johnson et al - 2002 - audit-firm tenure and the quality of financial reports

KENNETH REYNOLDS, Louisiana State University Abstract This study examines whether the length of the relationship between a company and an audit firm audit-firm tenure is associated with

Audit-Firm Tenure and the Quality of

Financial Reports*

VAN E JOHNSON, Georgia State University

INDER K KHURANA, University of Missouri-Columbia

J KENNETH REYNOLDS, Louisiana State University

Abstract

This study examines whether the length of the relationship between a company and an audit firm (audit-firm tenure) is associated with financial-reporting quality Using two proxies for financial-reporting quality and a sample of Big 6 clients matched on industry and size, we find that relative to medium audit-firm tenures of four to eight years, short audit-firm tenures

of two to three years are associated with lower-quality financial reports In contrast, we find

no evidence of reduced financial-reporting quality for longer audit-firm tenures of nine or more years Overall, our results provide empirical evidence pertinent to the recurring debate regarding mandatory audit-firm rotation — a debate that has, to date, relied on anecdotal evidence and isolated cases.

rotation

Condensé

Les auteurs étudient l’incidence de la durée du mandat des cabinets d’expertise comptable sur la qualité de l’information financière Les rapports financiers sont l’un des principaux outils de communication de l’information financière aux tiers Il existe une asymétrie de l’information et des facteurs de motivation conflictuels entre les gestionnaires qui ont la res- ponsabilité de préparer les rapports et les utilisateurs de ces rapports, et la vérification des états financiers contribue à réduire l’incidence de ces conflits en améliorant la qualité de l’information communiquée par les gestionnaires Pourtant, la vérification n’améliore la qualité de l’information que si elle réduit l’occurrence d’inexactitudes dans les états financiers.

La capacité de la vérification de réduire ces inexactitudes est généralement considérée comme une fonction dépendant de deux variables : la capacité du vérificateur de déceler les inexactitudes (soit la compétence du vérificateur) et son comportement subséquent, c’est-à- dire le fait qu’il s’assure que les correctifs nécessaires soient apportés aux inexactitudes décelées (soit le comportement de communication du vérificateur).

Earl Wilson, two anonymous reviewers, participants at the 1999 American Accounting tion midyear auditing section meeting, the central states accounting research workshop, and workshop participants at University of Illinois, University of Kansas, University of Missouri, and University of North Texas for their valuable comments on this paper.

Associa-638 Contemporary Accounting ResearchL’on a souvent supposé que la durée des mandats des cabinets d’expertise comptable avait des répercussions négatives sur la compétence des vérificateurs, leur comportement de communication ou les deux La durée du mandat est la période pendant laquelle est maintenue

la relation entre une société et ses vérificateurs Ceux qui débattent de la question de la rotation des vérificateurs invoquent des arguments antagonistes relatifs aux conséquences positives

ou négatives de relations prolongées entre une société et ses vérificateurs En apparence, les arguments des deux camps se défendent, bien que la majorité des preuves invoquées jusqu’à maintenant dans les discussions tiennent essentiellement de l’anecdote et de la conjecture Il existe peu de données empiriques relatives à l’incidence de la durée des mandats des cabinets d’expertise comptable sur l’information financière La présente étude vise à combler ce vide

et à contribuer à faire avancer le débat sur la durée des mandats des cabinets d’expertise comptable.

Dans leur analyse empirique, les auteurs classent la durée des mandats des cabinets d’expertise comptable selon qu’elle est courte, moyenne ou longue Suivant leur définition,

un mandat de courte durée est une relation vérificateur-client de deux à trois ans, un mandat

de durée moyenne, une relation de quatre à huit ans, et un mandat de longue durée, une relation

de neuf ans ou plus ; les tests effectués par les auteurs ne sont cependant pas sensibles aux autres découpages possibles Les auteurs formulent l’hypothèse selon laquelle les durées courte et longue seraient toutes deux associées à une qualité d’information financière inférieure à celle qui correspond à la durée moyenne.

Les auteurs s’attendent à ce que les mandats de courte durée aient une incidence négative sur la qualité de l’information, principalement parce que la société faisant l’objet de la vérification est peu familière aux vérificateurs Bon nombre d’études ont invariablement démontré que les vérificateurs ont tendance à fournir un travail légèrement moins efficace

au cours des deux premières années de leur mandat qu’au cours des années subséquentes Outre cette lacune, le vérificateur peut également faire face à différents facteurs de motivation durant les premières années du mandat, comparativement aux années subséquentes Il devra,

en effet, trouver un compromis entre le désir de tirer parti des possibilités commerciales qu’offre le client et celui de préserver la réputation du cabinet et d’éviter les litiges onéreux Les facteurs de motivation initiaux du vérificateur peuvent être partiellement modifiés par l’impératif du maintien de la relation avec le client pendant la période nécessaire au recouvre- ment des cỏts lorsqu’il y a sous-facturation systématique des services (ce que l’on appelle

la pratique du leurre-prix), au cours des premières années du mandat, dans le but d’attirer le client.

Les auteurs s’attendent à ce que les mandats de longue durée aient une incidence négative sur la qualité de l’information, principalement en raison de problèmes de motivation Plus le vérificateur accumule d’expérience en travaillant auprès du client, moins il est sensible au risque de litige ou de préjudice à la réputation et plus ses motivations s’orientent vers la fidélisation du client et ce qu’il peut rapporter De plus, le vérificateur risque de devenir moins vigilant dans la détection des inexactitudes en raison de la confiance qu’il a cultivée

au fil de ses relations prolongées avec le client.

Pour déterminer l’incidence de la durée des mandats d’un cabinet d’expertise comptable sur la qualité de l’information financière, les auteurs évaluent cette qualité à l’aide de deux mesures Premièrement, ils utilisent la valeur absolue des ajustements imprévus à titre de sub- stitut à l’ampleur des interventions de la direction dans les résultats déclarés La comptabilité

Audit-Firm Tenure and the Quality of Financial Reports 639d’exercice donne aux gestionnaires une grande latitude dans la détermination des résultats Les recherches précédentes ont fait ressortir que cette latitude peut être exploitée de façon opportuniste, ce qui risque de réduire la qualité des rapports financiers En l’absence d’attentes précises a priori en ce qui a trait aux facteurs de motivation des gestionnaires, les chercheurs ont généralement utilisé la valeur absolue des ajustements imprévus pour cerner

le comportement interventionniste de la direction Deuxièmement, les auteurs étudient la mesure dans laquelle les ajustements d’un exercice persistent dans les résultats de l’exercice subséquent L’utilisation opportuniste des ajustements aura tendance à augmenter la portion transitoire des résultats de l’exercice, ce qui en diminue la persistance.

Les auteurs bornent leur analyse empirique aux clients des Six Grands cabinets d’expertise comptable, étant donné que les recherches précédentes ont révélé d’importantes différences entre les vérificateurs des Six Grands cabinets et les autres vérificateurs À chacun des cabinets appartenant au groupe de ceux dont la durée des mandats est courte (le plus petit des trois groupes), les auteurs associent des cabinets de taille comparable et du même secteur, appartenant aux groupes de ceux dont la durée des mandats est moyenne et longue, afin d’éliminer les différences dans la qualité de l’information financière attribuables à des facteurs autres que la durée des mandats En utilisant les échantillons finals résultant des combinaisons de 2 463 pour le test de la valeur absolue des ajustements et de 2 280 pour

le test de la persistance des ajustements, ils constatent uniformément que les mandats de courte durée des cabinets d’expertise comptable sont associés à des rapports financiers

de qualité inférieure En revanche, pour les deux tests, les auteurs ne relèvent rien qui permette

de conclure à une diminution de la qualité de l’information financière pour les mandats de durée plus longue.

Les résultats obtenus par les auteurs viennent enrichir le fonds croissant des travaux sur

la qualité de la vérification En utilisant un échantillon de sociétés clientes des services de vérification des Six Grands cabinets d’expertise comptable, les auteurs démontrent que l’on peut observer des variations de qualité de l’information financière — et, par déduction, des variations de qualité de la vérification — dans les missions de vérification exécutées par les Six Grands Les résultats augmentent aussi la documentation relative à la qualité de l’infor- mation financière Dans l’optique selon laquelle les rapports financiers sont le résultat du travail effectué de concert par la société et ses vérificateurs, les auteurs démontrent qu’il pourrait être important de prendre en considération le vérificateur dans les prochaines analyses

de la qualité des rapports financiers Enfin, les auteurs abordent la question de la rotation des vérificateurs dans une perspective empirique Leurs constatations viennent confirmer les échos selon lesquels la qualité de l’information est inférieure pendant les premières années

de la relation vérificateur-client, mais elles ne permettent pas de conclure que, dans les années subséquentes, les rapports sont de qualité inférieure, tout au moins sous le régime de réglementation actuel.

1 Introduction

Congress and regulators periodically turn their attention to the role that auditorsplay in the financial-reporting process (U.S Governmental Accounting Office(GAO) 1996) During these periods, which often follow high-profile frauds orbankruptcies, the closeness of audit-firm–client relationships is frequently scrutinized

640 Contemporary Accounting Research

(cf McClaren 1958; Winters 1976; United States Senate (Metcalf committee)1976; Hoyle 1978; GAO 1991) Also during these periods, mandatory audit-firmrotation is offered as a possible means of improving the quality of financial reporting.1There is limited empirical evidence regarding the relationship between audit-firm tenure (the length of the auditor – client relationship) and financial-reportingquality Thus, it is not clear whether the problem that mandatory rotation isintended to solve is real or illusory In this paper, we examine whether short andlong audit tenures are associated with the issuance of lower-quality financialreports using two proxies for financial-reporting quality First, we use the absolutevalue of unexpected accruals to proxy for the extent of management interventions

in reported earnings numbers Second, we investigate the extent to which currentaccruals persist into earnings in the subsequent year as a proxy for the quality ofaccruals reported in current period earnings

Based on an industry- and size-matched sample of publicly traded companiesaudited by Big 6 audit firms, our results suggest that short audit-firm – client rela-tionships (two to three years) are associated with lower-quality financial reportsrelative to medium audit-firm–client relationships (four to eight years) We observeevidence of greater management intervention in reported earnings and lower-qualityaccruals (current accruals that are less likely to persist in one-period-ahead earn-ings) for short audit-firm tenures

In contrast to the results for short audit-firm tenures, the same tests do not vide evidence that long audit-firm – client relationships (nine years or longer) areassociated with reduced financial-reporting quality relative to medium audit-firm–client relationships We are unable to detect statistically significant differences inmanagement interventions in reported earnings or accrual quality for long audit-firm tenures

pro-Our results provide needed empirical evidence pertinent to the recurringdebate regarding mandatory audit-firm rotation — a debate that has, until recently,relied on anecdotal evidence and isolated cases This study, when combined withother recent research, such as Dopuch, King, and Schwartz 2001 and Geiger andRaghunandan 2002, can be used to move the debate forward Our results documentlower financial-reporting quality for short audit tenures, but not for long audit ten-ures It is important to note that our results are based on the current regulatoryregime, and cannot be generalized to a regime in which audit-firm rotation is man-datory Under such a regime, where the horizon for the relationship between theclient and the firm is known, auditor incentives may differ significantly

Our results also add to the growing body of literature on audit quality Severalprior studies have investigated whether Big 6 auditors provide higher-qualityaudits than non–Big 6 auditors (cf DeAngelo 1981; Teoh and Wong 1993; Becker,DeFond, Jiambalvo, and Subramanyam 1998; Francis, Maydew, and Sparks 1999)

We investigate audit tenure, a factor that varies within auditor size class rather thanacross auditor size classes Given the relative dominance of the Big 6 in the audits ofpublicly listed companies, our study highlights quality differences within the Big 6class More importantly, we demonstrate that auditor tenure may be an additionalvariable influencing financial-reporting outcomes Our results are also consistent

Audit-Firm Tenure and the Quality of Financial Reports 641with prior work (e.g., Knapp 1991; O’Keefe, King, and Gaver 1994) that has iden-tified the importance of client-specific knowledge to audit quality.

The remainder of the paper is organized as follows In section 2, we developour hypotheses In section 3, we discuss specific research design issues associatedwith the methodology used, and describe sample selection Results are presented

in section 4, and conclusions are presented in the final section of the paper

2 Hypotheses development

Financial reports are a principal means of communicating financial information tothose outside an entity Given the existence of information asymmetries and thepotential for conflicts of interest between company management and outside users

of financial information, an audit of financial reports by a third party (or alternativemonitoring arrangements) can enhance the quality of the financial informationreported by management (Dopuch and Simunic 1982; Watts and Zimmerman1986) and improve the quality of information that investors have about the value oftraded securities (Ronnen 1996)

Recognizing the importance of auditing in the financial-reporting process,Antle and Nalebuff (1991) suggest that financial statements should be viewed as ajoint statement from the audit firm and company management In general, the abil-ity of the audit function to enhance financial-reporting quality is dependent on boththe likelihood that the audit will detect a material misstatement or omission(henceforth auditor competence) and the auditor’s behavior subsequent to thedetection of a material misstatement (henceforth, auditor-reporting behavior) Ifmaterial misstatements are detected and corrected (or revealed), the quality of thefinancial report is improved Alternatively, a failure to detect material misstate-ments or a failure to require that they be corrected before issuing a clean auditreport would not improve the quality of the financial report

Prior work has documented that Big 5/6/8 audit firms are associated withsuperior financial reporting outcomes (cf Teoh and Wong 1993; Beasley andPetroni 1996; Becker et al 1998; Francis et al 1999) The explanations offered forthe superiority of the larger firms generally focus on advantages in (1) perceivedcompetence (by virtue of their heavy spending on auditor-training facilities and pro-grams), and (2) perceived independence in reporting (by virtue of their size and largeportfolio of clients, which presumably gives them the financial strength to stand up

to, or walk away from, a client if necessary) We investigate the potential effects ofaudit tenure on financial-reporting quality by considering how changes in auditorknowledge and incentives may impact financial-reporting quality as audit tenurechanges

Short audit-firm tenure

Knowledge is a critical input to the auditor’s ability to detect material misstatements

A great deal of knowledge necessary to the audit (such as knowledge of the client’saccounting system and internal control structure) is client-specific.2 Althoughauditors use other types of knowledge (such as general knowledge and industryknowledge) to produce an audit, the importance of client-specific knowledge

642 Contemporary Accounting Research

creates a significant learning curve for new auditors (Knapp 1991) and results insignificant start-up costs (DeAngelo 1981) Less client-specific knowledge in theearly years of an engagement may result in a lower likelihood of detecting materialmisstatements, thereby giving auditors a comparative advantage in detecting errorsover time as they obtain a deeper understanding of the client’s business (Beck,Frecka, and Solomon 1988).3

An initial lack of client-specific knowledge on an engagement may not beassociated with lower financial-reporting quality if it is possible to overcome thelack of knowledge by employing additional effort on new engagements.4 However,knowledge and effort may not be perfect substitutes for one another Arrunada andPaz-Ares (1997) suggest that there may be a technological limit to the replacement

of client-specific assets; that many, if not most, of them cannot be replaced ately Thus, financial-reporting quality is expected to increase as client-specificknowledge increases in the early years of an audit engagement

immedi-Prior research also suggests that auditor incentives may differ in the earlyyears of an audit engagement Generally, auditor incentives are traded off betweenthe auditor’s desire to maintain and profit from the auditor – client relationship(Chow and Rice 1982; Citron and Taffler 1992) and the desire to protect the firm’sreputation (brand name) and to avoid costly litigation (Balachandran and Nagara-jan 1987; DeJong 1985; Melumad and Thoman 1990; Narayanan 1994; Nelson,Ronen, and White 1988) DeAngelo (1981) noted that client-specific assets (such

as knowledge) along with transactions costs allow the incumbent auditor to earnquasi rents from maintaining existing client relationships Financial-reportingquality could be reduced in early engagement years if the existence of quasi rentsskews the auditor’s incentives toward maintaining the client relationship Geigerand Raghunandan (2002) suggest that the competitive practice of low balling mayfurther skew the auditor’s incentives and cause the auditor to employ less effort or

be more accommodating to the client in the early years of an engagement in anattempt to limit losses on the current engagement and to ensure a repeat engagement.The above discussion leads to the following hypothesis (stated in the alternativeform)

lower when the audit firm’s tenure is short than when the audit firm’s tenure

is medium.

Long audit-firm tenure

Most arguments surrounding audit tenure and incentives have suggested that ceterisparibus, over time, the auditor’s incentives shift toward maintaining and profitingfrom the client and the auditor becomes less concerned with litigation relating tothe client Accordingly, the auditor may become less objective and apply less efforttoward the detection of material misstatements (Hoyle 1978; Arrunada and Paz-Ares 1997).5 Given the increased client-specific knowledge obtained from multiplerepeat engagements, some reduction in effort would be expected without threaten-ing audit quality However, arguments regarding the detrimental effects of long

Audit-Firm Tenure and the Quality of Financial Reports 643audit-firm tenures implicitly assume that reductions in effort will exceed an opti-mal level Shockley (1981) characterizes this situation as the audit firm having a

“learned confidence” in the client as a result of the long relationship and suggeststhat this learned confidence may result in the audit firm using less strenuous andless innovative audit procedures.6

These arguments lead to the following hypothesis

lower when the audit firm’s tenure is long than when the audit firm’s tenure

is medium.

The available empirical evidence regarding both hypotheses is limited Afterinvestigating 406 alleged cases of audit failures involving Securities and ExchangeCommission (SEC) clients, an AICPA quality control committee concluded thataudit failures are 3 times more likely in the first 2 years of an engagement than insubsequent years (AICPA 1992) Two studies examining lawsuits involving audi-tors found that audit failures are more common when audit tenure is 3 years or less(St Pierre and Anderson 1984; Stice 1991) Knapp (1991) varied audit tenure in anexperimental setting and found that experienced audit committee members per-ceived that auditors with a 5-year tenure were more likely to detect errors thanauditors in the first year of an engagement or auditors with an audit tenure of 20years Most recently, Geiger and Raghunandan (2002) found that long-tenure audi-tors were more likely than short-tenure auditors to issue going-concern opinionsfor clients that subsequently declared bankruptcy A series of studies examininggovernmental audits consistently documented a negative correlation between auditquality (measured as compliance with audit standards) and audit tenure (cf Deis andGiroux 1992; Giroux, Deis, and Bryan 1995; Deis and Giroux 1996; Copley andDoucet 1993) To date, there is limited empirical evidence regarding the associa-tion between short or long audit tenures and the quality of financial informationissued by publicly traded companies This study is intended as a first step towardproviding such evidence

3 Method

To investigate whether audit-firm tenure is associated with financial-reporting quality,

we use two empirical proxies for financial-reporting quality These two proxies, themeasurement of audit-firm tenure, the control variables used in the investigation,and the sample selection methods are discussed below

Proxies for financial-reporting quality

Absolute value of unexpected accruals

Dechow (1994) highlights the potential timing and matching problems associatedwith the use of cash flows as a short-term performance measure Accrual-basedearnings under generally accepted accounting principles (GAAP) contain accrualsand deferrals to overcome the inherent limitations of cash flows However, GAAP

644 Contemporary Accounting Research

also affords management substantial flexibility in reporting accrual-based earnings.Prior research has noted that management may use this flexibility to opportunisticallymanage earnings Such opportunistic use of accruals by management will result inlower-quality financial reports

Several papers have used unexpected accruals as a proxy for management’sactive intervention in reporting earnings The decision to use directional unex-pected accruals or the absolute value of unexpected accruals is driven by the nature

of the study; specifically, whether there is an a priori expectation regarding ment’s incentives For example, Jones (1991) expected that import relief investigationswould motivate managers to decrease earnings during the investigation period.Accordingly, the tests were designed to detect significant income-decreasing unex-pected accruals Teoh, Welch, and Wong (1998) hypothesized that upcoming stockissues would motivate managers to prefer higher income levels They designedtests to detect significant income-increasing unexpected accruals When aresearcher has an a priori expectation of management’s incentives, directionalunexpected accruals represent a more powerful test

manage-Alternatively, several papers have examined the impact of factors that are notassociated with a clear directional management incentive For example Warfield,Wild, and Wild (1995) examine the association between managerial ownership andearnings management Klein (2002) examines the association between corporategovernance mechanisms and earnings management In each study, the data ispooled over a long time period Because they do not have a priori directionalexpectations regarding management’s motivation for particular firm-year observa-tions, both Warfield et al and Klein use the absolute value of unexpected accruals

to capture management’s intervention behavior, noting that the magnitude of cretionary accrual adjustments serves to measure the extent to which managersintervene in reporting accounting earnings numbers Similarly, Bartov, Gul, andTsui (2000) interpret a positive association between the absolute value of a firm’sunexpected accruals and the likelihood of receiving a qualified audit report as evi-dence that unexpected accruals capture the extent of earnings management behavior.Following prior research, we use the absolute value of unexpected accruals as

dis-a proxy for findis-ancidis-al reporting qudis-ality.7 The magnitude of absolute value of pected accruals measures a company’s success in managing earnings either up ordown, as needed, depending on year-specific situations (Reynolds and Francis 2000)

unex-In general, using unexpected accruals as a proxy for financial-reporting quality is ajoint test of earnings management and the model of expected accruals used.8

The persistence of the accrual components of earnings

As a second proxy for financial-reporting quality, we examine the relationshipbetween current-period accruals and future income The time series properties ofearnings have been studied extensively in accounting (cf Freeman, Ohlson, andPenman 1984; Sloan 1996) One approach used in prior research is to estimate thefollowing regression equation

Audit-Firm Tenure and the Quality of Financial Reports 645

The slope coefficient, α1, represents the extent to which earnings performance intime t is expected to persist in subsequent-period earnings A slope coefficientequal to zero suggests that current-period earnings are purely transitory whereas aslope coefficient equal to one suggests that earnings follow a random walk Priorresearch has generally found the slope coefficient to be between zero and one, sug-gesting that earnings are mean reverting

The extent to which current-period earnings persist or are purely transitory (asreflected by the magnitude of the slope coefficient α1) is not independent of theaccounting choices of management The opportunistic use of accruals tends toreduce the slope coefficient, while the use of accruals to signal private informationtends to increase it As an example, consider a manager with private informationthat collection periods are increasing and several large customers are in financialdistress This information suggests that future earnings may be negatively affected.The manager may signal this information by increasing the size of the reserve fordoubtful accounts, or he or she may choose to postpone any adjustment to the netrealizable value of receivables The two choices generally have quite differenteffects on the extent to which current-period earnings persist in the future, with theformer choice resulting in a larger slope coefficient than the latter

Measurement of audit-firm tenure

Audit-firm tenure is the length of the audit-firm–client relationship as of the fiscalyear-end covered by the audited financial statements.9 Auditor data are available

on the 1995 annual COMPUSTAT files beginning in 1976 Accordingly, the tion date of the auditor – client relationship is censored on the left in some casesbecause we do not have auditor data before 1976 Firms that are added to theCOMPUSTAT data base over time are included in the sample subject to the con-straint that audit tenure can be computed accurately (i.e., if the initiation date of theauditor–client relationship is available, or if the company has had the same auditorfor nine or more years)

initia-Following prior research (e.g., St Pierre and Anderson 1984; Stice 1991), wedefine audit tenure as short when the same auditor has audited the financial state-ments of a company for two or three years (as discussed below, we omit the year ofthe auditor change to control for potential confounds).10 We define audit tenure aslong when the same auditor has audited the financial statements of a company fornine or more years.11 On the basis of the definition of short and long tenure, wedefine audit tenure as medium when the same auditor has audited the financialstatements for four to eight years However, given the data-availability constraint

on the initiation date of the auditor–client relationship and our definition of audittenure (short is two to three years, medium is four to eight years, and long is nine

or more years), we can accurately (without measurement error) classify tions as of 1986 (the beginning of our sample period)

observa-Sample selection

The set of initial candidates for inclusion in the sample was all U.S corporations

on the COMPUSTAT full coverage and research files that did not change fiscal

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year-ends in the 10-year test period 1986–95 We then deleted individual firm-yearobservations for the following reasons:

1 Data considerations: Observations were deleted if (a) financial data were notavailable on COMPUSTAT; or (b) the auditor could not be determined fromthe annual COMPUSTAT tapes.12

2 Auditor considerations: Observations were deleted if (a) the company was notaudited by a Big 6 auditor; (b) the company received a modified audit opinionwithin two years before or after the fiscal year-end; or (c) the companychanged auditors within one year before or after the fiscal year-end

These screens resulted in 11,148 firm-year observations.13 The screens ing to data considerations are obvious; however, the screens relating to auditorconsiderations warrant some discussion First, we restricted our investigation toBig 6 auditors Prior research suggests that audit quality and perceptions of auditquality differ for companies audited by Big 6 auditors versus those audited bynon–Big 6 auditors (Becker et al 1998; Francis et al 1999; Teoh and Wong 1993)

relat-As discussed previously, restricting our sample to Big 6 auditors avoids a potentialconfound and allows us to study an observable auditor characteristic that varieswithin a particular size class The screens relating to opinion qualifications andauditor changes are also used to avoid potentially confounding factors Priorresearch has documented that the market’s responsiveness to earnings announce-ments is significantly lower in periods before and after the issuance of qualifiedaudit reports (Choi and Jeter 1992; Subramanyam and Wild 1996) Similarly, priorresearch has found that auditor behavior may differ in the year before and after anauditor change (DeFond and Subramanyam 1998)

In an attempt to enhance our ability to attribute differences in financial ing quality to audit-firm tenure, we also match on industry and size Matching onindustry can rule out alternative explanations because companies from the sameindustry are more likely to face similar supply and demand uncertainties, to engage

report-in similar transactions, and to use similar accountreport-ing methods (Teoh and Wong1993) Prior research has conjectured that the ability of companies to use discre-tionary accruals in financial reporting (Francis et al 1999) may vary acrossindustries Matching on company size can rule out the alternative explanation ofauditor independence because larger clients generally represent a greater potentialloss of revenue to the auditor if the client switches to a different auditor Priorresearch (Haskins and Williams 1990; Krishnan 1994) has also documented a neg-ative relation between client size and auditor switching

We selected the industry- and size-matched sample in the following manner.Companies audited by short-tenure audit firms were selected and matched withcompanies audited by medium-tenure and long-tenure audit firms in the same fis-cal year and four, three, and two-digit Standard Industrial Classification (SIC)code, depending on data availability, and that are closest in size (defined in terms

of book value of total assets) The sample is further restricted to exclude tions falling in the extreme 1 percent of the entire distribution of variables used totest Hypothesis 1 and Hypothesis 2 This procedure yielded a matched sample of

observa-Audit-Firm Tenure and the Quality of Financial Reports 6472,463 (2,280) firm-year observations for the unexpected accruals (persistence)tests The sample observations are evenly distributed across years.

Table 1 presents the descriptive statistics for the industry- and size-matchedsample companies, divided by tenure group, along with significance levels ofunivariate tests comparing the mean values of the variables between medium- andshort-, and medium- and long-tenure groups.14 The table includes variables used inprior research to proxy for economic environment Observations in the short-tenuregroup are not significantly different (p-value > 0.10) than the observations in themedium-tenure group for any of the variables reported in Table 1 Similarly, nosignificant differences emerge between the long- and medium-tenure groups forany of the variables except age (computed as the number of years since the listingdate) Although no matching procedure can rule out all alternative explanations,the descriptive statistics in Table 1 suggest that any differences in financial-reportingquality that are observed in the matched sample are unlikely to be due to differences

in growth opportunities, company size, risk, financial health, or profitability ever, because there was a significant age difference for the long-tenure group, weexplicitly control for age in subsequent analyses

How-Control variables

Although our primary variable of interest in this investigation is audit-firm tenure,other audit-firm characteristics and client characteristics can affect financial-reportingquality To the extent that another variable affecting financial-reporting quality iscorrelated with audit-firm tenure, there is a potential that this other variable may bedriving any observed difference in financial-reporting quality

In a broad sense, the client characteristics that affect financial-reporting ity can be grouped according to whether they are likely to affect the sophistication(or accuracy) of the financial-reporting system or the incentives of management.The sophistication (or accuracy) of the financial-reporting system is likely to differwith the size and age of the company, with larger, more mature companiesexpected to have more sophisticated financial-reporting systems Management’sincentives regarding financial reporting are a well-researched topic, and prior workhas identified factors such as the financial condition of the company and the tightness

qual-of debt constraints Companies in financial distress or under near-debt constraintsmay be more motivated to manage earnings (DeFond and Jiambalvo 1994)

As previously noted, our primary tool for controlling for alternative tions is the use of an industry- and size-matched sample As reported in Table 1,the matching procedure was quite effective at minimizing differences in growthopportunities, company size, risk, financial health, and profitability Thus, even ifthese factors are correlated with financial-reporting quality, they will not be viableexplanations for any observed differences in financial-reporting quality across ten-ure categories Still, including variables that may affect financial-reporting quality(or our specific proxies) sharpens the analysis by increasing the explanatory power

explana-of the model and enhancing our ability to detect differences that are associatedwith the variable of interest

648 Contemporary Accounting Research

* Two to three years of audit-client relationship.

† Four to eight years of audit-client relationship.

‡ Nine or more years of audit-client relationship.

§ Significantly different from the medium group (p-value < 0.01).

MB is the ratio of the market-to-book value of common equity.

SIZE is the total assets in millions of dollars.

LEV is the ratio of total liabilities to total assets.

FC is the Altman-Z computed as 1.2*(working capital/total assets) + 1.4*(retained

earnings/total assets) + 3.3*(earnings before interest and taxes/total assets) +

0.6*(market value of equity/book value of total debt) + 1.0*(sales/total assets).

BETA is the value-weighted beta estimated over the fiscal year.

ROA is the ratio of operating income to total assets.

AGE is the number of years since listing date.

∆CFO is the change in operating cash flows scaled by assets.

GROWTH is the one-year growth in assets.

∆ACQN is the change in acquisition expenditures scaled by assets.

∆TIE is the change in times interest earned scaled by assets.

∆FIN is the change in new financing scaled by assets.

SI is one if a firm reported a special item, zero otherwise.