chi et al - 2011 - the effects of audit partner pre-client and client-specific experience on earnings quality and on perceptions of audit quality

The Effects of Audit Partner Pre-Client and Client-Specific Experience on Earnings Quality and on Perceptions of Audit Quality SUMMARY: We examine the effects of auditors‘ pre-client an

The Effects of Audit Partner Pre-Client and Client-Specific Experience

on Earnings Quality and on Perceptions of Audit Quality

Wuchun Chi Department of Accounting National Chengchi University Taipei, Taiwan Email: wchi@nccu.edu.tw

Linda A Myers Department of Accounting University of Arkansas Fayetteville, Arkansas 72701 Email: lmyers@walton.uark.edu

Thomas C Omer Department of Accounting Texas A&M University College Station, Texas 77843 Email: tomer@mays.tamu.edu

Hong Xie Von Allmen School of Accountancy University of Kentucky Lexington, Kentucky 40506 Email: hongxie98@uky.edu

November 2011

We thank Brian Bratten, Monika Causholli, Guojin Gong, Ole-Kristian Hope, Yue Li, Linda McDaniel, James Myers, Robert Ramsay, Steven Salterio, Marjorie Shelley, Shui-Liang Tung, Chung-Fern Wu, Minlei Ye, David Ziebart, participants at the 2nd Symposium of China Journal of Accounting Research, the 2010 CAPANA

Conference, and the 2011 European Accounting Association conference, as well as workshop participants at National Taiwan University and at the University of Kentucky for helpful comments and suggestions Wuchun Chi gratefully acknowledges the financial support from National Science Council (Project No NSC 94-2416-H-004- 036) Linda Myers gratefully acknowledges financial support from the Garrison/Wilson Chair at the University of Arkansas Thomas Omer gratefully acknowledges financial support from Ernst & Young Hong Xie gratefully acknowledges financial support from the Von Allmen Research Support endowment and the PWC fellowship endowment at the University of Kentucky

The Effects of Audit Partner Pre-Client and Client-Specific Experience

on Earnings Quality and on Perceptions of Audit Quality

SUMMARY: We examine the effects of auditors‘ pre-client and client-specific experience on

earnings quality and on perceptions of audit quality for both public and private companies using audit data from Taiwan, where the names of signing audit partners are disclosed and both public and large private companies are required to publish audited financial statements We use discretionary accruals to proxy for earnings quality and the bank loan interest rate spread to proxy for creditor perceptions of audit quality We find that for public companies, an audit partner‘s pre-client experience enhances earnings quality, but the effect of pre-client experience

on earnings quality is smaller than that of client-specific experience, suggesting a transition cost

in terms of earnings quality associated with mandatory auditor rotation For private companies,

we find some evidence that pre-client experience improves earnings quality and that specific experience improves earnings quality, thus extending our understanding of the benefits

client-of audit partner and audit firm tenure from public to private companies Finally, we find that both pre-client experience and client-specific experience improve creditor perceptions of audit quality for both private and public companies Our findings are important because they reveal the effects of more finely parsed measures of auditor experience (tenure) on earnings quality and

on creditor perceptions of audit quality for both public and private companies Our study is timely in light of the Public Company Accounting Oversight Board‘s 2011 call for comments on mandatory auditor rotation In addition, our findings provides evidence consistent with the beliefs underlying the Public Company Accounting Oversight Board‘s proposal to disclose the name of the engagement partner in the audit report – that the disclosure of the engagement audit

partner could provide useful information to investors

Keywords: Audit partner experience; Auditor rotation; Earnings quality; Audit quality

Data Availability: Data are available from public sources identified in the text

INTRODUCTION

The effect of auditor tenure on earnings quality and on perceptions of audit quality has been the focus of intense debate and research in the recent accounting literature Prior studies using U.S data measure auditor tenure at the audit firm level (e.g., Myers et al 2003; Mansi et al 2004) while studies using non-U.S data measure auditor tenure at the audit partner level (e.g., Carey and Simnett 2006; Chen et al 2008) As such, these studies examine the effects of

auditors‘ client-specific experience, as captured by audit firm tenure and/or audit partner tenure,

on earnings quality and on various measures of the cost of debt (which proxies for creditor

perceptions of audit quality) These studies generally find that longer tenure is associated with higher earnings quality and with a lower cost of debt (so higher perceived audit quality)

However, an audit partner‘s pre-client experience (the number of years as the signing partner for

other clients prior to the current client) can also play an important role, especially when clients experience audit firm or audit partner turnover, and whether pre-client experience affects

earnings quality and/or perceptions of audit quality is unexplored in the extant literature

Studying the effect of pre-client experience is important and timely because of ongoing arguments for and against audit partner (and audit firm) rotation that center on the potential detriments associated with longer tenure, as well as the potential benefits from bringing a ―fresh look‖ to the audit engagement The issue of mandatory auditor rotation is once again in the spotlight with the 2011 Public Company Accounting Oversight Board (PCAOB) call for

comments on their concept release proposing mandatory audit firm rotation (Cohn 2011a; Cohn 2011b).1 A more complete analysis of the issues surrounding mandatory audit firm rotation should include a consideration of whether the pre-client experience of an incoming audit partner compensates for the loss of client-specific experience of an outgoing partner While the benefits

1 Also see ―Accounting board to seek comments on rotating auditors‖ in the New York Times (August 17, 2011).

and detriments to audit quality from long (audit firm and audit partner) tenure have been tested in numerous studies in the U.S and international settings, the benefits of an incoming audit

partner‘s pre-client experience are unexplored.2

Thus, our focus on the effects of an audit partner‘s pre-client experience can add to the discussion of the relative costs and benefits of an incoming partner‘s ―fresh look.‖ Moreover, our examination of an audit partner‘s pre-client and client-specific experience can also shed light on the potential benefits of recent PCAOB concept releases that call for disclosure of an audit partner‘s identity in the audit report (PCAOB 2009; PCAOB 2011)

In this paper, we examine the effects of auditors‘ pre-client and client-specific experience

on earnings quality and on creditor perceptions of audit quality using samples of public and private companies in Taiwan.3 Unlike in the U.S., audit reports in Taiwan contain not only the audit opinion and audit firm name but also the names of the two signing audit partners In

addition, large private companies were required, like public companies, to file and publish their audited financial statements before 2002 These distinctive features of the Taiwanese audit market allow us to develop a more complete set of auditor experience measures than are

examined in prior literature In particular, we measure the audit partner‘s pre-client experience

for both public and private companies as the cumulative number of years from the first year that the auditor became a signing partner for any company to the first year that he became a signing partner for the current client Our client experience measures allow us to estimate the potential impact on earnings quality and on perceptions of audit quality of an incumbent audit partner‘s

2

Studies that address audit firm tenure address the potential benefits of a ―fresh look‖ to some extent but do not consider pre-client experience of the incoming audit partner Thus, we argue that studying the effects of a ―fresh look‖ at the audit firm level may be necessary but not sufficient

3

Public companies are those whose shares are traded on the Taiwan Stock Exchange Corporation or on the GreTai Securities Market, which are analogous to the New York Stock Exchange and National Association of Securities Dealers Automated Quotation System, respectively, in the U.S Private companies are those whose shares are not listed (publicly traded) on any stock exchange

client-specific experience and of a successor audit partner‘s pre-client experience Results using our pre-client experience measure suggest that the level of auditor pre-client experience is likely

to be important under a mandatory rotation system

Our measures of the audit partner‘s client-specific experience differ somewhat between

public and private companies For public companies, we separate audit partner tenure, and audit firm tenure, into two periods: (1) the period before the company‘s initial public offering (IPO); and (2) the period after the IPO Specifically, we measure the cumulative number of years in which the audit partner audited the company while it was still private, as well as the cumulative number of years in which the audit partner audited the company once it had gone public We label the former pre-listing audit partner tenure and the latter post-listing audit partner tenure

We define pre-listing audit firm tenure and listing audit firm tenure similarly Our listing audit partner tenure and post-listing audit firm tenure measures correspond to audit

post-partner tenure and audit firm tenure in prior studies (e.g., Chen et al (2008) and Myers et al (2003), respectively) but our pre-listing audit partner tenure and pre-listing audit firm tenure measures are not examined in prior literature For private companies, we use audit partner tenure (i.e., the cumulative number of years that the auditor has been a signing partner in the current client-partner relationship) and audit firm tenure (i.e., the number of consecutive years that the current client-firm relationship has existed) as our measures of client-specific experience

We address several research questions in this paper First, we investigate the effect of auditors‘ pre-client experience (taking into account the effect of client-specific experience) on earnings quality and on creditor perceptions of audit quality for public companies An implicit

assumption underlying mandatory audit partner rotation is that the incoming audit partner‘s lack

of client-specific experience can be alleviated by his client experience so that when this

pre-client experience is coupled with (presumably) enhanced auditor independence, mandatory partner rotation enhances earnings quality and perceptions of audit quality Zerni (2011) finds that perceptions of higher audit quality associated with individual partners‘ industry

specialization (even after controlling for audit firm industry specialization) influence audit fees for industry specialist auditors He suggests that audit partner identity is important to the

market‘s perceptions of ex ante audit quality However, whether pre-client experience enhances

earnings quality (and is as effective as client-specific experience in enhancing earnings quality)

or affects perceptions of audit quality is unexplored in the extant literature.4 Our findings can shed light on these important issues

Second, we examine the effects of pre-listing audit partner tenure and pre-listing audit firm tenure on earnings quality and on creditor perceptions of audit quality for public companies Here, we examine whether client-specific experience accumulated over the years during which a public company was still private can benefit the auditor‘s work for that company once it has gone public This also allows us to test whether market pressures faced by public companies affect auditor oversight The effects of pre-listing experience on earnings quality and on creditor perceptions of audit quality are also unexplored in the literature

Finally, we also examine the effects of auditors‘ pre-client experience (taking into

account the effect of client-specific experience) on earnings quality and on creditor perceptions

of audit quality for private companies Although private companies make up a large portion of the economy and audit firms do much of their work for private clients (especially those seeking debt financing), little is known about the financial reporting practices of private companies (Hope and Langli 2010; Chen et al 2011) and very little of the extant literature provides

4 The extant literature provides evidence that client-specific experience as captured by audit firm tenure (e.g., Myers

et al (2003)) or as captured by audit partner tenure (e.g., Chen et al (2008) and Chi et al (2011)) is important for earnings quality However, it does not consider the effect of pre-client experience

evidence about how auditor experience affects earnings quality or creditor perceptions of audit quality (and hence the cost of debt) for private companies The exception is Chi et al (2011) In concurrent work, Chi et al (2011) use samples of public and private Taiwanese companies to investigate whether client importance, measured at the audit partner level, impairs auditor

independence.5 Although their variable of interest is partner-level client importance, they control for audit partner tenure but they do not consider the effect of audit firm tenure so the incremental effect of audit partner tenure cannot be determined In addition, they do not separately

investigate the effects of pre-client experience and do not study creditor perceptions of audit quality (cost of debt) Thus, our study contributes to the literature because extant literature has not examined the effects of pre-client experience and audit partner tenure, after controlling for audit firm tenure, on the earnings quality of private companies, nor the effects of pre-client and client-specific experience on creditor perceptions of audit quality for private companies

Following a long line of research (e.g., Chen et al 2008; Francis and Yu 2009; Prawitt et

al 2010; among others), we measure earnings quality using performance-adjusted, modified Jones model-estimated discretionary accruals For public companies, we find that pre-client experience reduces the magnitude (i.e., the absolute value) of discretionary accruals and

constrains extreme negative discretionary accruals (but not extreme positive discretionary

accruals) Regarding client-specific experience, we find that pre-listing partner tenure constrains the magnitude of discretionary accruals as well as extreme negative discretionary accruals Pre-listing audit firm tenure also constrains extreme negative discretionary accruals.6 Our post-

5

Chi et al (2011) measure client importance measure as the natural logarithm of client sales divided by the sum of the natural logarithm of sales for all of the audit partner‘s clients They proxy for auditor independence using performance-adjusted discretionary accruals, the auditor‘s propensity to issue modified audit opinions, and the client‘s probability of meeting or just beating earnings benchmarks

6 Note that previous studies using samples of public companies find that audit firm tenure constrains both positive and negative accruals but these studies do not consider pre-listing experience (i.e., they consider only post-listing experience)

listing partner tenure and post-listing firm tenure results are consistent with those in Chen et al (2008) in that earnings quality tends to increase in both post-listing partner tenure and post-

listing firm tenure Finally, our tests suggest that the effect of pre-client experience on earnings quality is smaller than that of client-specific experience This implies that the loss of the

outgoing partner‘s client-specific experience cannot be fully compensated for by the incoming

partner‘s non-client-specific experience in a mandatory audit partner rotation regime

For private companies, we find that greater pre-client experience reduces extreme

positive discretionary accruals but does not affect the magnitude of discretionary accruals or negative discretionary accruals This finding is somewhat similar to our findings for public companies in that greater pre-client experience enhances earnings quality but for public

companies we find a constraint on absolute and negative rather than positive accruals In

addition, we find that for private companies, discretionary accruals become less extreme and that both negative and positive discretionary accruals are constrained as audit partner tenure increases, consistent with Chi et al (2011) We also find that discretionary accruals become less extreme and positive discretionary accruals are constrained as audit firm tenure increases Finally,

similar to our findings for public companies, we find that for private companies, the effect of pre-client experience on earnings quality is smaller than that of client-specific experience so the

loss of the outgoing partner‘s client-specific experience cannot be fully compensated for by the

incoming partner‘s non-client-specific experience

Similar to Mansi et al (2004), we use bank loan pricing to proxy for creditor perceptions

of audit quality, and use this proxy for both public and private companies.7 For public

companies, we find a negative association between pre-client experience and the bank loan

7 Mansi et al (2004) study the relation between audit firm tenure (equivalent to our post-listing audit firm tenure) and the cost of debt for public companies in the U.S

interest rate spread, suggesting greater perceived audit quality with increased pre-client

experience In addition, the interest rate spread is lower for all of our measures of client-specific experience—pre-listing audit partner tenure, pre-listing audit firm tenure, post-listing audit partner tenure, and post-listing audit firm tenure For private companies, we find that pre-client experience and client-specific partner tenure lower the interest rate spread However, we find no incremental effect of client-specific audit firm tenure on the interest rate spread Finally, for both public and private companies, we find that the effect of pre-client experience on creditor perceptions of audit quality is indistinguishable from that of client-specific experience

We conjecture that our measures of pre-client experience and client-specific experience affect creditor perceptions of audit quality for both public and private companies because

creditors in our study (who are primarily Taiwanese banks) likely have greater confidence in audit partners with more auditing experience, regardless of whether that experience is

accumulated with the current client or with prior clients

Our study contributes to the auditing literature by examining the effects of a more

complete set of auditor experience measures (both pre-client and client-specific) on earnings quality and on perceptions of audit quality for both public and private companies Our

examination of these effects for private companies is among the first in the literature We also contribute to the auditing literature by separating perceptions of the audit quality associated with

the audit partner versus the audit firm We document that pre-client experience has an

incremental positive impact on earnings quality and on perceptions of audit quality but its effect

on earnings quality is smaller than the effect of client-specific experience This implies a net transition cost associated with mandatory audit partner rotation, although the transition cost is decreasing in audit partner pre-client experience Moreover, we document that client-specific

experience accumulated at the audit partner and audit firm levels during the years in which a public company was still private (i.e., the pre-listing audit partner tenure and pre-listing audit firm tenure) has an incremental positive impact on earnings quality and on perceived audit quality, even after controlling for client-specific audit partner tenure and audit firm tenure

following the client‘s IPO

These findings have a number of implications First, prior studies suggest that mandatory partner rotation does not enhance earnings quality (Chi et al 2009) or is unlikely to enhance earnings quality (Chen et al 2008) Our findings imply that using an incoming audit partner with greater pre-client experience to replace the outgoing audit partner (who has greater client-

specific experience) can partially, albeit not fully, mitigate the detrimental effects on earnings

quality of audit partner rotation Second, on July 28, 2009, the PCAOB issued a concept release seeking public comments on its proposal to require that the engagement audit partner sign the audit report.8 On October 11, 2011, the PCAOB issued a new proposal for public comment that would require the engagement partner‘s name be disclosed in the audit report, making the

engagement partner‘s name readily available to audit report users.9 Underlying the Board‘s position is a belief that audit partner disclosure identity ―would increase transparency about who

is responsible for performing the audit, which could provide useful information to investors‖ (PCAOB 2009, 5) Our finding that creditors in Taiwan perceive audit quality to be higher when audit partners with more experience sign financial statements provides evidence consistent with the Board‘s belief

8 This is consistent with actions in foreign countries For example, in 2006, the European Union (EU) issued the Eighth Company Law Directive, which requires member states, under Article 28, to adopt a mandate requiring the engagement audit partner to sign the audit report In addition, proposals requiring mandatory audit firm are

currently being discussed in the EU (see ―EU to propose audit-only firms and mandatory rotation‖ in Accountancy Age (September 26, 2011))

9 See ―PCAOB proposes disclosure of engagement partner name‖ in Accounting Today (October 11, 2011) and PCAOB Proposes Amendments to Improve Transparency through Disclosure of Engagement Partner and Certain Other Participants in Audits at http://pcaobus.org/News/Releases/Pages/10112011_OpenBoardMeeting.aspx

Our findings supplement those in Ball and Shivakumar (2005) and Burgstahler et al (2006).10 These papers, among others, find that the financial reporting quality of private

companies is lower than that of public companies presumably due to a lower demand for

financial statement quality for private companies relative to public companies Our results suggest that the earnings quality of private companies, as well as that of public companies, is increasing in auditor experience Thus, auditor experience can mitigate the financial reporting quality problems inherent in private companies

Our findings also supplement those in Kim et al (2011) and in Minnis (2011) Using a sample of private Korean companies, Kim et al (2011) find that the cost of debt capital is lower for companies with voluntary audits than for companies without voluntary audits (although whether the audits are performed by Big 4 auditors or by non-Big 4 auditors has no effect on the cost of debt) Similarly, Minnis (2011) find that the cost of debt is significantly lower for U.S private companies whose financial statements are voluntarily audited than U.S private

companies whose financial statements are not audited In contrast, we find that for large private Taiwanese companies whose financial statements were mandatorily audited before 2002, auditor characteristics such as pre-client experience, client-specific experience, and audit firm size (i.e., Big 4 auditors) are negatively associated with the cost of debt

10 Ball and Shivakumar (2005) argue that although private companies in the United Kingdom (U.K.) are subject to essentially the same regulatory provisions as U.K public companies, the market for financial reporting differs substantially between private and public companies because private companies are less likely to use financial statements in contracting with lenders and other stakeholders In addition, their financial reporting is more likely to

be influenced by taxation, dividend policy, and other company policies These differences imply a lower demand for financial statement quality (and hence, lower earnings quality) for private companies relative to public

companies Consistent with this, Ball and Shivakumar (2005) find that U.K public companies practice more timely loss recognition than do U.K private companies Similarly, using a variety of earnings management metrics Burgstahler et al (2006) document that in the European Union, private companies are more likely than public companies to manage earnings

In the next section, we review the prior literature and develop our hypotheses This is followed by sections that describe our sample selection, and our empirical models and results The final section concludes

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

Numerous studies investigate the relation between audit firm tenure and earnings quality

in the U.S setting These studies use discretionary accruals (Johnson et al 2002; Myers et al 2003), restatements (Stanley and DeZoort 2007), and fraudulent financial reporting (Carcello and Nagy 2004) to proxy for earnings quality Studies investigating the relation between audit firm tenure and perceptions of audit quality include Mansi et al (2004), which uses the cost of debt financing to proxy for creditor perceptions of audit quality, and Ghosh and Moon (2005), which uses earnings response coefficients to proxy for investor perceptions We focus on discretionary accruals because this proxy for earnings quality is available for both private and public

companies in our sample, and we focus on bank loan pricing because this proxy for perceptions

of audit quality is available for both private and public companies in our sample

The basic argument in these studies revolves around claims made by supporters of

mandatory audit firm rotation—that long auditor tenure leads to complacency over time and, thus,

to a reduction in audit quality and earnings quality, and around counter-arguments made by opponents of mandatory audit firm rotation—that mandatory rotation imposes costs on the audit process that result in reduced audit quality and earnings quality in the early years of the audit engagement.11 Overall, results of archival studies in the U.S setting provide no evidence of a

11

Objections to mandatory firm rotation from public accounting firms emphasize the positive role of auditor

experience For example, in recent letter to the PCAOB, Ernst and Young LLP states, ―Experience with and

knowledge of the personalities and technical abilities of the entity‘s various employees helps inform audit planning and may prompt increased skepticism in specific areas of the audit (or, in some instances, about certain members of

deterioration of earnings quality with longer audit firm tenure However, a limitation of these studies is that they cannot take into account the contemporaneous effect of audit partner tenure because audit partner identity is not publicly available in the U.S

Several studies in international settings consider the joint effects of audit firm tenure and audit partner tenure, or consider the effects of audit partner tenure in isolation For example, Carey and Simnett (2006) use Australian data to investigate whether audit partner tenure is associated with the auditor‘s propensity to issue a going-concern audit opinion to distressed companies, the direction and amount of abnormal working capital accruals, and the propensity to just beat earnings benchmarks They do not find an association between long partner tenure and abnormal working capital accruals, but they find a lower propensity to issue going-concern opinions and some evidence that clients are more likely to just beat earnings benchmarks when partner tenure is long Overall, their results suggest, at least in the Australian audit market, that long partner tenure tends to reduce earnings quality They acknowledge, however, that the diminution in earnings quality is generally confined to clients of non-Big 5 audit firms

Prior research using samples of public companies in the Taiwanese setting provides conflicting results regarding the effects of audit partner tenure and audit firm tenure on

discretionary accruals In early work, Chi and Huang (2005) find that the association between both audit partner tenure and audit firm tenure and signed discretionary accruals is negative when tenure is five years or less, but that it becomes positive when tenure exceeds five years However, they do not consider the absolute value of discretionary accruals nor do they examine positive and negative discretionary accruals separately, which Myers et al (2003) reveal to be management)‖ (see

http://www.ey.com/Publication/vwLUAssets/CommentLetter_BB2219_FirmRotation_18November2011/%24FILE/ CommentLetter_BB2219_FirmRotation_18November2011.pdf).

important for determining the effect of long tenure In later work, Chen et al (2008) use the absolute value of performance-adjusted discretionary accruals as well as positive and negative accruals to proxy for earnings quality They find that absolute and positive discretionary

accruals decrease with partner tenure, and that absolute discretionary accruals decrease with audit firm tenure (after controlling for audit partner tenure)

As noted previously, an important assumption underlying mandatory audit partner

rotation is that the incoming partner‘s lack of client-specific experience can be alleviated by his pre-client experience However, this implicit assumption has not been tested empirically in the extant literature because although prior studies investigate the effects of audit partner tenure and audit firm tenure (i.e., client-specific experience), they do not address the effects of audit partner pre-client experience Given prior findings that the signing partner‘s lack of client-specific experience adversely affects earnings quality (Chen et al 2008), it is important to investigate the extent to which the signing partner‘s pre-client experience impacts earnings quality and

perceptions of audit quality

We suggest that signing partner pre-client experience likely impacts earnings quality because auditor experience can improve error or misstatement detection (Tubbs 1992;

Hammersley 2006) and can reduce auditor reliance on management‘s favorable assessments (Kaplan et al 2008).12 Specifically, Tubbs (1992) investigates how experience changes auditors‘ knowledge of errors and irregularities He finds that more experienced auditors recognize more atypical errors and recall more errors, and suggests that this should improve audit quality; we suggest that it should also improve earnings quality Similarly, Hammersley (2006) finds that

12

Note that one argument advanced as supporting audit partner rotation is that the new auditor is less likely to concede to management pressure for reporting specific financial outcomes and because he brings ‗a fresh set of eyes‘

to the table, and thus is more likely to detect errors than are audit partners who may have become complacent

because of their long tenure

industry experience allows auditors to develop better knowledge structures which allow them to identify misstatements for companies in their industry and to specify the appropriate audit

response even when they receive only partial information about a misstatement Kaplan et al (2008) test whether experience limits auditor reliance on management-provided information when that information is more favorable than an objective benchmark They find that as auditors gain experience, they are more able to deflect management‘s persuasion attempts In addition,

we posit that the experience effects noted above also impact perceptions of the audit quality, and thus, engagement partners with more experience are likely to be perceived as providing higher quality audits

Theoretical and empirical research in a variety of disciplines similarly demonstrates the positive effect of experience on performance Learning-by-doing theory suggests that increased experience reduces the cost of performing a task, resulting in improved performance (Arrow 1962; Anzai and Simon 1979) Empirical studies find that more experienced individuals place greater weight on relevant cues (Brucks 1985), have more highly developed cognitive structures (Chi et al 1981), and search for more information, while focusing on more relevant and more important information (Chiesi et al 1979)

Shelton (1999) and Trotman et al (2005) are also relevant to our hypotheses Shelton (1999) finds that experience reduces the impact that irrelevant information can have on audit judgments, suggesting that signing partners with greater pre-client experience may be better able

to focus on relevant information Moreover, Trotman et al (2005) find that engaging in mock negotiations about financial reporting issues prior to client negotiations improves auditor

negotiation performance, suggesting that signing partner pre-client experience should improve

auditor performance in negotiations with clients, and we suggest that this should improve audit quality.13

In addition, Bonner and Walker (1994) suggest that performance improves only when experience is coupled with feedback Auditors receive feedback on the quality of accruals when future cash flows are realized and whenever prior financial statements are found to be misstated Thus, pre-client experience should improve auditors‘ performance on general auditing tasks However, whether the effect of pre-client experience is equivalent to that of client-specific experience is an empirical issue

Mansi et al (2004) study the effect of audit quality on the cost of debt and find that the costs of debt financing are lower for clients of Big N audit firms and for companies with longer auditor-client relationships This suggests that creditors perceive audit quality to increase in audit firm tenure However, the results in Mansi et al (2004) cannot speak to the relation

between individual audit partner experience (either pre-client experience or client-specific

experience) and perceptions of audit quality (and so the cost of debt) because of data limitations

in the U.S setting We posit that a signing partner with substantial pre-client experience and/or client-specific experience is more likely to be known to creditors in the Taiwanese market, and that, all else equal, an audit partner with more experience will be perceived as a providing higher audit quality

To summarize, we investigate the effects of auditors‘ pre-client and client-specific

experience on earnings quality and on perceptions of audit quality for both public and private companies in Taiwan Our hypotheses, stated in the alternative, are as follows:

H1: Earnings quality is increasing in auditors‘ pre-client and client-specific experience

for public or private companies

H2: Creditor perceptions of audit quality are increasing in auditors‘ pre-client and

client-specific experience for public or private companies

SAMPLE SELECTION

Taiwanese Company Law and the Taiwan Securities and Exchange Act divide limited liability companies into two categories: (1) those that are required to file audited financial statements with the regulatory authority and make these statements available to the general public; and (2) those that are not required to file or publish audited financial statements

Beginning in 1980, the laws in Taiwan required all publicly listed companies (i.e., companies whose stocks are traded publicly on a Taiwanese stock exchange) and privately-held companies whose capital level exceeds a certain threshold to file and publish audited financial statements The threshold was 200,000,000 New Taiwan Dollars (TWD) until 2000 but it was increased to 500,000,000 TWD in 2000 in response to critics‘ concerns that the benefit of requiring large private companies to file and publish audited financial statements may not exceed the cost of compliance However, concerns remained, and on November 12, 2001, the requirement that large private companies file and publish audited financial statements was rescinded Although some large private companies continued to publish audited financial statements after 2001, an increasing number chose to cease publication over time Note, however, that publicly listed companies have been required to file and publish audited financial statements throughout our sample period

In Taiwan, public companies and large private companies are subject to identical

financial reporting requirements and auditing standards The Taiwan Economic Journal (TEJ)

collects financial statement data for both public and large private companies, and also collects stock market data for public companies A company is included in TEJ‘s public company

database for the years during which it is listed on a Taiwanese stock exchange and is included in the TEJ‘s private company database for the years during which it is not traded on a Taiwanese stock exchange If a company changes its type in a year (e.g., from private to public), the TEJ includes that company‘s public years in the public company database and its private years in the

private company database (i.e., it does not retroactively reclassify the company‘s prior years

according to its latest type)

We collect data for 1990 through 2001 from the 2008 TEJ annual database Our sample period starts in 1990, following Chen et al (2008), because companies were initially required to prepare statements of cash flow in that year and we use the statement of cash flow approach to calculate total accruals (Hribar and Collins 2002) Our sample period ends in 2001 because large private companies were no longer required to file and publish audited financial statements after

2001 and because the formal announcement of a new mandatory partner rotation requirement

was made in April 2003, thus affecting audited financial statements (which are not due until four

months after the end of the fiscal year in Taiwan) for 2002 Ending the public companies sample period in 2001 allows us to avoid any potential effects of the adoption of mandatory audit partner rotation on accruals

We initially obtain 5,797 (22,225) company-year observations from 2008 TEJ‘s public (private) company database Consistent with prior studies, we delete 419 (636) observations in the financial services industry In addition, we eliminate 174 (9,492) observations because of missing beginning-of-the-year total assets, cash from operations, growth, and tenure measures for our public (private) companies We also delete 67 (1,606) observations in industries with less

than 8 observations available for calculating discretionary accruals Finally, we delete 718 public company observations in the year of an initial public offering (IPO) because Teoh et al (1998a) and Teoh et al (1998b) find that earnings management patterns differ for IPO firms.14 This provides us with 4,419 (10,491) public (private) company-year observations in our

discretionary accruals sample We use this sample to examine the effects of pre-client

experience and client-specific experience on earnings quality In the next section, we describe how we derive our bank loan pricing sample from this discretionary accruals sample, and we use the bank loan pricing sample to examine the effects of pre-client experience and client-specific experience on creditor perceptions of audit quality

EMPIRICAL MODELS AND RESULTS

In this section, we examine the effects of auditors‘ pre-client and client-specific

experience on earnings quality and on perceptions of audit quality for public and private

companies, respectively We first present our empirical models and results using abnormal accruals to proxy for earnings quality We then present our empirical models and results using bank loan pricing to proxy for creditor perceptions of audit quality

Accrual-based Proxies for Earnings Quality

Variable Measurement and Empirical Model

Prior literature uses various measures of accruals to proxy for earnings quality We follow prior literature and calculate performance-adjusted discretionary accruals using the

following modified Jones (1991) model:15

TAC t = α t (1/TA t–1 ) + β t (∆SALES t – ∆AR t ) + γ t PPE t + ζ t ROA t–1 + ε t (1)

14 Untabulated tests reveal that our results are robust to their inclusion

15 We omit company subscript i for brevity

where:

TAC t = total accruals in year t, calculated using the statement of cash flow approach

recommended by Hribar and Collins (2002) as income before discontinued operations and extraordinary items – (cash from operations – discontinued operations and extraordinary items from the statement of cash flows);

TA t–1 = total assets at the end of year t-1;

∆SALES t = the change in sales revenue between year t and year t-1;

∆AR t = the change in accounts receivable between year t and year t-1;

PPE t = the gross amount of property, plant and equipment at the end of year t; and

ROA t–1 = return on assets in year t-1, calculated as the ratio of income before

discontinued operations and extraordinary items to total assets

TAC t , ∆SALES t , ∆AR t , and PPE t are scaled by lagged total assets (TA t–1) We estimate equation (1) in the cross section in each year (i.e., from 1990 through 2001) for each TEJ industry

classification with at least eight available observations The residuals from equation (1) are our

performance-adjusted discretionary accruals (PADJDA t)

Beginning in 1983, audit reports for both public and large private companies in Taiwan were required to be signed by two audit partners The names of the audit firm and of the two signing partners are disclosed in the audit reports However, the audit report does not indicate which partner is the lead (or review) partner Following Chen et al (2008), we assume that the audit partner whose client-specific tenure is longer has more influence on the audit work, and thus measure partner-related experience variables based on this audit partner

For each observation in our public companies sample, we separate audit partner tenure and audit firm tenure into two parts: the portion during which the company was private and the portion during which the company was public Specifically, we measure the cumulative number

of years during which the partner audited the current public company from 1983 or the year of its establishment, whichever is later, to the IPO year and label this pre-listing audit partner tenure

(PreListPT) We then measure the cumulative number of years during which the partner audited

the current public company from the IPO year to the current year and label this post-listing audit

partner tenure (PostListPT) Thus, the total number of years during which the partner audited the current public company is the sum of PreListPT and PostListPT Similarly, we measure the

consecutive number of years during which the audit firm audited the current public company from 1983 or the year of its establishment, whichever is later, to the IPO year and label this pre-

listing audit firm tenure (PreListFT) We then measure the consecutive number of years during

which the audit firm audited the current public company from the IPO year to the current year

and label this post-listing audit firm tenure (PostListFT).16 Thus, the total number of years

during which the audit firm audited the current public company is the sum of PreListFT and PostListFT

To measure pre-client experience for our public companies sample, we trace the audit partner back to 1983 to identify the first year in which this partner became a signing partner for

any company (public or private) We define partner total experience (TotExp) as the cumulative

number of years from this partner‘s first year as a signing partner to the current year We also identify the first year in which this partner was a signing partner for the current company and

define pre-client experience (PreClientExp) as the cumulative number of years from this

partner‘s first year as signing partner for any company to his first year as signing partner for the

current company (so PreClientExp = TotExp – (PreListPT + PostListPT))

For each observation in our private companies sample, we measure the cumulative

number of years during which the partner has been a signing partner for the current company (since 1983 or the year of the company‘s establishment, whichever is later), and define this as

audit partner tenure (PT) We also measure the number of consecutive years that the audit firm has been auditing the current company and define this as audit firm tenure (FT) Finally, we

16 TEJ calculates and provides PreListPT, PostListPT, PreListFT, and PostListFT TEJ calculates audit partner

tenure using the cumulative number of years but audit firm tenure using the consecutive number of years

define partner total experience (TotExp) and partner pre-client experience (PreClientExp) in the same way as for public companies (so PreClientExp = TotExp – PT)

Our measure of client-specific experience differs slightly between public and private

companies For public companies, we use pre-listing audit partner tenure (PreListPT), listing audit partner tenure (PostListPT), pre-listing audit firm tenure (PreListFT), and post- listing audit firm tenure (PostListFT) to measure client-specific experience gained prior to and after the IPO year but for private companies, we use audit partner tenure (PT) and audit firm tenure (FT) to measure client-specific experience In contrast, our measure of pre-client

post-experience (PreClientExp) is the same for both public and private companies

We note several differences between our measures of auditor experience and those used

in prior studies First, pre-client experience is unexplored in the extant literature for both public and private companies Second, Chen et al (2008) and Myers et al (2003) measure audit partner tenure and audit firm tenure for public companies using only the years during which their sample

companies were public, and so their measures correspond to our PostListPT and PostListFT Prior research has not examined the effects of PreListPT and PreListFT on earnings quality or on

perceptions of audit quality Finally, as described previously, Chi et al (2011) control for audit partner tenure when examining the relation between auditor independence and client importance

Their partner tenure variable corresponds to the sum of PreListPT and PostListPT for public companies and to PT for private companies They do not, however, control for audit firm tenure

or examine the effect of pre-client experience on earnings quality or the effect of pre-client and client-specific experience on perceptions of audit quality

In order to examine the effects of pre-client and client-specific experience on earnings quality for public and private companies, respectively, we adapt the model in Chen et al (2008) and use the following models for our analyses

For public companies:

PADJDA = β 0 + β 1 PreClientExp + β 2 PreListPT + β 3 PreListFT+ β 4 PostListPT

+ β 5 PostListFT + β 6 Size + β 7 Growth + β 8 CFO + β 9 BigN + β 10 Age + κYear + μIndustry + δ (2)

For private companies:

PADJDA = α 0 + α 1 Pre-ClientExp + α 2 PT + α 3 FT + α 4 Size + α 5 Growth + α 6 CFO

+ α 7 BigN + α 8 Age + εYear + ζIndustry + ρ (3)

where:

PADJDA = performance-adjusted, modified Jones model-estimated discretionary

accruals, measured in absolute, positive, and negative values in year t;

TotExp = the audit partner‘s total experience for both private and public

companies = the cumulative number of years from the first year in

which the partner became a signing partner for any company to the

current year (t);

PreClientExp = pre-client audit partner experience = the cumulative number of years

from the partner‘s first year as signing partner for any company to his

first year as signing partner for the current company For public

companies, PreClientExp = TotExp – (PreListPT + PostListPT) For private companies, PreClientExp = TotExp – PT

PreListPT = pre-listing audit partner tenure for public companies = the cumulative

number of years (since 1983 or the year of the company‘s establishment, whichever is later) during which the partner audited the current company while it was private, to the IPO year;

PostListPT = post-listing audit partner tenure for public companies = the cumulative

number of years during which the partner audited the current company from its IPO year to the current year (t);

PT = audit partner tenure for private companies = the cumulative number of

years (since 1983 or the year of the company‘s establishment, whichever

is later) during which the audit partner audited the current private company, to the current year (t);

PreListFT = pre-listing audit firm tenure for public companies = the number of

consecutive years (since 1983 or the year of the company‘s establishment, whichever is later) during which the audit firm audited the company while it was private, to the IPO year;