ghosh and moon - 2005 - auditor tenure and audit quality [mar]

Further, we find that the influence of reported earnings on stock rankings becomes larger with extended tenure, although the association between debt ratings and reported earnings does

Author(s): Aloke Ghosh and Doocheol Moon

Source: The Accounting Review, Vol 80, No 2 (Apr., 2005), pp 585-612

Published by: American Accounting Association

Stable URL: http://www.jstor.org/stable/4093070

and Baruch College-The City University of New York

Doocheol Moon State University of New York at Old Westbury ABSTRACT: We analyze how investors and information intermediaries perceive auditor tenure Using earnings response coefficients from returns-earnings regressions as a

proxy for investor perceptions of earnings quality, we document a positive association

between investor perceptions of earnings quality and tenure Further, we find that the

influence of reported earnings on stock rankings becomes larger with extended tenure, although the association between debt ratings and reported earnings does not vary with tenure Finally, we find that the influence of past earnings on one-year-ahead earnings forecasts becomes greater as tenure increases In general, our results are

consistent with the hypothesis that investors and information intermediaries perceive auditor tenure as improving audit quality One implication of our study is that imposing mandatory limits on the duration of the auditor-client relationship might impose unin- tended costs on capital market participants

Keywords: auditor tenure; auditor independence; audit quality; earnings quality; man-

datory auditor rotation; capital market perceptions

Data Availability: All data used in this study are available from public sources

Editor's note: This paper was accepted by Terry Shevlin, Senior Editor

Submitted August 2002 Accepted August 2004

585

I INTRODUCTION

he recent rise in accounting irregularities has reopened questions about auditor ten-

ure, independence, and audit quality (Bricker 2002).' Recent studies provide valuable insights into the debate surrounding auditor tenure by examining the association between tenure and (1) accounting accruals, (2) analysts' forecast errors, and (3) the cost

of debt Myers et al (2003) conclude that longer auditor tenure constrains managerial discretion with accounting accruals, which suggests high audit quality Johnson et al (2002) also find that accruals are larger and less persistent for firms with short auditor tenure relative to those with medium or long tenure Using credit spreads between bond yields and matched Treasury yields as the cost of debt, Mansi et al (2004) find that the cost of debt declines with longer tenure, which suggests bondholders perceive audit quality as improving with extended tenure In contrast, Davis et al (2002) conclude that audit quality declines with extended tenure because, as tenure increases, client firms have greater re- porting flexibility and earnings forecast errors decline

This study focuses on how investors and information intermediaries perceive auditor tenure Using earnings response coefficients from returns-earnings regressions as a proxy for investor perceptions of earnings quality, we analyze whether investors perceive earnings quality as being affected by tenure Given the importance of information intermediaries who receive and process financial information for investors, we also analyze whether in- dependent rating agencies and financial analysts incorporate the potential effects of tenure

on earnings quality Specifically, we examine whether tenure affects the relationship be- tween reported earnings and (1) stock rankings, (2) debt ratings, and (3) analysts' earnings forecasts

A key distinction between our study and those of Davis et al (2002) and Mansi et al (2004) is the difference in the research design We examine whether the extent to which analysts rely on past reported earnings to predict future earnings varies with tenure, whereas Davis et al (2002) explore the association between forecast errors and tenure Our research design might be better suited because it is difficult to draw unambiguous inferences about analysts' perceptions from an association between forecast errors and tenure Lower forecast errors with longer tenure might suggest that earnings quality is perceived as improving with tenure because earnings are more predictable However, it could also suggest lower earnings quality if managers increasingly guide earnings forecasts as auditor tenure lengthens Fur- ther, Mansi et al (2004) investigate the influence of tenure on the cost of debt, whereas

we examine whether the influence of reported earnings on debt ratings varies with tenure Although Mansi et al (2004) examine the effect of tenure on debt ratings, their primary aim is to purge (orthogonalize) the information effects of tenure and other control variables related to debt ratings and ultimately examine the insurance role of tenure on the cost of debt In contrast, our emphasis is on the informational role of tenure Our fundamental objective is to provide insights into any changes in the perceived credibility of reported earnings with extended auditor tenure

Emphasis on capital market perceptions of independence and audit quality is consistent

with the Financial Accounting Standards Board's (FASB) conceptual framework for finan- cial reporting and principles of auditor independence (Carmichael 1999) According to the

Regulators express concerns that pressure to retain client firms and the "comfort level" created between auditors

Accounting Office [GAO] 2003) The accounting profession, on the other hand, claims that the likelihood of audit failures is greater during the initial period of an auditor-client relationship because of lack of information

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Statement of Financial Accounting Concepts (SFAC No 1, FASB 1978), "financial state- ments are often audited by independent accountants for the purpose of enhancing confidence

in their reliability." The AICPA (1994) also acknowledges the importance of considering investor perceptions of auditor independence A former chairman of AICPA, Elliott (2000) says "[The AICPA] believe[s] that appearances are very important and capital markets require confidence in financial statements and audit reports, and the member firms of the AICPA are basing their business of auditing on their reputations, and that is heavily affected

by appearance."

Other things remaining constant, audited financial statements are less reliable (or of lower perceived quality) for investment and credit decisions if users of financial statements view lengthy tenure as having an adverse effect on auditor independence and audit quality Alternatively, investors and information intermediaries are more likely to rely on reported accounting numbers if they perceive that greater auditor expertise from longer tenure im- proves independence and audit quality We assert that the relationship between perceptions

of earnings quality and auditor tenure provides insights into how capital market participants view auditor tenure as affecting audit quality

We use earnings response coefficients (ERCs) from contemporaneous returns-earnings regressions to measure investor perceptions of earnings quality After controlling for the other determinants of ERC-such as the age of the firm, the quality of auditors, growth, earnings persistence, earnings volatility, systematic risk, firm size, financial leverage, and regulatory environment-we find that the magnitude of the ERC increases as the auditor- client relationship lengthens One concern is that if the market anticipates a portion of current earnings more than one-year-ahead of the earnings release, then the estimated ERC might be biased downward (Kothari 1992; Kothari and Sloan 1992) Additionally, if the market is more likely to anticipate current earnings for firms with longer tenure, then the bias might be associated with tenure Consistent with the premise that prices lead earnings, the estimated ERC for firms with extended tenure is larger when we increase the returns measurement window or when we use non-market metrics, such as total assets, to deflate earnings Thus, the ERC-based findings are consistent with the hypothesis that investors perceive auditor tenure as enhancing earnings quality

Further, controlling for the other determinants of stock rankings, we find that the influ- ence of reported earnings on Standard & Poor's (S&P) common stock rankings becomes larger with extended tenure In contrast, the association between S&P debt ratings and reported earnings does not vary with tenure Thus, our results provide modest evidence that independent rating agencies perceive reported earnings as being more reliable for firms with longer tenure

Finally, after controlling for factors that affect analysts' earnings forecasts, we find that the influence of past earnings on one-year-ahead earnings forecasts becomes larger over extended auditor-client relationships All else equal, analysts are more likely to rely on reported earnings to predict future earnings with longer tenure Thus, the results from analyst earnings forecasts also suggest that analysts perceive earnings quality as improving

with longer auditor tenure

While our results are based on a large sample of firms spanning 11 years, there is one concern with our dataset If auditor tenure is endogenous to audit quality, then the results are also consistent with an alternative hypothesis that auditor turnover is high for firms with low earnings quality In other words, high-quality auditors might terminate engage- ments with client firms that prefer low-quality financial statements (DeFond and Subramanyam 1998) We address potential concerns about frequent auditor turnover by constructing a subsample for which the auditor-client relationship lasts for at least five

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years, as in Myers et al (2003) When we use this subsample, our inferences remain unchanged for all our tests

In sum, our results are generally consistent with the hypothesis that reported earnings are perceived as being more reliable as auditor tenure increases One implication of our results is that capital market participants view longer auditor tenure as having a favorable impact on audit quality Our results suggest that imposing mandatory limits on the duration

of the auditor-client relationship might impose unintended costs on capital markets How- ever, results from a regime without auditor term limits may not be applicable to a regulated environment because of differences in economic incentives for both auditors and clients The rest of the paper is organized as follows Section II establishes the links between tenure, independence, and perceptions of audit quality Section III discusses the research design, and Section IV describes the sample selection procedure Section V reports the results of the association between tenure and perceptions of earnings quality Section VI concludes the paper

II TENURE, INDEPENDENCE, AND PERCEPTIONS OF AUDIT QUALITY Independent auditors are considered the "gatekeepers" of the public securities markets (SEC 2001, III.A) However, the recent rash of accounting irregularities has led many to question auditor independence (Wall Street Journal 2002a, 2002b) One perception is that auditors are more likely to agree with managers on important reporting decisions as the length of the audit engagement increases (Ryan et al 2001; Farmer et al 1987) Therefore, imposing mandatory limits on auditor tenure is expected to improve audit quality by re- ducing client firms' influence over auditors (Turner 2002; Brody and Moscove 1998; SEC 1994; AICPA 1978; U.S Senate 1977; Mautz and Sharaf 1961)

An opposing viewpoint is that problem audits occur more frequently for newer clients because auditors have less information about these firms (AICPA 1992) Client-specific knowledge of items such as operations, accounting system, and internal control structure

is crucial for auditors to detect material errors and misstatements In particular, Johnson et

al (2002) argue that lack of adequate client-specific knowledge during the early years of engagement decreases the likelihood of detecting material errors and misstatements As the auditor-client relationship lengthens, firm-specific expertise allows auditors to rely less on managerial estimates and become more independent of management (Solomon et al 1999) The crux of the debate rests on how tenure affects auditor independence Proponents

of mandatory auditor rotation claim that lengthy auditor tenure erodes independence, which

in turn impairs audit quality Others argue that independence and audit quality increase with longer tenure because of improved auditor expertise from superior client-specific knowledge.2 Since independence is not observable, regulators, practitioners, and academics often rely on the appearance dimension to define auditor independence (Dopuch et al 2003; Kinney 1999)

Our study investigates whether capital market participants perceive longer tenure as affecting audit quality Insights from a market-based approach are important along at least two dimensions First, academics often emphasize the need to understand capital market perceptions of auditor independence and audit quality because ultimately the value of au- diting services depends on perceptions of independence (Dopuch et al 2003; Shockley

2 Expert knowledge gained through years of on-the-job experience increases the likelihood that auditors will detect errors in financial statements (Ashton 1991; Libby and Frederick 1990) In contrast, industry specialization, another frequently used proxy for auditor expertise, is based on training and practical experience gained from

et al 1995)

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1981) Second, regulatory institutions such as the FASB (SFAC No 1) and SEC (2000) emphasize the importance of capital market perceptions of auditor independence A per- ception that the auditors' work is more objective and independent inspires greater confi- dence in auditor opinion, which increases the perceived reliability or quality of reported accounting numbers (Ryan et al 2001; Elliott and Jacobson 1998) Independent auditors increase the reliability of financial statements because (1) they are more likely to prevent

or detect and correct material misstatements/omissions, and (2) they ensure that financial statements comply with generally accepted accounting principles (Carmichael 1999) There- fore, to the extent that capital market participants view tenure as improving independence and audit quality, financial statements are perceived as more reliable for financial decisions

as tenure lengthens

In this study, we focus on the perceptions of investors because they are the principal users of financial statements In its Conceptual Framework, the FASB defines "quality" in relation to the usefulness of financial statements to investors and links "usefulness" in turn

to constructs such as relevance and reliability (SFACs No 1 [FASB 1978] and No 2 [FASB 1980]) To draw inferences about investors' perceptions of earnings quality, researchers tend

to use stock-market-based metrics such as earnings response coefficients from regressions

of returns on earnings (Schipper and Vincent 2003; Warfield et al 1995) Prior studies document that investors pay a larger premium for "high-quality" earnings because high- quality earnings are viewed as sustainable (Schipper and Vincent 2003; Teoh and Wong 1993) Thus, examining the influence of auditor tenure on the pricing of earnings is likely

to provide valuable insights into investors' views of the association between the length of the auditor-client relationship and earnings quality

Given that information intermediaries constitute an integral part of the capital market

by providing stock recommendations, debt ratings, and earnings forecasts (Lang and Lundholm 1996), we also analyze how independent rating agencies and financial analysts view auditor tenure Hunt (2002) states that independent rating agencies provide information about the creditworthiness of issuers and that credit ratings play a significant role in in- vestment decisions Extant research finds links between earnings and debt ratings/stock rankings issued by independent rating agencies (Bhojraj and Sengupta 2003; Ziebart and Reiter 1992; Van Horne 1992; Kaplan and Urwitz 1979), suggesting that perceptions of earnings quality could be an important input in determining rankings/ratings Similarly, financial analysts also play a prominent role as information intermediaries in capital markets because of their ability to incorporate value-relevant information in their published reports, which impacts security prices (Francis and Soffer 1997; Schipper 1991; Lys and Sohn 1990; Brown et al 1987) Prior research finds that analysts rely on earnings releases to estimate future earnings (Kasznik and McNichols 2002; Barron et al 2002; Stickel 1989), which suggests that the extent to which analysts depend on reported earnings to make earnings forecasts might vary with perceptions of earnings quality

Extending this line of research, we examine the association between auditor tenure and (1) stock rankings, (2) debt ratings, and (3) analysts' forecasts of earnings per share Ad- ditionally, we analyze how auditor tenure affects the association between reported earnings and rankings, ratings, and earnings forecasts If auditor tenure is perceived as enhancing earnings quality, then, all else equal, the influence of reported earnings on rankings/ratings and earnings forecasts is expected to become larger with longer auditor tenure because reported earnings are viewed as more informative about future earnings The converse is true if information intermediaries perceive longer auditor tenure as eroding earnings quality Based on the association between our proxy measures for perceptions of earnings qual- ity and auditor tenure, we infer how investors and information intermediaries view auditor

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tenure as affecting audit quality A positive relationship between the proxies for perceptions

of earnings quality and auditor tenure is consistent with the hypothesis that longer tenure

is perceived as improving independence and audit quality In contrast, a negative relation- ship is consistent with the hypothesis that lengthy tenure is viewed as eroding independence and audit quality

III RESEARCH DESIGN

We use the following basic regression framework to analyze whether investors, inde- pendent rating agencies, and financial analysts perceive earnings quality as being affected

is interacted with E/AE and is also included as a separate independent variable Details on the dependent and control variables are provided in subsequent subsections

The sum of earnings levels and changes coefficients (p, + 132) or the "earnings response coefficient" (ERC) is our proxy for capital markets' perceptions of earnings quality Our interest is in the sum of the E*Tenure and AE*Tenure coefficients (P3 + 14) If investors, rating agencies, and analysts perceive earnings quality as improving (declining) with longer auditor tenure, 133 + 34 is expected to differ from zero

Perceptions of Investors and Auditor Tenure

We measure investor perceptions of earnings quality using 12-month (ending three months after the fiscal year-end) cumulative market-adjusted returns (CAR) as the dependent variable in Equation (1) Market-adjusted returns are the difference between raw returns and value-weighted CRSP market returns

We include earnings changes and earnings levels in the same regression because in- cluding both increases the explanatory power and magnitude of earnings response coeffi- cients when earnings contain both transitory and permanent components (Easton and Harris 1991; Ali and Zarowin 1992) E is income before extraordinary items (Compustat #18) and

AE is the difference between income before extraordinary items for the current year and that of last year Both E and AE are deflated by market value of equity (Compustat #25

x #199) at the beginning of the year

We include various control variables because the ERC is associated with other firm characteristics (Warfield et al 1995; Dhaliwal and Reynolds 1994; Collins and Kothari 1989), which, in turn, might be associated with tenure The control variables are defined

as follows: FirmAge, computed using the beginning and end dates as reported in CRSP,

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measures the number of years that the firm has been publicly traded as of the fiscal year- end; Big4 is an indicator variable that equals 1 when the client's auditor is a large account- ing firm (Compustat #149); Growth is the sum of the market value of equity (Compustat

#25 x #199) and the book value of debt (Compustat #9 + #34) scaled by the book value

of total assets (Compustat #6); Persistence (Volatility) is the first-order autocorrelation (stan- dard deviation) of income before extraordinary items per share (Compustat Quarterly #8/ Quarterly #61) for the past 16 quarters;3 Beta is systematic risk computed using the past

60 monthly stock returns; Size is the logarithmic transformation of the fiscal year-end market value of equity (Compustat #25 x #199) of the prior year; Leverage is the ratio of total debt (Compustat #9 + #34) to total assets (Compustat #6); and Regulation is an indicator variable that equals 1 for firms in a regulated industry with two-digit standard industry classification codes between 40 and 49 or between 60 and 63

We include FirmAge for two reasons: (1) older firms are more likely to be stable with less information asymmetry problems, which suggests higher ERCs; and (2) Tenure and FirmAge are positively correlated We control for Big4 because large auditors are generally associated with high-quality audits (Becker et al 1998; Teoh and Wong 1993) The inclu-

sion of Growth, Persistence, Volatility, and Beta is primarily motivated by valuation con-

siderations (Warfield et al 1995) The inclusion of Size is motivated by the political cost theory: managers of large, politically sensitive firms are more likely to exploit the latitude

in accounting to reduce political costs, which affects earnings quality We include Leverage because of contracting considerations: firms with high leverage are more likely to use the latitude in accounting to avoid possible debt-covenant violations (DeFond and Jiambalvo 1994) Finally, the quality of earnings is affected in a regulated environment (Regulation) because managers have limited scope for opportunistic behavior (Warfield et al 1995) Perceptions of Information Intermediaries and Auditor Tenure

Independent Rating Agencies

Our analysis of how tenure affects independent rating agencies' perceptions of earnings quality is based on estimates from Equation (1) using Standard & Poor's (S&P) common stock rankings (Stock Rankings) and senior debt ratings (Debt Ratings) as dependent vari- ables Stock Rankings represent numerical values of 1 to 7, corresponding to S&P common stock rankings (Compustat #282) A value of 1 is assigned if a firm's common stock ranking

is rated as A+ and as S&P common stock rankings decline, the numerical value increases

by 1.4 Similarly, Debt Ratings are assigned a value of I if a firm's S&P senior debt (Com- pustat #280) is rated as AAA As S&P debt ratings decline from AAA (the highest) to D (payment default), the numerical value increases by 1

We include Growth, Volatility, Beta, Size, and Leverage to control for cross-sectional

differences in firm quality and riskiness (Bhojraj and Sengupta 2003; Van Home 1992; Ziebart and Reiter 1992; Kaplan and Urwitz 1979) Growing firms with high earnings volatility tend to be more risky, Beta controls for both operating and financial risk, large firms tend to be less risky, and firms with higher leverage have greater financial risk We

also include FirmAge, Big4, Persistence, and Regulation because the association between reported earnings and rankings/ratings might depend on the firm's life-cycle, whether firms

for stock-splits and stock dividends that occur subsequent to the end of a given period using the adjustment

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use big audit firms, whether earnings are persistent, and whether firms are in a regulated environment

In a recent study, Mansi et al (2004) find that longer tenure lowers the rate of return required by bondholders and that the impact is larger for "information-sensitive" securities such as non-investment grade bonds (debt ratings less than BBB-) Therefore, we also separately estimate the effects of tenure on investment and non-investment grade debt ratings

Financial Analysts

Finally, our analysis of whether tenure influences financial analysts' perceptions of earnings quality is based on the estimates from Equation (1) using earnings forecasts (FEPS,) as the dependent variable FEPS, is the consensus analyst forecasts of annual earnings per share from the Institutional Brokers Estimation System (I/B/E/S) database Our proxy for consensus forecasts is the mean one-year-ahead forecast for year t issued immediately following the earnings announcement for year t- 1 (earnings announcement dates are obtained from Compustat).5 We restrict the forecasts to those issued immediately following earnings announcements, as in Kasznik and McNichols (2002) and Barron et al (2002), because (1) any change in analysts' perceptions of earnings quality is more likely

to be updated following earnings releases (Barron et al 2002), (2) it excludes stale forecasts since forecast revisions are more common following earnings announcements (Stickel 1989), and (3) it conditions the forecasts on the same set of publicly disclosed information Reported earnings per share (EPS,_, and AEPS,_,) are used as measures for E and AE

in Equation (1) EPS,_, is annual earnings per share reported for year t- 1, and AEPS,_, is the absolute change in earnings per share for year t- 1 defined as the difference in annual earnings per share in year t- I and that in year t-2 (IEPS,_, - EPS,_-2), both obtained from the I/B/E/S database As in Barron et al (2002), we include the absolute value of changes in earnings because a larger earnings surprise tends to be temporary, which reduces the potential usefulness of past earnings in predicting future earnings

Since prior studies find that analysts' incentives to acquire information about future earnings are affected by firm characteristics (DeFond and Hung 2003; Barron et al 2002; Lang and Lundholm 1996), we include the following control variables: FirmAge because older firms are more likely to be stable and consequently earnings might be easier to predict; auditor type (Big4) because analysts might perceive earnings quality as improving for firms with big auditors; Growth because high-growth firms tend to generate greater demand for private information, thereby reducing the reliance on reported earnings (Barron et al 2002; Lang and Lundholm 1996); Volatility because analysts are more likely to attach lower importance on reported earnings for firms with higher earnings volatility (DeFond and Hung 2003); risk using a market-based measure (Beta) and a balance-sheet-based measure (Lev- erage); Size because prior studies find that firm size is associated with risk and the infor- mation environment, which affects earnings predictability (DeFond and Hung 2003; Barron

et al 2002); Regulation because the predictability of earnings might vary between industries (O'Brien 1990); and the number of analysts (Analysts) providing annual earnings per share

SWe prefer consensus forecasts to individual forecasts because prior research finds that consensus forecasts are

forecast errors made by individual analysts are less than perfectly correlated and therefore in the process of

results are similar when we use either the mean or the median forecast

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forecasts for a firm (Lang and Lundholm 1996) All the control variables including Tenure are measured at the end of year t- 1

In a recent study, Davis et al (2002) find that forecast errors decline as tenure in- creases.6 However, it is difficult to draw unambiguous inferences about perceptions of analysts from an association between forecast errors and tenure Lower forecast errors might suggest that analysts perceive earnings quality as improving with tenure because earnings are more predictable Alternatively, lower forecast errors with longer tenure might suggest lower earnings quality if managers are more likely to guide earnings forecasts as auditor tenure lengthens.7 Hence, we do not focus on earnings forecast attributes such as forecast errors and dispersion

IV DATA

We construct a sample from the list of publicly traded firms in the 2001 Compustat annual files (active and research) Since the 2001 Compustat files cover 20 years of data, and financial data are available from 1982, auditor tenure is 1 for the first year by construc- tion The analysis begins with 1990 to provide some variation for auditor tenure and ex- cludes the year 2001 because of possible missing and incomplete data.8 Stock return and firm age data are obtained from the 2001 CRSP files We get earnings forecast data from the 2001 Institutional Brokers Estimation System (I/B/E/S) Summary Estimates

We impose the following restrictions on the sample: (1) we delete the top and bottom

1 percent of observations for the level of earnings (E), changes in earnings (AE), annual earnings per share (EPS), and the absolute change in annual earnings per share (AEPS); (2) we remove all observations with the absolute value of cumulative market-adjusted re- turns (CAR) greater than 100 percent; and (3) we also winsorize the top and bottom 1

percent of observations for Growth, Persistence, Volatility, Beta, and Leverage.9 This sample

selection procedure results in a maximum of 38,794 observations for the "full" sample over the years 1990 through 2000

Some concerns remain with the full sample Firms might frequently switch auditors either because of "opinion shopping" (SEC 1988) or because of auditors' preference for conservative accounting choices (DeFond and Subramanyam 1998) Alternatively, high- quality auditors might end engagements with clients that prefer low quality of financial

to negative earnings (see Ghosh et al 2005; Bartov et al 2002; Myers and Skinner 2002; Skinner and Sloan

by guiding analyst expectations to avoid overly optimistic forecasts Although existing studies suggest that

know whether tenure affects managers' propensity to guide analysts' expectations

1982 even if the auditor was the same for the prior years However, when we replicate our analysis computing

Mansi et al (2004), our conclusions remain unaffected

However, when we delete the top and bottom 1 percent of CAR, we get similar results The results on tenure

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reporting We avoid some of these biases by constructing a subsample in which the auditor- client relationship lasts for at least five years For auditor-client relationships lasting less than five years, we delete all of the firm-year observations The maximum number of observations for the "restricted" sample is 35,826 firm-years.'0

Table I reports summary statistics for both the full sample (Panel A) and the restricted sample (Panel B) We report the mean, minimum, first quartile, median, third quartile, and maximum for Tenure, FirmAge, CAR, E, AE, Stock Rankings, Debt Ratings, and FEPS Auditor tenure is longer for the restricted sample than for the full sample; the mean/median

TABLE 1 Descriptive Statistics

Panel A: Full Sample

The full sample includes Compustat firms with available data from 1990 to 2000 The restricted sample consists

of firms in the full sample with auditor-client relationships lasting for at least five years Tenure is the duration

(senior debt) is rated as A+ (AAA), and as the S&P common stock rankings (debt ratings) decline, the

is that we include many more variables in our analyses, which reduces the size of our full sample Thus, fewer observations are lost from requiring that the auditor-client relationship lasts for at least five years in our study relative to those in Myers et al (2003)

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Tenure for the full sample is 8.5/8 years, while the corresponding number for the restricted sample is 9.1/9 years The mean FirmAge for the full sample is 17.6 years, compared to a mean of 18.0 years for the restricted sample FirmAge ranges between 3.4 years and 75 years for the full and restricted samples

The summary statistics for CAR, E, and AE indicate few differences across the two samples The mean/median CAR for the full sample is -0.060/-0.108, while that for the restricted sample is -0.054/-0.102.1 The mean/median E for the full sample is -0.007/ 0.048, compared to a mean/median of 0.000/0.050 for the restricted sample The mean/ median AE is identical for the full and restricted samples (0.006)

Similarly, there are almost no differences in Stock Rankings, Debt Ratings, and earnings forecasts (FEPS) between the two samples The average firm in both samples has a B S&P common stock ranking (a numerical score of 5), and a BBB S&P senior debt rating (a numerical score of about 9) The mean/median one-year-ahead analysts' earnings per share forecasts (FEPS) is $1.05/$0.89 and $1.05/$0.89 for the full and restricted samples, respectively

Table 2 reports the Pearson correlation (p) matrix between CAR, E, AE, Stock Rankings,

Debt Ratings, FEPS, Tenure, and FirmAge for the full sample The high correlation between Stock Rankings and Debt Ratings (p = 0.686) suggests that stock rankings and debt ratings

issued by independent rating agencies contain significant overlapping information However, low correlations across variables that measure investor, rating agency, and financial analyst perceptions indicate that analysis of each market participant's perceptions provides distinct insights into the overall perceptions of the quality of accounting information Finally, the correlation between Tenure and FirmAge is positive and statistically significant (p = 0.337, p-value = 0.001), which underscores the need to control for FirmAge when analyzing

Tenure

V RESULTS All the regression results reported in Tables 3 to 7 are based on yearly regressions from

1990 to 2000 The reported coefficients are the average of 11 yearly coefficients, and the corresponding t-statistics are computed by comparing the average coefficient to its time- series standard error We prefer this approach to a pooled time-series cross-sectional esti- mation because the standard errors in the latter approach are not adjusted for the correlation

of regression residuals across firms, which lead to inflated t-statistics The estimation pro- cedure of year-by-year cross-sectional regressions and the use of average slopes and their time-series standard errors to draw inferences allow for residual cross-correlation (for de- tails, see Fama and French 2000)

Perceptions of Investors and Auditor Tenure

In this subsection, we report the findings of how auditor tenure affects the returns- earnings association Our interest is in the sign and magnitude of the sum of the coefficients

on E*Tenure and E*Tenure (33 + 134) Consistent with prior research, we find that reported

earnings (E and AE) are significantly positively associated with returns (CAR) in Table 3 The sum of the coefficients on E and AE, or ERC, is 0.507 (t-statistic = 10.30) in the first

" Prior studies also find negative mean CAR: (1) DeFond and Hung (2003) report that the mean CAR measured over fifteen months for a sample of 21,908 observations from 1993 to 1999 is -0.05 (-0.04) for firms with

4,355 (7,219) observations

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TABLE 2 Pearson Correlation Matrix

(senior debt) is rated as A+ (AAA), and as the S&P common stock rankings (debt ratings) decline, the

publicly traded as of the fiscal year-end

regression without the control variables using the full sample More important, 33 +

34 is positive and significant (0.012, t-statistic = 3.45) Regression estimates indicate that inves- tors on average pay a premium of 2.4 percent (= 0.012/0.507) for earnings as the auditor- client relationship increases by an additional year The coefficient on Tenure (13) is also significant (0.005, t-statistic = 4.06), indicating that auditor tenure is positively associated with returns

The ERC is 0.432 (t-statistic = 9.00) in the second regression when we include a number of control variables 133 + 34 remains positive and significant (0.008, t-statistic

= 2.48) The parameter estimates suggest that, after controlling for the other determinants

of ERC, investors pay a premium of 2 percent (= 0.008/0.432) for earnings as the audit engagement increases by an additional year Even though the magnitude of

133

smaller in the second regression, we find it reassuring that the results continue to be sig- nificant even after including many control variables When we estimate the augmented model using the restricted sample for which the auditor-client relationship lasts for at least five years, we find similar results Specifically, 13 + 13 is positive and significant at the 5 percent level (0.008, t-statistic = 2.03) in the third regression

The parameter estimates of the components of ERC provide added insights into investor perceptions of the time-series properties of earnings The coefficients on E and AE in all

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three regressions are positive and significant at the 1 percent level Considering that earnings levels (earnings changes) are more important for pricing decisions when earnings contain transitory (permanent) components (Easton and Harris 1991; Ali and Zarowin 1992), the results suggest that investors view reported earnings as containing both transitory and per-

manent components Individual coefficients on E*Tenure (13) and AE*Tenure (14) also

TABLE 3 Earnings Response Coefficients and Perceptions of Investors

Full Sample Variables (Coefficients) (1) (2) Restricted Sample Intercept (a) -0.037 (-5.82)*** -0.096 (-6.40)*** -0.088 (-5.87)***

AE (12) 0.151 (8.09)*** 0.171 (5.04)*** 0.232 (5.60)***

E*Tenure (P3) 0.007 (2.49)** 0.006 (1.80)* 0.009 (2.18)** AE*Tenure (134) 0.005 (3.39)*** 0.002 (1.34) -0.001 (-0.78)

(13 + 13) 0.012 (3.45)*** 0.008 (2.48)** 0.008 (2.03)** Tenure (13) 0.005 (4.06)*** 0.003 (5.68)*** 0.003 (5.29)*** Control Variables