcan be tantamount to audit firm rotation, reducing audit quality and increasing thelikelihood of audit failures in the initial years of a partner on an engagement.

However, there are important differences between audit firm rotation and auditpartner rotation which in turn lead to different predictions about the effect of tenure onaudit quality. Unlike the case of a new audit firm on an engagement, there may be lesslikelihood of significant deterioration in audit quality in the first years of an engagementif the new audit partner was from the same audit firm as the outgoing audit partner.Audit firms have processes in place for managing the transition from one engagementpartner to another[9]. As a result, a new lead partner from the same audit firm is likely tobe more familiar with the client’s business and risks than a new partner from a differentaudit firm. A new partner should also find it easier to consult with a former partner onthe engagement if the former partner was from the same audit firm. Therefore, thelearning curve for an incoming audit partner from the same audit firm is likely to be lesssteep than if the incoming audit partner were from a different audit firm. Indeed, it ispossible that by bringing “fresh eyes” to the engagement, a new audit partner from thesame audit firm might actually increase the quality of the audit. That is, the tradeoffbetween bringing fresh eyes to an engagement and the potential loss in the quality of theengagement team may favor audit partner rotation but not audit firm rotation.

In addition, the incentives facing an audit partner are likely to be different from thosefacing an audit firm which can also lead to a different relationship of tenure with auditquality[10]. As the length of time on an engagement increases the economic incentives tobond with the client may be more strongly present at the partner level than at the auditfirm level. Audit partners have compensation incentives that are related to the feesreceived from client-firms (Trompeter, 1994)[11]. Failure to keep a client satisfied canlead to a client’s dismissal of the audit firm. Loss of a client affects an audit partner moredirectly than the audit firm because the latter is able to diversify its revenues over itsexisting and future client base. Loss of a valued client can lead to an audit partner’sdismissal or limit future opportunities offered to that partner by the audit firm[12]. As anaudit partner’s tenure on an engagement increases, the economic incentives to bond withthe client may become stronger. For these reasons, it is possible that the quality of anaudit suffers as the tenure of the audit partner on an engagement increases.

In summary, this paper suggests that a policy of rotation of audit partners on anengagement may have the potential to increase audit quality. Although audit partnerrotation creates a new learning curve for the incoming partner, it also brings fresh andskeptical eyes into the audit. Importantly, the audit firm can continue to build itsrelationship with the client and provide high-quality client service while accumulating


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knowledge about the client’s operations. Therefore, in contrast to audit firm rotation,the benefits of bringing new blood to an engagement may be greater than the potentialloss of audit quality due to changing the engagement team. As tenure increases,however, the incentives to bond with a client may be more strongly evident at the auditpartner level than the audit firm level. Therefore, in contrast to AUDTEN, lengthyaudit PARTEN may, in fact, decrease audit quality.

We examine three related hypotheses regarding the effect of a rotation of auditpartners on client managers’ accounting discretion. First, we examine whether clientmanagers’ accounting discretion increases as audit PARTEN increases. An increase inclient managers’ accounting discretion with audit PARTEN would be supportive of apolicy requiring the rotation of audit partners on an engagement[13]. This hypothesisis stated below in the null form:

H1. All else constant, there is no change in client managers’ accounting discretionas audit PARTEN on an engagement increases.

Our next hypotheses contrast audit quality in the initial years of a new audit partner onan engagement with that in the later years of the partner’s tenure. As discussed, priorUS research indicates that in the initial years of a new partner being engaged there is asignificant deterioration in audit quality when the new partner is from a different auditfirm[14]. However, this research has not examined whether audit quality is low in thefirst years of a new audit partner when the new auditor is from the same firm. Prior USstudies also find that audit quality is higher in firms whose auditors have lengthytenure. Again, these studies do not control for audit PARTEN. They treat an audit firmwith a lengthy tenure and frequent audit partner rotation the same as an audit firmwith a lengthy tenure and infrequent audit partner rotation[15].

Following the method in Carcello and Nagy (2004) our hypotheses compare auditquality associated with short- and long-tenured audit partners with audit qualityassociated with medium-tenured audit partners. The hypotheses are stated below inthe null form:

H2. All else constant, there is no difference in client managers’ accountingdiscretion across short- and medium-tenured audit partners.

H3. All else constant, there is no difference in client managers’ accountingdiscretion across medium- and long-tenured audit partners.

Research designModels used to test the hypothesesThe following regression models are used to test the hypotheses:

. Model A:

jDACCRjit ¼ a0 þb1PARTENit þb2AUDTENit þb3FIRMAGEit þb4LNSIZEit

þb5INDGROWit þb6BIGFIVEit þb7ROAit þb8ROAPLUSit

þb9OCFit þb10OCFPLUSit þb11ACCit þb12ACCPLUSit

þb13ISSUEit þb14LEVit þX

kakINDDUMkit

þX

lalYEARDUMlit þ1it

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. Model B:

jDACCRjit ¼ a0 þ b121PARTEN–SHORTit þ b122PARTEN–LONGit

þ b2AUDTENit þ b3FIRMAGEit þ b4LNSIZEit þ b5INDGROWit

þ b6BIGFIVEit þ b7ROAit þ b8ROAPLUSit þ b9OCFit

þ b10OCFPLUSit þ b11ACCit þ b12ACCPLUSit þ b13ISSUEit

þ b14LEVit þX

kakINDDUMkit þ

XlalYEARDUMlit þ 1it

where, jDACCRj, absolute value of discretionary accruals; PARTEN, audit PARTEN;PARTEN-SHORT, indicator variable which is 1 if PARTEN is less than three years,and 0 otherwise; PARTEN-LONG, indicator variable which is 1 if PARTEN is greaterthan six years and 0 otherwise; AUDTEN, audit firm tenure; FIRMAGE, length ofyears since the ASX listing year; LNSIZE, natural log of total assets measured indollars; INDGROW: XN

i¼1

Salesi;t 2XNi¼1

Salesi;t21

!

XNi¼1

Salesi;t21

by industry code; BIGFIVE, indicator variable which is equal to 1 if the new auditor isone of the Big 5, and 0 otherwise; ROA, net income in year-1 divided by total assets inyear-2; ROAPLUS, 0 if ROA is less than zero and ROA if ROA is greater than or equalto zero; OCF, cash flow from operations divided by average total assets; OCFPLUS, 0 ifOCF is less than zero and OCF if OCF is greater than or equal to zero; ACC, totalaccruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less thanzero and ACC if ACC is greater than or equal to zero; ISSUE, indicator variable which is1 if the number of shares outstanding is increased more than 10 percent and0 otherwise; LEV, total liabilities divided by total assets; INDDUM, industry indicatorvariables; and YEARDUM, year indicator variables.

Measuring discretionary accrualsWe measure client managers’ accounting discretion using absolute jDACCRj based onthe Cross Sectional Modified Jones-model. The use of absolute jDACCRj is consistentwith client managers using positive jDACCRj to manage current earnings upward andnegative jDACCRj for building “cookie jar reserves” for increasing earnings insubsequent years. Our proxy for jDACCRj follows the method used by Myers et al.(2003), Johnson et al. (2002) and others. In addition to using the absolute value ofjDACCRj we also use their signed raw values. Additionally, we separately estimate ourmodels for income increasing ACC and income decreasing ACC[16].

Measuring audit partner tenureWe measure audit PARTEN as the number of consecutive years an audit partnerserves as the signing partner on an engagement. A positive and significant coefficienton PARTEN in Model A would support the argument that client managers’ accountingdiscretion increases as PARTEN increases. Model B replaces PARTEN with two


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dummy variables, PARTEN-SHORT and PARTEN-LONG, which are intended to testthe association of client managers’ accounting discretion with short- and long-tenuredaudit partners, respectively. A negative (positive) coefficient on PARTEN-SHORT(PARTEN-LONG) would support the argument that client managers’ accountingdiscretion decreases (increases) in the initial (later) years of tenure of an audit partner.

Measuring audit firm tenureWhile the primary purpose of this paper is to measure the effect of audit PARTEN onclient managers’ accounting discretion, we also need to measure AUDTEN for thissample of firms. We use AUDTEN as a control variable in our regression model[17].We measure AUDTEN in the following way:

. for client firms that engaged an audit firm in our sample for the first time duringour sample period, AUDTEN is the number of consecutive years the audit firmwas retained by the client (47 percent of observations);

. for client firms that first listed on the Australian Stock Exchange (ASX) duringour sample period, we compute AUDTEN assuming the year of the listing is theaudit firm’s first year of tenure (19 percent of observations); and

. for all remaining client firms we compute AUDTEN assuming 1990, the firstyear of coverage on the database used in this study, is the first year ofAUDTEN[18].

We acknowledge that this approach does not measure AUDTEN accurately in certaincases, however, we attempt to alleviate this concern by conducting additional tests forrobustness of the results (see “additional analyses”).

Measuring other control variablesWe control for factors found by previous work to impact client managers’ jDACCRj.Based on Myers et al. (2003), we include client-firm age (FIRMAGE) which is measuredas the number of years since the client firm was first listed on the ASX. Industry growth(INDGROW) is included because this variable has been shown to be positivelyassociated with the jDACCRj (Myers et al., 2003). Because large client firms tend torecord more stable ACC (Dechow and Dichev, 2002; Lee and Mande, 2003), we include thenatural log of total assets (LNSIZE). Past return on assets (ROA) and current operatingcash flows (OCF) are included because these variables have been shown to affect themagnitude of jDACCRj (Dechow et al., 1995; Chung and Kallapur, 2003). Leverage (LEV)ratio is included because prior studies find that client managers of high-LEV firms havegreater incentives to manage earnings to avoid violating debt covenants (DeFond andJiambalvo, 1994; DeAngelo et al., 1994; Becker et al., 1998; Frankel et al., 2002). A variablerepresenting past total ACC is included in the regression to control for the normalrelation between ACC of past years and ACC of successive years. Similar to Chung andKallapur (2003) we interact ROA, OCF and ACC with indicator variables denoting thesigns of ROA, OCF and ACC. Using these indicator variables allows for differentcoefficients on negative and positive ROA, OCF and ACC. Consistent with prior studiesshowing that stock issuances (ISSUE) are associated with the amount of abnormal ACC(Firth, 1997; DeFond and Subramanyam, 1998; Chung and Kallapur, 2003), we include acontrol for shares issued by the client firm. Auditor type (BIGFIVE) is included becauseprior studies suggest that, when compared to small audit firms, large audit firms tend to

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be more conservative and limit extreme client jDACCRj to a greater extent (Becker et al.,1998; Francis et al., 1999; Francis and Krishnan, 1999). We also include dummy variablesrepresenting industry and year because the magnitude of ACC has been shown to varyby industry (Barth et al., 2001) and year (Myers et al., 2003).

Sample selectionOur initial sample consists of the population of publicly traded Australian firms thatwere publicly traded on the ASX for which annual reports were available to us over theperiod 1990-2004 (14 years). The annual reports were obtained from DatAnalysis, adatabase produced by Aspect Huntley Pty. Ltd, that provides annual reports for mostcompanies listed, or formerly listed, on the ASX. Annual reports were available on thedatabase for 1,311 Australian firms for at least one year during the period 1990through 2004[19].

During most of our sample period audit partner rotation was voluntary. In 2002, theAustralian Professional Statement F1 (ICAA, 2002, Joint Code of Professional Conduct)introduced formal requirements requiring the rotation of the signing audit partner everyseven years or less. The standard allows some degree of flexibility over timing of rotationswhere an audit firm has only a few audit partners with the necessary knowledge andexperience to serve as lead engagement partner (Joint Code of Professional Conduct,Appendix 2 Application of Principles to Specific Situations, paragraph 2.52 and 2.53). Theprofessional statement went into effect for assurance reports dated after December 31,2003 (paragraph 29)[20]. In June 2004, extensive changes were made to the AustralianCorporations Law (CLERP 9) that included the mandated rotation of the signing auditpartner on an audit every five years or less. The effective date of CLERP 9 changes arefinancial years beginning in July 2006 which are outside of our sample period.

From the annual reports, we obtained the name of the signing audit partner on theengagement and the name of the audit firm retained by the client. Because DatAnalysisis maintained in a text format, these names were hand-collected from the annualreports. To facilitate the time consuming task of hand-collecting partner names fromannual reports, we limited our analyses to those firms for which the names of signingpartner and audit firm were available for at least three consecutive years[21]. Thisrestriction also ensures that our sample does not include newly listed firms and firmsfor which there was only recent coverage on DatAnalysis. This restriction resulted insample of 1,306 firms or 12,077 firm-year observations.

Our next step was to measure the tenure of a new signing partner on an auditengagement. A new signing audit partner’s tenure was measured beginning with thefirst year the audit partner became the signing partner during our sample periodfollowing an audit partner change. There were 6,326 firm-year observations where anew audit partner joined (i.e. firm-years after the first partner switch) an engagement asa signing partner during our sample period. For these audit partners we could accuratelymeasure their tenure beginning with their first year on an audit engagement as signingpartner. The remaining 5,751 observations consisting of firm-year observations wheresigning partners’ tenure could not be accurately measured were discarded. That is, allobservations were excluded prior to the first change in signing auditor that could beidentified[22]. Because of our paper’s focus on audit partner rotation, we also discarded2,299 firm-years[23] where the incoming new partner was from a different audit firm,which left 4,027 firm-years representing 839 firms.


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We required firms to have financial statement data needed for our tests on theAspect database, which left 3,047 firm-years representing 715 firms[24]. Then,we eliminated firms in banking, investment, property management, and insuranceindustries. This left us with a final sample of 2,495 firm-years representing 590 firms.This sample includes tenure data on all incoming partners on an audit engagementduring our sample period from the same audit firm. While our sampling methodensures that the tenure of the incoming partner from the same audit firm is correctlymeasured for every firm-year, there is also a substantial amount of sample attrition dueto this approach. Specifically, we had to discard observations for outgoing partnerswhere we could not determine using DatAnalysis when the outgoing audit partner firstjoined the engagement as a signing partner[25]. The characteristics of the sample arediscussed below.

Empirical resultsOur sample consists of firms from 20 industries; the number and proportion of firmsbelonging to each industry group are reported in Table I, Panel B. No single industrygroup appears to dominate the sample; 68 percent of the sample firms are representedby six industry groups. Despite the data attrition due to our sampling procedures, thesample composition is consistent with the composition of the ASX with the greatestconcentration of firms coming from the miscellaneous industrials group representingapproximately 17 percent of the total observations, and the mining and other metalssegments with 30 percent of the total observations. Also, consistent with our sampleselection criteria requiring a clear change in the signing partner, and consistent withbetter data availability from DatAnalysis in recent years, most observations are drawnafter 1998 (4 in 1992; 15 in 1993; 46 in 1994; 70 in 1995; 117 in 1996; 168 in 1997; 190 in1998; 227 in 1999; 270 in 2000; 341 in 2001; 375 in 2002; 357 in 2003; 315 in 2004). Theresults must be interpreted with respect to the period of our sample.

Summary statistics for the main variables are presented in Table II, Panel A. Themean (median) value of absolute jDACCRj is 0.1893 (0.0795). The mean (median) value ofPARTEN is 2.74 years (two years) while the mean (median) value of AUDTEN is 7.72years (eight years). About 56.7 percent of the observations have the value of PARTENless than three years while about 5.3 percent of the observations have the value ofPARTEN greater than six years[26]. About 73 percent of sample firms were audited byBig 5 auditors. Table II, Panel B, provides a correlation matrix which shows that, ingeneral, the variables are not highly correlated. The largest correlations are betweenOCF and OCFPLUS (r ¼ 0.58) and between ACC and ACCPLUS (r ¼ 0.56)[27].

Results under Model A in Table III show the association of absolute jDACCRj withPARTEN and the control variables (i.e. Model A results). The adjusted R 2 of theregression is 0.22. Regarding the control variables, the coefficients on firm size (LNSIZE),past return on assets (ROA and ROAPLUS), current operating cash flows (OCF andOCFPLUS) and total past accruals (ACC and ACCPLUS) and stock ISSUE are significantat the 1 percent (one-tail) level of testing, while the coefficient on LEV and FIRMAGE arestatistically significant at the 5 percent and 1 percent (one-tail) level of testing,respectively. The signs of the coefficients on the above control variables are in thepredicted direction. Another interesting finding is that AUDTEN is negatively associatedwith absolute jDACCRj (t ¼ 23.40) which is supportive of US studies suggesting that asthe tenure of audit firms increases audit quality also increases. However, the main result of

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fras

tru

ctu

re5

451.

80D

evel

oper

s6

883.

53B

uil

din

gm

ater

ials

749

1.96

Alc

ohol

and

tob

acco

845

1.80

Foo

dan

dh

ouse

hol

d9

602.

40C

hem

ical

s10

20.

08E

ng

inee

rin

g11

672.

69P

ack

agin

g12

281.

12R

etai

l13

692.

77T

ran

spor

tati

on14

411.

64M

edia

1510

44.

17T

elec

omm

un

icat

ion

s18

923.

69H

ealt

hca

reb

iote

chn

olog

ies

2118

37.

33M

isc

ind

ust

rial

s22

438

17.5

6D

iver

sifi

ed23

125

5.01

Tou

rism

leis

ure

2488

3.53

Tot

al2,

495

100.

00

Table I.Data collection and

distribution


171

PanelA.Descriptive

statistics

Variables

Mean

Median

SD

Firstquartile

Thirdquartile

Maximum

Minim

um

jDA

CC

Rj

0.18

930.

0795

0.54

720.

0318

0.20

2022

.044

70.

0000

PA

RT

EN

2.74

272.

0000

1.89

341.

0000

4.00

0012

.000

01.

0000

AU

DT

EN

7.72

798.

0000

3.61

675.

0000

10.0

000

15.0

000

1.00

00F

IRM

AG

E15

.919

012

.000

012

.551

08.

0000

19.0

000

134.

0000

3.00

00L

NS

IZE

17.5

810

17.2

675

2.24

7615

.958

918

.964

825

.165

510

.092

3IN

DG

RO

W1.

1890

1.12

760.

7143

1.04

871.

2258

14.2

082

0.53

71B

IGF

IVE

0.72

751.

0000

0.44

540.

0000

1.00

001.

0000

0.00

00R

OA

20.

1243

20.

0039

1.16

532

0.14

670.

0621

2.80

272

39.9

533

RO

AP

LU

S0.

0446

0.00

000.

1160

0.00

000.

0621

2.80

270.

0000

OC

F2

0.02

890.

0206

0.27

312

0.10

070.

0991

1.02

882

3.95

95O

CF

PL

US

0.06

340.

0206

0.06

340.

0000

0.09

911.

0288

0.00

00A

CC

20.

0905

20.

0516

0.52

732

0.13

780.

0015

6.60

472

17.1

332

AC

CP

LU

S0.

0441

0.00

000.

2758

0.00

000.

0015

6.60

470.

0000

ISS

UE

0.33

190.

0000

0.47

100.

0000

1.00

001.

0000

0.00

00L

EV

0.51

270.

3967

3.20

390.

1384

0.56

1411

6.96

000.

0000

PanelB.Personcorrelation

matrix

Variable

(p-value)

PARTEN

PARTEN-SHORT

PARTEN-LONG

AUDTEN

FIRMAGE

LIN

SIZE

INDGROW

BIGFIVE

jDA

CC

Rj

0.02

99(0

.136

)2

0.02

97(0

.137

)2

0.00

91(0

.650

)2

0.05

81(0

.003

)2

0.05

10(0

.011

)2

0.18

90(0

.000

)2

0.00

82(0

.682

)2

0.07

12(0

.001

)P

AR

TE

N2

0.79

52(0

.000

)0.

6421

(0.0

00)

0.19

96(0

.000

)0.

1513

(0.0

00)

0.07

51(0

.000

)2

0.01

32(0

.507

)2

0.11

41(0

.000

)P

AR

TE

N-S

HO

RT

20.

2713

(0.0

00)

20.

1825

(0.0

00)

20.

1168

(0.0

00)

20.

0579

(0.0

03)

0.00

36(0

.857

)0.

0769

(0.0

00)

PA

RT

EN

-LO

NG

0.09

33(0

.000

)0.

0945

(0.0

00)

0.04

63(0

.021

)2

0.01

33(0

.503

)2

0.09

51(0

.000

)A

UD

TE

N0.

3502

(0.0

00)

0.12

59(0

.000

)0.

0484

(0.0

15)

0.10

05(0

.000

)F

IRM

AG

E0.

2712

(0.0

00)

0.01

37(0

.492

)0.

0958

(0.0

00)

LN

SIZ

E0.

0461

(0.0

21)

0.31

92(0

.000

)IN

DG

RO

W2

0.00

81(0

.686

)B

IGF

IVE

RO

AR

OA

PL

US

OC

FO

CF

PL

US

AC

CA

CC

PL

US

ISS

UE

(continued

)

Table II.Descriptive statistics andcorrelation matrix

MAJ23,2

172

PanelB.Personcorrelation

matrix

Variable

(p-value)

ROA

ROAPLUS

OCF

OCFPLUS

ACC

ACCPLUS

ISSUE

LEV

jDA

CC

Rj

20.

0279

(0.1

63)

0.00

49(0

.805

)2

0.16

97(0

.000

)2

0.05

03(0

.012

)0.

1532

(0.0

000)

0.36

44(0

.000

0)0.

1077

(0.0

00)

0.04

59(0

.021

)P

AR

TE

N0.

0193

(0.3

34)

20.

0107

(0.5

93)

0.04

23(0

.034

)0.

0221

(0.2

69)

20.

0051

(0.7

99)

20.

0270

(0.1

77)

20.

0274

(0.1

71)

20.

0012

(0.9

53)

PA

RT

EN

-SH

OR

T2

0.00

34(0

.862

)0.

0071

(0.7

23)

20.

0073

(0.7

16)

20.

0198

(0.3

21)

0.02

04(0

.308

)0.

0159

(0.4

27)

0.02

02(0

.313

)0.

0136

(0.4

96)

PA

RT

EN

-LO

NG

0.01

87(0

.349

)0.

0047

(0.8

13)

0.05

06(0

.011

)0.

0109

(0.5

84)

0.00

82(0

.680

)2

0.02

17(0

.277

)2

0.03

46(0

.083

)0.

0021

(0.9

16)

AU

DT

EN

0.01

00(0

.614

)2

0.00

09(0

.964

)0.

0320

(0.1

09)

0.05

55(0

.005

)0.

0129

(0.5

16)

20.

0061

(0.7

58)

20.

0541

(0.0

06)

20.

0469

(0.0

19)

FIR

MA

GE

0.04

09(0

.040

)0.

0064

(0.7

48)

0.11

49(0

.000

)0.

1283

(0.0

00)

0.01

89(0

.343

)2

0.04

52(0

.023

)2

0.14

69(0

.000

)2

0.01

13(0

.571

)L

NS

IZE

0.15

65(0

.000

)0.

1277

(0.0

00)

0.45

50(0

.000

)0.

2901

(0.0

00)

0.09

47(0

.000

)2

0.06

52(0

.001

)2

0.21

05(0

.000

)2

0.04

34(0

.029

)IN

DG

RO

W0.

0102

(0.6

09)

0.01

54(0

.440

)0.

0110

(0.5

81)

20.

0229

(0.2

53)

0.01

53(0

.444

)0.

0075

(0.7

06)

20.

0094

(0.6

38)

20.

0059

(0.7

68)

BIG

FIV

E0.

0456

(0.0

22)

0.07

35(0

.000

)0.

1519

(0.0

00)

0.15

27(0

.000

)2

0.01

82(0

.363

)2

0.05

41(0

.006

)2

0.12

87(0

.000

)2

0.04

26(0

.033

)R

OA

0.15

52(0

.000

)0.

2948

(0.0

00)

0.11

01(0

.000

5)0.

3991

(0.0

00)

20.

2056

(0.0

00)

20.

0819

(0.0

10)

0.01

57(0

.430

)R

OA

PL

US

0.22

07(0

.000

)0.

3089

(0.0

00)

0.09

44(0

.026

)0.

2160

(0.0

00)

20.

0912

(0.0

00)

0.07

59(0

.000

)O

CF

0.57

87(0

.000

)0.

1472

(0.0

00)

20.

0588

(0.0

03)

20.

2847

(0.0

00)

20.

0026

(0.8

95)

OC

FP

LU

S0.

0086

(0.6

65)

20.

0354

(0.0

76)

20.

2329

(0.0

00)

20.

0121

(0.5

46)

AC

C0.

5637

(0.0

00)

20.

0583

(0.0

03)

20.

0047

(0.8

13)

AC

CP

LU

S0.

0151

(0.4

49)

0.01

04(0

.604

)IS

SU

E2

0.03

65(0

.068

)

Notes:p-

val

ues

are

inth

ep

aren

thes

is.N¼

2,49

5V

aria

ble

defi

nit

ion

s:jD

AC

CRj,

abso

lute

val

ue

ofd

iscr

etio

nar

yac

cru

als;

PA

RT

EN

,au

dit

par

tner

ten

ure

;PA

RT

EN

-SH

OR

T,i

nd

icat

orv

aria

ble

wh

ich

is1

ifp

artn

erte

nu

re(P

AR

TE

N)

isle

ssth

anth

ree

yea

rs,

and

0ot

her

wis

e;P

AR

TE

N-L

ON

G,i

nd

icat

orv

aria

ble

wh

ich

is1

ifp

artn

erte

nu

re(P

AR

TE

N)

isg

reat

erth

ansi

xy

ears

and

0ot

her

wis

e;A

UD

TE

N,a

ud

itfi

rmte

nu

re;F

IRM

AG

E,l

eng

thof

yea

rssi

nce

the

AS

Xli

stin

gy

ear;

LN

SIZ

E,

nat

ura

llo

gof

tota

las

sets

mea

sure

din

dol

lars

;IN

DG

RO

W:ðP N i¼

1S

ales

i;t2P N i¼

1S

ales

i;t2

1Þ=P N i¼

1S

ales

i;t2

1b

yin

du

stry

cod

e;B

IGF

IVE

,in

dic

ator

var

iab

lew

hic

his

equ

alto

1if

the

new

aud

itor

ison

eof

the

Big

5,an

d0

oth

erw

ise;

RO

A,n

etin

com

ein

yea

r-1

div

ided

by

tota

las

sets

iny

ear-

2;R

OA

PL

US

,0if

RO

Ais

less

than

zero

and

RO

Aif

RO

Ais

gre

ater

than

oreq

ual

toze

ro;O

CF

,cas

hfl

owfr

omop

erat

ion

sd

ivid

edb

yav

erag

eto

tala

sset

s;O

CF

PL

US

,0if

OC

Fis

less

than

zero

and

OC

Fif

OC

Fis

gre

ater

than

oreq

ual

toze

ro;

AC

C,t

otal

accr

ual

sin

yea

r-1

div

ided

by

tota

las

sets

iny

ear-

2;A

CC

PL

US

,0

ifA

CC

isle

ssth

anze

roan

dA

CC

ifA

CC

isg

reat

erth

anor

equ

alor

zero

;IS

SU

E,i

nd

icat

orv

aria

ble

wh

ich

is1

ifth

en

um

ber

ofsh

ares

outs

tan

din

gis

incr

ease

dm

ore

than

10p

erce

nt

and

0ot

her

wis

e;an

dL

EV

,to

tal

liab

ilit

ies

div

ided

by

tota

las

sets

Table II.


173

this regression concerns the coefficient on PARTEN which is positive and statisticallysignificant at the 1 percent level (two-tail) of testing (t-value ¼ 3.41) indicating that asauditor PARTEN increases client managers’ accounting discretion also increases.

Results under Model B in Table III show the association of absolute jDACCRj withPARTEN-SHORT, PARTEN-LONG and the control variables. The adjusted R 2 andresults on the control variables are similar to those obtained from the estimation ofModel A. Of main interest are the coefficients on PARTEN-SHORT and PARTEN-LONG.The coefficient on PARTEN-SHORT is negative and statistically significant at the 1percent level (two-tailed) of testing. This suggests that compared to audit partners withmedium tenure (between three and six years), audit partners with short tenure (less than

Variables Expected signModel A coefficient

(t-value)Model B coefficient

(t-value)

Intercept ^ 0.5512 (4.58) * * * 0.6384 (5.26) * * *

PARTEN-SHORT ^ 20.0566 (22.69) * * *

PARTEN ^ 0.01859 (3.41) * * *

PARTEN-LONG ^ 0.0059 (0.13)AUDTEN 2 20.0106 (23.40) * * * 20.0105 (23.35) * * *

FIRMAGE þ 0.0012 (1.36) * 0.0013 (1.46) *

LNSIZE 2 20.0244 (24.18) * * * 20.0241 (24.13) * * *

INDGROW þ 0.0112 (0.75) 0.0100 (0.67)BIGFIVE 2 0.0199 (0.84) 0.0147 (0.62)ROA þ 0.1058 (8.99) * * * 0.1055 (8.96) * * *

ROAPLUS 2 20.5379 (25.61) * * * 20.5365 (25.59) * * *

OCF 2 20.3081 (26.11) * * * 20.3022 (25.98) * * *

OCFPLUS þ 0.6219 (4.87) * * * 0.6130 (4.79) * * *

ACC 2 20.1994 (26.64) * * * 20.1983 (26.59) * * *

ACCPLUS þ 1.0519 (18.83) * * * 1.0489 (18.75) * * *

ISSUE þ 0.0565 (2.51) * * * 0.0561 (2.49) * * *

LEV þ 0.0070 (2.11) * * 0.0072 (2.16) * *

F-value 16.47 * * * 16.00 * * *

R 2-adj 0.2183 0.2168Number of observations ¼ 2,495

Notes: *, * * and * * * indicate significance (one-tailed tests with expected signs) at the 10, 5, and 1percent levels, respectively. To keep the presentation brief, coefficient estimates for the 19 industry(INDDUM) and 12 year (YEARDUM) dummy variables are not presentedVariable definitions:PARTEN, audit partner tenure; PARTEN-SHORT, indicator variable which is 1 if partner tenure(PARTEN) is less than three years, and 0 otherwise; PARTEN-LONG, indicator variable which is 1 ifpartner tenure (PARTEN) is greater than six years and 0 otherwise; AUDTEN, audit firm tenure;FIRMAGE, length of years since the ASX listing year; LNSIZE, natural log of total assets measured indollars; INDGROW:ð

PNi¼1 Salesi;t 2

PNi¼1 Salesi;t21Þ=

PNi¼1 Salesi;t21by industry code; BIGFIVE,

indicator variable which is equal to 1 if the new auditor is one of the Big 5, and 0 otherwise; ROA,net income in year-1 divided by total assets in year-2; ROAPLUS, 0 if ROA is less than zero and ROA ifROA is greater than or equal to zero; OCF, cash flow from operations divided by average total assets;OCFPLUS, 0 if OCF is less than zero and OCF if OCF is greater than or equal to zero; ACC, totalaccruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less than zero and ACC ifACC is greater than or equal to zero; ISSUE, indicator variable which is 1 if the number of sharesoutstanding is increased more than 10 percent and 0 otherwise; and LEV, total liabilities divided bytotal assets; INDDUM, industry indicator variables; and YEARDUM, year indicator variables

Table III.Regression results usingabsolute jDACCRj

MAJ23,2

174

three years) are better able to limit their client managers’ accounting discretion. Thecoefficient on PARTEN-LONG is positive suggesting that compared to auditors withmedium tenure, jDACCRj are higher when the client firm is audited by an audit partnerwith long tenure (greater than six years). The coefficient on PARTEN-LONG, however, isnot statistically significant.

Results under Column A, Table IV show results of the association of raw signedjDACCRj with PARTEN and the control variables (i.e. Model A results). Whencompared to Table III results, the explanatory power of the independent variablesdecreases (Adjusted R 2 ¼ 0.13) as does the statistical significance of the coefficients onthe independent variables. ROA, ROAPLUS, OCFPLUS, ACC, and ACCPLUS aresignificantly related to raw signed jDACCRj at the 1 percent level (two-tail) of testing orless. The coefficient on AUDTEN is not significant. The coefficient on PARTEN,however, is positive and statistically significant at the 10 percent level (two tail) oftesting supporting the position of proponents of audit partner rotation. Results underColumn B, Table IV contain results of the association of raw signed jDACCRj withPARTEN-SHORT, PARTEN-LONG and control variables (Model B). Consistent withthe results in Column A, the associations of these variables with raw signed jDACCRjare weaker than those with absolute jDACCRj[28].

Table IV, Columns C and D contain results based on separate estimations for positive(DACCR þ ) and negative (DACCR 2 ) jDACCRj. The adjustedR 2s of the models usingpositive and negative jDACCRj are 0.24 (Column C) and 0.25 (Column D), respectively.Consistent with the results in Table III, Model A, PARTEN is positively associated withthe positive jDACCRjwhile AUTEN is negatively associated with the positive jDACCRjsignificant at least at the 5 percent levels (Column C) suggesting that the magnitude ofpositive jDACCRj increases (decreases) as PARTEN (auditor tenure) increases. Some ofthe control variables in the negative jDACCRj models have the opposite signs to thosefound with jDACCRj as a dependent variable (Column D)[29]. Only AUDTEN is positiveand significant at the 10 percent level in the negative jDACCRj model.

Finally, Table IV, Columns E and F present results of separate estimations for positiveand negative ACC with PARTEN-SHORT and PARTEN-LONG as independentvariables. We find a significant association of PARTEN-SHORT with positive jDACCRj.The coefficient on PARTEN-SHORT is not statistically significant in the estimation usingnegative jDACCRj; the coefficient on PARTEN-LONG is statistically insignificant in bothpositive and negative jDACCRj estimations. We conclude that during our sample period,as audit PARTEN lengthens, an audit partner’s ability to constrain client managers’accounting discretion is diminished. In particular, as audit PARTEN lengthens, an auditpartner’s ability to constrain income increasing jDACCRj is diminished.

Additional analysesTo increase confidence in our results we compare audit quality when audit partners arerotated versus when audit firms are rotated[30]. As discussed, in the initial years of anaudit, we should expect audit quality to increase (decrease) in the case of audit partner(audit firm) rotation. Whether the differences in audit quality between the two groupswill continue to persist in the later years of audit PARTEN is an empirical question. Asaudit PARTEN becomes lengthy, it is possible that no differences remain in theacquired expertise and incentives of an audit partner regardless of whether he/she was


175

Var

iab

le

(A)

Mod

elA

DA

CC

Rco

effi

cien

t(t

-val

ue)

(B)

Mod

elB

DA

CC

Rco

effi

cien

t(t

-val

ue)

(C)

Mod

elA

DA

CC

Rþ

coef

fici

ent

(t-v

alu

e)

(D)

Mod

elA

DA

CC

R2

coef

fici

ent

(t-v

alu

e)

(E)

Mod

elB

DA

CC

Rþ

coef

fici

ent

(t-v

alu

e)

(F)

Mod

elB

DA

CC

R2

coef

fici

ent

(t-v

alu

e)

Inte

rcep

t2

0.08

05(2

0.60

)2

0.02

35(2

0.17

)0.

7082

(2.9

2)*

**

20.

3746

(24.

21)*

**

0.92

24(3

.77)

**

*2

0.39

04(2

4.35

)**

*

PA

RT

EN

-SH

OR

T2

0.03

64(2

1.55

)2

0.13

11(2

2.91

)**

*0.

0098

(0.6

8)P

AR

TE

N0.

0102

(1.6

8)*

0.03

19(2

.76)

**

*2

0.00

52(2

1.39

)P

AR

TE

N-L

ON

G2

0.04

79(2

0.94

)2

0.09

47(2

0.97

)2

0.04

05(2

1.30

)A

UD

TE

N2

0.00

34(2

0.99

)2

0.00

33(2

0.95

)2

0.01

72(2

2.57

)**

0.00

38(1

.79)

*2

0.01

83(2

2.73

)**

*0.

0037

(1.7

7)*

FIR

MA

GE

0.00

01(0

.62)

0.00

07(0

.72)

0.00

24(1

.16)

20.

0002

(20.

30)

0.00

31(1

.44)

20.

0002

(20.

30)

LN

SIZ

E0.

0091

(1.4

0)0.

0093

(1.4

3)2

0.03

33(2

2.75

)**

*0.

0191

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Table IV.Regression results usingsigned/positive/negativejDACCRj

MAJ23,2

176

from the same or a different audit firm at the time of initial engagement. Thisdiscussion forms the basis for H4 stated in the null form:

H4. There is no difference in the association between client managers’ accountingdiscretion and audit PARTEN when the incoming and outgoing auditpartners are from the same audit firm (audit partner rotation) versus when theincoming and outgoing audit partners are from different audit firms (auditfirm rotation).

To our existing dataset we add firm-year observations relating to audit firmchanges during our sample period. Specifically, we identify all cases where an auditfirm was changed by a client firm during our sample period and compute the newaudit partner’s tenure beginning with the first year the audit firm was changed. Theadditional observations included in the dataset have the property that in each caseAUDTEN is equal to audit PARTEN as a change in audit firm will result in achange in the partner signing the audit opinion. Next, for these observations weobtain jDACCRj and all of the control variables discussed earlier. We then estimateModels C and D below using a pooled dataset, allowing the intercepts andcoefficients on audit PARTEN to vary depending on whether the new audit partnerwas from the same or a different audit firm as the outgoing partner. Finally, we usean F-test to determine whether we can reject that the different coefficients on auditPARTEN are equal across both groups. Our pooled data set has 1,162 additionalfirm-year observations representing 384 client firms that changed audit firms duringour sample period.

The following regression models are used to test H4:. Model C:

jDACCRjit ¼ a021SAMEit þ a022DIFFit þ b121PARTEN–SAMEit

þ b122PARTEN–DIFFit þ b2AUDTEN–SAMEit þ b3FIRMAGEit

þ b4LNSIZEit þ b5INDGROWit þ b6BIGFIVEit þ b7ROAit

þ b8ROAPLUSit þ b9OCFit þ b10OCFPLUSit þ b11ACCit

þ b12ACCPLUSit þ b13ISSUEit þ b14LEVit þX

kakINDDUMkit

þX

lalYEARDUMlit þ 1it

. Model D:

jDACCRjit ¼ a021SAMEit þa022DIFFit þb121PARTEN–SHORT–SAMEit

þb122PARTEN–SHORT–DIFFit þb123PARTEN–LONG–SAMEit

þb124PARTEN–LONG–DIFFit þb2AUDTEN–SAMEit

þb3FIRMAGEit þb4LNSIZEit þb5INDGROWit þb6BIGFIVEit

þb7ROAit þb8ROAPLUSit þb9OCFit þb10OCFPLUSit

þb11ACCit þb12ACCPLUSit þb13ISSUEit þb14LEVit

þX

kakINDDUMkit þ

XlalYEARDUMlit þ 1it


177

where, SAME, indicator variable 1 if the auditor is from the same audit firm as theoutgoing partner and 0 otherwise; DIFF, indicator variable 1 if the auditor is from adifferent audit firm as the outgoing partner and 0 otherwise; PARTEN-SAME,indicator variable which is equal to PARTEN if the auditor is from the same auditfirm as the outgoing partner and 0 otherwise; PARTEN-DIFF, indicator variablewhich is equal to PARTEN if the auditor is from a different audit firm as theoutgoing partner and 0 otherwise; PARTEN-SHORT-SAME, indicator variablewhich is 1 if PARTEN is less than three years and the new audit partner is fromthe same firm as the outgoing partner and 0 otherwise; PARTEN-SHORT-DIFF,indicator variable which is 1 if PARTEN is less than three years and the new auditpartner is from a different firm as the outgoing partner and 0 otherwise;PARTEN-LONG-SAME, indicator variable which is 1 if PARTEN is greater thansix years and the new audit partner is from the same audit firm as the outgoingpartner and 0 otherwise; and PARTEN-LONG-DIFF, indicator variable which is 1 ifPARTEN is greater than six years and the new audit partner is from a differentaudit firm as the outgoing partner and 0 otherwise; AUDTEN-SAME, indicatorvariable which is equal to AUTEN if the auditor is from the same audit firm as theoutgoing partner and 0 otherwise.

All other variables are as defined earlier.Results shown in Table V, Column A indicate that as audit PARTEN increases

absolute jDACCRj increase (decrease) when the new partner is from the same (adifferent) audit firm as the outgoing partner. The coefficients on PARTEN-SAME(PARTEN-DIFF) are statistically significant at the 1 (5) percent level. Results shown inTable V, Column B indicate that during the initial years of audit PARTEN, absolutejDACCRj increase when the new audit partner is from a different audit firm as theoutgoing partner, whereas they decrease when a new audit partner is from the sameaudit firm as expected. Specifically, the coefficient on PARTEN-SHORT-DIFF(PARTEN-SHORT-SAME) is positive (negative) and statistically significant at the 10(5) percent level. F-tests reject the equality of the coefficients on PARTEN-SAME andPARTEN-DIFF (F-value ¼ 12.87, p ¼ 0.000) and those on PARTEN-SHORT-DIFF andPARTEN-SHORT-SAME (F-value ¼ 6.26, p ¼ 0.012). As PARTEN lengthens,however, we do not find a significant relation of audit PARTEN with absolutejDACCRj. Coefficients on PARTEN-LONG-DIFF and PARTEN-LONG-SAME arestatistically insignificant[31].

Similar to Myers et al. (2003), we re-estimated the models omitting observations in theextreme (top and bottom) 0.5 percent of ROA (measured by year and industry) to controlfor the possibility that the association between audit PARTEN and ACC is the result ofextreme financial performance early in the auditor’s tenure. For the non-extreme ROAsub-sample, our results on tenure for income-increasing ACC are generally consistentwith the results in Table IV, columns C and E. In addition, eliminating the extremeobservations does not improve the statistical significance of PARTEN orPARTEN-SHORT with the income-decreasing jDACCRj. Thus, we conclude that ourmain results are not driven by extreme performance.

ConclusionOur paper examines the association between audit PARTEN and client managers’accounting discretion. Prior US research indicates that lengthy AUDTEN is associated

MAJ23,2

178

Variables

(A)Model C coefficient

(t-value)

(B)Model D coefficient

(t-value)

SAME 0.5662 (4.58) * * * 0.6534 (5.22) * * *

DIFF 0.5957 (4.92) * * * 0.5173 (4.23) * * *

PARTEN-SAME 0.0171 (2.61) * * *

PARTEN-DIFF 20.0231 (22.48) * *

PARTEN-SHORT-SAME 20.0519 (22.03)PARTEN-SHORT-DIFF 0.0546 (1.58) *

PARTEN-LONG-SAME 0.0017 (0.03)PARTEN-LONG-DIFF 20.0096 (20.11)AUDTEN-SAME 20.0110 (22.98) * * * 20.0105 (22.84) * * *

FIRMAGE 0.0011 (1.21) 0.0011 (1.28)LNSIZE 20.0234 (23.85) * * * 20.0239 (23.93) * * *

INDGROW 0.0081 (0.52) 0.0073 (0.47)BIGFIVE 0.0167 (0.73) 0.0143 (0.63)ROA 0.0036 (1.04) 0.0037 (1.06)ROAPLUS 20.0375 (20.44) 20.0404 (20.46)OCF 20.5367 (212.61) * * * 20.5325 (212.49) * * *

OCFPLUS 0.8473 (7.32) * * * 0.8391 (7.23) * * *

ACC 20.0067 (20.41) 20.0066 (20.41)ACCPLUS 0.2352 (7.76) * * * 0.2355 (7.76) * * *

ISSUE 0.0391 (1.81) * 0.0393 (1.82) *

LEV 0.0045 (1.45) 0.0046 (1.48)F-value 20.89 * * * 19.89 * * *

R 2-adj 0.2070 0.2053Number of observations ¼ 3,657

Notes: *, * * and * * * indicate significance at the 10, 5, and 1 percent levels, respectively. All exceptPARTEN-SHORT related coefficients are based on the two-tailed tests (the expected sign ofPARTEN-SHORT-SAME (PARTEN-SHORT-DIFF) is negative (positive)). To keep the presentation brief,coefficient estimates for the 19 industry (INDDUM) and 12 year (YEARDUM) dummy variables are not presentedVariable definitions:SAME, indicator variable 1 if the auditor is from the same audit firm as the outgoing partner and 0 otherwise;DIFF, indicator variable 1 if the auditor is from a different audit firm as the outgoing partner and 0 otherwise;PARTEN-SAME, indicator variable which is equal to PARTEN if the auditor is from the same audit firm as theoutgoing partner and 0 otherwise; PARTEN-DIFF, indicator variable which is equal to PARTEN if the auditor isfrom a different audit firm as the outgoing partner and 0 otherwise; PARTEN-SHORT-SAME, indicator variablewhich is 1 if PARTEN is less than three years and the new audit partner is from the same firm as the outgoingpartner and 0 otherwise; PARTEN-SHORT-DIFF, indicator variable which is 1 if PARTEN is less than threeyears and the new audit partner is from a different firm as the outgoing partner and 0 otherwise;PARTEN-LONG-SAME, indicator variable which is 1 if PARTEN is greater than six years and the new auditpartner is from the same audit firm as the outgoing partner and 0 otherwise; and PARTEN-LONG-DIFF,indicator variable which is 1 if PARTEN is greater than six years and the new audit partner is from a differentaudit firm as the outgoing partner and 0 otherwise; AUDTEN-SAME, indicator variable which is equal toAUTEN if the auditor is from the same audit firm as the outgoing partner and 0 otherwise; FIRMAGE,length of years since the ASX listing year; LNSIZE, natural log of total assets measured in dollars;INDGROW:ð

PNi¼1 Salesi;t 2

PNi¼1 Salesi;t21Þ=

PNi¼1 Salesi;t21by industry code; BIGFIVE, indicator variable

which is equal to 1 if the new auditor is one of the Big 5, and 0 otherwise; ROA, net income in year-1 divided bytotal assets in year-2; ROAPLUS, 0 if ROA is less than zero and ROA if ROA is greater than or equal to zero; OCF,cash flow from operations divided by average total assets; OCFPLUS, 0 if OCF is less than zero and OCF if OCF isgreater than or equal to zero; ACC, total accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC isless than zero and ACC if ACC is greater than or equal to zero; ISSUE, indicator variable which is 1 if the number ofshares outstanding is increased more than 10 percent and 0 otherwise; and LEV, total liabilities divided by totalassets

Table V.Pooled regression resultsusing absolute jDACCRj


179

with higher audit quality. This research, however, has not examined how audit PARTENimpacts audit quality. It treats an audit firm with long tenure and frequent audit partnerrotation the same as an audit firm with long tenure and infrequent audit firm rotation. Incontrast, we separate the impact of audit PARTEN and audit firm tenure on audit quality.Using a sample of Australian firms we examine the effects on audit quality from auditpartner changes within the same audit firm. We conjecture that when the new auditpartner is from the same audit firm as the outgoing audit partner, audit quality increasesbecause the new audit partner brings “fresh eyes” to the engagement. However, when thenew audit partner is from a different audit firm as the outgoing partner, the clientmanager’s accounting discretion increases in those initial years because the new partnerfaces a very steep learning curve regarding the client’s operations. Our results confirmthese conjectures. We find that in the initial years of tenure of a new audit PARTEN clientmanagers’ accounting discretion decreases (increases) when the new partner is from thesame (a different) audit firm as the outgoing partner. These results suggest that auditpartner rotation increases audit quality during the initial years on the engagement whileaudit firm rotation decreases audit quality in those initial years. Our findings also indicatethat as audit PARTEN increases client managers’ accounting discretion also increases.These results are consistent with audit partner judgment being impaired as tenure on anengagement become lengthy. Together, these results suggest that “fresh skeptical eyes”from within the same audit firm need to be brought into an engagement to ensure thathigh-audit quality is maintained. While our study provides support for the recentlegislation restricting the length of audit PARTEN in the US it should also be of interest toother regulatory bodies considering new legislation to require audit partner rotation[32].

Several limitations of this study need to be acknowledged. First, while client managers’accounting discretion increases with audit PARTEN, the costs to clients and audit firmsfrom requiring audit partner rotation are not examined in this study[33]. Without acost-benefit analysis, we cannot draw definite conclusions on the merits of regulatorypolicy requiring audit partner rotation. Second, our sample consists only of firms thatvoluntarily changed audit partners on the engagement. Caution is needed in generalizingthese results to a regime with mandatory audit partner rotation. Third, our sample spans arelatively short time-period of 14 years. While our tests provide strong evidence thatshort-tenured audit partners are associated with higher audit quality than medium tenuredaudit partners from the same audit firm, our ability to examine the effects of long-tenuredaudit partners on audit quality was constrained by data availability. Although we conductseveral sensitivity tests to increase confidence in our test result, we cannot completelyeliminate concerns about the skewness in audit PARTEN data that is present in oursample[34]. As new databases continue to become available to researchers, future studiescan potentially provide more insights on the relationship between PARTEN and auditquality using a longer time series, as well as, testing this relationship in other countries.

Notes

1. The debate over auditor rotation is not new. In 1976, the US Senate issued what is known asthe “Metcalf Report” which recommended mandatory auditor rotation. In response to theMetcalf Report, the AICPA’s Cohen Commission issued its own report in 1978 arguing thatmandatory firm rotation would be too costly to implement. In recent years, followinghigh-profile scandals, the issue of auditor rotation has resurfaced. See GAO (2003) for adiscussion of the history of the auditor rotation debate.

MAJ23,2

180

2. Among those opposed to mandatory auditor rotation is former SEC Chairman (Senate Report107-205 2002), Hills, who testified that “a change of auditors can only lower the quality ofaudits and increase their costs”.

3. Effective July 7, 2004, the GAO’s legal name became the Government Accountability Office.

4. An “audit partner” is defined as a partner who is a member of the audit engagement teamwho has decision-making responsibility on significant auditing, accounting and reportingmatters that affect financial statements or who maintains regular contact with themanagement and audit committee. The definition also includes the lead and concurringpartners and partners who serve the company at the company level (other than a partnerwho consults with others on the audit engagement team regarding technical orindustry-specific issues) and the lead partner on subsidiaries of the issuer whose assets orrevenues constitute 20 percent or more of the consolidated assets or revenues of thecompany.

5. Unlike the case of audit firm rotation, Sarbanes-Oxley did not direct the SEC or the GAO tostudy the issue of audit partner rotation prior to the issuance of the new rules.

6. Australian Corporations Act, 2001, Commonwealth of Australia, Section 324 (10).

7. Similar to the audit firms, the AICPA (1992) has taken the position that audit quality increaseswith auditor tenure and that mandatory rotation will impair audit quality. Changing auditorscan also be costly for client-firms. Client-managers worry about the new auditor havingindustry expertise and the additional resources needed to audit a new client (Dunham, 2002).

8. Their tests measure audit quality using a weighted quality score based on 232 qualitycontrol review letters for audits conducted by the Audit Division of the Texas EducationAgency between 1984 and 1989.

9. Boards of directors and CFOs of client firms are also interested in having a smooth transitionfrom one engagement partner to the next and may require their audit firm to have transitionprocesses in place.

10. The quality of an audit is also possibly more directly impacted by the accounting expertiseof the partner-in-charge of the audit than by the audit firm engaged by the client.

11. Using US survey data, Trompeter (1994) finds that audit partners with compensation closelytied to client retention were less likely to require downward adjustments to their client’s netincome.

12. Other incentives that may be present for an audit partner to benefit directly from his/herrelationship to the client include opportunities for consulting with the client, the possibilityof being hired as the client’s CFO in the future, etc. Some of these arrangements are nowprohibited by the Sarbanes-Oxley Act (2002).

13. A cost-benefit analysis would be required before one can draw definite conclusions onwhether audit partners should be rotated.

14. This statement assumes that when a new audit firm is engaged, the partner on the audit isalso new (i.e. the new partner is not the same as the predecessor audit partner from thepredecessor audit firm).

15. Indeed, if audit firms do not rotate partners or do so infrequently, their results couldimply that lengthy audit partner tenure (audit firm tenure serving as a proxy) increases auditquality.

16. The following model is used to compute DACCR:

ACCR ¼ a01

TA21þ a1

ðDSALES 2 DARÞ

TA21þ a2

PPE

TA21þ e


181

where ACCR is total accruals deflated by total assets at the beginning of the year(TA21); total accruals are measured as the difference between earnings beforeextraordinary items and net cash flow from operations; AR is accounts receivable; PPEis property, plant, and equipment. The model is separately estimated for each industryand year. DACCR is the estimated residual of the above model. Alternative proxies forDACCR suggested by Jones (1991), Kasznik (1999) and Klein (2002) were also used andsimilar results were obtained.

17. Our primary interest is not to measure the effect of audit firm tenure on accountingdiscretion. Our sample selection procedures are intended to obtain data for firms where auditpartner tenure (not audit firm tenure) could be measured accurately. This also implies thatwe discarded some observations where audit firm tenure could be computed accurately butcomplete data were not available to compute audit partner tenure.

18. US studies (Myers et al., 2003; Ghosh and Moon, 2005) compute US audit firm tenure byassuming that the first year of auditor tenure is the first year the audit-firm name wasdisclosed on COMPUSTAT. However, unlike COMPUSTAT which has been providing thisinformation since 1974, the database used in this study, DatAnalysis, has only providedadequate coverage from 1990.

19. Coverage of Australian firms by DatAnalysis has become more comprehensive in recentyears. Prior to 1990, coverage was limited to a few hundred firms. There is no other databaseavailable that readily identifies signing partners for publicly traded Australian firms duringthis period.

20. The effect of Professional Statement F1 on our tests is minimal. Our sample includes 13client-firms whose partner tenure was seven years as of the end of 2003. Six of these did notswitch their audit partners in 2004. There are additional 14 observations where the signingpartner tenure was longer than seven years in 2003. These clients were audited by smallaudit firms likely to qualify for an exemption, or a delayed transition, to the rotationrequirements in Professional Statement F1. As a check for sensitivity we excluded theseobservations from the sample; our conclusions were unchanged.

21. Coverage on DatAnalysis for some firms is not complete. A firm may be covered byDatAnalysis in a certain year, dropped in the next year, and then covered again a few yearslater. For this firm, collecting data on partner names would not result in any usableobservations in our tests; as explained later we would not be able to compute audit partnertenure for these firms. For this reason, we used the above screen, namely that firms have atleast three years of consecutive data.

22. For example, if the first audit partner change for a firm occurred in 1996 (i.e. the signingpartner in 1996 was different from the previous signing partner), we would code 1996 as thenew partner’s first year on the engagement, 1997 would be coded year 2 and so on.Observations prior to 1996 would be discarded because we could not determine when thepredecessor audit partner first joined the engagement from DatAnalysis.

23. These 2,299 observations representing 569 firms are used later as a base set for the “controlsample” for comparison with our main sample. Owing to financial data being unavailable forthis sub-sample we were left with 1,525 firm-year observations representing 439 firms.Firm-year observations belonging to finance, investment, property trusts, and insuranceindustries were also discarded. These procedures left us with 1,162 firm-years representing384 firms for our comparison analyses.

24. The Aspect database, like its US counterpart COMPUSTAT, covers financial statement datafor publicly traded firms in Australia.

25. This method of measuring partner tenure possibly results in discarding outgoing partners,some of whom may have long tenure, from our analyses. We conduct sensitivity tests where

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we examine changes in audit quality for a sub-sample of long-tenured partners and find thatour conclusions are not changed.

26. While our method of measuring partner tenure (combined with a short sample period) resultsin a sample consisting of a majority of partners with tenure of less than three years, this doesnot invalidate our test results. Our method assures that partner tenure is accuratelymeasured for each partner. After controlling for all known factors that affect discretionaryaccruals, our tests allow us to compare discretionary accruals for firms with short-tenuredpartners with those of medium and long-tenured auditors. We also conduct sensitivity testswhere we examine changes in audit quality for a sub-sample of long-tenured partners andfind that our conclusions are not changed.

27. Dropping one or both of these variables does not change our conclusions.

28. The weaker results on raw signed discretionary accruals are also consistent with findings ofJohnson et al. (2002). Myers et al. (2003) also cautions against using raw discretionaryaccruals to proxy for earnings management.

29. Similar phenomenon has also reported in Myers et al. (2003).

30. Our results in Table III also show that as audit firm tenure increases audit quality increases.However, the sample used for these tests is restricted to observations with changes insigning auditor within the same audit firm. The tests in this section are designed to measureaudit firm tenure more accurately.

31. We could not reject the equality of the coefficients on PARTEN-LONG-DIFF andPARTEN-LONG-SAME (F-value ¼ 0.01, p ¼ 0.911). This result is similar to findings inJohnson et al. (2002) who report that long audit-firm tenure is not statisticallysignificantly associated with reduced absolute discretionary accruals but short auditfirm tenure is statistically significantly associated with high absolute discretionaryaccruals.

32. The European Union, for example, is currently considering proposals to limit audit partnerand audit firm tenure, www.cfo.com/article.cfm/3011703/c_3042499?f ¼ TodayInFinance_Inside. Australia has adopted mandatory rotation of employees who play a significant role inthe audit for more than five out of seven years (CLERP 9, 2004).

33. Costs include direct costs for training new audit partners about the client company’soperations resulting in higher audit costs. Some audit firms with a small number ofaudit partners may find it impossible or difficult to rotate partners and may have togive up some business. There is a cost to having fewer audit firms in the profession ifaudit partner rotation forces some audit firms to exit the business. The US rulesprovide relief to audit firms with fewer than five SEC registrants and less than tenpartners (SEC, 2003).

34. For example, to increase confidence in our sample that audit partner rotation increases auditquality in the initial years, we compare discretionary accruals of firms with short-tenuredaudit partners from the same audit firm with those of client firms with short-tenuredauditors from a different audit firm.

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Corresponding authorHo-Young Lee can be contacted at: [email protected]

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