cameran et al - 2013 - are there adverse consequences of mandatory auditor rotation - evidence from the italian experience

Since rotation is costly and earnings quality improves with longer auditor tenure, the evidence from Italy does not support the case for mandatory rotation.. Since rotation is costly and

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Behavioral Research in Accounting • Current Issues in Auditing Journal of Emerging Technologies in Accounting • Journal of Information Systems

Journal of International Accounting Research Journal of Management Accounting Research • The ATA Journal of Legal Tax Research

The Journal of the American Taxation Association

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Are There Adverse Consequences of Mandatory Auditor Rotation?

Evidence from the Italian Experience

by

Mara Cameran*, Jere R Francis**, Antonio Marra*, and Angela Pettinicchio*

*Bocconi University, Italy

**University of Missouri, USA

Draft Date: October 10, 2013

Contact Author:

Jere Francis

Email: francis@missouri.edu

SUMMARY: Mandatory auditor rotation was recently proposed for the European Union and is

also under consideration in the United States There has been little research into either the benefits or costs of rotation in a true mandatory setting that could inform intelligent policy making Our paper helps fill this gap by examining Italy where mandatory rotation of auditors has been required since 1975 We find that outgoing auditors do not shirk on effort (or quality), but final year fees are 7 percent higher than normal which may indicate opportunistic pricing The fees of incoming auditors are discounted by 16 percent even though they have abnormally higher engagement hours in the first year (17 percent), which is suggestive of low balling However, subsequent fees are abnormally higher and exceed the initial fee discount Thus the costs of mandatory rotation are nontrivial Higher costs could be acceptable if rotation improves audit quality, but we find evidence of the opposite Namely, the quality of audited earnings is lower in the first three years following rotation, relative to later years of auditor tenure Since rotation is costly and earnings quality improves with longer auditor tenure, the evidence from Italy does not support the case for mandatory rotation

Keywords: auditor rotation, audit fees, earnings quality, audit market regulation

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Are There Adverse Consequences of Mandatory Auditor Rotation?

Evidence from the Italian Experience

SUMMARY: Mandatory auditor rotation was recently proposed for the European Union and is

also under consideration in the United States There has been little research into either the benefits or costs of rotation in a true mandatory setting that could inform intelligent policy making Our paper helps fill this gap by examining Italy where mandatory rotation of auditors has been required since 1975 We find that outgoing auditors do not shirk on effort (or quality), but final year fees are 7 percent higher than normal which may indicate opportunistic pricing The fees of incoming auditors are discounted by 16 percent even though they have abnormally higher engagement hours in the first year (17 percent), which is suggestive of low balling However, subsequent fees are abnormally higher and exceed the initial fee discount Thus the costs of mandatory rotation are nontrivial Higher costs could be acceptable if rotation improves audit quality, but we find evidence of the opposite Namely, the quality of audited earnings is lower in the first three years following rotation, relative to later years of auditor tenure Since rotation is costly and earnings quality improves with longer auditor tenure, the evidence from Italy does not support the case for mandatory rotation

Keywords: auditor rotation, audit fees, earnings quality, audit market regulation.

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Are There Adverse Consequences of Mandatory Auditor Rotation?

Evidence from the Italian Experience

an auditor could be re-appointed The Commission has the legal authority to issue a directive requiring auditor rotation, which would then be implemented by each member country However, due to the broad reach of the proposal, including European-wide licensing and supervision of auditors, the Commission has chosen to implement these reforms through a statutory regulation which must be approved by the European Parliament This approach would impose stronger obligations on member countries to comply with auditor rotation as regulations are immediately effective in each member state without the need to be approved by the separate national parliaments of each European Union country On April 24, 2013, the Legal Affairs Committee approved a proposal for a 14-year rotation rule However, the full European Parliament has not yet acted on the recommendation

The United States is also considering mandatory audit firm rotation In June 2011, James Doty, Chairman of the PCAOB suggested that rotation might be a desirable way to strengthen auditor independence and objectivity (Doty 2011) The PCAOB followed this up with a background paper on August 16, 2011 (PCAOB 2011) This document invited public comment through December 14, 2011, with public hearings on March 21-22, June 28, and October 18,

2012 No further action has been taken However, on July 8, 2013, the U.S House of

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Representatives approved a bill that would ban mandatory rotation The bill must yet be passed

by the U.S Senate, and signed by the President, to become law

The case for mandatory rotation rests on two assertions (European Commission 2011, p 3; PCAOB 2011, pp 11-12):

1 The Problem: auditors with long tenure can develop close relationships with clients that

2 The Solution: a periodic change of auditors will bring a fresh perspective to the audit, leading

to more skepticism, greater auditor objectivity, and improved audit quality

While the idea of rotation has intuitive appeal, the European Commission does not cite empirical evidence or make rigorous arguments, nor did the Commission’s earlier “Green Paper” (2010) Instead, the case for rotation is supported by anecdotal assertions like the following: “Situations where a company has appointed the same audit firm for decades seems incompatible with desirable standards of independence” (European Commission 2010, p 11) The PCAOB (2011) presents a more balanced discussion of benefits and potential negative consequences of rotation, but it too relies entirely on anecdotes to make the case for mandatory rotation For example, the PCAOB report (p 12) cites John Biggs, then CEO of the pension fund TIAA-CREF, who asserts

“… auditor rotation is a ‘powerful antidote’ to auditor conflict of interests, which reduces dramatically the financial incentives for the audit firms to placate management.” On p 15, the report also cites concerns of the PCAOB’s Investor Advisory Group: “Key to concern of independence was the level of ‘coziness’ the firm had with management of the company being audited Many of the auditors of large companies had long running audit relationships with those companies.”

1 The alleged independence threat arising from close relations with clients is termed self-serving bias by Bazerman

et al (1997) Self-serving bias means that auditors are unable to conduct fully impartial and objective audits because their self-interest is closely tied to clients The bias operates at both a conscious and unconscious level, which leads Bazerman et al (1997) to conclude that it is impossible for auditors to be independent This is a strong claim and has been refuted by Nelson (2006) and King (2002)

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As is clear from the above quotes, at the heart of the case for mandatory rotation is the belief that “bad things” can happen when auditors have long tenure While there is only limited research in true mandatory settings, there is a large body of research on audit firm tenure in a voluntary setting What have we learned from this research? Lennox (2013) provides a comprehensive review, and concludes that with the exception of one study (Davis et al 2009), the general finding is that longer audit firm tenure (in voluntary settings) does not appear to harm audit quality, and there is some counter-evidence that long tenure may improve audit quality (e.g., Meyers et al 2003) Interestingly, the PCAOB report (p 16) also notes that PCAOB inspection data show no association between long-tenure audits and negative comments in inspection reports

On the other hand, it may be the case that “bad things” do happen in the short-tenure setting due to a learning curve effect Short tenure occurs when there is a change in auditor, and there is evidence that earnings quality is lower during the first few engagement years, which is consistent with a learning curve on new audits (Johnson et al 2002) Auditors are also more likely to encounter material irregularities in the initial engagement year, which puts these audits

at greater risk (Loebbecke et al 1989; Carcello and Nagy 2004; PCAOB 2011, p 16)

Given the existing body of evidence, it appears the European Commission is advocating a major change to the audit market that is not supported by extant research Even, worse, the Commission could cause lower quality audits since there would be more frequent auditor changes under a mandatory rotation rule, and therefore more frequent audits with short tenure and potentially lower quality

While acknowledging academic research on tenure and audit quality, the PCAOB (2011,

p 17) explicitly cautions that we should be careful in drawing the conclusion that audit quality

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suffers following an auditor change Their reasoning is that voluntary auditor changes often occur in a broader context of auditor-client disagreements, or other client difficulties such as financial distress and declining performance, and that these circumstances may “overstate” the negative effects on audit quality following auditor changes that has been documented in academic research Lennox (2013) also notes the difficulty in determining causality in a voluntary rotation setting

Given these concerns, the purpose of our study is to investigate the potential negative consequences of auditor rotation in a true mandatory rotation setting As Lennox (2013) concludes, there is limited research in such settings Our objective is to provide evidence that could guide intelligent policy making and help regulators to better assess the consequence of fixed-term limits on auditor appointments To do so we draw on the Italian experience with the

While the EC proposal is silent on negative consequences, the PCAOB (2011) identifies three potential negative consequences of mandatory rotation that guides our investigation:

1 The PCAOB report (p 38) notes that at the end of the mandatory fixed-term appointment, the outgoing auditor may not have incentives to perform high-quality audits since they cannot be reappointed This may create a moral hazard problem in which the outgoing auditor shirks on effort resulting in lower-quality audits.3

2 While our focus is on Italy, there has been some research on mandatory audit firm rotation in Spain and Korea Ruiz-Barbadillo et al (2009) examine the effect of the proposed mandatory rotation rule in Spain on the likelihood the auditor issues a going concern audit report While they find no statistical association, the authors point out that the rotation rule was withdrawn before it officially went into effect, so that their study only measures the impact of the "announcement" of a mandatory audit firm rotation rule In Korea, an auditor change can be imposed on Korean companies judged by the Financial Supervisory Commission as having high potential to manipulate accounting results In this setting, Kim and Yi (2009) find that there is less earnings management following a regulator-imposed auditor change However, Kim and Yi (2009, p 207) recognize the uniqueness of the Korean auditor replacement rule and note that their conclusions cannot be generalized to a mandatory rotation setting

3 It is also possible outgoing auditors will be especially careful and put in greater effort because the new auditor will review their work (PCAOB 2011, p 17) We find no evidence of greater effort, but we do find evidence of abnormally higher fees in the final year, which suggests there may be opportunistic pricing by the outgoing auditor

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2 The PCAOB report (p 11) recognizes that rotation could impose significant switching costs

on clients, including larger audit fees if audit start-up costs are large and these costs are passed on to the client

3 The incoming auditor may not be able to initially perform high-quality audits due to learning curve effects (PCAOB 2011, p 13 and pp 16-17) In other words, even though new auditors may bring a “fresh perspective” to the audit, they may not be as competent or experienced as the prior auditor, at least in the short-term Alternatively, if the EC and PCAOB are correct in their assertions, then audit quality could improve following a mandatory rotation

Our main findings are as follows First, for the outgoing auditor, there is no evidence of lower-quality audits due to shirking in the final-year engagement However, there is some evidence of abnormally higher fees, as the final-year fees are 7 percent higher than normal This suggests there may some opportunistic pricing since we find no evidence of abnormally higher audit effort in the final-year engagement The PCAOB report does not identify this as a negative consequence, but our evidence suggests it adds to the cost of mandatory rotation Second, for the incoming auditor, audit effort (hours) is abnormally higher by 17 percent in the initial engagement, but initial fees are discounted by 16 percent relative to ongoing engagements However, we also find that future audit fees following the first-year audit are abnormally higher

by approximately 76 percent of first-year fees Interestingly, the PCAOB (2011, p 17) speculates that mandatory rotation might eliminate low balling and subsequent fee recovery which they view as a threat to auditor independence, but our evidence suggests otherwise Third, we document that earnings quality is lower during the first three engagement years relative to later years of auditor tenure (larger abnormal accruals and less timely loss recognition) On average, abnormal accruals are 36% larger in the first three years relative to later years of tenure The results in Italy are comparable to Johnson et al (2002) in a voluntary auditor change setting who find that earnings quality is lower in the first three-years relative to engagements with longer tenure Thus the consequences of mandatory rotation appear to be (1) higher audit fees, and (2)

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lower quality audited earnings following rotation, which is consistent with the evidence in mandatory settings

non-The next section discusses the mandatory auditor rotation requirement in Italy This is followed by the sample, descriptive statistics, and empirical results In the concluding section we discuss how a mandatory rotation rule might affect larger scale audit markets in countries such as the United States

AUDITOR ROTATION IN ITALY

Mandatory rotation was adopted in Italy in 1975 by Presidential Decree D.P.R 136/1975 which required audit firm rotation for all listed companies in Italy, and was later extended to

reforms in 1998, the Italian market was considered to be very thin with auditors competing for a relatively small number of statutory audits (Gietzmann and Sen, 2002) Further reforms in 1998 and 2003 substantially increased the number of companies subject to external auditing including all non-listed companies which are controlled by listed companies, non-listed companies that control listed companies, and some private (limited liabilities) companies Even though the audit market expanded with the 1998 and 2003 changes, the market is still relatively small compared

to countries like the United States and United Kingdom

The Italian institutional setting also has some distinctive features that make it an attractive research setting with respect to auditor rotation Mandatory rotation is potentially of greater value in a country like Italy with a thin audit market, but we know little about the costs or

4 The law originally stipulated an appointment term of three years, renewable two times, for a maximum of nine years The cooling off period was set at five years, but was later reduced to three years by a Legislative Decree

issued in 1998, the so called “Legge Draghi.” The current requirement is a maximum auditor appointment of nine

years, with a three year “cooling off period,” as well as the required rotation of the engagement partner every six years (and a three-year cooling off period before an engagement partner can be re-appointed)

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providing many types of non-audit services As a result the Big 4 earn approximately 90 percent

of their revenues from audit-only services (Cameran et al 2010), which means empirical results are less likely to be confounded by non-audit services/fees Lastly, there has been relatively little research on auditor rotation in Italy, and the results to date are mixed as described below

Concurrent Italian Research

Cameran and Pettinicchio (2011) document a steady increase over time in the market share

in Italy held by large international accounting firms, with an even stronger effect in the Italian market segments subject to mandatory rotation This is ironic because a rationale for rotation was

to increase market competition but it appears to have had the opposite effect, which illustrates how unintended negative consequences can occur in audit market regulation They also find more partner suspensions for poor quality work related to the first year of an audit engagement, compared to all other years, and this finding provides some evidence that audit quality may initially suffer as a result of auditor rotation, consistent with a learning curve effect on new audits (PCAOB 2011, p 16) In other related studies, SDA Bocconi School of Management (2001) surveyed internal auditors, managers, and Big 5 auditors of Italian listed companies and reports that the first-year audit engagement requires more time by both the auditor and the client While mandatory rotation could potentially affect audit quality, there is no evidence the stock market reacts to news of auditor changes (SDA Bocconi School of Management 2001; 2004)

5 Gietzmann and Sen (2002) argue that the mandatory rotation rule would have the most beneficial effects in thin markets like Italy because a few large clients dominate such audit markets As a result, they argue that the risk of collusion between the auditor and a large client is more likely in absence of a mandatory rotation rule or strong legal liability laws Italy is a civil law country and is characterized as having weak legal enforcement and weak investor protection (Choi and Wong 2007) Italy also has low litigation risk based on the index in Wingate (1997) The litigation risk index score is 6.22 for Italy, while Anglo-Saxon countries report scores above 10, with a maximum score of 15 for the US The score assigned to Italy is equal to other non-Anglo-Saxon European countries like France, Germany, Netherlands, Norway, and Switzerland

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Our focus on rotation costs differs from prior studies in Italy that do not examine how mandatory rotation affects fees and engagement hours However, there are two concurrent studies which also examine the effect of mandatory rotation on earnings quality Cameran et al (2012) use pre-IFRS data for a sample of 1,184 firm-year observations from 1985-2004 in which the appointment term was on a three year basis, renewable two times (the so called “3+3+3” rule) Their focus is on the auditor’s incentives to be reappointed at the end of the first and the second 3-year appointment periods by allowing clients greater discretion to manage earnings in these periods In contrast they predict earnings quality will be higher in the third (last) 3-year appointment term compared to the previous two, because the auditor cannot be reappointed and therefore has no incentives to allow clients to manage earnings Their results are consistent with this prediction In contrast, our study examines the effect on earnings quality immediately after rotation (the first three years), and the more general relation between auditor tenure and earnings quality Livne and Pettinicchio (2012) report evidence suggesting that mandatory rotation does not improve earnings quality Their focus and research design differs from our study as follows They investigate a setting where firms are expected to have a demand for high-quality audits (as proxied by complexity, leverage, and level of intangibles), and test if mandatory rotation improves earnings quality for these firms Their focus is not on auditor tenure, per se, and they

RESEARCH APPROACH

We draw on the PCAOB (2011) to motivate our investigation of how mandatory rotation may affect the behaviour of the outgoing and incoming auditors with respect of audit fees, engagement hours, and audit quality The following questions are examined:

6 Another concurrent study by Corbella et al (2012) reports that earnings management declines in the year immediately following mandatory audit firm rotation We do not find this result in our data, but given the many research design differences, it is difficult to directly compare the two studies

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1 Does rotation cause outgoing auditors to shirk on effort and quality, in the absence of appointment incentives, or, is the behaviour of outgoing auditors unaffected by mandatory rotation?

re-2 Does rotation cause incoming auditors to have higher engagement hours and charge

3 Does rotation cause incoming auditors to have lower quality in the short-term following rotation due to learning curve effects, or are new auditors able to maintain or even improve upon the quality of the prior auditor? The pro-rotation argument assumes the new auditor will have a fresh perspective and can be more objective, which could lead to higher quality audits post-rotation

While we could make formal directional predictions for our analyses, there is no theoretical or a priori basis for doing so Instead, our study is descriptive in the sense that we are using the Italian experience to examine the potential negative consequences of mandatory rotation

A unique feature of our study is the use of private data on audit fees and engagement hours provided to us by the Big 4 accounting firms in Italy This allows us to accurately measure the effect of mandatory rotation on audit engagement hours and audit fees In order to assess the cost of mandatory auditor rotation, we examine if audit fees and audit effort (engagement hours)

in the last year of the outgoing auditor, and the first year of the new auditor, are significantly different than fees/hours of other engagement years An additional consequence of rotation would occur if audit quality changes around the rotation event, and to assess this possibility we examine the quality of audited earnings (abnormal accruals and timely loss recognition)

7 Alternatively, the incoming auditor may engage in low balling DeAngelo (1981) argues that low balling (fee discounting) occurs in the expectation an auditor can set higher fees in the future and earn economic rents due to the transaction cost advantages of incumbency A fixed-term limit could actually increase the level of low balling if the rotation rule makes the auditor’s tenure over the appointment term relatively more certain than would otherwise be the case in a voluntary unregulated setting For example, a nine-year appointment with certainty would have a larger expected value relative to a situation in which there is only a 40 percent ex ante likelihood of having 15-year tenure (i.e., an expected tenure of only 6 years) Earlier studies report evidence consistent with low balling (e.g., Simon and Francis 1988; Hay et al 2006), but a more recent study by Ghosh and Lustgarten (2006) finds low balling has dissipated or disappeared altogether in the United States

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SAMPLE AND DATA

The sample is comprised of 204 publicly-listed companies in Italy audited by the Big 4 accounting firms over the period 2006-2009, resulting in 667 firm-year observations in the sample, although the specific sample size varies from test to test depending on data availability During the sample period, there were 232 non-financial companies listed on the Milan Stock

composition is as follows: 37 percent of companies are in “manufacturing activities,” 13 percent are in the “professional, technical and scientific services” sector, 10 percent in “information and communications” and the rest of the sample is evenly distributed across 12 other industry

of firms), plus another 16 auditor changes which are voluntary (7.8 percent of firms) For mandatory rotations, the largest switches are from PricewaterhouseCoopers to Deloitte (22 percent), and from Deloitte to Ernst & Young (14 percent)

As mentioned above, a unique feature of the sample is that the Big 4 accounting firms in Italy provided us with proprietary data on actual audit engagement hours and audit fees for the consolidated group-entity accounts We use this data in conjunction with publicly-available data from consolidated annual reports, to measure the effect of auditor rotation on audit fees and audit effort, as well as the quality of audited earnings around the rotation event Using the audit fee data provided directly by auditors allows us to be more accurate in our analysis Publicly-

8 We do not examine listed companies in the financial sector as audit fees and accruals are fundamentally different

in this industry sector, nor did the Big 4 accounting firms provide us with data for this sector

9 We use the ATECO industry classifications This is the Italian version of the European nomenclature, Nace Rev

2, published in the Official Journal of 20 December 2006 (Regulation (EC) no 1893/2006 of the European Parliament and of the Council of 20 December 2006) This classification results in 16 industry sectors The other 12 industry sectors in addition to four larger sectors mentioned in the text are: agriculture, forestry and fishing; minerals extraction; electric energy and gas supply; water supply and garbage disposal activities; construction activities; wholesale and retail trading; transport and storing activities; lodging and catering services; real estate; hiring services and travel agencies; entertainment and sport activities; other services

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disclosed audit fee data has been required since 2007 but we find some evidence that reported

is more accurate, as a robustness test and sensitivity analysis, we also examine the differences in publicly-disclosed fees and the proprietary fee data provided by the Big 4 accounting firms, and

Variable definitions are presented in Table 1, and descriptive statistics are reported in Table 2 Median audit fees are 219,476 Euros, with an inter-quartile range of 129,185 to 395,933

median firm in the sample has total assets of 457.8 million Euros, total debt equals to 65.3 percent of assets, ROA of 2.6 percent, inventories that are 6.7 percent of assets, and receivables that are 23.1 percent of assets The median firm has 14 subsidiaries, 3 operating segments, and 23.4 percent of the firm-years in the sample had an operating loss in year t-1

[Insert Tables 1 and 2 here]

With respect to the auditor rotation variables, 5.4 percent of firm-years are coded one for the first engagement year following a mandatory rotation (MANROT), and 7.3 percent of firm-years are coded one for the last year of the outgoing auditor prior to rotation (PRE_MANROT) For completeness we also examine voluntary auditor changes, where 2.4 percent of firm-years

10 The problem is that amount of fees paid to the auditor and disclosed in the annual report may not necessarily relate to the current fiscal year being audited In addition, although companies are required to make separate disclosures of fees for audit and non-audit services, in some cases the amount of audit fees declared in the annual report includes fees paid for work that is unrelated to the audit opinion and vice-versa (fees classified as non-audit which are in fact audit related) For example, one company in our sample reports in its notes to the consolidated financial statements a fee for auditing services of approximately two million Euros, which includes an unspecified amount of fees related to a new share issue filing and therefore is not technically audit-related fees Another company in our sample reported as a non-audit fee, work related to the audit of a subsidiary company that was part

of the overall audit of the company’s consolidated financial statements, so these fees were incorrectly excluded 11

While the results are qualitatively similar, the magnitude of low balling and subsequent fee recovery is much larger using the publicly-reported data

12 Descriptive statistics in Table 2 report natural logs of audit fees (LN_AF), audit hours (LN_H), and firm size (SIZE), as these are the variables used in regression analyses

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are coded one for the first engagement year following a voluntary rotation (VOLROT) and 1.6

percent of firm-years are coded one for the last year of the outgoing auditor prior to a voluntary

auditor change (PRE_VOLROT).The default comparison group is all other engagement years

RESULTS

This section reports the empirical findings Table 3 reports model estimations in which

the dependent variables are audit fees, total engagement hours, and abnormal working capital

accruals All models are estimated with year fixed effects to control for systematic temporal

variation The models are also estimated with firm fixed effects which is a strong control for

heteroskedasticity-robust standard errors that are clustered by each unique company P-values are

reported as two-tail probabilities since no directional predictions are made There is no evidence

of multicollinarity threats as VIF’s are all under 4, well below the threshold of 10 suggested by

Kennedy (2008)

Audit Fees and Audit Hours

We estimate the audit fee model in equation (1) to test the effect of rotation on audit fees

around the rotation event, using private data supplied to us by the Big 4 accounting firms:

LN_AF i,t = β0 + β1MANROTi,t + β2VOLROTi,t + β3PRE_MANROTi,t + β4PRE_VOLROTi,t +

β5LN_Hi,t + β6IND_SPECi,t + β7SIZEi,t + β8LEVERAGEi,t + β9LAG_LOSSi,t + β10ROAi,t

+β11INVi,t + β12RECi,t + β13NSUBi,t + β14FOREIGNREVi,t + β15NSEGi,t + β16CFOi,t + Firm

are MANROT, which is an indicator variable denoting the first year of the new auditor

13 As explained later in the section “Robustness Tests” we re-estimate the models using industry fixed effects in lieu

of firm fixed effects with comparable results on the test variables

14 Audit fees are the total fees (in euros) for a given engagement provided to us by the audit firms Following prior

studies, we use the natural log of fees for the analysis

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following mandatory rotation, and PRE_MANROT, which is an indicator variable denoting the

final year of the outgoing auditor Following the audit fee literature (Hay et al 2006), we also control for industry specialization, firm size, leverage, prior-year loss, profitability, inventories, receivables, number of subsidiaries, foreign operations, number of operating segments, and operating cash flows Because we have proprietary data on engagement hours (LN_H) it is also

also analyze voluntary auditor changes (VOLROT and PRE_VOLROT), and these tests are reported later in the paper

We begin with a baseline model of audit fees in column (1) in which firm-year

has high explanatory power with an R-square of 0.901 Audit fees are an increasing function of audit hours and firm size, but other control variables are not significant However, this is a consequence of estimating the model with firm fixed effects, plus the control variable log of audit hours When we drop firm fixed effects and log of audit hours, then other variables become significant and are consistent with prior studies: specifically, LEVERAGE, REC, FOREIGNREV and NSEG are positively associated with audit fees, along with SIZE However, the model R-square is higher when firm fixed effects and audit hours are included

[Insert Table 3 Here]

The test of audit fees in equation (1) is reported in Table 3, Column (2) The test variable MANROT has a negative coefficient of -0.179 and is significant at p-value = 0.000 (two-tail)

15 We address the possibility that audit hours and audit fees are endogenously determined by estimating a “2SLS regression model” where lagged audit hours are used as instruments for audit hours in the audit fee model (Caramanis and Lennox, 2008) This approach yields results comparable to those reported in Table 3 and low balling

is confirmed (coef.: - 0.265; p =0.000) We also use the same approach for the fee models in Table 4, and again the tabled results are confirmed.

16 This explains the different number of observations reported in column (1) of Table 3, compared to columns (2), (3) and (4)

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The test variable PRE_MANROT has a positive coefficient of 0.071 and is significant at p-value

= 0.011 (two-tail) Using the procedures in Craswell et al (1995) and Simon and Francis (1988), the coefficients indicate a fee premium of 7.4 percent by the outgoing auditor, and a fee discount

Next we test the effect of mandatory rotation on audit engagement hours:

LN_Hi,t = β0 + β1MANROTi,t + β2VOLROTi,t + β3PRE_MANROTi,t + β4PRE_VOLROTi,t +

β5IND_SPECi,t + β6SIZEi,t + β7LEVERAGEi,t + β8LAG_LOSSi,t + β9ROAi,t +β10INVi,t + β11RECi,t

Effects + εi,t (2)

The effect of rotation on engagement hours is reported in column (3) of Table 3 The model is significant and the R-square is 0.530 The coefficient on MANROT is +0.158 and is significant at p-value = 0.014 (two-tail), which suggests an average increase in total audit hours

of approximately 17 percent, using the procedure described in footnote 17 The coefficient on PRE_MANROT is insignificant (p-value = 0.796), indicating that the outgoing auditor does not shirk on effort (hours) relative to ongoing engagements

Putting the above two results together, for the outgoing auditor there is no evidence of shirking because engagement hours are no different from ongoing engagements, but there is

17 Following Craswell et al (1995), the fee premium is calculated as e z -1, where the z exponent value is the coefficient value of 0.071 for the variable PRE_MANROT The fee discount is 16.4 percent in the model in column (2), calculated by taking the antilog of the coefficients as described in Simon and Francis (1988) Specifically, the procedure calculates the percentage effect of the intercept shift on the logged dependent variable and is defined as 1- (1/e z ), where the z exponent value is the coefficient value of 0.179 for MANROT (i.e the absolute value of the coefficient)

a consistent model specification

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some evidence of opportunistic pricing in the final year as fees are abnormally higher by 7.4

percent While opportunistic pricing by the outgoing auditor is not mentioned by the PCAOB

(2011), it appears to be a potential cost of mandatory rotation For the incoming auditor, the first

year audit results in 17 percent more effort (more engagement hours), but the overall fee is

discounted by an average of 16 percent Thus the tests suggest low balling of approximately 33

percent: the fee discount of 16 percent, plus the uncharged additional hours which are 17 percent

higher in the first engagement year Contrary to the PCAOB’s (2011) speculation, mandatory

rotation does not appear to eliminate low balling We report evidence later in the paper that audit

fees increase with each year of auditor tenure following the initial engagement year, which is

consistent with the initial-year low balling amount being “recovered” through higher future fees

Thus while fees are initially lower, they are subsequently higher which represents another cost of

mandatory rotation

Earnings Quality

The analysis of auditor rotation on earnings quality uses abnormal working capital

accruals based and is estimated as follows:

AWCA,t = β0 + β1MANROTi,t + β2VOLROTi,t + β3PRE_MANROTi,t + β4PRE_VOLROTi,t +

β5IND_SPECi,t + β6SIZEi,t + β7LEVERAGEi,t + β8LAG_LOSSi,t + β9ROAi,t + β10NSUBi,t +

Following DeFond and Park (2001), abnormal accruals are calculated as the difference between

20

We do not include audit hours in the AWCA regression as audit hours are not a typical control variable in the

earnings quality literature However, all results hold if we include audit hours as an additional control In addition,

we include a control variable using an instrument for audit hours as described in footnote 15 The variable is

negative and significant indicating that higher audit hours are associated with smaller accruals, but the rotation test

preprint accepted manuscript

actual accruals and expected accruals based on the prior-year relation between a firm’s sales and its working capital accruals Later, as a robustness test, we report results using timely loss recognition (Basu, 1997) The control variables are the same as those in the tests of fees and audit hours except for INV and REC, which are dropped as they are more specific to the fee model literature In addition, following prior earnings quality research (e.g., Anderson et al., 2004; Xie et al., 2003; and Dechow et al., 1996), we include three additional controls for the corporate governance effects in constraining low-quality of earnings: the percentage of independent directors on the board (IND), the separation of CEO and Chair positions (CEODUAL) following Dechow et al (1996), and board size (BDSIZE) based on (Klein, 2002)

The test of earnings quality is reported in Column (4) of Table 3 The two test variables

of interest, MANROT and PRE_MANROT, are not significant at the 0.10 level We also test separately those observations with positive abnormal accruals and those with negative abnormal accruals The rotation variables continue to be insignificant There is no evidence that rotation causes a decline in first-year earnings quality (relative to other engagement years) However, the next section shows that earnings quality improves with tenure and that the first three years of earnings following a mandatory rotation are significantly lower in quality, on average, compared

to those engagements with longer auditor tenure

Alternative Analysis Using Auditor Tenure

An alternative approach to assessing mandatory auditor rotation is to examine the more general effect of auditor tenure on fees, hours, and earnings quality To do so, we create an audit firm tenure variable (FTEN) which is coded 0 for the first year of auditor tenure, 1 if the second year, 2 if the third year, and so on By coding the first-year audit as zero, this is the default

variables of interest are unchanged when audit hours are added as an additional control Finally, as an additional robustness test, we include all of the control variables from the fee/hours models, and the results are qualitatively unchanged

preprint accepted manuscript

comparison group and the variable FTEN captures the time trend effect after the first-year engagement, rather than the one-period snap shot immediately after rotation as reported in Table

3 We use this alternative metric and re-estimate the models in Table 3 as follows:

LN_AF i,t = β0 +β1FTENi,t + β2LN_Hi,t + β3INDSPECi,t +β4SIZEi,t + β5LEVERAGEi,t +

β6LAG_LOSSi,t + β7ROAi,t +β8INVi,t + β9RECi,t + β10NSUBi,t + β11FOREIGNREVi,t + β12NSEGi,t

LN_H i,t = β0 +β1FTENi,t + β2INDSPECi,t +β3SIZEi,t + β4LEVERAGEi,t + β5LAG_LOSSi,t +

β6ROAi,t +β7INVi,t + β8RECi,t + β9NSUBi,t + β10FOREIGNREVi,t + β11NSEGi,t + β12CFOi,t + Firm

β6ROAi,t + β7NSUBi,t + β8FOREIGNREVi,t + β9NSEGi,t + β10CFOi,t + β11INDi,t + β12CEODUAL

The results of estimating these models with FTEN as the test variable are reported in Table 4, Panel A All models are significant at p-value < 0.01, and there is no evidence of multicollinarity threats as VIF’s are all under 4, well below the threshold of 10 suggested by Kennedy (2008) The effect of tenure on audit fees is reported in Table 4, Panel A, Column (1) The test variable FTEN is positive and significantly related to audit fees (coef.: 0.021; p-value 0.000, two-tail), which means that audit fees increase by 2.12 percent with each additional year

of auditor tenure following the initial engagement year (using the procedure in footnote 17) For example, the year 2 fee (two years after the first year) is higher by two times 2.12 percent (4.24), the year 3 fee is higher by three times 2.12 (6.36), and so on To estimate the cumulative effect over the eight-years of audit tenure after the first year (assuming the maximum nine-year limit),

we sum the yearly effects, i.e., the sum of years 1 through 8, or 36, and multiply 36 by the yearly increase of 2.12 percent This gives a cumulative increase in abnormal audit fees of 76 percent relative to the first-year engagement fee, i.e., those observations where tenure is coded zero