pott - 2009 - review of empirical research on rotation and non-audit service - auditor independence in fact vs. appearance

Along with other regulatory aspects, requirementsrelated to audit partner rotation and bans on providing concurrent non-audit serviceswere implemented to maintain auditor independence, b

DOI 10.1007/s11301-009-0043-0

S T A T E - O F - T H E - A R T - A R T I K E L

Review of empirical research on rotation

and non-audit services:

auditor independence in fact vs appearance

Christiane Pott · Theodore J Mock · Christoph Watrin

Received: 14 May 2008 / Accepted: 16 December 2008 / Published online: 29 January 2009

Abstract Confidence in the processes of corporate reporting and auditing has rapidly

decreased recently due to front-page accounting scandals in both the United Statesand Europe The goal of audit regulations, such as the Sarbanes Oxley Act in theUnited States (US) and the 8th Directive in the European Union (EU), is to restorepublic trust in the auditing process Along with other regulatory aspects, requirementsrelated to audit partner rotation and bans on providing concurrent non-audit serviceswere implemented to maintain auditor independence, both in fact and in appearance.However, the implementation of audit regulation implies that increased requirementsare able to enhance the failed audit function Empirical research should help to un-derstand the impact of these two regulatory aspects and indicate their effectiveness inmaintaining auditor independence Thus, we outline the newest empirical research re-lated to audit partner rotation and non-audit services and independence in fact or inappearance Overall, we conclude that prior research does not point to one particu-lar requirement that would most effectively restore trust in the audit function Ratherthe existence of multiple threats to auditor independence might demand a combina-tion of several requirements to maintain auditor independence Thus, more research

Anderson Graduate School of Management, University of California, 900 University Avenue,

Riverside, California 92521, USA

is needed to investigate the joint effects of different threats to auditor independence,

e g., non-audit fees and audit partner tenure

Keywords Auditor independence· European Union · Regulation

Zusammenfassung Durch Bilanzskandale in den USA und Europa wurde das

Vertrauen in die Unternehmens-berichterstattung und die Abschlusspr¨ufung starkersch¨uttert Das Ziel von Gesetzesinitiativen wie der Sarbanes-Oxley Act in denUSA und der 8 EU-Richtlinie ist daher die Wiederherstellung des Vertrauens in dieAbschlusspr¨uferfunktion Neben anderen regulatorischen Maßnahmen betreffen diegesetzliche ¨Anderungen die Rotation des verantwortlichen Pr¨ufungspartners und dasVerbot, bestimmte Nicht-Pr¨ufungsleistungen f¨ur Pr¨ufungsmandanten zu erbringen.Diese Regelungen wurden implementiert, um ,,auditor independence in fact“ und,,auditor independence in appearance“ zu erhalten Die Einf¨uhrung der gesetzlichenAnforderungen impliziert ex ante, dass die jeweiligen gesetzlichen Bestimmungen

in der Lage sind, die deutlich in Kritik geratene Abschlusspr¨uferfunktion zu lisieren Empirische Forschungsergebnisse k¨onnen in diesem Zusammenhang dazudienen, den Einfluss der drei oben genannten gesetzlichen ¨Anderungen im Hinblickauf die Erhaltung der Abschlusspr¨uferunabh¨angigkeit zu beurteilen Daher stellt die-ser Beitrag die neueste empirische Forschung zur Abschlusspr¨uferrotation und zuNicht-Pr¨ufungsleistungen in Bezug auf ,,auditor independence in fact“ und ,,auditorindependence in appearance“ vor Insgesamt lassen die empirischen Befunde keineAussage dar¨uber zu, welcher spezifische Regulierungsaspekt zur Wiederherstellungdes Vertrauens in die Abschlusspr¨ufung beitr¨agt Vielmehr k¨onnte das gleichzeitigeVorliegen verschiedener Bedrohungen f¨ur die Abschlusspr¨uferunabh¨angigkeit eineKombination verschiedener regulatorischer Maßnahmen erforderlich machen Umdiesen Zusammenhang zu untersuchen, sind jedoch weitere empirische Untersuchun-gen n¨otig, die sich gezielt mit der gleichzeitigen Auswirkung der Rotation des verant-wortlichen Pr¨ufungspartners und dem Verbot, bestimmte Nicht-Pr¨ufungsleistungen

the United States, the Enron collapse had a major impact on relevant regulations.However, almost every European country also experienced an accounting scandalaround 2001 SAirGroup in Switzerland had to acknowledge corporate governanceviolations in 2001, the Belgian company Lernout & Hauspie was accused of fraudand market price manipulation in 2001, and by 2003, the Netherlands was unset-tled by Ahold’s exaggerated earnings forecasts (Peem¨oller and Hofmann2005) Thelist of companies facing similar issues is quite long, including Parmalat in Italy in

2003, the Austrian company Yline in 2003, and Philipp Holzmann and Comroad

in Germany in 2002 In response, regulating bodies in the United States and theEuropean Union each issued major pieces of legislation: in the United States, theSarbanes-Oxley Act in 2002, and in the European Union, the revised 8th Direc-tive (2006) These regulations include more severe penalties and larger enforcementbudgets to protect financial markets from fraud (see, e g., Krishnamurthy, Zhou, andZhou2006)

According to Bolkestein (2003, p 1), the “Directive aims to reinforce the tory audit function in the Euroepan Union, which is one of the crucial elements forunderpinning the trust in the functioning of the European capital market.” The re-vised 8th Directive was intended to become law by mid-2005, but it was not finallyissued until the end of June 2006 The Member States had to incorporate the minimalrequirements of the Directive into national law by June 2008 Among other things,the 8th Directive (2006) establishes principles concerning auditor independence, yetthe requirements of the Directive do not directly address the auditor (at least in thisstage of regulation) Moreover, this regulation addresses Member States because theymust first incorporate the requirements into their own national law before the rules be-come binding on auditors and other involved parties Member States often add localrequirements to the minimum requirements issued, and thus each State differs in how

statu-it establishes statu-its requirements

Here, we build on the existing literature by providing insights into the new andfast-growing research area of the impact of regulation on auditors Dissociatingthemselves from the institutional system of self-regulation, auditors are faced with

a continuously growing set of additional requirements For example, auditors are nowcharged with understanding and applying the relevant local regulations to ensurecompliance The auditor is now required to rotate from his or her audit client to avoidaudit bias

Prior literature reviews on auditor independence were done several years ago and,consequently, do not include important empirical findings from the post-SOX period(see, e g., Ewert2003) Also, many literature reviews focus on empirical findings re-lated to one independence issue, such as non-audit services (Schneider, Church, andEly2006) or audit firm rotation (Cameran, Di Vincenzo, and Merlotti2005) Priorliterature is the only evidence available by which we can study the real effects of regu-lation Therefore, we present a structured review of the most important empirical andexperimental literature on auditor independence This analysis will lead to an assess-ment of the probable effectiveness of auditor independence regulation Therefore, wetry to answer the following question: Is the regulation of auditor independence ef-fective and necessary? We arrive at the answer through the findings of the existingempirical literature

Our paper proceeds as follows: Section2 defines auditor independence in bothfact and appearance and explains different theoretical approaches to auditor inde-pendence The regulation related to auditor independence is presented in Sect.3.Section4presents and discusses prior empirical research on auditor independence.Section5concludes with perspectives on future research.

2 Auditor independence

The ex ante value of an audit to consumers of audit services (including current and

potential owners, managers, shareholders and consumers of the firm’s products) pends on the auditor’s perceived ability to: (1) Discover errors or breaches in theaccounting system, and (2) withstand client pressure to disclose selectively in theevent a breach is discovered In this context, the level of auditor independence can bedefined as the conditional probability that – given that a breach has been discovered –the auditor will report the breach (DeAngelo1981a, pp 115–116;1981b)

de-For the purposes of many regulatory frameworks, independence is separated intotwo related concepts First, independence requires independence in mind, defined as

a state of mind that (1) is unaffected by influences that might compromise sional judgment, and that (2) allows an individual to act with integrity and to exer-cise objectivity and professional skepticism (International Federation of Accountants

profes-2004, p 17).1 Regulatory frameworks also often use the phrase “independence infact” when referring to independence in mind (Securities and Exchange Commission

2001; European Commission2002) Second, independence requires independence inappearance, which is described as the avoidance of significant facts and/or circum-stances that would reasonably cause a rational and informed third party to concludethat a firm’s (or a member of the assurance team’s) integrity, objectivity or profes-sional skepticism had been compromised (International Federation of Accountants

2004, p 17) The appearance of an independence failure is enough to undermine fidence in auditing and financial reporting This is due to the suspicion (belief) thatindependence is impaired, because independent behavior (independence in fact) isunobservable The result of evidence (or simple belief) of auditor failure leads to

con-a loss of trust in the con-audit process con-and, more genercon-ally, in fincon-ancicon-al reporting, thusdestabilizing markets (Fearnley and Beattie2004, p 121)

Originally deserved trust, defined as the expectation people have of each other(Barber1983), can also be unsettled by other means Aside from financial statementsand audit reports, users and auditors in today’s world are flooded with informationfrom a number of sources (e g., business magazines, newspapers, internet, television,etc.) According to extant research, this kind of information influences decision-makers’ perceptions, attitudes, decisions, and behaviors (e g., Barber and Odean

Accountants (IFAC) serves the public interest by setting – independently and under its own authority – high quality standards dealing with auditing, review, other assurance, quality control and related services, and facilitating the convergence of national and international standards This enhances the quality and uniformity of practice in these areas throughout the world, as well as strengthened public confidence in financial reporting generally.

2008) Additionally, this information can influence decision-makers’ ex post ations of other professionals’ behaviors and responsibilities (e g., Bonner2008) Insummary, several prior studies have found that users have disproportionate expecta-tions of auditors, whereas the auditor’s performance does not (have to) meet thoseexpectations Extensive media reporting on audit scandals and inappropriate auditorbehavior leads users to experience the gap between their expectations and the ac-tual behavior of the auditor (e g., Porter1993), which cannot be directly attributed to

evalu-a fevalu-ailure of independence either in fevalu-act or in evalu-appeevalu-arevalu-ance

Explanations for the loss of trust in audit quality are largely based on the opment of the auditing sector over the last four decades Following their geographicexpansion and increased competition, audit firms have been driven towards prof-itability and growth to maintain competitiveness The industry has had to generatemore revenue by both securing new audit clients and retaining existing ones Due

devel-to the demand of globally-operating clients, other services became alternative profitgenerators Thus, a growing percentage of public accounting firms’ total revenuesbegan to come from non-audit services, such as tax advice, information systems de-sign and implementation, human resource management and general consulting (see,

e g., Palmrose1986; DeFond, Raghunandan, and Subramanyan2002) This increasereflects an absolute growth in non-audit activities coupled with stagnation in theaudit-service market However, the joint provision of audit and non-audit services to

a client implies the existence of different contractual relationships between the tor and the client (Antle1982,1984)

audi-Agency theory explains this phenomenon in terms of the separation of ownership

by investors and control by management (Jensen and Meckling1976) The agency lationship is specified by the contract under which the owners (principals) engage themanagement (agent) to manage the firm on their behalf Since both parties to the re-lationship are utility maximizers, the agent will not always act in the best interest ofthe principals (Antle1984, p 2) This may result in divergent interests and investorlosses, due to opportunistic agent behavior

re-The use of an external auditor is one control mechanism for reducing the risk ofmanagers’ opportunism However, the external auditor is still hired by the owner as anagent The auditor-agent must produce information to be used in contracting with themanager (Antle1984, p 2) Therefore, the auditor is required to maintain indepen-dence from the client management In considering the impact of non-audit services

on auditor independence, it is important to point out that where audit and non-auditservices are provided to the same client, two different contractual relationships exist(Beattie, Fearnley, and Brandt1999) The non-audit services contractual relationship

is with the client In the auditing contractual relationship, however, the auditor owes

an additional duty to the stakeholders Moreover, the audit is subject to regulatoryoversight However, the audit firm may perceive the purchase of an audit in the samelight as that of any other service

The provision of non-audit services to audit clients increases the economic bondbetween the audit firm and the client This bond could lead to impaired independencebecause (1) the audit firm is unwilling to criticize the work done by its non-audit ser-vice department, (2) the audit firm does not want to lose lucrative non-audit servicesprovided to the audit client, and (3) the audit firm does not want to lose the audit en-

gagement In such a situation, the auditor may be inclined to agree with managementinterpretations of accounting issues In this respect moral hazard could lead the audi-tor to agree with a certain level of dependency on the client in response to receiving anadditional amount of non-audit service fees In such a situation moral hazard would

be covered legally under the additional non-audit service fees Thus, the auditor hasher or his own opportunistic incentives, which may lead to biased judgments aboutthe nature and scope of the examination (audit work) made and biased reporting as towhether the financial statements fairly represent the financial condition of the auditedfirm (financial reporting) (Goldman and Barlev1974).2

As long as client-specific quasi-rents can be earned, the auditor has an economicsincentive to keep this client Quasi-rents arise naturally in longer audit-client relation-ships, when the auditor invests in the current period with the expectation of return

in future periods (Lee and Gu1998) Substantial future quasi-rents are generated asthe result of the start-up or learning costs of the initial audits and the rotation coststhat all clients must incur when changing auditor Furthermore, the economies ofscale resulting from combining auditing and other services are an additional source

of quasi-rents It is true that the provision of service increases auditor quasi-rents that

are specific to the client.

With a positive initial investment in a new client, the future revenues must behigher than future costs in order that the auditor is interested in keeping the relation-ship with the client Thus, the auditor has no incentives to tell the “truth” when thetruth is “bad news” from the client’s perspective (DeAngelo1981a, p 116) However,

if no client-specific quasi-rents are expected from a given client relationship, an ditor is indifferent to the termination of that relationship Consequently; he has noeconomic incentive to conceal a discovered breach In this case, the auditor is per-fectly independent with respect to that particular client Thus, if contracting amongthe auditor and the client were costless, then auditors would always be perfectly inde-pendent from their clients It follows that a necessary condition for a positive demandfor costly auditing and less than perfect auditor independence is that contractingamong auditor and clients be costly

au-However, when contracting is costly, incumbent auditors need to possess a parative advantage over their competitors in future periods, in order to expect toearn quasi-rents Competition for initial auditing contracts leads many auditors toset the fees for their initial audit engagement below the total current costs (called

com-“low-balling”) (DeAngelo1981a,1981b) Therefore, the competition for the erty rights” of incumbency forces auditors to “low ball” in the initial period Thus,

“prop-“low balling” is a competitive response to the expectation of future-quasi rents, anddoes not itself impair independence In fact, it is the client-specific quasi-rents that arethe necessary condition for impaired independence

3 Auditor independence regulation

The need for financial regulation is often justified by the potential for market ure that can result when managers possess inside information while investors do not(called “information asymmetry”), as well as from the inappropriate behavior of au-ditors, (called “moral hazard”3) New laws that attempt to address these issues in theUnited States (Sarbanes-Oxley Act of2002) and in the European Union (Council ofthe European Communities2006) indicate that the predominant view among legisla-tors is that we need more regulation, more severe penalties, and larger enforcementbudgets to protect financial markets from fraud

fail-The Sarbanes-Oxley Act (SOX) of 2002 has been the most significant legislativeresponse to corporate scandals such as Enron The stated purpose of the act “is to pro-tect investors by improving the accuracy and reliability of corporate disclosures madepursuant to the securities laws, and for other purposes” (SOX2002) As a correc-tive measure in light of significant accounting failures, SOX strongly reinforces theposition of investors first defined by the Securities and Exchange Commission ThisAct is applicable to publicly traded companies, and it created the Public CompanyAccounting Oversight Board under the supervision of the Securities and ExchangeCommission (Title I) It also imposes greater restrictions and requirements in terms

of auditor independence (Title II)

The role, position, and liabilities of the statutory auditor within the EuropeanUnion are inconsistently regulated by each Member State (Quick, Turley, andWillekens2008).4However, the increasing number of important financial failures hasled to a call for a minimum level of harmonization of the auditing function There is

an increasing belief that the lack of common practices and/or standards has a tive impact on auditing quality and on the freedom to establish and provide services

nega-in the auditnega-ing field (European Commission1996) Therefore, the European sion proposed a revised Directive, to ensure that investors and other interested partiescould fully rely on the accuracy of audited accounts, and also to enhance commonprotection within the European Union This might be an indication that harmoniza-tion on a voluntary basis was not fully effective The 8th European Directive will bemandatory by June 2008 for the entire European Union (Council of the EuropeanCommunities2006) The revised 8th Directive states that Member States shall ensurethat the auditor (or the key audit partner responsible for carrying out the audit on be-half of the audit firm) rotates from the audit engagement within a maximum period offive years (Article 40) SOX requires auditor and review partner rotation within thesame timeframe

Commis-SOX makes it unlawful for a registered public accounting firm (or any person sociated with the firm, to the extent determined appropriate by the Securities andExchange Commission) to provide to a client – contemporaneous with the audit – anynon-audit service This service may be in the form of bookkeeping, or other servicesrelated to accounting records or financial statements, financial information systems

Watrin (2001).

design and implementation, appraisal or valuation services and fairness opinions; tuarial services, internal audit services, management functions or human resources;broker-dealer services, legal services, and any other service that the board of direc-tors determines to be impermissible by regulation However, a public accounting firmmay engage in any non-audit service for an audit client (including tax services notdescribed above) if the activity is approved in advance by the client’s corporate auditcommittee (SOX Section 201(a)).

ac-When a statutory audit is carried out in a Member State, the 8th Directive requiresthat the statutory auditor (or audit firm) be independent from the audited entity andnot be in any way involved in management decisions of the audited entity Further-more, a statutory auditor (or audit firm) is prohibited from conducting a statutoryaudit if it has any financial, business, employment or other relationships with theaudited entity (including the provision of additional, non-audit services) that mightcompromise the independence of the statutory auditor (or audit firm) (Article 23.1).Likewise, as an example of how the profession has the ability to regulate itselfand does not shy away from adopting a tougher stance on its members, the Inter-national Federation of Accountants (IFAC) issued a Code of Ethics for ProfessionalAccountants (revised2005) The Code is divided into three sections The first in-cludes principles that are applicable to all professional accountants, while the secondand third parts distinguish between those principles that affect professional accoun-tants in public practice and those that are applicable to other accountants employed

in business and industry These new rules of independence set out a conceptualframework that focuses on the factors that pose a threat to independence for all as-surance engagements, and the safeguards auditors should put in place to preservetheir independence In addition, the updated Code provides concrete examples of howthe conceptual approach to independence is to be applied to specific circumstancesand relationships Thus we find situations of conflict being addressed, such as em-ployment with assurance clients, provision of non-assurance services to assuranceclients including temporary staff assignments, recruiting of senior management, pro-vision of tax and legal services, and preparation of accounting records and financialstatements

4 Empirical research on auditor independence

The taxonomy used to structure the empirical literature on auditor independence lows the two major requirements of both SOX and the EU Directive: Research onauditor rotation and non-audit services Furthermore, in contrast to other literaturereviews (e g., Schneider et al.2006), we distinguish between empirical research re-lated to independence in fact and independence in appearance Independence in fact ismeasured by the actual behavior of auditors, audit opinions issued, earnings manage-ment and quality, and restatements of financial data (Ewert2003, p 531) FollowingEwert (2003), studies related to independence in appearance can be compared de-pending on whether the direct assessments of stakeholders or the association betweenthe client’s earnings and capital market reaction and behavior related to the choice

fol-of auditor is measured as the dependent variable We also indicate whether the

stud-ies were conducted in the US, Europe or elsewhere, in order to consider potentialdifferences in findings related to jurisdictional differences.

A long relationship between audit partners and their clients might further influencethe auditor’s independence and objectivity In the early years of tenure an audit part-ner is most certain to be independent and to apply creative audit-testing approaches(AICPA 1978; Hoyle 1978) With an increasing period of engagement, the auditprograms may become routine, as a result of the auditors’ deeper knowledge of theclient’s systems and control procedures (Hoyle1978) Shockley (1981) asserts that

“complacency, lack of innovation, less rigorous audit procedures and a developedconfidence in the client may arise after a long association with the client.” The majorconcern then is that the auditors are anticipating the results on the basis of prioraudit years, instead of being alert to detect material misstatements (Arrunada and Paz-Ares1997; Quick2004) Third, over time, the auditor’s incentives shift toward main-taining and profiting from the client and the audit The prospect of “client-specificrents” that the auditor can extract only over time may create an economic dependency

on the client, which impairs the auditor’s independence (DeAngelo1981a,1981b).The auditor expertise hypothesis is based on the information asymmetry betweenthe client and the auditor, which is reduced over time as auditors acquire client-specific knowledge Because increased client-specific knowledge provides a compar-ative advantage in detecting material misstatements in financial reports, the lack ofthis knowledge in the early years of an audit engagement may result in a lower qualityaudit (e g., Beck, Frecka, and Solomon1988; Geiger and Raghunandan2002)

Dopuch, King, and Schwartz (2001) observed that the highest frequencies of

au-ditors’ selections of favorable reports, as a measure of the actual behavior of the auditor, occurred in regimes without mandatory audit firm rotation or retention This

qual-ity Myers et al (2003) emphasize the higher audit costs in the early periods of audit tenure and the increase in client and industry knowledge gained over repeated audits.

result is consistent with the notion that auditors in these regimes react to economic centives to bias their reports in favor of management But managers also made higherinvestments than predicted in these non-retention, non-rotation regimes, thereby rais-

in-ing the probability they would have high assets These higher investments reduced the

overall risk to the auditors of having liability penalties imposed on them In effect, thecombination of high investments and high favorable reports increased the welfare ofboth parties

Two studies proxy independence in fact by audit opinions issued Geiger and

Raghunandan (2002) studied the relationship between audit firm tenure and audit

re-porting as a proxy for audit failure The authors present evidence that auditors may

be more likely to be less objective in the initial years of an audit engagement, cause reporting failures were more likely to occur in those initial years Thus, thisresearch could imply that with mandatory auditor rotation in place, the risk of auditfailure (e g., issuance of an incorrect audit opinion) might increase However, sincetenure is measured as audit-firm tenure rather than individual-auditor tenure, the re-sults cannot be generalized to the effectiveness of audit partner rotation Addressingthe dominance of United States evidence on public firms, Knechel and Vanstraelen(2007) studied the effect of audit firm tenure on audit quality for private companies

be-in Belgium The authors use the likelihood of an auditor issube-ing a gobe-ing-concern dit opinion as an indicator of audit quality Similar to that of Geiger and Raghunandan(2002), their sample consists of stressed bankrupt and non-bankrupt companies.They presume that a decrease in audit quality is indicated by an increase in thelikelihood that an auditor does not issue a going-concern opinion on a company thatsubsequently goes bankrupt, or an increase in the likelihood that an auditor issues

au-a going-concern opinion to au-a compau-any thau-at survives Knechel au-and Vau-anstrau-aelen (2007)found that auditors do not become less independent over time, nor do they becomebetter at predicting bankruptcy Thus, their results refute the contention that long-termauditor-client relationships undermine audit quality

Studies using different measures of earnings management and quality as the pendent variable only investigate audit firm tenure Myers, Myers, and Omer (2003)

de-examined the relation between auditor firm tenure and earnings quality to

calcu-late abnormal or discretionary accruals, using the Jones Model6and absolute currentaccruals7as proxies for earnings quality Lower accrual levels are associated withgreater auditor conservatism, which has been interpreted as being suggestive ofhigher-quality audits They concluded that longer auditor tenure results in auditorsplacing greater constraints on extreme management decisions in the reporting of fi-nancial performance Opposing these findings, Davis, Soo, and Trompeter (2007)find that firms with both short (two to three years) and long (13–15 years or more)tenure are more likely to report levels of abnormal accruals that allow the client tomeet or beat earnings forecasts The results suggest that while regulatory mandates

cash flow as income before discontinued operations and extraordinary items from the statement of cash flows.

current assets; CASH, cash and cash equivalents; CL, total current liabilities; STDEBT, the current maturities of long-term debt and other short-term debt included in current liabilities.

for periodic auditor turnover have negative effects, sustained long-term auditor-clientrelationships may also be detrimental to audit quality.

Carcello and Nagy (2004) examined the relation between audit firm tenure and

fraudulent financial reporting Comparing firms that were cited for fraudulent ing between 1990 and 2001 with both: (1) A matched set of non-fraud firms and(2) the available population of non-fraud firms, they found that fraudulent financialreporting is more likely to occur in the first three years of the auditor-client rela-tionship The authors failed to find any evidence that fraudulent financial reporting

report-is more likely after a long (nine years or more) auditor tenure Using two proxiesfor financial-reporting quality and a sample of Big Six clients (matched by industryand size), Johnson, Khurana, and Reynolds (2002) found that relative to medium au- dit firm tenures of four to eight years, short audit-firm tenures of two to three years

are associated with lower quality financial reports They measure the absolute value

of unexpected accruals as a proxy for financial reporting quality The magnitude ofabsolute value of unexpected accruals measures a company’s success in managingearnings either up or down, as needed, depending on year-specific situations In gen-eral, using unexpected accruals as a proxy for financial-reporting quality is a joint test

of earnings management and the model of expected accruals used As a second proxyfor financial-reporting quality, they examine the relationship between current-periodaccruals and future income However, they find no evidence of reduced financial-reporting quality for longer audit-firm tenures of nine or more years

Research on the relationship between audit firm rotation and auditor independence

in appearance, measured as the association between client’s earnings and capital market reactions, also produces mixed results Gates, Lowe, and Reckers (2007) re-ported that even in an environment of strong corporate governance controls, auditfirm rotation does not incrementally influence individuals’ confidence in reported fi-nancial statements, measured as the assessed quality of a company’s earnings

Little research studies audit firm tenure and its effects on auditor independence

in appearance (as the association between client’s earnings and capital market actions) Mansi, Maxwell, and Miller (2004) found that the requirement of investorsford lower rates of return as the length of tenure increased provides direct evidence ofthe value that investors attach to audit tenure These data suggest that mandatory au-ditor rotation may not be uniformly beneficial and could, in fact, be viewed negatively

re-by the capital market for riskier firms Gosh and Moon’s (2005) results are tent with the hypothesis that investors and information intermediaries perceive longerauditor tenure as improving audit quality

consis-Azizkhani, Monroe, and Shailer (2007) use the client-specific ex ante cost of

equity capital to measure whether audit firm tenure and rotation affect analysts’ assessments as direct assessments of stakeholders of financial data credibility The

authors use a sample of Australian based companies with data from 1995 to 2005 totest these relationships They determined that for non-Big Four audit firms, audit firm

tenure is significantly associated with a lower ex ante cost of equity capital Audit firm rotation is not significantly associated with changes in the ex ante cost of equity

capital

The varied results of rotation and tenure studies may be due to the use of the noisy measure of audit firm rotation when audit partner rotation and audit firm tenure when

audit partner tenure should be measured instead Therefore, the results on the

ef-fect of audit firm rotation and tenure are difficult to generalize However, researchershave only recently investigated the change in regulations on audit partner changes bycollecting individual signatures, which have to be provided in audit reports in somecountries as an indication of audit engagement partner rotation, e g., in Australia andGermany

Most research investigates the effects of audit partner rotation using abnormal

ac-cruals following Jones (1991), abnormal working capital accruals following DeFondand Park (2001)8and/or current accruals, as measures of earnings management and quality Chi, Huang, Liao, and Xie (2005) investigated whether the mandatory auditpartner rotation implemented in 2004 in Taiwan has had a positive influence on auditquality They find that audit quality is higher for companies subject to the manda-tory rotation regime in 2004, compared to firms not subject to rotation in the sameyear The authors use absolute and signed abnormal accruals and abnormal workingcapital accruals as proxies for audit quality Hamilton, Ruddock, Stokes, and Tay-lor (2005) use a sample of 3,621 firm-years between 1998 and 2003 from Australianbased companies, and report that audit partner changes most likely to reflect partnerrotation (when the company is not due for a switch of audit firm) are associated withlower signed abnormal accruals in Australia They conclude that this result is con-sistent with more conservative reporting following an auditor rotation Furthermore,this explanation is supported by evidence that suggests a significant increase in theasymmetrically timed recognition of economic losses when firms have a change ofaudit partner Using unique data from Germany, where both the audit engagementand review partner can be identified, Watrin, Lindscheid, and Pott (2008) investigatedthe effect of partner switches Using exact, absolute, and signed values of abnormalworking capital accruals and current accruals as proxies for audit quality, they findevidence of more income-increasing earnings management when the audit reviewpartner switches Thus, mandatory audit review partner rotation might lead to moreaggressive accounting practices However, they do not find an effect for any of our ac-crual measures when the audit engagement partner switches Therefore, their findings

do not support a mandatory audit engagement partner rotation

Also, some studies have investigated audit partner tenure Depending on the

meas-ure of audit quality used, Carey and Simnetts’ (2006) results imply different effects.The three measures of audit quality examined are the auditor’s propensity to issue

a going-concern audit opinion for distressed companies, the direction and amount of

abnormal working capital accruals, and just beating (missing) earnings benchmarks;

all as measures of earnings management and quality Their sample contains 1,021

Australian listed (since 1995) companies First, when studying the propensity of anauditor to issue ongoing-concern audit opinions for distressed companies, their re-sults indicate that such opinions diminish over the audit partner’s tenure However,this result is associated with non-Big Six audit firms For long tenure observations,

de-notes non-cash working capital computed as (current assets minus cash and short term investments)