chi et al - 2009 - mandatory audit partner rotation, audit quality, and market perception - evidence from taiwan [mapr]

However,their sample periods are prior to 2003 when partner rotation in Taiwan was voluntary.These studies, thus, do not directly investigate the effect of mandatory audit part-ner rotat

Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan*

WUCHUN CHI, National Chengchi University

HUICHI HUANG, Syracuse University

YICHUN LIAO, National Taiwan University

HONG XIE, University of Kentucky

1 Introduction

Mandatory audit partner rotation has existed in the United States since the 1970s,when the American Institute of Certified Public Accountants (AICPA) required thataudit partners in charge of Securities and Exchange Commission (SEC) audits berotated at least once every seven years The Sarbanes-Oxley Act of 2002 (SOX)further strengthens this requirement by mandating a five-year rotation for the leadand concurring partners An implicit assumption in a policy of mandatory partnerrotation is that such rotation enhances audit quality However, this assumption hasnot been systematically tested in the literature due to the lack of partner informa-tion in U.S audit reports

Unlike in the United States, audit reports in Taiwan contain both audit firmand audit partner names Exploiting this institutional feature, Chen, Lin, and Lin(2008) and Chi and Huang (2005) examine the relation between earnings qualityand partner tenure They find that earnings quality tends to increase in partner tenure,consistent with findings in the United States based on audit firm tenure However,their sample periods are prior to 2003 when partner rotation in Taiwan was voluntary.These studies, thus, do not directly investigate the effect of mandatory audit part-ner rotation on earnings quality or audit quality.1

In this paper, we use audit data in Taiwan, where a five-year audit partner tion became de facto mandatory in 2004, to examine the effectiveness of mandatoryaudit partner rotation in promoting audit quality and perceived audit quality.Inspired by SOX, two principal stock exchanges in Taiwan — Taiwan Stock

rota-* Accepted by Michael Willenborg An earlier version of this paper was presented at the 2005

Chartered Accountants, the Certified General Accountants of Ontario, the Certified agement Accountants of Ontario, and the Institute of Chartered Accountants of Ontario We appreciate valuable comments from Linda Bamber (discussant), Rajib Doogar, Chan-Jane Lin, James Myers, Dan Simunic, Ira Solomon, Theodore Sougiannis, Michael Willenborg (associate editor), two anonymous reviewers, participants at the 2005 Contemporary Accounting Research

Man-Conference, and workshop participants at National Chengchi University and National Taipei versity Professor Chi gratefully acknowledges the financial support from National Science Council (NSC 93-2416-H-004-036).

Uni-360 Contemporary Accounting Research

Exchange Corporation (TWSE) and GreTai Securities Market (GTSM) — adopted

a set of rules in April 2003 that, in effect, require a five-year mandatory partnerrotation.2 These rules became fully effective in 2004 for both semi-annual andannual reports, with 2003 as a transition period (more detail below) We use the

2004 semi-annual reports of Taiwanese companies listed in the Taiwan Economic Journal (TEJ) database for this study Semi-annual reports in Taiwan are audited

no differently from annual reports, and the 2004 semi-annual reports are the first set

of data that reflect the full force of the mandatory partner rotation rule in Taiwan.Following prior studies (e.g., Myers et al 2003), we examine the effect ofmandatory audit partner rotation on audit quality using absolute and signedperformance-matched abnormal accruals (Kothari, Leone, and Wasley 2005) asproxies for audit quality We identify a sample of companies in 2004 whose auditpartners were subject to mandatory rotation within the same audit firm (the manda-tory rotation sample) and compare it with three benchmark samples.3 First, wecompare the mandatory rotation sample with companies in 2004 whose audit part-ners were not subject to mandatory rotation (the nonrotation sample) We find nodifference in audit quality between these two samples Second, we compare themandatory rotation sample with itself one year earlier (2003) (the mandatory rotationsample in the prior year) We find that the audit quality of companies in the manda-tory rotation sample under new audit partners is lower than the audit quality ofthese same companies one year earlier under old audit partners Third, we compareour mandatory rotation sample with companies in years before 2003 whose auditpartners were voluntarily rotated within the same audit firm (the voluntary rotationsample) We again find no difference in audit quality between these two samples

In sum, we find no support for the belief that mandatory audit partner rotationenhances audit quality Our findings are robust to various sensitivity checks.Next, we examine the effect of mandatory audit partner rotation on investorperceptions of audit quality, using the earnings response coefficient (ERC) as aproxy for perceived audit quality (Teoh and Wong 1993; Ghosh and Moon 2005).After controlling for common determinants of the ERC, we find that the ERC ofthe mandatory rotation sample is not significantly different from that of the non-rotation sample or that of the mandatory rotation sample in the prior year, but issignificantly larger than the ERC of the voluntary rotation sample Overall, we find

no consistent support for the belief that mandatory audit partner rotation enhancesinvestor perceptions of audit quality

This paper contributes to the literature on auditor tenure and audit quality Toour knowledge, we are among the first to directly examine the effect of mandatorypartner rotation on audit quality Our findings are inconsistent with the implicitbelief in a mandatory partner rotation policy that such rotation enhances auditquality or perceptions of audit quality Rather, our findings are consistent, in spirit,with findings in the United States that mandatory audit firm rotation may not nec-essarily improve audit quality (Johnson, Khurana, and Reynolds 2002; Myers et al.2003; Ghosh and Moon 2005; Blouin, Grein, and Rountree 2007)

Our findings, however, must be interpreted with caution Our inferences aboutthe effect of mandatory partner rotation on audit quality and perceptions of audit

Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 361quality critically depend on the ability of our accrual-based proxies (abnormalaccruals) and market-based proxy (ERC) to capture audit quality and perceivedaudit quality Although widely used in the accounting literature, both types ofproxies are noisy, which weakens our inferences In addition, our findings, based

on Taiwanese data, may not be generalizable to a post-SOX U.S audit market orother audit markets where mandatory audit partner rotation is adopted, due to insti-tutional differences between Taiwan and those markets We note, however, thataccounting and auditing standards in Taiwan are similar to those in the UnitedStates and that important empirical regularities in the U.S audit market (e.g.,Myers et al 2003) can also be found in Taiwanese audit data (Chen et al 2008).Thus, there are significant similarities between Taiwan and the United States, mak-ing our findings relevant for the U.S audit market

The remainder of the paper is organized as follows Section 2 describes ese regulation of mandatory audit partner rotation Section 3 reviews the literatureand develops hypotheses We describe data and sample selection in section 4 Wepresent empirical models and findings in section 5 and conclude in section 6

Taiwan-2 Mandatory audit partner rotation in Taiwan

Unlike in the United States, where audit reports of public companies show onlyaudit firm names, audit reports in Taiwan show both firm and partner names.4

Again unlike in the United States, where partner rotation every seven years haslong been required, audit partner rotation in Taiwan was entirely voluntary until2003

In April 2003, after the passage of SOX in the United States, TWSE andGTSM, two principal stock exchanges in Taiwan, promulgated two rules that, ineffect, require a five-year mandatory partner rotation First, both stock exchangesamended the procedures for auditing the financial statements of listed companiesand added a clause, stating that if the lead or concurring partner has performedaudit services for a listed company in five consecutive years (applied retroactively),then that company’s financial statements are subject to the stock exchange’s

“substantive review” procedure.5 Specifically, the stock exchange audits financialstatements of a company targeted for substantive review and takes appropriateactions if significant irregularities are found (more below) Second, there was alarge percentage of audit firms with both partners auditing the same client in theprevious four or more years in Taiwan as of 2003 The Taiwanese AccountantsUnion argued that it would be difficult for audit firms, especially small audit firms,

to rotate two partners in the same year In response to this and other concerns, bothstock exchanges postponed the effective time for full implementation of the five-year rule for both audit partners to 2004, with 2003 (annual audits) as a transitionperiod when audit firms were allowed to have one partner, but not both, auditingthe same client for five or more years

After a stock exchange determines that a company’s financial statements aresubject to substantive review, it will request and review audit working papers fromthe audit partners If the exchange finds significant violations of accounting orauditing standards, it will refer the case to relevant government agencies for

362 Contemporary Accounting Research

administrative or punitive actions, which range from reprimand to suspension oflicense or even criminal charges Because the potential punishments are severe, thetwo stock exchanges’ new rules that subject a company’s financial statements tosubstantive review when audited by the same lead or concurring audit partner in therecent five consecutive years, in effect, mandate a five-year rotation for both partners

3 Literature review and hypothesis development

The separation of ownership and control in public companies creates conflicts ofinterest between management and outside stakeholders Due to the conflicts of inter-est and asymmetric information, financial statements prepared by management areaudited by a third party (an auditor) to mitigate agency costs (Watts and Zimmer-man 1986) The value of an audit, however, depends on audit quality, which, inturn, depends on auditor competence and independence (DeAngelo 1981).6 Auditorcompetence and independence thus are critically important to the value or per-ceived value of an audit.7

Mandatory audit partner rotation and audit quality

Mandatory audit partner rotation is adopted or considered in many countries as amechanism to enhance auditor independence and audit quality In the UnitedStates, the AICPA has required partner rotation every seven years since the 1970s.Moreover, SOX section 203 mandates a five-year rotation for the lead and review-ing partners Internationally, mandatory partner rotation is currently practiced inAustralia (Carey and Simnett 2006), Singapore, United Kingdom, France, Spain,the Netherlands, Japan, and Germany, and is being considered in Canada (GeneralAccounting Office [GAO] 2003, Appendix V)

The arguments for and against mandatory partner rotation, to a certain extent,are parallel to those for and against mandatory audit firm rotation and center on thecosts and benefits of the rotation The costs of mandatory partner rotation include(a) increased likelihood of audit failures due to new partners’ lack of client-specificknowledge of risk, operations, and financial reporting practices in the initial years(American Institute of Certified Public Accountants [AICPA] 1992; Pricewater-houseCoopers 2002); and (b) direct increases in costs incurred by both audit firmsand client companies due to the need for the new partner(s) to become familiarwith the client practices The benefits of mandatory partner rotation, on the otherhand, include a “fresh look” by the new partner(s) and enhanced auditor independ-ence.8 The adoption of mandatory partner rotation in the United States and else-where suggests that the regulators believe that the benefits of rotation outweigh thecosts and thus a policy of mandatory partner rotation enhances audit quality How-ever, as we review below, the validity of such a belief has not been tested in theaccounting literature

Literature review

Prior studies often use absolute and signed abnormal accruals as proxies for ings quality or audit quality.9 Abnormal accruals have become an accepted proxyfor earnings management, and thus earnings quality, in the accounting literature

earn-Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 363(e.g., Healy and Wahlen 1999; Kothari 2001) A main justification for also usingabnormal accruals as a proxy for audit quality is that audited financial statementsshould be viewed as a joint outcome from the audit firm and company management(Antle and Nalebuff 1991) — that is, earnings quality as captured by abnormalaccruals is also affected by the audit firm and thus reflects audit quality.

Another justification for using abnormal accruals as a proxy for audit quality

is the large volume of studies documenting a link between abnormal accruals andaudit quality For example, Heninger (2001) documents a positive relation betweenauditor litigation and the level of income-increasing abnormal accruals Menonand Williams (2004) find that companies employing former audit partners as offic-ers or directors (“the revolving door”) report larger signed and unsigned abnormalaccruals Richardson, Tuna, and Wu (2002) show that earnings restatements arepositively related to various accrual measures Finally, many studies use abnormalaccruals as a metric to gauge audit quality differential between, for example, Big 6and non–Big 6 auditors (Becker et al 1998) and between auditors with and with-out industry expertise (Krishnan 2003)

Using accrual-based proxies for audit quality, recent studies have examinedthe relation between audit firm tenure and audit quality For example, Johnson et al.(2002) document that short audit firm tenure of two to three years is associatedwith lower-quality financial reporting relative to medium (four to eight years) orlong (nine or more years) tenure Similarly, Myers et al (2003) find a positive rela-tion between audit quality and audit firm tenure

Several recent studies examine the relation between audit partner tenure andaudit quality For example, using data from Australia, where partner information ispublicly disclosed and when partner rotation was voluntary, Carey and Simnett(2006) find a diminution in audit quality, as proxied by the propensity to issuegoing-concern opinions and the incidence of just beating (missing) earningsbenchmarks, for long partner tenure In contrast, using data from Taiwan whenpartner rotation was voluntary, Chen et al (2008) find that audit quality, as measured

by absolute abnormal accruals, increases with partner tenure after controlling foraudit firm tenure On the other hand, Chi and Huang (2005) find that audit quality,

as proxied by signed abnormal accruals, initially increases but starts to decrease aspartner tenure exceeds five years when they examine the effect of partner tenurealone on earnings quality.10 After including audit firm tenure in regression analy-ses, they find that audit quality initially increases in audit firm tenure but starts todecrease as firm tenure exceeds five years but the coefficients on partner tenure andpartner tenure squared are both insignificant

Recent studies also use market-based measures, such as the cost of debt andthe ERC, as proxies for investor perceptions of audit quality For example, Mansi

et al (2004) find a significantly negative relation between the cost of debt and auditfirm tenure, suggesting that audit firm tenure enhances audit quality.11 Similarly,Ghosh and Moon (2005) use the ERC as a proxy for investor perceptions of auditquality and find a positive association between perceived audit quality and auditfirm tenure

364 Contemporary Accounting Research

Hypotheses

To summarize, recent studies on audit firm tenure suggest that audit qualityincreases with firm tenure, consistent with a “learning curve” for new auditors andthe critical importance of client-specific knowledge and experience, which canonly be acquired over time with the client, for producing a high-quality audit.Recent studies on audit partner tenure, however, produce conflicting evidenceregarding the relation between partner tenure and audit quality Importantly, allthese studies examine the relation between auditor tenure (firm or partner) andaudit quality under voluntary rotation regimes and, thus, do not directly examinethe effect of mandatory partner rotation on audit quality Because the incentivesand behavior of auditors may change significantly under a mandatory rotationregime, relative to a voluntary rotation regime, whether prior findings under a vol-untary audit firm or partner rotation regime can be generalized to a mandatoryaudit firm or partner rotation regime is ultimately an empirical question (Johnson

et al 2002, 640; Myers et al 2003, 796; Ghosh and Moon 2005, 588; Carey andSimnett 2006, 674) In brief, the extant literature has not examined the effect ofmandatory audit partner rotation on audit quality and has not tested the validity

of the implicit belief that mandatory audit partner rotation enhances audit quality

We examine the effect of mandatory audit partner rotation on audit quality andperceptions of audit quality using audit data from Taiwan under the mandatorypartner rotation regime We formulate the following two hypotheses (stated inalternative form) based on the implicit assumption in a mandatory partner rotationpolicy:

HYPOTHESIS 1 The audit quality of companies whose audit partners are datorily rotated is higher than the audit quality of companies whose audit partners are not required to rotate.

man-HYPOTHESIS 2 Investor perceptions of audit quality of companies whose audit partners are mandatorily rotated are higher than investor percep- tions of audit quality of companies whose audit partners are not required

to rotate.

4 Sample selection and data

Data for this study are collected from the 2004 semi-annual TEJ database for panies listed on TWSE or GTSM We identify a sample of companies in 2004whose audit partners (at least one of them) were subject to mandatory rotation(MROTA sample) and another sample of companies in 2004 whose partners (both

com-of them) were not required to rotate (NROTA sample) using the following procedure.First, we identify 1,022 companies in 2002 (annual data) from the TEJ databaseafter excluding three Taiwan depository receipts (TDR) because semi-annual finan-cial statements of TDRs are only reviewed rather than audited.12 We delete 21companies with missing audit partner information and three companies with non-calendar fiscal year-ends We thus obtain a preliminary sample of 998 companies

in 2002

Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 365Second, we trace audit partners of these 998 companies in past years up to

2002 and find 832 companies with at least one partner who had performed auditservices for the same client for at least four consecutive years by the end of 2002and 166 companies with both partners who had performed audit services for thesame client for less than four consecutive years by 2002 We classify the 832 com-panies into our mandatory rotation sample (MROTA), because at least one auditpartner is subject to rotation either for the 2003 annual audits or 2004 semi-annulaudits.13 On the other hand, we classify the 166 companies identified above intothe nonmandatory rotation sample (NROTA) because none of their audit partners issubject to mandatory rotation for the 2004 semi-annual audits

Third, we trace audit partners of companies in our MROTA and NROTA ples to years 2003 – 4 to determine whether they are rotated for 2004 semi-annualreports We lose additional companies for the following reasons in the MROTA(NROTA) samples: (a) 30 (7) companies due to delisting; (b) 78 (not applicable)companies due to their changing audit firms during 2003 and 2004;14 (c) 109 (0)companies because one audit partner was rotated off in 2003 but came back in2004;15 (d) 1 (0) company because both audit partners were rotated off in 2003 but

sam-at least one came back in 2004; (e) 15 (0) companies for which one audit partnershould have been rotated in 2004 but was not rotated; (f ) 28 (0) companies forwhich both audit partners should have been rotated in 2004 but only one audit part-ner was rotated; (g) 18 (23) companies in financial industries whose accruals aredifficult to interpret; (h) 54 (9) companies with missing data for tracing audit firmtenure; and (i) 6 (2) companies due to our requirement of at least eight observa-tions to estimate abnormal accruals for each industry-year combination using themodified Jones 1991 model The above process generates 493 (125) companies inour MROTA and NROTA samples, respectively Table 1, panel A summarizes thesample selection process

To test our hypotheses, we compare the MROTA sample with three marks The first benchmark is the nonrotation sample (NROTA) described above.The second benchmark is the mandatory rotation sample itself in the prior year(MBEFR sample) MBEFR and MROTA samples thus contain exactly the samecompanies, but semi-annual financial statements of MBEFR sample were auditedunder the old audit partners in 2003, whereas those of the MROTA sample wereaudited under new audit partners (at least one) in 2004 The third benchmark is thevoluntary rotation (VROTA) sample described below

bench-The sample selection process for our VROTA sample is summarized in Table 1,panel B Specifically, we identify companies before 2003 for which at least onepartner was voluntarily rotated within the same audit firm We want to haveroughly the same number of observations in VROTA as in MROTA, and need only

go back to 1999 because we already identified 638 company-year observations by

1999 We delete 77 observations in financial institutions, 41 observations due tomissing audit firm tenure, and 7 observations due to fewer than eight companies intheir industry classifications in a year The final VROTA sample consists of 513company-year observations

366 Contemporary Accounting Research

5 Empirical models and findings

In this section, we examine the effect of mandatory audit partner rotation on auditquality and investor perceptions of audit quality We first present the empiricalmodel and findings using accrual-based proxies for audit quality, and then theempirical model and findings using the market-based proxy for perceived auditquality

Accrual-based proxies for audit quality

Variable measurement and empirical model

Johnson et al (2002) and Myers et al (2003) use the Jones 1991 model-estimatedabnormal accruals as proxies for audit quality We use the modified Jones modelTABLE 1

Sample selection

Companies on TWSE or GTSM in 2002 from the TEJ database

Less

Less

Companies rotating one audit partner in 2003 but the audit

Companies rotating both audit partners in 2003 but one of

Companies rotating both audit partners in 2003 but both

Companies should rotate both audit partners but rotated

Companies with less than eight observations in a

(The table is continued on the next page.)

Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 367

(Dechow, Sloan, and Sweeney 1995) to estimate abnormal accruals and then do

performance matching according to Kothari et al (2005) because they demonstrate

that performance-matched abnormal accruals capture earnings management better

than do traditional Jones model-estimated abnormal accruals

Specifically, we first estimate raw abnormal accruals (MJAbnA) as the

residu-als from the modified Jones model below (company subscript i is omitted except in

places where doing so causes confusion):

TAC t/TA t 1t(1/TA t 1) t(SALES t/TA t 1AR t/TA t 1)

t(PPE t/TA t 1)  t (1),where

TAC t  total accruals in the first half of year t, calculated using the statement

of cash flow approach recommended by Hribar and Collins 2002

 income before discontinued operations and extraordinary items  (cash

from operations  discontinued operations and extraordinary items

from the statement of cash flows);

SALES t  change in sales revenue between the first half of year t and the first

Observations with missing data for tracing

Observations with fewer than eight companies in

Note:

audit partners within the same audit firm, that company is still included in the

NROTA sample because the switch of audit firm or rotation of audit partners is

not required by the mandatory partner rotation rule.

Number of companies

Cumulative company-year observations

368 Contemporary Accounting Research

AR t  change in accounts receivable between the first half of year t and the

first half of year t 1;

PPE t  gross amount of property, plant, and equipment at the end of the first

half of year t; and

TA t  1  total assets at the end of year t  1 (i.e., total assets at the beginning

of the first half of year t).

We estimate (1) in the cross-section in each year (from 1999 to 2004) for each TEJ

industry classification with at least eight observations using all companies with

required data in the TEJ database

We then do performance matching based on current-period return on assets

(ROA t ) Specifically, for each company i (i

year combination in year t, we find another company j, where j i, among the

remaining companies (n  1) in the same industry-year combination whose return on

assets (ROA jt ) is closest to that of company i (ROA it) Our performance-matched,

modified Jones model-estimated abnormal accruals (PMMJAbnA) for company i in

year t are the difference in raw abnormal accruals between companies i and j.

After obtaining PMMJAbnA for all companies with required data in the TEJ

database during 1999–2004, we keep only company-year observations in our

man-datory rotation sample (MROTA) and three benchmark samples (NROTA,

MBEFR, and VROTA)

Following Myers et al 2003, we examine the effectiveness of mandatory audit

partner rotation in promoting audit quality using the following regression model:

Acc    1BMK  2Age  3Size  4IndGrw  5CFO  6Big4

 7FTenure  (2),where

Acc  performance-matched abnormal accruals (PMMJAbnA), measured in

absolute, positive, and negative values;

BMK  a dummy variable equal to 1 if observations are from one of the three

benchmark samples (NROTA, MBEFR, or VROTA), and equal to 0

otherwise;

Age  number of years since the company was listed;

Size  natural logarithm of total assets at the end of the first half of year t;

IndGrw industry growth



by the TEJ industry classification, and t and t  1 refer to the first half

of years t and t  1, respectively;

Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 369

CFO  cash from operations from the statement of cash flows for the first half

of year t, scaled by total assets at the end of year t  1;

Big4  a dummy variable equal to 1 if the auditor is from a Big 4 or Big 5

audit firm, and equal to 0 otherwise;16 and

FTenure audit firm tenure, measured as the number of consecutive years since

1988 that the company has retained the audit firm.17

We estimate (2) in each of the three comparison samples: MROTA versusNROTA, MROTA versus MBEFR, and MROTA versus VROTA We first estimate(2) over a comparison sample using the ordinary least squares (OLS) method whenthe absolute value of accruals (PMMJAbnA) is the dependent variable We then estimate (2) over truncated subsamples, PMMJAbnA

respectively, using the maximum likelihood method when the truncated signedvalue of accruals is the dependent variable where OLS would bias coefficient esti-mates toward zero (see Myers et al 2003)

Our variable of primary interest is BMK Hypothesis 1 predicts a positive coefficient on BMK when using PMMJAbnA as the dependent variable and a positive (negative) coefficient on BMK for the positive (negative) PMMJAbnA sub-

sample in a truncated regression In other words, our first hypothesis predicts thataccruals are more extreme (and thus audit quality is lower) for the benchmark sample

(i.e., BMK  1), relative to the mandatory rotation sample (i.e., BMK  0).

We include several control variables for other known determinants of accruals

in (2), based on Myers et al 2003 and other prior studies First, we include Age to

control for changes in accruals over a company’s life cycle (Anthony and Ramesh

1992) and expect accruals to become less extreme as a company’s age increases Second, we include Size to control for a size effect and expect accruals for larger

companies to be less extreme (Watts and Zimmerman 1986) Third, we include

IndGrw to control for a potentially positive effect of industry growth on a

com-pany’s accruals However, Myers et al show a mixed relation between accruals and

IndGrw Therefore, we do not predict the sign for IndGrw Fourth, we include CFO

to control for a negative relation between accruals and cash from operations(Dechow 1994) On the basis of findings in Myers et al., we expect a negative coef-

ficient on CFO Fifth, we include Big4 to control for prior findings that Big 4 or

Big 5 audit firms tend to be more conservative and tend to limit their clients’

extreme accruals However, Myers et al find mixed results for Big4 and, thus, we

do not predict the sign for Big4 Finally, we include FTenure to control for the

effect of audit firm tenure on accruals and expect accruals to be less extreme forcompanies with longer firm tenure (Johnson et al 2002; Myers et al 2003)

Empirical findings based on performance-matched abnormal accruals

To mitigate the potential undue influences of extreme values, we winsorize

PMMJAbnA, Age, Size, IngGrw, and CFO at the top and bottom 1 percent of their

respective distributions.18 Descriptive statistics for variables in (2) are reported inTable 2 First, we compare the MROTA sample with the NTOTA sample The

370 Contemporary Accounting Research

(The table is continued on the next page.)

Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 371

mean PMMJAbnA for the MROTA sample is 0.063, whereas that for the NROTA sample is 0.068 A two-tailed t-test suggests that the difference of 0.005 is insignif-

icantly different from zero In addition, a two-tailed nonparametric Wilcoxon z-test

suggests that the median PMMJAbnA for the MROTA sample is insignificantly

different from that for the NROTA sample Thus, univariate comparisons of themean and median PMMJAbnA suggest that audit quality of the mandatory rota-

tion sample is indifferent from that of the nonrotation sample, failing to supportHypothesis 1 Turning to other variables, the differences in means and medians

between MROTA and NROTA samples are all insignificant except for Big4 and

FTenure The mean Big4 for the MROTA sample is 0.826, whereas that for the

NROTA sample is 0.744 A two-tailed t-statistic suggests that the difference of

0.082 is significant at the 0.1 level We indicate this significance by placing

a ‡ sign on the mean Big4 for the NROTA sample without reporting the specific

t-statistic As for FTenure, the mean and median for the MROTA sample are both

significantly larger than their counterparts for NROTA.19

Second, we compare the MROTA sample with itself one year earlier (MBEFR)

We find that the mean, but not the median, PMMJAbnA for the MROTA sample is

TABLE 2 (Continued)

Notes:

Variables are defined as follows:

PMMJAbnA  absolute performance-matched abnormal accruals;

IndGrw  industry growth



firm, and equal to 0 otherwise; and

FTenure  number of consecutive years since 1988 that the company has retained the

audit firm.

sample significant at the 0.01 level using a two-tailed t-test (Wilcoxon z-test).

sample significant at the 0.05 level using a two-tailed t-test (Wilcoxon z-test).

sample significant at the 0.10 level using a two-tailed t-test (Wilcoxon z-test).

372 Contemporary Accounting Research

significantly larger (i.e., the audit quality is lower) than that for the MBEFR ple.20 Third, we find no significant differences in the mean and median PMMJAbnA

sam-between the MROTA and VROTA samples Both findings are inconsistent withHypothesis 1

Next, we examine the effect of mandatory audit partner rotation on audit ity in a multivariate setting using (2) Table 3, panel A reports our findings usingabsolute abnormal accruals (PMMJAbnA) as the dependent variable First, we find that the coefficient on BMK is insignificant (0.001, t  0.166) in the “MROTAversus NROTA” column This suggests that PMMJAbnA (i.e., audit quality) is

qual-indistinguishable between our mandatory rotation sample and the nonrotationsample, after controlling for common determinants of abnormal accruals in (2).21

Second, the coefficient on BMK is significantly negative ( 0.010, t  2.750) in

the “MROTA versus MBEFR” column This suggests that the audit quality of panies subject to mandatory rotation in 2004 under new audit partners is lower thanthe audit quality of these same companies one year earlier under old partners

com-Third, the coefficient on BMK is insignificant in the “MROTA versus VROTA”

col-umn (0.002, t  0.521), suggesting that the audit quality of the mandatory

rotation sample is not different from that of the voluntary rotation sample

TABLE 3

Performance-matched abnormal accruals and mandatory audit partner rotation

(The table is continued on the next page.)

MROTA versus NROTA

MROTA versus MBEFR

MROTA versus VROTA

Mandatory Audit Partner Rotation, Audit Quality, and Market Perception 373Following Myers et al 2003, we also estimate (2) for positive and negativeabnormal accruals separately.22 We report our findings from the truncated regres-sions in Table 3, panels B and C First, for income-increasing accruals (panel B),

the coefficient on BMK is significantly negative ( 0.022, t  1.756) for the

“MROTA versus MBEFR” column, suggesting that new audit partners in the MROTAsample constrain extremely positive accruals to a smaller extent than old auditpartners in the MBEFR sample Second, for income-decreasing accruals (panel C),

the coefficient on BMK is significantly positive (0.066, t  1.998) for the “MROTAversus MBEFR” column, again suggesting that new audit partners in the MROTAsample constrain extremely negative accruals to a smaller extent than do old auditpartners in the MBEFR sample Both findings suggest that the audit quality ofcompanies subject to mandatory rotation under new audit partners is lower than theaudit quality of these same companies one year earlier under old audit partners.Third, the audit quality of the mandatory rotation sample is indistinguishable fromthat of the nonrotation sample (the “MROTA versus NROTA” column) and the vol-untary rotation sample (the “MROTA versus VROTA” column), as indicated by

insignificant coefficients on BMK in Table 3, panels B and C.

(The table is continued on the next page.)

MROTA versus NROTA

MROTA versus MBEFR

MROTA versus VROTA

374 Contemporary Accounting Research

In sum, we have two major findings in Table 3 First, the audit quality of themandatory rotation sample is indistinguishable from the audit quality of the non-rotation sample and the voluntary rotation sample Second, the audit quality ofcompanies in the mandatory rotation sample under new audit partners is lower thanthe audit quality of these same companies one year ago under old audit partners.Chen et al (2008) document that audit quality is positively related to auditpartner tenure under the voluntary rotation regime in Taiwan The essence of Chen

et al 2008, Johnson et al 2002, and Myers et al 2003 is that client-specific edge and experience, as captured by the length of audit partner or audit firm tenure,

Variable definitions: BMK is a dummy variable equal to 1 if observations are from one of the

three benchmark samples (NROTA, MBEFR, or VROTA), and equal to 0 otherwise Other variables are as defined in Table 2.

panel A and a two-tailed z-statistic (in brackets) in panels B and C.

panel A and a two-tailed z-statistic (in brackets) in panels B and C.

panel A and a two-tailed z-statistic (in brackets) in panels B and C.

MROTA versus NROTA

MROTA versus MBEFR

MROTA versus VROTA