gold et al - 2012 -the effect of engagement and review partner tenure and rotation on audit quality - evidence from germany [mapr]

The Effect of Engagement and Review Partner Tenure and Rotation on Audit Quality: Evidence from Germany Anna Gold* VU University Amsterdam anna.gold@vu.nl 82592 We thank the participant

The Effect of Engagement and Review Partner Tenure and Rotation on Audit Quality: Evidence from Germany

Anna Gold*

VU University Amsterdam anna.gold@vu.nl

82592

We thank the participants of the 2009 European Accounting Association Annual Meeting, the 2009 Meeting of the Accounting Section of the German Academic Association for Business Research (AS-VHB) in collaboration with the International Association for Accounting Education and Research (IAAER), the

2009 Annual meeting of the German Academic Association for Business Research (VHB), the 2009 EARNet Symposium, and the 2010 AAA American Accounting Association Annual Meeting for many helpful suggestions We greatly appreciate the opportunity to use The Annual-Report-database available from the Chair of Business Administration and Controlling at the Westfälische Wilhelms-Universität Münster All remaining errors are our own

The Effect of Engagement and Review Partner Tenure and Rotation on Audit Quality: Evidence from Germany

Abstract:

This study contributes to the recent debate over the effect of audit partner tenure and rotation on auditor independence, expertise and, ultimately, audit quality We investigate the effect of partner tenure and rotation on audit quality, using unique 1995-2010 data from all German listed companies for which we identify not only the audit engagement but also the quality review partner Using multiple absolute and signed values earnings management measures as proxies for audit quality, we find evidence of less income-reducing accounting with an increase in review partner tenure (but not engagement partner tenure) Further, rotation of the review partner (but not the engagement partner) is associated with more income-reducing accounting These findings underline the importance of distinguishing between

the two partner roles and support the expertise hypothesis with respect to the

review partner

Keywords: Audit partner rotation; Audit partner tenure; Audit quality;

Review partner

JEL descriptors: G34, G38, M41, M42, M48

The Effect of Engagement and Review Partner Tenure and Rotation on Audit Quality: Evidence from Germany

1 Introduction

The harsh criticism of the auditing profession in the wake of corporate scandals had a significant impact on regulators‘ activities worldwide One issue early on identified as potentially problematic (e.g., AICPA 1977; European Commission 1996) is the possibility of an excessive tenure period for audit partners, the consequence of which might be that the auditor accepts questionable accounting and reporting practices because of familiarity threats and/or in order to retain the

client This reasoning is often referred to as the independence hypothesis (e.g.,

Mautz and Sharaf 1961; AICPA 1978; DeAngelo 1981a; SEC 1994; IFAC 2008)

As part of regulatory initiatives world-wide, the Sarbanes-Oxley Act (SOX 2002) now requires rotation of both the audit engagement and review partner every five (previously seven) years Similarly, the 8th EU directive 2006/43/EC (European Commission 2006) requires all 27 EU member states to implement mandatory rotation of both engagement and review partners for audit reports dated after June

2008.1 The major expected benefit is that rotation will improve audit quality because inappropriate accounting practices are more likely identified when a new, and hence more independent, engagement partner assumes responsibility for the audit (Carey and Simnett 2006) Meanwhile, opponents to the rotation

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Member states are given discretion with regard to the exact rotation period

requirement suggest a number of potential pitfalls that may counter the benefits Aside from the additional costs incurred to audit firms, a new partner may lack the client-specific knowledge of risk, operations, and financial reporting practices, which could potentially lead to lower audit quality—an argument known as the

expertise hypothesis (e.g., Solomon et al 1999; Johnson et al 2002) Therefore,

despite the widely adopted requirement of audit partner rotation, the standard‘s consequences remain unclear and could be either beneficial or harmful for the quality of the audit

Recently, a few archival studies in Australia, Taiwan, and the United States have examined tenure and rotation at the within-firm partner level by observing signature changes on audit reports With few exceptions (i.e., Chen et

al 2008), results of these studies suggest that (excessive) tenure adversely affects audit quality (Chi and Huang 2005; Carey and Simnett 2006; Manry et al 2008) and that audit quality is higher for firms under a mandatory partner rotation regime than for firms not subject to rotation (Chi et al 2009) Hence, these studies largely support the independence hypothesis

While prior studies have focused exclusively on tenure and/or rotation of

the engagement partner, relevant standards clearly require rotation of all key partners, hence including the quality review partner (hereafter called ‗review

partner‘) alongside the engagement partner (e.g., SOX 2002; European Commission 2006) The purpose of the engagement quality review is to provide

quality control for audit engagements and to serve as an evaluation of the performance of the audit engagement partner and team (Epps and Messier 2007)

As such, the review partner plays a vital role in the audit review process and for the attainment of a high quality audit; however, no prior research has examined either tenure or rotation effects with respect to the review partner separately In Germany, both partners‘ signatures must be visible and identifiable in the audit report and both partners are formally responsible for the audit (§ 322 HGB of the German Commercial Code) This practice is a characteristic of the dual control principle common in German business law As such, German audit report data offers the unique opportunity to examine tenure and rotation of the review partner separately from the engagement partner by means of the location of their respective signatures in the audit report While (excessive) tenure of the engagement partner has largely been shown to aggravate audit quality and there is some evidence that engagement partner rotation provides a viable solution, dynamics might be significantly different when considering the role of the review partner More specifically the review partner might be relatively less susceptible

to independence threats than the engagement partner, because involvement with the client is less extensive and frequent due to the review partner‘s primary role of quality control Further, it is possible that the review partner would primarily benefit from tenure and that rotation might reduce audit quality, because the accumulated experience with the client is not always transferred to a new review

partner While refraining from formulating directional hypotheses in this regard, this paper contributes to the literature by examining whether explanations of independence or expertise differ for tenure/rotation effects of the engagement and review partner, respectively

Consistent with prior studies (e.g., Chi et al 2009), we examine these effects using absolute and signed performance-matched abnormal accruals as proxies for audit quality We identify a sample of 2,636 firm-year observations for the period 1995-2010 in Germany, hence including a period where partner rotation was legally mandated from 2002 onwards.2 Descriptive results reveal that

in the German mandatory rotation setting, rotation occurs even more frequently than the standard requires, such that the mean of partner tenure is less than three years, and the great majority of German firms implement rotation of the review partner (98.56%) and audit engagement partner (99.81%) before the seventh year

of tenure Our regression results suggest that tenure of the review partner is associated with an increase in audit quality (reflected by income-decreasing accounting procedures), while rotation of the review partner leads to a significant decrease in audit quality Interestingly, audit quality is not significantly associated with either engagement partner tenure or engagement partner rotation Overall, our paper provides evidence in favor of the expertise hypothesis, but only for the review partner

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The standard was introduced retro-actively; meaning that engagement and review partners starting in 1995 or earlier were forced to rotate ultimately by 2002

Our study contributes to the debate on mandatory auditor rotation in at least two respects First, in an extension of Chi and Huang (2005), Carey and Simnett (2006), Chen et al (2008), and Manry et al (2008), our analysis provides new empirical evidence by using financial reports on partner (and firm) level rotation and tenure data in a highly developed audit environment, i.e., Germany Second and more importantly, our unique distinction between engagement partner and review partner signatures allows us to differentiate between tenure and rotation of these two partner roles, respectively, and to further disentangle competing hypotheses of expertise and independence Although our findings are

in part based on a time period preceding the introduction of mandatory rotation,

we believe study results are interesting for policy makers and regulators in countries where empirical investigation of engagement and review partner tenure and rotation is difficult or impossible (e.g., the United States)

The remainder of the paper is organized as follows Section 2 describes recent key policy initiatives in the areas of audit partner rotation and the role of the review partner in major jurisdictions (including Germany), reviews related empirical literature, and develops study hypotheses Section 3 discusses the research design, sections 4 and 5 report the empirical results, and section 6 concludes the paper

2 Recent key policy initiatives, literature review and hypotheses

Audit partner tenure and rotation

Audit partner rotation is required in many countries, but the maximum tenure allowed varies considerably In the 1970s, the United States was the first legislation to require rotation of the audit partner after seven years of tenure on audits of SEC-registered clients With the implementation of SOX in 2002, the rotation period was further reduced to five years for public company engagements and now includes the rotation of both the engagement partner and the review partner Similarly, the Department of Trade and Industry and the U.K Treasury implemented a regulation that requires rotation of the lead engagement partner after five years and of other key engagement partners after seven years By the end of June 2008, all member states of the European Union were required to enact the revised 8th Directive‘s requirements into national law (European Commission 2006) One important detail of the Directive is rotation of the key audit partner,3but member states are given discretion regarding the maximum tenure allowed

Even before the EU Directive was issued, Germany had revised its

Commercial Code by means of the ‘Gesetz zur Kontrolle und Transparenz im Unternehmensbereich’ implemented in March 1998, with the rotation requirement

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The key audit partner is typically the partner that signs the audit report, but may also denote either (a) the statutory auditor(s) designated by an audit firm for a particular audit engagement as being primarily responsible for carrying out the statutory audit on behalf of the audit firm; or (b) in the case of a group audit, at least the statutory auditor(s) designated by an audit firm as being primarily responsible for carrying out the statutory audit at the level of the group and the statutory auditor(s) designated as being primarily responsible at the level of material subsidiaries.

becoming effective in 2002 As a result, an audit partner was forced to rotate from the engagement if he/she had signed the audit report six times during a ten-year

auditor-client relationship The ‘Bilanzrechtsreformgesetz’ in October 2004

modified the existing requirement to a situation where rotation was mandated after a seven-year engagement This law is considered a direct response to SOX (2002) and the European Commission Recommendation (European Commission 2002) (Veltins 2004).4 Next, we discuss prior research and develop hypotheses regarding the potential effects of engagement partner tenure and rotation on audit quality

Engagement partner tenure, rotation, and audit quality

Audit quality is defined as the joint probability that an auditor will both detect and report material misstatements (DeAngelo 1981b) According to this definition, audit quality is a function of the auditor‘s ability to detect material misstatements (auditor expertise) and to report those detected misstatements (auditor independence) Prior literature and theory explain how the length of the relationship between the auditor and the client (i.e., tenure) may affect audit quality Interestingly, there is an inherent conflict regarding such effects, as

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As part of this major reform, § 319a HGB was issued for public interest companies This legislation defines circumstances under which an auditor must immediately be excluded from the audit Beyond the reasons stated in § 319 II and III HGB, an auditor is also excluded from the audit of a client using an organized market, as defined in § 2 V Securities Trading Act4

(Wertpapierhandelsgesetz), if the key audit partner(s) has issued (i.e signed) the audit opinion (Bestätigungsvermerk–§ 322 HGB) for seven or more consecutive years (§ 319a I no 4) This

requirement is waived if there has been a cooling-off period of three or more years since the last audit

reflected by the hypotheses of independence and expertise (e.g., Mautz and Sharaf 1961; Shockley 1981; Iyer and Rama 2004)

On one hand, audit quality may be compromised as auditor tenure

increases, an argument often referred to as the independence hypothesis More

specifically, an increase in audit partner tenure might introduce a familiarity threat

to auditor independence (IFAC 2008) The IFAC Code of Ethics states that a

―familiarity threat occurs when, by virtue of a close relationship with an assurance client, its directors, officers or employees, a firm or a member of the assurance team becomes too sympathetic to the client‘s interests‖ (IFAC 2008, p 18) This threat could result in a decline in the audit partner‘s ability to accurately judge the company‘s performance and the client‘s reporting decisions A related explanation is the threat of routine While an audit partner will likely apply creative approaches to audit-testing in the early years of tenure (AICPA 1978; Hoyle 1978; McLaren 1958), deeper knowledge over time about the client‘s systems and control procedures may result in more routine audit programs (Hoyle 1978) Shockley (1981, p 789) asserts that ―complacency, lack of innovation, less rigorous audit procedures and a developed confidence in the client may arise after

a long association with the client.‖ The major concern is that prior year audits may cause the partner to anticipate current results instead of carefully and objectively examining the current year‘s data for material misstatements (Arrunada and Paz-Ares 1997) In conclusion, the independence hypothesis

predicts that auditor tenure is negatively associated with audit quality, while auditor rotation would have positive outcomes

In contrast, the expertise hypothesis (e.g., Solomon et al 1999; Johnson et

al 2002) contends that audit quality may increase with auditor tenure because the auditor gains more knowledge of the client and the client‘s industry over time This explanation is based on information asymmetry between the client and the auditor, which decreases over time, as the auditor acquires client- and industry-specific knowledge Because increased client-specific knowledge provides a comparative advantage in detecting material misstatements in financial reports, lack of this knowledge in the early years of an audit engagement may result in a lower quality audit, while tenure should have a favorable effect on audit quality (Beck et al 1988; Hoyle 1978; Knapp 1991; Solomon et al 1999; Geiger and Raghunandan 2002; Myers et al 2003) Consequently, auditor rotation would have adverse effects on audit quality according to the expertise hypothesis

Given the limited availability of empirical data on the association between auditor tenure/rotation and audit quality at the audit partner level, most prior research has examined this relationship at the audit firm level Archival evidence

on audit firm tenure shows mixed results as to which theory dominates with respect to audit quality – the independence hypothesis (e.g., Kealey et al 2007; Mansi et al 2004; Stanley and DeZoort 2007) or the expertise hypothesis (e.g., Carcello and Nagy 2004; Davis et al 2009; DeFond and Subramanyam 1998;

Ghosh and Moon 2005; Johnson et al 2002) However, Bamber and Bamber (2009) caution that findings based on audit firm rotation may not be generalizable

to audit partner rotation, because of different cost and benefits effects

Recent archival research has considered the issue of rotation and tenure at the engagement partner level and provides mixed results The mandatory inclusion of partner signatures on audit reports in some countries, such as Australia and Taiwan, has enabled such endeavors Carey and Simnett (2006) conducted one of the first studies in this area by examining Australian listed companies The authors reach varying conclusions, depending on the measure of audit quality used The non-Big 6 (but not Big 6) auditors‘ propensity to issue going-concern audit opinions for distressed companies was less likely as audit partner tenure increased However, the authors found no evidence of an association between audit partner tenure and either the signed or absolute amount

of abnormal working capital accruals Using Taiwanese data, Chi and Huang (2005) found that engagement partner (and audit firm) tenure initially led to higher earnings quality (particularly for Big 5 auditors), but excessive familiarity with the client (i.e., more than five years) negatively affected earnings quality Again using a sample of Taiwanese companies, Chen et al (2008) found that the absolute and positive values of discretionary accruals decreased significantly with audit partner tenure, hence leading to an increase in audit quality Chi et al (2009) investigated the effects on audit quality of the mandatory audit partner rotation

implemented in Taiwan in 2004 Using absolute and signed abnormal accruals and abnormal working capital accruals as proxies for audit quality, they found that in 2004, audit quality was higher for companies subject to the mandatory rotation regime than for firms not subject to rotation Finally, the only United States study on audit partner tenure to date (Manry et al 2008) found that partner tenure was positively associated with audit quality, using estimated discretionary accruals as a proxy Excessive tenure (i.e., more than seven years) again had negative effects on audit quality, but only for small clients

In experimental settings, partner rotation decreases auditors‘ willingness to

issue biased audit reports (Dopuch et al 2001) and strengthens independence in appearance of non-professional investors (Kaplan and Mauldin 2008), suggesting

that partner rotation may have favorable effects on audit quality However, while audit firm rotation evoked higher confidence in financial statements by MBA and law students, partner rotation did not have this effect (Gates et al 2007)

In summary, archival and experimental results are inconsistent with respect to the association between engagement partner tenure/rotation and audit quality Some research supports the independence hypothesis; other results confirm the expertise hypothesis Some studies even fail to find an effect of tenure/rotation on audit quality, which could indicate that the two explanations compensate for each other Because no solid theoretical support is available to predict directional hypotheses, we posit two null hypotheses to empirically test

these relationships in the German setting, which uniquely allows us to isolate engagement partners from engagement quality review partners

HYPOTHESIS 1a: Engagement partner tenure is not associated with audit quality

HYPOTHESIS 1b: Engagement partner rotation is not associated with audit quality

Next, we consider how tenure and rotation of the review partner may affect audit

quality

Quality review partner tenure, rotation, and audit quality

The general purpose of the engagement quality review is to provide quality control for audit engagements and to serve as an evaluation of the performance of the engagement partner and the engagement team (Epps and Messier 2007) The potential strengths of the review partner are manifold First, while the engagement partner is susceptible to familiarity threats (leading to possibly favorable attitudes toward the client and potential reluctance in the final review stage to challenge or question decisions made in earlier stages), the review partner has significantly less interaction with the client, which may reduce such familiarity threats in the first place (Schneider et al 2003) Second, review partners typically hold little accountability toward the client but have considerable knowledge about the client‘s industry; therefore, they offer an opportunity for objective and high-level judgments and decisions (Matsumura and Tucker 1995;

Rich et al 1997) According to German audit standards, the review partner‘s responsibilities include obtaining information about the fundamental content of the audit opinion, the structure of the audit, and its material aspects Furthermore, adequate information procurement includes a critical review of the audit report Consistent with other legislations, a review of the audit report by a separate review partner who is not involved in planning and conducting the audit is mandatory for German financial statement audits (§ 24d II BS WP/vBP–

Berufssatzung für Wirtschaftsprüfer/vereidigte Buchprüfer) The review process

consists of evaluating whether the audit procedures and audit results are consistent (§ 24d I BS WP/vBP)

Germany provides a unique setting for researchers, because both the engagement partner and the review partner are formally responsible for the audit and the reasonableness of the audit opinion, and both partners‘ signatures must be visible and identifiable in the audit reports (§ 322 HGB of the German Commercial Code).5 By providing signatures in the audit report, both partners accept the role as key audit partners with the consequence of having to rotate after seven years of tenure with the audit client Relevant to our study, it is common dual control practice in Germany that the review partner‘s signature is located on

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Although the 8 th

EU directive requires only the signature of one audit partner responsible for the audit, it is German audit practice to provide the signature of the review partner in addition

Providing both signatures in the audit report is a characteristic of the dual control principle

common in German business law For instance, legislation mandates company representation by at least two directors (§ 709 Abs 1 BGB und § 35 Abs 2 Satz 1 GmbHG, § 77 Abs 1 Satz 1 AktG) and dual quality control of audit firms (§ 24d Abs 1 Satz 1 BS WP/vBP)

the lower left-hand side of the audit report, next to the right-hand side signature of the engagement partner (§ 27a BS WP/vBP).6 Both engagement partner and review partner have reached partner level and typically work for the same audit firm.7 The review partner‘s signature implies that the signer is sufficiently familiar with the audit to be able to take co-responsibility for the audit opinion

Although recently established regulation in Germany and elsewhere underlines the importance of the engagement quality review as an effective technique to uncover potential failures and detect deficiencies in financial statements (Luehlfing et al 1995), only a handful of (experimental and analytical) studies to date have examined audit review partner effectiveness with respect to audit quality In an experiment, Kraut and Davidson (1998) found that review partners‘ audit opinions (vis-à-vis engagement partners) were influenced by neither client importance nor the importance of the client‘s industry, thus confirming their relative strength in independence Matsumura and Tucker investigated analytically and experimentally how engagement partners respond to

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To verify this signature practice for our study, we elicited survey responses of more than half of the audit firms in our sample The results clearly support that the signature on the left-hand side of the audit report always identifies the person who conducted the quality review Furthermore, to support the survey results, we received the internal directives on quality assurance detailing the in- house practice of three of the Big 4 audit firms The directive explicitly states that the partner providing the audit quality review signs the left-hand side of the audit report and the audit

engagement partner signs the right-hand side of the report Thus, we can safely conclude that the location of the signature in the audit report informs us of the role that an individual served during the audit process (Gelhausen 2007)

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As explained in more detail in our results section, we observe 24 joint audits in our sample suggesting that two firms jointly conducted the audit and therefore a total of four partners (two engagement partners and two review partners) sign the audit report (i.e., four signatures)

Controlling for joint audit cases in our regression models does not change our results

the presence of a review partner and found that engagement partners planned higher levels of audit testing (Matsumura and Tucker 1995) and exhibited less reporting bias (Tucker and Matsumura 1997) in the presence of a review partner Without second-partner reviews, engagement partners showed significantly more strategic behavior in their reporting Similarly, Ayers and Kaplan (2003) found that engagement partners performed better audit risk assessments during client acceptance in the presence of a review partner

To our knowledge, no prior research has investigated the effect of auditor tenure or rotation on review partners‘ reporting decisions, with two notable exceptions employing experimental methods First, Favere-Marchesi and Emby‘s (2005) results revealed that continuing review partners (i.e., those with prior involvement in the previous year‘s engagement) were less likely than new review partners (i.e., no prior involvement) to reach conclusions that differed from the engagement partner when the evidence refuted the engagement partner‘s view This finding may suggest that not even review partners are immune to potential independence threats However, Schneider et al (2003) manipulated prior review partner involvement in audit planning and found that the degree of a review partner‘s agreement with an engagement team‘s conclusion was unaffected by prior involvement; hence, this finding suggests that review partners have the ability to remain objective

On one hand, we suggest that the likelihood of independence threats due to tenure could be significantly lower for review partners than for engagement partners Review partners remain at a greater distance from the client and are less involved in daily audit practices Given such circumstances, they are in a unique position to enjoy the learning benefits without risking the accompanying and potentially detrimental independence threats Hence, the expertise hypothesis could more likely be at stake for review partners as compared to the independence hypothesis However, as suggested by the experimental results of Favere-Marchei and Emby (2005), even review partners appear to be susceptible to bias in their reporting decisions Given limited and inconclusive prior research evidence, we posit two null hypotheses to empirically test the association between review partner tenure and audit quality, and review partner rotation and audit quality, respectively:

HYPOTHESIS 2A: Review partner tenure is not associated with audit quality

HYPOTHESIS 2B: Review partner rotation is not associated with audit quality

3 Research design

Sample

Our data were obtained from two different sources First, the accruals data were obtained from the Compustat Global Industrial database As shown in Table 1, the

initial sample consisted of 9,597 firm-year observations of German listed companies, excluding financial institutions and insurance companies and covering the period 1995-2010 We removed 4,026 observations with missing accrual items

[Insert Table 1 about here]

The data on audit firm, audit engagement, and review partner signatures was manually collected either from an Annual Reports database containing consolidated financial statements or from the respective company‘s website We collected data from all German-listed companies for which annual financial statements including the auditor‘s report were available Our final sample consists

of 2,636 firm-year observations including data on the audit firm, audit engagement and audit review partner

Empirical model

Audit quality can be measured in multiple ways Experimental and survey research commonly assesses perceptions of audit quality (for a review, see Quick 2004) Proxies for audit quality in archival research include materiality judgments (e.g., Kemp et al 1983), propensity to issue unqualified audit opinions (e.g., Vanstraelen 2000) and audit firm litigations (e.g., Latham et al 1998) More recent studies have used a firm‘s accrual accounting behavior as a proxy for audit quality (e.g., Myers et al 2003, Chi et al 2005, Carey and Simnett 2006; Francis and Wang 2008; Cameran et al 2008) Lower accrual levels are associated with

greater auditor conservatism and are interpreted as indicating higher quality audits, mitigating extreme management reporting decisions Johnson et al (2002) and Myers et al (2003) use the Jones 1991 model-estimated abnormal accruals as proxies for audit quality Consistent with Chi et al (2009), we use the modified Jones model (Dechow et al 1995) to estimate abnormal accruals

Assuming that the total accruals of a firm can be divided into discretionary and non-discretionary accruals and that the apportionment cannot be observed, our measure estimates discretionary accruals Following Dechow et al (1995), we calculate total accruals as the change in current accruals minus the change in current liabilities other than financial liabilities and less depreciation :8

(1)

Where

= Total accruals of firm i in year t

= Non-discretionary accruals of firm i in year t

= Discretionary accruals of firm i in year t

= Change in current assets of firm i from year t to year t-1

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We are aware of the limitations of using balance sheet data to partition net income into accruals and operating flows (Collins and Hribar 2002) However, in accordance with prior research using international data (e.g., Leuz, Nanda and Wysocki 2003) we use the indirect approach to compute total accruals, due to the lack of cash flow data for international firms in the commonly used databases.

= Change in cash of firm i from year t to year t-1

= Change in current liabilities of firm i from year t to year t-1 = Change in short-term debt of firm i from year t to year t-1 = Depreciation of firm i in year t

Our measure is a modification of the original Jones model (Jones 1991), that is,

we use the cash flow Jones model (Kasznik 1999) These models are both based

on the assumption that the model indicates non-discretionary accruals They assume non-discretionary accruals as a component of total accruals for an estimation period, which is not (or at least less) affected by earnings management The coefficients resulting from this regression are used to estimate the total accruals of the firms in the actual sample period Comparing the results from this regression to the expected total accruals calculated by the model (equation (1)) results in differences that are considered to be discretionary accruals To control for industry-specific effects on the accruals, the model is calibrated separately for each industry sector The original Jones model (Jones 1991) is based on the idea that the non-discretionary part of the accruals is dependent on economic conditions of each firm Therefore, property, plant and equipment and change in revenues are included in the model to control for changes in non-discretionary accruals caused by changing conditions

The original Jones model is modified in multiple ways The model implies that changes in revenues are non-discretionary Dechow et al (1995) modified the

Jones model by reducing the revenues by the receivables as receivables could increase current assets if they include bad debt Kasznik (1999) included a change

in the cash flow This model assumes that the accruals of a current period are dependent on the cash flows of the previous period Therefore the coefficients of the cash flow Jones model (Kasznik 1999) are estimated for each industry sector based on the following equation9:

Where

= Last year‘s total assets of firm i in industry sector p

= Change in revenues of firm i in industry sector p

= Change in receivables of firm i in industry sector p

= Property, plant and equipment of firm i in industry sector p = Change in cash flow of firm i in industry sector p

All variables are scaled by total assets to control for size effects and to reduce the possibility of heteroscedasticity To test hypotheses H1a and H2a, we examine the

impact of audit engagement tenure (EPTENURE) and review partner tenure (RPTENURE) on earnings management using the following regression model:

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In non-tabulated tests we compare the explanatory power of five different measures to estimate abnormal accruals: the Jones 1991 model, the modified Jones model, the cash flow model, the performance-matched Jones and modified Jones model We selected the measure of abnormal accruals with the most consistent R- square overall for our different industry sectors, leaving us with the cash flow model

= discretionary accruals by cash flow Jones

measured in absolute, positive and negative values = years of tenure of the engagement partner

conducting the audit (i.e., first year = 1; second year

= 2; etc.) = tenure of the engaged review partner

= tenure of the engaged audit firm

= dummy variable equal to ―1‖ if the auditor is from a

Big 4 audit firm, and equal to ―0‖ otherwise = sales growth rate calculated as the sales in year t

minus sales in t-1 and scaled by sales in year t-1

= natural logarithm of total sales

= cash flow in year t scaled by total assets in year t-1

= ratio of retained earnings to total common equity

To test hypotheses H1b and H2b, we examine the impact of audit engagement

partner switches (EPS) and review partner switches (RPS) on earnings

management using the regression model below

in absolute, positive and negative values = dummy variable equal to ―1‖ if the audit

engagement partner was switched from t-1 to t, and

equal to ―0‖ otherwise = dummy variable equal to ―1‖ if the audit review

partner was switched from t-1 to t, and equal to ―0‖

otherwise = tenure of the engaged audit firm

= dummy variable equal to ―1‖ if the auditor is a Big 4

audit firm, and equal to ―0‖ otherwise = sales growth rate calculated as the sales in year t

minus sales in t-1 and scaled by sales in year t-1

= natural logarithm of total sales

= cash flow in year t scaled by total assets in year t-1

= ratio of retained earnings to total common equity Consistent with prior studies (Cameran et al 2008; Chi et al 2009), we use the exact value, the absolute value, and the signed values of accruals as dependent variables for our measures To control for industry-specific effects, we use one-digit codes from the North American Industry Classification system (NAICS) We further include fixed effects for year

We include several control variables for other known determinants of accruals in our model (l) (e.g., Chen et al 2008; Chi et al 2009; Myers et al

2003) First, we include audit firm tenure in our models to control for any effect

on audit quality from the number of years that a given audit firm has been performing the audit Moreover, since accrual models are often unable to completely capture the effects of companies‘ performance on nondiscretionary

accruals (Dechow et al 1995; Kothari et al 2005), we include cash flow to

control for the nondiscretionary component of accruals, which is not extracted by

our accrual model We include lifecycle to control for changes in accruals over a

company‘s life cycle (Anthony and Ramesh 1992; Dechow et al 2001)

Furthermore, the size of a company determines its earnings management behavior

in the sense that larger companies face higher political costs (Watts and Zimmerman 1983; 1986; 1990) and higher litigation risk (Lang and Lundholm 1993) In addition, larger companies tend to report larger and more stable accruals

(Dechow and Dichev 2002) The growth of a company‘s sales is likely to increase the absolute value of accruals Finally, we control for Big4 audit firms, which tend

to be more conservative and to limit their clients‘ extreme accruals more than non-Big 4 firms However, findings related to this argument are mixed (Myers et

and individual rotation of audit partners as well as audit firms

[Insert Table 2 about here]

Out of a total of 2.636 audits, 758 (687) engagement partner (review partner) switches occurred during our sample period, compared with 1.878

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Results remain unchanged when we include leverage calculated as total liabilities/equity in all

our models However, since our sample size decreases to 2,367 we refrain from the inclusion of

leverage in our main tests

(1.949) observations during which no partner switch took place Thus, we find engagement (review) partner switches in about 29 percent (26 percent) of the observations In 124 cases of the 758 engagement partner switches (about five percent), the engagement partner became review partner Out of 687 review partner rotations, 58 partners (about two percent) rotated to a role as engagement partner.11 Further, rotation at the audit firm level occurred for 228 audit engagements, constituting about nine percent of all audits in the sample In 189 cases (about seven percent) the engagement partner rotated simultaneously with the audit firm The review partner rotated with the audit firm in 199 (about eight percent) out of 228 audit firm switches.12

Panel B of Table 2 shows details on firm tenure,13 engagement partner tenure and review partner tenure for the full sample as well as for the five subsamples, corresponding to the five different indices of the German stock exchange, i.e DAX30, MDAX, TecDAX, SDAX and CDAX The average audit firm tenure is 5.23 years The engagement partner rotates on average after a period of 2.55 years, whereas the average review partner tenure is slightly longer with 2.80 years.14,15 We find similar mean values for the subsample of firms listed