Managerial Auditing Journal

Emerald Article: The effect of audit partner tenure on client managers' accounting discretion Neil Fargher, Ho-Young Lee, Vivek Mande

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To cite this document: Neil Fargher, Ho-Young Lee, Vivek Mande, (2008),"The effect of audit partner tenure on client managers' accounting discretion", Managerial Auditing Journal, Vol. 23 Iss: 2 pp. 161 - 186 Permanent link to this document: http://dx.doi.org/10.1108/02686900810839857 Downloaded on: 07-04-2012 References: This document contains references to 45 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 1881 times.

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The effect of audit partner tenure on client managers accounting discretion

Neil Fargher
Macquarie University, Sydney, Australia

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Ho-Young Lee
Yonsei University, Seoul, South Korea, and

Vivek Mande
California State University-Fullerton, Fullerton, California, USA
Abstract
Purpose This paper aims to examine the effect of audit partner tenure (PARTEN) on client managers accounting discretion. Design/methodology/approach The authors contend that, when a new audit partner is from the same audit rm as the outgoing audit partner (audit partner rotation), audit quality increases because the new audit partner brings fresh eyes to the engagement. Findings The results conrm this conjecture. The authors nd that, in the initial years of tenure of a new audit partner, client managers accounting discretion decreases when the new partner is from the same audit rm as the outgoing partner. However, when the new audit partner is from a different audit rm as the outgoing partner (audit rm rotation), it is found that client managers accounting discretion increases in those initial years. Originality/value The results provide support for recent legislation in the US restricting audit PARTEN and should be of interest to other regulatory bodies contemplating mandatory audit partner rotation. Keywords Auditors, Financial reporting Paper type General review

Introduction The purpose of this paper is to examine the effect of audit partner tenure (PARTEN) on client managers accounting discretion. Following recent high-prole audit failures such as Enron and WorldCom, the effect of lengthy auditor tenure on audit quality has become the subject of extensive public debate in the USA. As early as 1999, the US Securities and Exchange Commission (SEC) had begun to express concerns about the effects of long auditor tenure on auditor independence[1]. Then Chief Accountant of the SEC, Lynn Turner called on academics to investigate whether the quality of nancial reporting deteriorated as client managers developed long-lasting relationship with their auditors (Turner, 1999). Arthur Levitt, the Chairman of the SEC in 2000, echoed the anxiety of his Chief Accountant that auditor judgment was impaired when auditors remained on an engagement for a lengthy period of time (Levitt, 2000). Later, Levitt (2002) testied before the Senate Committee on Governmental Affairs that:
The data used are from public sources identied in the paper.

Managerial Auditing Journal Vol. 23 No. 2, 2008 pp. 161-186 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900810839857

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. . . serious consideration be given to requiring companies to change their audit rm not just the partners every 5-7 years to ensure that fresh and skeptical eyes are always looking at the numbers.

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However, these views expressed above are not universally accepted. Opposed to auditor rotation is the auditing profession which has argued that as auditor tenure increases, so does an auditors understanding of the clients business, control risks and other factors that contribute to audit failures (AICPA, 1992; PricewaterhouseCoopers, 2002)[2]. Given the conicting views on auditor tenure, Congress in 2002, decided not to require the mandatory rotation of audit rms. Instead, it directed the General Accounting Ofce (GAO)[3] to conduct research on the potential effects of mandatory audit rm rotation on audit quality. The GAOs (2003) study of the largest public accounting rms and their Fortune 1000 publicly traded client-companies concluded that mandatory audit rm rotation may not be the most efcient way to strengthen auditor independence and improve audit quality. In 2002, Congress also considered the issue of whether lengthy audit PARTEN adversely affected audit quality. Contrary to the case of audit rm rotation, Congress decided that it was necessary to require mandatory partner rotation every ve years to increase audit quality. Section 203 of the Sarbanes-Oxley Act (2002) provides that it is:
. . . unlawful for a registered public accounting rm to provide audit services to an issuer if the lead audit partner (having primary responsibility for the audit) or the audit partner responsible for reviewing the audit that is assigned to perform those audit services has performed audit services for that issuer in each of the ve previous scal years of that issuer[4].

Following Sarbanes-Oxley, the SEC (2003) issued its rules on audit partner rotation in 2003. Several recent published US studies have examined the effect of audit rm tenure (AUDTEN) on audit quality (Ghosh and Moon, 2005; Carcello and Nagy, 2004; Myers et al., 2003; Johnson et al., 2002; Geiger and Raghunandan, 2002). The results of these studies are generally supportive of the GAOs conclusions that as AUDTEN increases, audit quality also increases. They show that audit failures are most likely to occur in the rst few years of tenure of an audit rm. However, there have only been a few studies that have examined whether audit partner rotation also adversely affects audit quality. As with audit rm rotation, rotation of audit partners can increase the risk of audit failures during a partners initial years on an engagement if rotation creates a steep learning curve about the clients operations for the new partner[5]. Our study contributes to the literature by providing some of the rst evidence on the relationship between audit PARTEN and audit quality. Specically, our paper examines the effect of audit PARTEN on client managers accounting discretion. We test our hypothesis using tenure data on Australian audit partners. Unlike US rules which only require the audit rms name to be disclosed underneath the auditors opinion, Australian law requires the auditors report to be signed by the partner-in-charge of the audit engagement[6]. Two papers have examined the effect of audit PARTEN on audit quality in the Australian context. Carey and Simnett (2006) nd a negative association between Australian audit PARTEN and audit report qualications which supports the case for mandatory rotation. Concurrent research by Hamilton et al. (2005) nd that audit

partner changes are associated with lower unexpected accruals (ACC) consistent with arguments in support of audit partner rotation. Unlike our study their tests focus on cross-sectional comparison of rms with auditor partner changes to all rms. Their results 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 nd that in the rst years of an engagement, client managers discretionary accruals (jDACCRj) are smaller than in the later years but only if the new audit partner is from the same audit rm as the outgoing partner (audit partner rotation). In contrast, client managers accounting jDACCRj are larger in the initial years when the new audit partner is from a different audit rm as the outgoing audit partner (audit rm rotation). These ndings suggest that new partners from the same audit rm bring fresh eyes to an engagement increasing audit quality, while new partners from a different audit rm (although they also bring fresh eyes) face a very steep learning curve regarding the clients operations as a result of which audit quality suffers. Our results support recent regulatory policy, for example in the USA, requiring the rotation of audit partners but not audit rms. The next section provides background on the Australian context, followed by a section on the development of our hypothesis. This is followed by a discussion of our research design and data collection methods. Results are presented next, followed by our conclusion. Background The International Federation of Accountants Code of Ethics (IFAC, 2003) recognizes that prolonged use of the same lead engagement partner on an audit may create a familiarity threat that by virtue of a close relationship with an assurance client, its directors, ofcers or employees, a member of the assurance team becomes too sympathetic to the clients interests. The code proposed that the lead engagement partner be rotated after a pre-dened 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 the USA (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 and since abandoned the policy (Cameran et al., 2005). The Australian professions standard on independence was revised in line with the IFAC Code of Ethics during 2001. The rst mandatory requirement for auditor rotation in Australia was issued in May 2002, Professional Statement F1 Professional Independence (Professional Statement F1) (Institute of Chartered Accountants in Australia (ICAA, 2002)). The effective date was December 31, 2003 with the partner rotation requirement impacting scal periods ending in 2004. Professional Statement F1 introduced the mandatory rotation of the lead engagement partner and the review partner on an engagement for publicly listed companies. With limited exceptions, the requirement was for the lead engagement partner to be rotated after a pre-dened period, no longer than seven years for audits of listed public companies. A partner rotating after a pre-dened period should not resume the lead engagement role until a further period of time, no less than two years has elapsed. Prior to the introduction of Professional Statement F1 there was no specic requirement 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 rotation after seven years. The other Big 6 rms were aware of the issue and undertook partner rotation but not on a mandatory basis. Subsequent to the period of this study further reforms were adopted in Australia: Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Act 2004 (Cth) (CLERP 9). CLERP 9 requires mandatory partner rotation every ve years. The legislation became effective from July 1, 2004 however the audit partner rotation requirements did not come into effect until after the period examined in this study. Hypothesis development Proponents of mandatory auditor rotation have argued that extended auditor tenure leads to low-quality audits. Low-quality audits can mislead investors and result in misallocated resources. In several class-action lawsuits, institutional investors have charged that a long relationship between the client and its auditor resulted in lower scrutiny by the auditor over the companys improper accounting practices (Accounting Today, 2004). As the regulator of US capital markets, the SEC has a keen interest in knowing whether the quality of nancial reports deteriorates as client managers develop long-lasting relationships with their auditors (Turner, 1999). In 2002, following a series of several high-prole audit failures, Congress passed the Sarbanes-Oxley Act. Congress considered the issue of the effect of auditor tenure on audit quality and directed the GAO to study whether rotation of audit rms should be required. Opponents of mandatory auditor changes include the public accounting rms which have argued that that mandatory auditor rotation increases audit start-up costs and the risk of audit failure in the initial years of an engagement because the incoming auditor is forced to place a higher level of reliance on the clients estimates and representations (PricewaterhouseCoopers, 2002). They have argued that as tenure increases, an auditor is able to gain rm-specic expertise and a better understanding of the clients business[7]. Several prior US studies have attempted to shed light on the debate about auditor tenure. Deis and Giroux (1992) nd that audit quality decreases as auditor tenure increases[8]. In contrast, St Pierre and Andersen (1984) nd that auditors of new clients (three years or less on the engagement) commit more errors and experience higher legal risk than auditors with a tenure greater than three years. Based on audit committee members responses to a survey, Knapp (1991) also concludes that as auditors gain more experience with individual clients, the likelihood of discovering material errors increases. More recently, Geiger and Raghunandan (2002) nd that long-tenured auditors are more efcient in the collection and evaluation of evidence than short-tenured auditors. Their results are consistent with long-tenured auditors having a more in-depth knowledge of their clients nancial status and operating systems than short-tenured auditors. Carcello and Nagy (2004) nd that fraudulent nancial reporting is more likely to occur in the rst three years of an audit. In addition, they nd no evidence of greater fraudulent nancial reporting by clients of long-tenured auditors. Finally, Myers et al. (2003) test for the association between auditor tenure and earnings quality where the auditor-client relationship lasted for at least ve years. They nd that the magnitude of both discretionary and current ACC declines with longer auditor tenure. They also nd evidence that lengthier auditor tenure is associated with less extreme ACC. Their results

suggest that as the relationship between the auditor and client lengthens, the auditor is able to limit managements ability to use ACC to manage earnings. However, the above research has only examined the effect of AUDTEN on audit quality. It has not examined how audit PARTEN on an engagement affects the quality of an audit. To the extent that an audit partners knowledge of a clients business increases with his/her tenure on the audit, audit partner rotation, like audit rm rotation, can arguably lead to a decrease in audit quality. Also, similar to audit rm rotation, audit partner rotation can lead to the most qualied audit partner on an engagement being replaced by a partner who is less qualied. The SEC (2003) acknowledges that the quality of the engagement audit team could, in fact, decrease as a result of its rules mandating audit partner rotation. This suggests that in some circumstances audit partner rotation can be tantamount to audit rm rotation, reducing audit quality and increasing the likelihood of audit failures in the initial years of a partner on an engagement. However, there are important differences between audit rm rotation and audit partner rotation which in turn lead to different predictions about the effect of tenure on audit quality. Unlike the case of a new audit rm on an engagement, there may be less likelihood of signicant deterioration in audit quality in the rst years of an engagement if the new audit partner was from the same audit rm as the outgoing audit partner. Audit rms have processes in place for managing the transition from one engagement partner to another[9]. As a result, a new lead partner from the same audit rm is likely to be more familiar with the clients business and risks than a new partner from a different audit rm. A new partner should also nd it easier to consult with a former partner on the engagement if the former partner was from the same audit rm. Therefore, the learning curve for an incoming audit partner from the same audit rm is likely to be less steep than if the incoming audit partner were from a different audit rm. Indeed, it is possible that by bringing fresh eyes to the engagement, a new audit partner from the same audit rm might actually increase the quality of the audit. That is, the tradeoff between bringing fresh eyes to an engagement and the potential loss in the quality of the engagement team may favor audit partner rotation but not audit rm rotation. In addition, the incentives facing an audit partner are likely to be different from those facing an audit rm which can also lead to a different relationship of tenure with audit quality[10]. As the length of time on an engagement increases the economic incentives to bond with the client may be more strongly present at the partner level than at the audit rm level. Audit partners have compensation incentives that are related to the fees received from client-rms (Trompeter, 1994)[11]. Failure to keep a client satised can lead to a clients dismissal of the audit rm. Loss of a client affects an audit partner more directly than the audit rm because the latter is able to diversify its revenues over its existing and future client base. Loss of a valued client can lead to an audit partners dismissal or limit future opportunities offered to that partner by the audit rm[12]. As an audit partners tenure on an engagement increases, the economic incentives to bond with the client may become stronger. For these reasons, it is possible that the quality of an audit 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 an engagement may have the potential to increase audit quality. Although audit partner rotation creates a new learning curve for the incoming partner, it also brings fresh and skeptical eyes into the audit. Importantly, the audit rm can continue to build its relationship with the client and provide high-quality client service while accumulating

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knowledge about the clients operations. Therefore, in contrast to audit rm rotation, the benets of bringing new blood to an engagement may be greater than the potential loss 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 audit partner level than the audit rm level. Therefore, in contrast to AUDTEN, lengthy audit PARTEN may, in fact, decrease audit quality. We examine three related hypotheses regarding the effect of a rotation of audit partners on client managers accounting discretion. First, we examine whether client managers accounting discretion increases as audit PARTEN increases. An increase in client managers accounting discretion with audit PARTEN would be supportive of a policy requiring the rotation of audit partners on an engagement[13]. This hypothesis is stated below in the null form: H1. All else constant, there is no change in client managers accounting discretion as audit PARTEN on an engagement increases. Our next hypotheses contrast audit quality in the initial years of a new audit partner on an engagement with that in the later years of the partners tenure. As discussed, prior US research indicates that in the initial years of a new partner being engaged there is a signicant deterioration in audit quality when the new partner is from a different audit rm[14]. However, this research has not examined whether audit quality is low in the rst years of a new audit partner when the new auditor is from the same rm. Prior US studies also nd that audit quality is higher in rms whose auditors have lengthy tenure. Again, these studies do not control for audit PARTEN. They treat an audit rm with a lengthy tenure and frequent audit partner rotation the same as an audit rm with a lengthy tenure and infrequent audit partner rotation[15]. Following the method in Carcello and Nagy (2004) our hypotheses compare audit quality associated with short- and long-tenured audit partners with audit quality associated with medium-tenured audit partners. The hypotheses are stated below in the null form: H2. All else constant, there is no difference in client managers accounting discretion across short- and medium-tenured audit partners. H3. All else constant, there is no difference in client managers accounting discretion across medium- and long-tenured audit partners. Research design Models used to test the hypotheses The following regression models are used to test the hypotheses: . Model A: jDACCRjit a0 b1 PARTENit b2 AUDTENit b3 FIRMAGEit b4 LNSIZEit b5 INDGROWit b6 BIGFIVEit b7 ROAit b8 ROAPLUSit b9 OCFit b10 OCFPLUSit b11 ACCit b12 ACCPLUSit X b13 ISSUEit b14 LEVit a INDDUMkit k k X a YEARDUMlit 1it l l

Model B: jDACCRjit a0 b121 PARTEN SHORTit b122 PARTEN LONGit b2 AUDTENit b3 FIRMAGEit b4 LNSIZEit b5 INDGROWit b6 BIGFIVEit b7 ROAit b8 ROAPLUSit b9 OCFit b10 OCFPLUSit b11 ACCit b12 ACCPLUSit b13 ISSUEit X X b14 LEVit a INDDUM a YEARDUMlit 1it k kit k l l

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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 greater than six years and 0 otherwise; AUDTEN, audit rm tenure; FIRMAGE, length of years since the ASX listing year; LNSIZE, natural log of total assets measured in dollars; INDGROW: ! N N X X Salesi;t 2 Salesi;t21
i1 N X i1 i1

Salesi;t21

by 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 if ROA is greater than or equal to zero; OCF, cash ow 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, total accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less than zero and ACC if ACC is greater than or equal to zero; ISSUE, indicator variable which is 1 if the number of shares outstanding is increased more than 10 percent and 0 otherwise; LEV, total liabilities divided by total assets; INDDUM, industry indicator variables; and YEARDUM, year indicator variables. Measuring discretionary accruals We measure client managers accounting discretion using absolute jDACCRj based on the Cross Sectional Modied Jones-model. The use of absolute jDACCRj is consistent with client managers using positive jDACCRj to manage current earnings upward and negative jDACCRj for building cookie jar reserves for increasing earnings in subsequent 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 of jDACCRj we also use their signed raw values. Additionally, we separately estimate our models for income increasing ACC and income decreasing ACC[16]. Measuring audit partner tenure We measure audit PARTEN as the number of consecutive years an audit partner serves as the signing partner on an engagement. A positive and signicant coefcient on PARTEN in Model A would support the argument that client managers accounting discretion 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 test the association of client managers accounting discretion with short- and long-tenured audit partners, respectively. A negative (positive) coefcient on PARTEN-SHORT (PARTEN-LONG) would support the argument that client managers accounting discretion decreases (increases) in the initial (later) years of tenure of an audit partner. Measuring audit rm tenure While the primary purpose of this paper is to measure the effect of audit PARTEN on client managers accounting discretion, we also need to measure AUDTEN for this sample of rms. We use AUDTEN as a control variable in our regression model[17]. We measure AUDTEN in the following way: . for client rms that engaged an audit rm in our sample for the rst time during our sample period, AUDTEN is the number of consecutive years the audit rm was retained by the client (47 percent of observations); . for client rms that rst listed on the Australian Stock Exchange (ASX) during our sample period, we compute AUDTEN assuming the year of the listing is the audit rms rst year of tenure (19 percent of observations); and . for all remaining client rms we compute AUDTEN assuming 1990, the rst year of coverage on the database used in this study, is the rst year of AUDTEN[18]. We acknowledge that this approach does not measure AUDTEN accurately in certain cases, however, we attempt to alleviate this concern by conducting additional tests for robustness of the results (see additional analyses). Measuring other control variables We control for factors found by previous work to impact client managers jDACCRj. Based on Myers et al. (2003), we include client-rm age (FIRMAGE) which is measured as the number of years since the client rm was rst listed on the ASX. Industry growth (INDGROW) is included because this variable has been shown to be positively associated with the jDACCRj (Myers et al., 2003). Because large client rms tend to record more stable ACC (Dechow and Dichev, 2002; Lee and Mande, 2003), we include the natural log of total assets (LNSIZE). Past return on assets (ROA) and current operating cash ows (OCF) are included because these variables have been shown to affect the magnitude of jDACCRj (Dechow et al., 1995; Chung and Kallapur, 2003). Leverage (LEV) ratio is included because prior studies nd that client managers of high-LEV rms have greater incentives to manage earnings to avoid violating debt covenants (DeFond and Jiambalvo, 1994; DeAngelo et al., 1994; Becker et al., 1998; Frankel et al., 2002). A variable representing past total ACC is included in the regression to control for the normal relation between ACC of past years and ACC of successive years. Similar to Chung and Kallapur (2003) we interact ROA, OCF and ACC with indicator variables denoting the signs of ROA, OCF and ACC. Using these indicator variables allows for different coefcients on negative and positive ROA, OCF and ACC. Consistent with prior studies showing that stock issuances (ISSUE) are associated with the amount of abnormal ACC (Firth, 1997; DeFond and Subramanyam, 1998; Chung and Kallapur, 2003), we include a control for shares issued by the client rm. Auditor type (BIGFIVE) is included because prior studies suggest that, when compared to small audit rms, large audit rms 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 variables representing industry and year because the magnitude of ACC has been shown to vary by industry (Barth et al., 2001) and year (Myers et al., 2003). Sample selection Our initial sample consists of the population of publicly traded Australian rms that were publicly traded on the ASX for which annual reports were available to us over the period 1990-2004 (14 years). The annual reports were obtained from DatAnalysis, a database produced by Aspect Huntley Pty. Ltd, that provides annual reports for most companies listed, or formerly listed, on the ASX. Annual reports were available on the database for 1,311 Australian rms for at least one year during the period 1990 through 2004[19]. During most of our sample period audit partner rotation was voluntary. In 2002, the Australian Professional Statement F1 (ICAA, 2002, Joint Code of Professional Conduct) introduced formal requirements requiring the rotation of the signing audit partner every seven years or less. The standard allows some degree of exibility over timing of rotations where an audit rm has only a few audit partners with the necessary knowledge and experience to serve as lead engagement partner (Joint Code of Professional Conduct, Appendix 2 Application of Principles to Specic Situations, paragraph 2.52 and 2.53). The professional statement went into effect for assurance reports dated after December 31, 2003 (paragraph 29)[20]. In June 2004, extensive changes were made to the Australian Corporations Law (CLERP 9) that included the mandated rotation of the signing audit partner on an audit every ve years or less. The effective date of CLERP 9 changes are nancial 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 the engagement and the name of the audit rm retained by the client. Because DatAnalysis is maintained in a text format, these names were hand-collected from the annual reports. To facilitate the time consuming task of hand-collecting partner names from annual reports, we limited our analyses to those rms for which the names of signing partner and audit rm were available for at least three consecutive years[21]. This restriction also ensures that our sample does not include newly listed rms and rms for which there was only recent coverage on DatAnalysis. This restriction resulted in sample of 1,306 rms or 12,077 rm-year observations. Our next step was to measure the tenure of a new signing partner on an audit engagement. A new signing audit partners tenure was measured beginning with the rst year the audit partner became the signing partner during our sample period following an audit partner change. There were 6,326 rm-year observations where a new audit partner joined (i.e. rm-years after the rst partner switch) an engagement as a signing partner during our sample period. For these audit partners we could accurately measure their tenure beginning with their rst year on an audit engagement as signing partner. The remaining 5,751 observations consisting of rm-year observations where signing partners tenure could not be accurately measured were discarded. That is, all observations were excluded prior to the rst change in signing auditor that could be identied[22]. Because of our papers focus on audit partner rotation, we also discarded 2,299 rm-years[23] where the incoming new partner was from a different audit rm, which left 4,027 rm-years representing 839 rms.

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We required rms to have nancial statement data needed for our tests on the Aspect database, which left 3,047 rm-years representing 715 rms[24]. Then, we eliminated rms in banking, investment, property management, and insurance industries. This left us with a nal sample of 2,495 rm-years representing 590 rms. This sample includes tenure data on all incoming partners on an audit engagement during our sample period from the same audit rm. While our sampling method ensures that the tenure of the incoming partner from the same audit rm is correctly measured for every rm-year, there is also a substantial amount of sample attrition due to this approach. Specically, we had to discard observations for outgoing partners where we could not determine using DatAnalysis when the outgoing audit partner rst joined the engagement as a signing partner[25]. The characteristics of the sample are discussed below. Empirical results Our sample consists of rms from 20 industries; the number and proportion of rms belonging to each industry group are reported in Table I, Panel B. No single industry group appears to dominate the sample; 68 percent of the sample rms are represented by six industry groups. Despite the data attrition due to our sampling procedures, the sample composition is consistent with the composition of the ASX with the greatest concentration of rms coming from the miscellaneous industrials group representing approximately 17 percent of the total observations, and the mining and other metals segments with 30 percent of the total observations. Also, consistent with our sample selection criteria requiring a clear change in the signing partner, and consistent with better data availability from DatAnalysis in recent years, most observations are drawn after 1998 (4 in 1992; 15 in 1993; 46 in 1994; 70 in 1995; 117 in 1996; 168 in 1997; 190 in 1998; 227 in 1999; 270 in 2000; 341 in 2001; 375 in 2002; 357 in 2003; 315 in 2004). The results must be interpreted with respect to the period of our sample. Summary statistics for the main variables are presented in Table II, Panel A. The mean (median) value of absolute jDACCRj is 0.1893 (0.0795). The mean (median) value of PARTEN is 2.74 years (two years) while the mean (median) value of AUDTEN is 7.72 years (eight years). About 56.7 percent of the observations have the value of PARTEN less than three years while about 5.3 percent of the observations have the value of PARTEN greater than six years[26]. About 73 percent of sample rms were audited by Big 5 auditors. Table II, Panel B, provides a correlation matrix which shows that, in general, the variables are not highly correlated. The largest correlations are between OCF and OCFPLUS (r 0.58) and between ACC and ACCPLUS (r 0.56)[27]. Results under Model A in Table III show the association of absolute jDACCRj with PARTEN and the control variables (i.e. Model A results). The adjusted R 2 of the regression is 0.22. Regarding the control variables, the coefcients on rm size (LNSIZE), past return on assets (ROA and ROAPLUS), current operating cash ows (OCF and OCFPLUS) and total past accruals (ACC and ACCPLUS) and stock ISSUE are signicant at the 1 percent (one-tail) level of testing, while the coefcient on LEV and FIRMAGE are statistically signicant at the 5 percent and 1 percent (one-tail) level of testing, respectively. The signs of the coefcients on the above control variables are in the predicted direction. Another interesting nding is that AUDTEN is negatively associated with absolute jDACCRj (t 2 3.40) which is supportive of US studies suggesting that as the tenure of audit rms increases audit quality also increases. However, the main result of

Panel A. Procedures used for data collection Firm-years 1,311 12,077 6,326 4,027 3,047 2,495 Sample rm-years N Percent 385 15.43 353 14.15 25 1.00 208 8.34 45 1.80 88 3.53 49 1.96 45 1.80 60 2.40 2 0.08 67 2.69 28 1.12 69 2.77 41 1.64 104 4.17 92 3.69 183 7.33 438 17.56 125 5.01 88 3.53 2,495 100.00 590 715 839 1,306 1,035 Firms

Group 1

Group 2

Group 3 Group 4

Group 5

Final sample

Procedures Firms whose annual reports are available on DatAnalysis for at least one year during the sample period Group 1 rms whose partner and audit rm names are available for at least three consecutive years Group 2 rms after the rst partner switch Group 3 rms whose audit partners are from the same audit rms Group 4 rms whose nancial data are available on Aspect Group 5 rms not belonging nance, insurance, investment, and property trusts industries SIC code 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 18 21 22 23 24

Panel B. Distribution of observations by industry

Industry classication Mining-gold Other metals Diversied resources Energy Infrastructure Developers Building materials Alcohol and tobacco Food and household Chemicals Engineering Packaging Retail Transportation Media Telecommunications Healthcare biotechnologies Misc industrials Diversied Tourism leisure Total

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Table I. Data collection and distribution

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Panel A. Descriptive statistics Variables Mean jDACCRj 0.1893 PARTEN 2.7427 AUDTEN 7.7279 FIRMAGE 15.9190 LNSIZE 17.5810 INDGROW 1.1890 BIGFIVE 0.7275 ROA 2 0.1243 ROAPLUS 0.0446 OCF 2 0.0289 OCFPLUS 0.0634 ACC 2 0.0905 ACCPLUS 0.0441 ISSUE 0.3319 LEV 0.5127 Median 0.0795 2.0000 8.0000 12.0000 17.2675 1.1276 1.0000 2 0.0039 0.0000 0.0206 0.0206 2 0.0516 0.0000 0.0000 0.3967 PARTEN-SHORT 2 0.0297 (0.137) 2 0.7952 (0.000) PARTEN-LONG 2 0.0091 (0.650) 0.6421 (0.000) 2 0.2713 (0.000) AUDTEN 2 0.0581 (0.003) 0.1996 (0.000) 2 0.1825 (0.000) 0.0933 (0.000) FIRMAGE 2 0.0510 (0.011) 0.1513 (0.000) 2 0.1168 (0.000) 0.0945 (0.000) 0.3502 (0.000) LINSIZE 2 0.1890 (0.000) 0.0751 (0.000) 2 0.0579 (0.003) 0.0463 (0.021) 0.1259 (0.000) 0.2712 (0.000) INDGROW 2 0.0082 (0.682) 2 0.0132 (0.507) 0.0036 (0.857) 2 0.0133 (0.503) 0.0484 (0.015) 0.0137 (0.492) 0.0461 (0.021) BIGFIVE 2 0.0712 (0.001) 2 0.1141 (0.000) 0.0769 (0.000) 2 0.0951 (0.000) 0.1005 (0.000) 0.0958 (0.000) 0.3192 (0.000) 2 0.0081 (0.686) SD 0.5472 1.8934 3.6167 12.5510 2.2476 0.7143 0.4454 1.1653 0.1160 0.2731 0.0634 0.5273 0.2758 0.4710 3.2039 First quartile 0.0318 1.0000 5.0000 8.0000 15.9589 1.0487 0.0000 2 0.1467 0.0000 2 0.1007 0.0000 2 0.1378 0.0000 0.0000 0.1384 Third quartile 0.2020 4.0000 10.0000 19.0000 18.9648 1.2258 1.0000 0.0621 0.0621 0.0991 0.0991 0.0015 0.0015 1.0000 0.5614 Maximum 22.0447 12.0000 15.0000 134.0000 25.1655 14.2082 1.0000 2.8027 2.8027 1.0288 1.0288 6.6047 6.6047 1.0000 116.9600 Minimum 0.0000 1.0000 1.0000 3.0000 10.0923 0.5371 0.0000 2 39.9533 0.0000 2 3.9595 0.0000 2 17.1332 0.0000 0.0000 0.0000

Panel B. Person correlation matrix Variable (p-value) PARTEN jDACCRj 0.0299 (0.136) PARTEN PARTEN-SHORT PARTEN-LONG AUDTEN FIRMAGE LNSIZE INDGROW BIGFIVE ROA ROAPLUS OCF OCFPLUS ACC ACCPLUS ISSUE

Table II. Descriptive statistics and correlation matrix

(continued )

Panel B. Person correlation matrix Variable (p-value) ROA jDACCRj 2 0.0279 (0.163) PARTEN 0.0193 (0.334) PARTEN-SHORT 2 0.0034 (0.862) PARTEN-LONG 0.0187 (0.349) AUDTEN 0.0100 (0.614) FIRMAGE 0.0409 (0.040) LNSIZE 0.1565 (0.000) INDGROW 0.0102 (0.609) BIGFIVE 0.0456 (0.022) ROA ROAPLUS OCF OCFPLUS ACC ACCPLUS ISSUE ROAPLUS 0.0049 (0.805) 2 0.0107 (0.593) 0.0071 (0.723) 0.0047 (0.813) 2 0.0009 (0.964) 0.0064 (0.748) 0.1277 (0.000) 0.0154 (0.440) 0.0735 (0.000) 0.1552 (0.000) OCF 2 0.1697 (0.000) 0.0423 (0.034) 2 0.0073 (0.716) 0.0506 (0.011) 0.0320 (0.109) 0.1149 (0.000) 0.4550 (0.000) 0.0110 (0.581) 0.1519 (0.000) 0.2948 (0.000) 0.2207 (0.000) OCFPLUS 2 0.0503 (0.012) 0.0221 (0.269) 2 0.0198 (0.321) 0.0109 (0.584) 0.0555 (0.005) 0.1283 (0.000) 0.2901 (0.000) 2 0.0229 (0.253) 0.1527 (0.000) 0.1101 (0.0005) 0.3089 (0.000) 0.5787 (0.000) ACC 0.1532 (0.0000) 2 0.0051 (0.799) 0.0204 (0.308) 0.0082 (0.680) 0.0129 (0.516) 0.0189 (0.343) 0.0947 (0.000) 0.0153 (0.444) 2 0.0182 (0.363) 0.3991 (0.000) 0.0944 (0.026) 0.1472 (0.000) 0.0086 (0.665) ACCPLUS 0.3644 (0.0000) 2 0.0270 (0.177) 0.0159 (0.427) 2 0.0217 (0.277) 2 0.0061 (0.758) 2 0.0452 (0.023) 2 0.0652 (0.001) 0.0075 (0.706) 2 0.0541 (0.006) 2 0.2056 (0.000) 0.2160 (0.000) 2 0.0588 (0.003) 2 0.0354 (0.076) 0.5637 (0.000) ISSUE 0.1077 (0.000) 2 0.0274 (0.171) 0.0202 (0.313) 2 0.0346 (0.083) 2 0.0541 (0.006) 2 0.1469 (0.000) 2 0.2105 (0.000) 2 0.0094 (0.638) 2 0.1287 (0.000) 2 0.0819 (0.010) 2 0.0912 (0.000) 2 0.2847 (0.000) 2 0.2329 (0.000) 2 0.0583 (0.003) 0.0151 (0.449) LEV 0.0459 (0.021) 2 0.0012 (0.953) 0.0136 (0.496) 0.0021 (0.916) 2 0.0469 (0.019) 2 0.0113 (0.571) 2 0.0434 (0.029) 2 0.0059 (0.768) 2 0.0426 (0.033) 0.0157 (0.430) 0.0759 (0.000) 2 0.0026 (0.895) 2 0.0121 (0.546) 2 0.0047 (0.813) 0.0104 (0.604) 2 0.0365 (0.068)

Notes: p-values are in the parenthesis. N 2,495 Variable denitions: jDACCRj, absolute value of discretionary accruals; 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 if partner tenure (PARTEN) is greater than P six years and 0 P otherwise; AUDTEN, PN audit rm tenure; FIRMAGE, length of N years since the ASX listing year; LNSIZE, natural log of total assets measured in dollars; INDGROW: N i1 Salesi;t 2 i1 Salesi;t 21 = i1 Salesi;t 21 by 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 if ROA is greater than or equal to zero; OCF, cash ow 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, total accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less than zero and ACC if ACC is greater than or equal or zero; ISSUE, indicator variable which is 1 if the number of shares outstanding is increased more than 10 percent and 0 otherwise; and LEV, total liabilities divided by total assets

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Table II.

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Variables Intercept PARTEN-SHORT PARTEN PARTEN-LONG AUDTEN FIRMAGE LNSIZE INDGROW BIGFIVE ROA ROAPLUS OCF OCFPLUS ACC ACCPLUS ISSUE LEV F-value R 2-adj Number of observations 2,495

Expected sign ^ ^ ^ ^ 2 2 2 2 2 2

Model A coefcient (t-value) 0.5512 (4.58) * * * 0.01859 (3.41) * * * 2 0.0106 (2 3.40) * * * 0.0012 (1.36) * 2 0.0244 (2 4.18) * * * 0.0112 (0.75) 0.0199 (0.84) 0.1058 (8.99) * * * 2 0.5379 (2 5.61) * * * 2 0.3081 (2 6.11) * * * 0.6219 (4.87) * * * 2 0.1994 (2 6.64) * * * 1.0519 (18.83) * * * 0.0565 (2.51) * * * 0.0070 (2.11) * * 16.47 * * * 0.2183

Model B coefcient (t-value) 0.6384 (5.26) * * * 2 0.0566 (2 2.69) * * * 0.0059 (0.13) 2 0.0105 (2 3.35) * * * 0.0013 (1.46) * 2 0.0241 (2 4.13) * * * 0.0100 (0.67) 0.0147 (0.62) 0.1055 (8.96) * * * 2 0.5365 (2 5.59) * * * 2 0.3022 (2 5.98) * * * 0.6130 (4.79) * * * 2 0.1983 (2 6.59) * * * 1.0489 (18.75) * * * 0.0561 (2.49) * * * 0.0072 (2.16) * * 16.00 * * * 0.2168

174

Table III. Regression results using absolute jDACCRj

Notes: *, * * and * * * indicate signicance (one-tailed tests with expected signs) at the 10, 5, and 1 percent levels, respectively. To keep the presentation brief, coefcient estimates for the 19 industry (INDDUM) and 12 year (YEARDUM) dummy variables are not presented Variable denitions: 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 if partner tenure (PARTEN) is greater than six years and 0 otherwise; AUDTEN, audit rm tenure; FIRMAGE, length of years natural log of total assets measured in P since the ASX PN listing year; LNSIZE, PN dollars; INDGROW: N i1 Salesi;t 2 i1 Salesi;t 21 = i1 Salesi;t 21 by 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 if ROA is greater than or equal to zero; OCF, cash ow 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, total accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less than zero and ACC if ACC is greater than or equal to zero; ISSUE, indicator variable which is 1 if the number of shares outstanding is increased more than 10 percent and 0 otherwise; and LEV, total liabilities divided by total assets; INDDUM, industry indicator variables; and YEARDUM, year indicator variables

this regression concerns the coefcient on PARTEN which is positive and statistically signicant at the 1 percent level (two-tail) of testing (t-value 3.41) indicating that as auditor PARTEN increases client managers accounting discretion also increases. Results under Model B in Table III show the association of absolute jDACCRj with PARTEN-SHORT, PARTEN-LONG and the control variables. The adjusted R 2 and results on the control variables are similar to those obtained from the estimation of Model A. Of main interest are the coefcients on PARTEN-SHORT and PARTEN-LONG. The coefcient on PARTEN-SHORT is negative and statistically signicant at the 1 percent level (two-tailed) of testing. This suggests that compared to audit partners with medium tenure (between three and six years), audit partners with short tenure (less than

three years) are better able to limit their client managers accounting discretion. The coefcient on PARTEN-LONG is positive suggesting that compared to auditors with medium tenure, jDACCRj are higher when the client rm is audited by an audit partner with long tenure (greater than six years). The coefcient on PARTEN-LONG, however, is not statistically signicant. Results under Column A, Table IV show results of the association of raw signed jDACCRj with PARTEN and the control variables (i.e. Model A results). When compared to Table III results, the explanatory power of the independent variables decreases (Adjusted R 2 0.13) as does the statistical signicance of the coefcients on the independent variables. ROA, ROAPLUS, OCFPLUS, ACC, and ACCPLUS are signicantly related to raw signed jDACCRj at the 1 percent level (two-tail) of testing or less. The coefcient on AUDTEN is not signicant. The coefcient on PARTEN, however, is positive and statistically signicant at the 10 percent level (two tail) of testing supporting the position of proponents of audit partner rotation. Results under Column B, Table IV contain results of the association of raw signed jDACCRj with PARTEN-SHORT, PARTEN-LONG and control variables (Model B). Consistent with the results in Column A, the associations of these variables with raw signed jDACCRj are weaker than those with absolute jDACCRj[28]. Table IV, Columns C and D contain results based on separate estimations for positive (DACCR ) and negative (DACCR 2 ) jDACCRj. The adjusted R 2s of the models using positive 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 with the positive jDACCRj while AUTEN is negatively associated with the positive jDACCRj signicant at least at the 5 percent levels (Column C) suggesting that the magnitude of positive jDACCRj increases (decreases) as PARTEN (auditor tenure) increases. Some of the control variables in the negative jDACCRj models have the opposite signs to those found with jDACCRj as a dependent variable (Column D)[29]. Only AUDTEN is positive and signicant at the 10 percent level in the negative jDACCRj model. Finally, Table IV, Columns E and F present results of separate estimations for positive and negative ACC with PARTEN-SHORT and PARTEN-LONG as independent variables. We nd a signicant association of PARTEN-SHORT with positive jDACCRj. The coefcient on PARTEN-SHORT is not statistically signicant in the estimation using negative jDACCRj; the coefcient on PARTEN-LONG is statistically insignicant in both positive and negative jDACCRj estimations. We conclude that during our sample period, as audit PARTEN lengthens, an audit partners ability to constrain client managers accounting discretion is diminished. In particular, as audit PARTEN lengthens, an audit partners ability to constrain income increasing jDACCRj is diminished. Additional analyses To increase condence in our results we compare audit quality when audit partners are rotated versus when audit rms are rotated[30]. As discussed, in the initial years of an audit, we should expect audit quality to increase (decrease) in the case of audit partner (audit rm) rotation. Whether the differences in audit quality between the two groups will continue to persist in the later years of audit PARTEN is an empirical question. As audit PARTEN becomes lengthy, it is possible that no differences remain in the acquired expertise and incentives of an audit partner regardless of whether he/she was

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Variable 0.7082 (2.92) * * * 0.0319 (2.76) * * * 2 0.0052 (2 1.39) 0.0038 (1.79) * 2 0.0002 (2 0.30) 0.0191 (4.51) * * * 2 0.0089 (2 0.67) 2 0.0146 (2 0.90) 2 0.0344 (2 3.86) * * * 0.2478 (3.31) * * * 0.3271 (9.75) * * * 2 0.6001 (2 7.50) * * * 0.0921 (3.71) * * * 2 0.3200 (2 5.27) * * * 2 0.0715 (2 4.57) * * * 2 0.0669 (2 6.03) * * * 11.93 * * * 0.2528 1,422 1,073 1,422 2 0.0947 (2 0.97) 2 0.0183 (2 2.73) * * * 0.0031 (1.44) 2 0.0341 (2 2.81) * * * 0.0129 (0.50) 0.0231 (0.46) 0.0521 (1.07) 0.1668 (0.63) 2 0.1301 (2 1.11) 0.1317 (0.37) 2 0.1042 (2 1.00) 1.1197 (8.77) * * * 0.0654 (1.20) 0.0039 (0.75) 8.28 * * * 0.2379 2 0.0405 (2 1.30) 0.0037 (1.77) * 2 0.0002 (2 0.30) 0.0191 (4.52) * * * 2 0.0094 (2 0.70) 2 0.0152 (2 0.94) 2 0.0344 (2 3.86) * * * 0.2488 (3.32) * * * 0.3274 (9.74) * * * 2 0.6013 (2 7.51) * * * 0.0923 (3.72) * * * 2 0.3203 (2 5.27) * * * 2 0.0721 (2 4.60) * * * 2 0.0673 (2 6.08) * * * 11.68 * * * 0.2527 2 0.0172 (2 2.57) * * 0.0024 (1.16) 2 0.0333 (2 2.75) * * * 0.0146 (0.57) 0.0278 (0.55) 0.0564 (1.16) 0.1562 (0.59) 2 0.1467 (2 1.25) 0.2030 (0.57) 2 0.1158 (2 1.11) 1.1326 (8.88) * * * 0.0539 (1.15) 0.0038 (0.73) 8.44 * * * 0.2380 1,073 2 0.3746 (2 4.21) * * * 0.9224 (3.77) * * * 2 0.1311 (2 2.91) * * * 2 0.3904 (2 4.35) * * * 0.0098 (0.68)

Intercept 2 0.0805 (2 0.60) 2 0.0235 (2 0.17) PARTEN-SHORT 2 0.0364 (2 1.55) PARTEN 0.0102 (1.68) * PARTEN-LONG 2 0.0479 (2 0.94) AUDTEN 2 0.0034 (2 0.99) 2 0.0033 (2 0.95) FIRMAGE 0.0001 (0.62) 0.0007 (0.72) LNSIZE 0.0091 (1.40) 0.0093 (1.43) INDGROW 0.0023 (0.14) 0.0011 (0.07) BIGFIVE 0.0018 (0.07) 2 0.0036 (2 0.14) ROA 0.0738 (5.63) * * * 0.0734 (5.60) * * * ROAPLUS 2 0.2954 (2 2.76) * * * 2 0.2924 (2 2.74) * * * OCF 0.0484 (0.86) 0.0545 (0.97) OCFPLUS 2 0.3971 (2 2.79) * * * 2 0.4072 (2 2.86) * * * ACC 2 0.1203 (2 3.59) * * * 2 0.1192 (2 3.56) * * * ACCPLUS 0.9383 (15.07) * * * 0.9352 (15.01) * * * ISSUE 2 0.0371 (2 1.48) 2 0.0379 (2 1.51) LEV 0.0062 (1.67) * 0.0063 (1.70) * F-value 9.30 * * * 9.09 * * * R 2-adj 0.1303 0.1299 Number of observations 2,495 2,495

Notes: *, * * and * * * indicate signicance at the 10, 5, and 1 percent levels, respectively. All coefcients are based on two-tailed tests. To keep the presentation brief,

coefcient estimates for the 19 industry (INDDUM) and 12 year (YEARDUM) dummy variables are not presented Variable denitions: DACCR, raw signed value of discretionary accruals; DACCR , positive value of discretionary; DACCR2 , negative value of discretionary accruals; 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 if partner tenure (PARTEN) is greater than six years P and 0 otherwise; PN AUDTEN, audit PN rm tenure; FIRMAGE, length of years since the ASX listing year; LNSIZE, natural log of total assets measured in dollars; INDGROW: N i1 Salesi;t 2 i1 Salesi;t21 = i1 Salesi;t21 by 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 if ROA is greater than or equal to zero; OCF, cash ow 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, total accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less than zero and ACC if ACC is greater than or equal to zero; ISSUE, indicator variable which is 1 if the number of shares outstanding is increased more than 10 percent and 0 otherwise; and LEV, total liabilities divided by total assets; INDDUM, industry indicator variables; and YEARDUM, year indicator variables

Table IV. Regression results using signed/positive/negative jDACCRj

(B) Model B DACCR coefcient (t-value) (C) Model A DACCR coefcient (t-value) (D) Model A DACCR 2 coefcient (t-value) (E) Model B DACCR coefcient (t-value) (F) Model B DACCR 2 coefcient (t-value)

(A) Model A DACCR coefcient (t-value)

from the same or a different audit rm at the time of initial engagement. This discussion forms the basis for H4 stated in the null form: H4. There is no difference in the association between client managers accounting discretion and audit PARTEN when the incoming and outgoing audit partners are from the same audit rm (audit partner rotation) versus when the incoming and outgoing audit partners are from different audit rms (audit rm rotation). To our existing dataset we add rm-year observations relating to audit rm changes during our sample period. Specically, we identify all cases where an audit rm was changed by a client rm during our sample period and compute the new audit partners tenure beginning with the rst year the audit rm was changed. The additional observations included in the dataset have the property that in each case AUDTEN is equal to audit PARTEN as a change in audit rm will result in a change in the partner signing the audit opinion. Next, for these observations we obtain jDACCRj and all of the control variables discussed earlier. We then estimate Models C and D below using a pooled dataset, allowing the intercepts and coefcients on audit PARTEN to vary depending on whether the new audit partner was from the same or a different audit rm as the outgoing partner. Finally, we use an F-test to determine whether we can reject that the different coefcients on audit PARTEN are equal across both groups. Our pooled data set has 1,162 additional rm-year observations representing 384 client rms that changed audit rms during our sample period. The following regression models are used to test H4: . Model C: jDACCRjit a021 SAMEit a022 DIFFit b121 PARTEN SAMEit b122 PARTEN DIFFit b2 AUDTEN SAMEit b3 FIRMAGEit b4 LNSIZEit b5 INDGROWit b6 BIGFIVEit b7 ROAit b8 ROAPLUSit b9 OCFit b10 OCFPLUSit b11 ACCit X b12 ACCPLUSit b13 ISSUEit b14 LEVit a INDDUMkit k k X a YEARDUMlit 1it l l
.

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Model D: jDACCRjit a021 SAMEit a022 DIFFit b121 PARTENSHORTSAMEit b122 PARTENSHORTDIFFit b123 PARTENLONGSAMEit b124 PARTENLONGDIFFit b2 AUDTENSAMEit b3 FIRMAGEit b4 LNSIZEit b5 INDGROWit b6 BIGFIVEit b7 ROAit b8 ROAPLUSit b9 OCFit b10 OCFPLUSit b11 ACCit b12 ACCPLUSit b13 ISSUEit b14 LEVit X X a INDDUM a YEARDUMlit 1it k kit k l l

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where, SAME, indicator variable 1 if the auditor is from the same audit rm as the outgoing partner and 0 otherwise; DIFF, indicator variable 1 if the auditor is from a different audit rm as the outgoing partner and 0 otherwise; PARTEN-SAME, indicator variable which is equal to PARTEN if the auditor is from the same audit rm as the outgoing partner and 0 otherwise; PARTEN-DIFF, indicator variable which is equal to PARTEN if the auditor is from a different audit rm as the outgoing partner and 0 otherwise; PARTEN-SHORT-SAME, indicator variable which is 1 if PARTEN is less than three years and the new audit partner is from the same rm 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 audit partner is from a different rm 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 audit partner is from the same audit rm 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 different audit rm as the outgoing partner and 0 otherwise; AUDTEN-SAME, indicator variable which is equal to AUTEN if the auditor is from the same audit rm as the outgoing partner and 0 otherwise. All other variables are as dened 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 (a different) audit rm as the outgoing partner. The coefcients on PARTEN-SAME (PARTEN-DIFF) are statistically signicant at the 1 (5) percent level. Results shown in Table V, Column B indicate that during the initial years of audit PARTEN, absolute jDACCRj increase when the new audit partner is from a different audit rm as the outgoing partner, whereas they decrease when a new audit partner is from the same audit rm as expected. Specically, the coefcient on PARTEN-SHORT-DIFF (PARTEN-SHORT-SAME) is positive (negative) and statistically signicant at the 10 (5) percent level. F-tests reject the equality of the coefcients on PARTEN-SAME and PARTEN-DIFF (F-value 12.87, p 0.000) and those on PARTEN-SHORT-DIFF and PARTEN-SHORT-SAME (F-value 6.26, p 0.012). As PARTEN lengthens, however, we do not nd a signicant relation of audit PARTEN with absolute jDACCRj. Coefcients on PARTEN-LONG-DIFF and PARTEN-LONG-SAME are statistically insignicant[31]. Similar to Myers et al. (2003), we re-estimated the models omitting observations in the extreme (top and bottom) 0.5 percent of ROA (measured by year and industry) to control for the possibility that the association between audit PARTEN and ACC is the result of extreme nancial performance early in the auditors tenure. For the non-extreme ROA sub-sample, our results on tenure for income-increasing ACC are generally consistent with the results in Table IV, columns C and E. In addition, eliminating the extreme observations does not improve the statistical signicance of PARTEN or PARTEN-SHORT with the income-decreasing jDACCRj. Thus, we conclude that our main results are not driven by extreme performance. Conclusion Our paper examines the association between audit PARTEN and client managers accounting discretion. Prior US research indicates that lengthy AUDTEN is associated

Variables SAME DIFF PARTEN-SAME PARTEN-DIFF PARTEN-SHORT-SAME PARTEN-SHORT-DIFF PARTEN-LONG-SAME PARTEN-LONG-DIFF AUDTEN-SAME FIRMAGE LNSIZE INDGROW BIGFIVE ROA ROAPLUS OCF OCFPLUS ACC ACCPLUS ISSUE LEV F-value R 2-adj Number of observations 3,657

(A) Model C coefcient (t-value) 0.5662 (4.58) * * * 0.5957 (4.92) * * * 0.0171 (2.61) * * * 2 0.0231 (2 2.48) * *

(B) Model D coefcient (t-value) 0.6534 (5.22) * * * 0.5173 (4.23) * * *

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2 0.0519 (2 2.03) 0.0546 (1.58) * 0.0017 (0.03) 2 0.0096 (2 0.11) 2 0.0105 (2 2.84) * * * 0.0011 (1.28) 2 0.0239 (2 3.93) * * * 0.0073 (0.47) 0.0143 (0.63) 0.0037 (1.06) 2 0.0404 (2 0.46) 2 0.5325 (2 12.49) * * * 0.8391 (7.23) * * * 2 0.0066 (2 0.41) 0.2355 (7.76) * * * 0.0393 (1.82) * 0.0046 (1.48) 19.89 * * * 0.2053

2 0.0110 (2 2.98) * * * 0.0011 (1.21) 2 0.0234 (2 3.85) * * * 0.0081 (0.52) 0.0167 (0.73) 0.0036 (1.04) 2 0.0375 (2 0.44) 2 0.5367 (2 12.61) * * * 0.8473 (7.32) * * * 2 0.0067 (2 0.41) 0.2352 (7.76) * * * 0.0391 (1.81) * 0.0045 (1.45) 20.89 * * * 0.2070

Notes: *, * * and * * * indicate signicance at the 10, 5, and 1 percent levels, respectively. All except PARTEN-SHORT related coefcients are based on the two-tailed tests (the expected sign of PARTEN-SHORT-SAME (PARTEN-SHORT-DIFF) is negative (positive)). To keep the presentation brief, coefcient estimates for the 19 industry (INDDUM) and 12 year (YEARDUM) dummy variables are not presented Variable denitions: SAME, indicator variable 1 if the auditor is from the same audit rm as the outgoing partner and 0 otherwise; DIFF, indicator variable 1 if the auditor is from a different audit rm as the outgoing partner and 0 otherwise; PARTEN-SAME, indicator variable which is equal to PARTEN if the auditor is from the same audit rm as the outgoing partner and 0 otherwise; PARTEN-DIFF, indicator variable which is equal to PARTEN if the auditor is from a different audit rm as the outgoing partner and 0 otherwise; PARTEN-SHORT-SAME, indicator variable which is 1 if PARTEN is less than three years and the new audit partner is from the same rm 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 audit partner is from a different rm 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 audit partner is from the same audit rm 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 different audit rm as the outgoing partner and 0 otherwise; AUDTEN-SAME, indicator variable which is equal to AUTEN if the auditor is from the same audit rm as the outgoing partner and 0 otherwise; FIRMAGE, length of years LNSIZE, natural log of total assets measured in dollars; PN listing year; PN P since the ASX INDGROW: N i1 Salesi;t 2 i1 Salesi;t 21 = i1 Salesi;t 21 by 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 if ROA is greater than or equal to zero; OCF, cash ow 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, total accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less than zero and ACC if ACC is greater than or equal to zero; ISSUE, indicator variable which is 1 if the number of shares outstanding is increased more than 10 percent and 0 otherwise; and LEV, total liabilities divided by total assets

Table V. Pooled regression results using absolute jDACCRj

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with higher audit quality. This research, however, has not examined how audit PARTEN impacts audit quality. It treats an audit rm with long tenure and frequent audit partner rotation the same as an audit rm with long tenure and infrequent audit rm rotation. In contrast, we separate the impact of audit PARTEN and audit rm tenure on audit quality. Using a sample of Australian rms we examine the effects on audit quality from audit partner changes within the same audit rm. We conjecture that when the new audit partner is from the same audit rm as the outgoing audit partner, audit quality increases because the new audit partner brings fresh eyes to the engagement. However, when the new audit partner is from a different audit rm as the outgoing partner, the client managers accounting discretion increases in those initial years because the new partner faces a very steep learning curve regarding the clients operations. Our results conrm these conjectures. We nd that in the initial years of tenure of a new audit PARTEN client managers accounting discretion decreases (increases) when the new partner is from the same (a different) audit rm as the outgoing partner. These results suggest that audit partner rotation increases audit quality during the initial years on the engagement while audit rm rotation decreases audit quality in those initial years. Our ndings also indicate that as audit PARTEN increases client managers accounting discretion also increases. These results are consistent with audit partner judgment being impaired as tenure on an engagement become lengthy. Together, these results suggest that fresh skeptical eyes from within the same audit rm need to be brought into an engagement to ensure that high-audit quality is maintained. While our study provides support for the recent legislation restricting the length of audit PARTEN in the US it should also be of interest to other 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 rms from requiring audit partner rotation are not examined in this study[33]. Without a cost-benet analysis, we cannot draw denite conclusions on the merits of regulatory policy requiring audit partner rotation. Second, our sample consists only of rms that voluntarily changed audit partners on the engagement. Caution is needed in generalizing these results to a regime with mandatory audit partner rotation. Third, our sample spans a relatively short time-period of 14 years. While our tests provide strong evidence that short-tenured audit partners are associated with higher audit quality than medium tenured audit partners from the same audit rm, our ability to examine the effects of long-tenured audit partners on audit quality was constrained by data availability. Although we conduct several sensitivity tests to increase condence in our test result, we cannot completely eliminate concerns about the skewness in audit PARTEN data that is present in our sample[34]. As new databases continue to become available to researchers, future studies can potentially provide more insights on the relationship between PARTEN and audit quality 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 as the Metcalf Report which recommended mandatory auditor rotation. In response to the Metcalf Report, the AICPAs Cohen Commission issued its own report in 1978 arguing that mandatory rm rotation would be too costly to implement. In recent years, following high-prole scandals, the issue of auditor rotation has resurfaced. See GAO (2003) for a discussion of the history of the auditor rotation debate.

2. Among those opposed to mandatory auditor rotation is former SEC Chairman (Senate Report 107-205 2002), Hills, who testied that a change of auditors can only lower the quality of audits and increase their costs. 3. Effective July 7, 2004, the GAOs legal name became the Government Accountability Ofce. 4. An audit partner is dened as a partner who is a member of the audit engagement team who has decision-making responsibility on signicant auditing, accounting and reporting matters that affect nancial statements or who maintains regular contact with the management and audit committee. The denition also includes the lead and concurring partners and partners who serve the company at the company level (other than a partner who consults with others on the audit engagement team regarding technical or industry-specic issues) and the lead partner on subsidiaries of the issuer whose assets or revenues constitute 20 percent or more of the consolidated assets or revenues of the company. 5. Unlike the case of audit rm rotation, Sarbanes-Oxley did not direct the SEC or the GAO to study 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 rms, the AICPA (1992) has taken the position that audit quality increases with auditor tenure and that mandatory rotation will impair audit quality. Changing auditors can also be costly for client-rms. Client-managers worry about the new auditor having industry 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 quality control review letters for audits conducted by the Audit Division of the Texas Education Agency between 1984 and 1989. 9. Boards of directors and CFOs of client rms are also interested in having a smooth transition from one engagement partner to the next and may require their audit rm to have transition processes in place. 10. The quality of an audit is also possibly more directly impacted by the accounting expertise of the partner-in-charge of the audit than by the audit rm engaged by the client. 11. Using US survey data, Trompeter (1994) nds that audit partners with compensation closely tied to client retention were less likely to require downward adjustments to their clients net income. 12. Other incentives that may be present for an audit partner to benet directly from his/her relationship to the client include opportunities for consulting with the client, the possibility of being hired as the clients CFO in the future, etc. Some of these arrangements are now prohibited by the Sarbanes-Oxley Act (2002). 13. A cost-benet analysis would be required before one can draw denite conclusions on whether audit partners should be rotated. 14. This statement assumes that when a new audit rm is engaged, the partner on the audit is also new (i.e. the new partner is not the same as the predecessor audit partner from the predecessor audit rm). 15. Indeed, if audit rms do not rotate partners or do so infrequently, their results could imply that lengthy audit partner tenure (audit rm tenure serving as a proxy) increases audit quality. 16. The following model is used to compute DACCR: 1 DSALES 2 DAR PPE a1 a2 e TA21 TA21 TA21

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ACCR a0

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17.

18.

19.

20.

21.

22.

23.

24. 25.

where ACCR is total accruals deated by total assets at the beginning of the year (TA2 1); total accruals are measured as the difference between earnings before extraordinary items and net cash ow from operations; AR is accounts receivable; PPE is property, plant, and equipment. The model is separately estimated for each industry and year. DACCR is the estimated residual of the above model. Alternative proxies for DACCR suggested by Jones (1991), Kasznik (1999) and Klein (2002) were also used and similar results were obtained. Our primary interest is not to measure the effect of audit rm tenure on accounting discretion. Our sample selection procedures are intended to obtain data for rms where audit partner tenure (not audit rm tenure) could be measured accurately. This also implies that we discarded some observations where audit rm tenure could be computed accurately but complete data were not available to compute audit partner tenure. US studies (Myers et al., 2003; Ghosh and Moon, 2005) compute US audit rm tenure by assuming that the rst year of auditor tenure is the rst year the audit-rm name was disclosed on COMPUSTAT. However, unlike COMPUSTAT which has been providing this information since 1974, the database used in this study, DatAnalysis, has only provided adequate coverage from 1990. Coverage of Australian rms by DatAnalysis has become more comprehensive in recent years. Prior to 1990, coverage was limited to a few hundred rms. There is no other database available that readily identies signing partners for publicly traded Australian rms during this period. The effect of Professional Statement F1 on our tests is minimal. Our sample includes 13 client-rms whose partner tenure was seven years as of the end of 2003. Six of these did not switch their audit partners in 2004. There are additional 14 observations where the signing partner tenure was longer than seven years in 2003. These clients were audited by small audit rms likely to qualify for an exemption, or a delayed transition, to the rotation requirements in Professional Statement F1. As a check for sensitivity we excluded these observations from the sample; our conclusions were unchanged. Coverage on DatAnalysis for some rms is not complete. A rm may be covered by DatAnalysis in a certain year, dropped in the next year, and then covered again a few years later. For this rm, collecting data on partner names would not result in any usable observations in our tests; as explained later we would not be able to compute audit partner tenure for these rms. For this reason, we used the above screen, namely that rms have at least three years of consecutive data. For example, if the rst audit partner change for a rm occurred in 1996 (i.e. the signing partner in 1996 was different from the previous signing partner), we would code 1996 as the new partners rst 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 the predecessor audit partner rst joined the engagement from DatAnalysis. These 2,299 observations representing 569 rms are used later as a base set for the control sample for comparison with our main sample. Owing to nancial data being unavailable for this sub-sample we were left with 1,525 rm-year observations representing 439 rms. Firm-year observations belonging to nance, investment, property trusts, and insurance industries were also discarded. These procedures left us with 1,162 rm-years representing 384 rms for our comparison analyses. The Aspect database, like its US counterpart COMPUSTAT, covers nancial statement data for publicly traded rms in Australia. 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

26.

27. 28.

29. 30.

31.

32.

33.

34.

we examine changes in audit quality for a sub-sample of long-tenured partners and nd that our conclusions are not changed. While our method of measuring partner tenure (combined with a short sample period) results in a sample consisting of a majority of partners with tenure of less than three years, this does not invalidate our test results. Our method assures that partner tenure is accurately measured for each partner. After controlling for all known factors that affect discretionary accruals, our tests allow us to compare discretionary accruals for rms with short-tenured partners with those of medium and long-tenured auditors. We also conduct sensitivity tests where we examine changes in audit quality for a sub-sample of long-tenured partners and nd that our conclusions are not changed. Dropping one or both of these variables does not change our conclusions. The weaker results on raw signed discretionary accruals are also consistent with ndings of Johnson et al. (2002). Myers et al. (2003) also cautions against using raw discretionary accruals to proxy for earnings management. Similar phenomenon has also reported in Myers et al. (2003). Our results in Table III also show that as audit rm tenure increases audit quality increases. However, the sample used for these tests is restricted to observations with changes in signing auditor within the same audit rm. The tests in this section are designed to measure audit rm tenure more accurately. We could not reject the equality of the coefcients on PARTEN-LONG-DIFF and PARTEN-LONG-SAME (F-value 0.01, p 0.911). This result is similar to ndings in Johnson et al. (2002) who report that long audit-rm tenure is not statistically signicantly associated with reduced absolute discretionary accruals but short audit rm tenure is statistically signicantly associated with high absolute discretionary accruals. The European Union, for example, is currently considering proposals to limit audit partner and audit rm tenure, www.cfo.com/article.cfm/3011703/c_3042499?f TodayInFinance_ Inside. Australia has adopted mandatory rotation of employees who play a signicant role in the audit for more than ve out of seven years (CLERP 9, 2004). Costs include direct costs for training new audit partners about the client companys operations resulting in higher audit costs. Some audit rms with a small number of audit partners may nd it impossible or difcult to rotate partners and may have to give up some business. There is a cost to having fewer audit rms in the profession if audit partner rotation forces some audit rms to exit the business. The US rules provide relief to audit rms with fewer than ve SEC registrants and less than ten partners (SEC, 2003). For example, to increase condence in our sample that audit partner rotation increases audit quality in the initial years, we compare discretionary accruals of rms with short-tenured audit partners from the same audit rm with those of client rms with short-tenured auditors from a different audit rm.

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