yazawa - 2014 - does long audit partner tenure decrease earnings quality - evidence from japan [mapr]

Does Long Audit Partner Tenure Decrease Earnings Quality?. Does Long Audit Partner Tenure Decrease Earnings Quality?. First, I find that the absolute and positive values of discretionary

Does Long Audit Partner Tenure Decrease Earnings Quality?

Evidence from Japan

Kenichi Yazawa 1 School of Business Administration, Aoyama Gakuin University

Current Version March 2014

Acknowledgement: I would like to thank Roger Simnett, Gary Monroe, Peter Roebuck, Elizabeth Carson,

and other participants in the 18th annual International Symposium on Audit Research for their valuable feedback on earlier versions of this paper I also would like to Tsuyoshi Numagami, Hironori Fukukawa, Mikiharu Noma, Soo-Joon Chae, Yuan Zhang and other participants in the Hitotsubashi G-COE Research Workshop on Innovation and Management

1 Address: 4-4-25 Sibuya, Shibuya-ku, Tokyo 150-8366, Japan

Tel./Fax: +81 (3) 3409-6272 Email address: yazawa@busi.aoyama.ac.jp

Does Long Audit Partner Tenure Decrease Earnings Quality? Evidence from Japan

Abstract:

This study examines the relationship between audit partner tenure and audit quality by using data on 7,567 Japanese listed companies from 1999 to 2006 First, I find that the absolute and positive values of discretionary accruals decrease significantly with increased length of audit partner tenure These findings are not consistent with the argument that earnings quality decreases with audit partner tenure, especially when income-increasing earnings management are the primary concern Second, I find that positive discretionary accruals decrease significantly with audit partner tenure only after the tenure exceeds seven years Given that half of the companies in the sample for this study have more than 50 years of business experience, these findings indicate that relatively long-term engagement

is required to effectively audit a company with a longer history Third, I find that the impact of tenure on earnings quality disappeared after the introduction of a periodic partner rotation rule in Japan in 2003 This is consistent with the argument that the purpose of audit partner rotation is to break up personal relationships between auditors and their clients and introduce fresh approaches to audits In addition, the results of my sensitivity checks reveal the same results as those of the main tests These findings contribute to the literature on auditor tenure and earnings quality

Does Long Audit Partner Tenure Decrease Earnings Quality? Evidence from Japan

1 Introduction

In many countries around the world, periodic audit partner rotation is mandatory for businesses An implicit assumption in a policy of mandatory audit partner rotation is that long relationships between audit partners and clients could lead to overfamiliarity and reduce earnings quality However, this assumption has not been systematically tested in the literature, due to the lack of audit partner information in US and major country’s audit reports In addition, some existing empirical research, which investigate firms in countries that practice the audit partner to sign the audit reports, has not provided consistent evidence

as to whether long audit partner tenure reduces earnings quality (Carey and Simnett, 2006; Chen, Lin, and Lin, 2008; Manry, Mock, and Turner 2008; Chi et al., 2009)

In addition, the maximum audit-partner tenure varies considerably in each country In the 1970s, the U.S was the first to require audit-partner rotation after seven years of tenure for Securities and Exchange Commission (SEC)-registered clients The Sarbanes–Oxley Act of

2002 (SOX) further strengthened this requirement by mandating a five-year rotation for the lead and concurring partners (SOX Sec.203) By the end of June 2008, all 27 Member States of the European Union (EU) were required to enact the revised 8th Directive’s (2006) requirements into national law One important detail of the Directive is key

audit-partner(s) rotation for seven years (2006/43/EC Article 42 2), but each Member State has the discretion to decide how long the tenure with the audit client should be For example, the UK rule requires rotation of the lead audit-engagement partner after five years and of other engagement partners after seven years Germany requires seven years, France requires six years, and Greece requires four years These facts suggest that regulation of audit partner rotation is not well underpinned by empirical findings

Regardless of the effectiveness of the audit partner rotation rule has not verified sufficiently, the European Union (EU) is currently scheduling the introduction of a new rotation rule, which mandates that European listed companies tender their audit firms (not audit partners) every 10 years and rotate auditors every 20 years The rule will be subject to the approval of the European Parliament, which will be determined in April 2014.2 This rule is based on the assumption that the negative impact caused by familiarity between auditors and clients is not effectively eliminated by changes of audit partner (EC green paper 2010).3 In contrast, in the US, Public Company Accounting Oversight Board (PCAOB) Chairman James Doty told the Securities and Exchange Commission (SEC) that

“we don’t have an active project or work going on within the board to move forward on a

2 Economia, 17 December 2013, Journal of Accountancy, 24 January 2014

3 An EC green paper (2010) says that “ situations where a company has appointed the same audit firm for decades seem incompatible with desirable standards of independence Even when ‘key audit partners’ are regularly rotated as currently mandated by the Directive, the threat of familiarity persists.”

term limit for auditors.”4 There are political factors behind the different approaches of the

EU and the US, but the differences have primarily resulted from the fact that no clear explanation of the economic consequences of auditor rotation exist, even for audit partners

In other words, the issue of audit partner rotation is still an open one

As mentioned above, the amount of existing empirical evidence on this topic is very limited The reason for this is that many countries do not require the signature of an audit partner in audit reports, although countries such as Taiwan and Australia are exceptions Japan is unique in that it requires that the signature of the audit partner who is in charge appear in audit reports In addition, Japan introduced an audit partner rotation rule similar

to those of the EU and US in 2003.5 These features make the Japanese audit market a suitable one for examining the relationship between audit partner tenure and audit quality,

as well as the effects of audit partner rotation rules

In this study, I examine the relationship between audit partner tenure and audit quality by using data on 7,567 Japanese listed companies from 1999 to 2006, in order to verify the impact of long audit partner tenure on earnings quality and the economic consequence of the introduction of the periodic partner rotation rule in Japan First, I find that the absolute

4 CFO journal, 6 February 2014

5 As explained later, Japanese rules require all listed firms to rotate audit-engagement partners after seven years, and require clients of large audit firms to rotate lead engagement partners after five years A “large audit firm” is defined as an audit firm that has more than 100 clients The large audit firms are the Japanese Big 4 audit firms, and included Azusa, Shin-Nihon, Tomastu, and ChuoAoyama at the time of this study

and positive values of discretionary accruals decrease significantly with increases in the length of audit partner tenure These findings are contrary to the argument that earnings quality decreases with the length of audit partner tenure, especially when income-increasing earnings management attempts are the primary concern Second, I find that positive discretionary accruals decrease significantly with audit partner tenure only after the tenure in question exceeds seven years As half of the businesses in the sample used in this study have more than 50 years of business history, these findings indicate that relatively long-term engagement is required to effectively audit a company with a longer history Third, I find that the impact of tenure on earnings quality disappeared after the introduction of the periodic rotation rule in Japan in 2003 This is consistent with the argument that the purpose of audit partner rotation is to break up personal relationships between audit partners and their clients, and to add fresh perspective to audits In addition, these results are robust, as revealed by the results of sensitivity checks

The findings of this study contribute to the literature on auditor tenure and earnings quality by providing evidence at the audit partner level Interestingly, the finding of this study are essentially the same as those of Chen, Lin, and Lin (2008) and Chi et al (2009), whose studies examine Taiwanese companies, while these are not consistent with the results of Carey and Simnett (2006) and Hamilton et al (2005), whose studies examine Australian companies, While doing so can prevent the generalization of findings, it is

important to consider the specific business practices of countries with regard to how they affect the impact of audit tenure on earnings quality Japan and Taiwan belong to the Asian economic zone and have a deep historical relationship with one another It is possible that the fact that Japanese companies prefer stable long-term relationships affects relationships between clients and audit partners If regulators regard the tenures of audit firms as influencing earnings quality but consider the tenures of audit partners to have no effects, a reasonable explanation for this approach is needed

The rest of this paper is organized as follows In Section 2, I discuss the institutional background of audit partner rotation in Japan and propose hypotheses In Section 3, I explain the methodology used to test these hypotheses In Section 4, I describe the sample used in this study and discuss the results Finally, I provide a summary and conclusion in Section 5

2 Background and Hypotheses

Audit market and institutional background in Japan

Japan has roughly 3,500 listed companies and Tokyo Stock Exchange is the third-largest capital market in the world after NYSE and NASDAQ in the US A securities and exchange law like that of the United States was introduced in Japan in the 1950s, and the capital market developed over the next several decades.As in the audit markets of the US

and the EU, the innumerable small audit firms that initially operated in Japan have integrated into the four largest audit firms in the country (the Big 4) over a period of several decades By the 2000s, the Big 4 in Japan held a market share of 80% of all accounts The Japanese Big 4 have partnerships with the global Big 4 accounting firms, and use audit standards that are in accordance with the International Standards on Auditing (ISAs), which are issued by the International Auditing Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC)

Japan introduced a periodic audit partner rotation rule similar to those of the EU and US

in 2003 by the amendment of the Certified Public Accountant Law.6 However, the rule did not come into force until March 31, 2010, because partners’ tenure was not counted retroactively To address this problem, the Big 4 audit firms and the Japanese Institution of Certified Public Accountants (JICPA) announced on September 13 2005 that all Big 4 firms would rotate audit partners over seven years until March 2007 as a means of self-regulation

Figure 1 shows transitions in audit partner tenure in the Japanese Big 4 and small to medium-sized audit firms (non-Big 4) from 1999 to 2006 The audit partner tenure for the non-Big 4 firms has remained stable at roughly 17 years On the other hand, the audit

partner tenure for the Big 4 firms was stable at 12 years until 2002, began to decrease in

6 Certified Public Accountant Act, 24(3)

2003, and had reduced to six years by 2006, which is half the tenure of only four years priorago As mentioned above, this is due to the fact that because the Big 4 have introduced

a partner rotation rulesystem as a means of self-regulation from in 2003 In this study, in order to analyze the relationship between long tenure and the audit quality, the sample is has been corrected from 1999 on In addition, in order to analyze how this relationship between them has changed with the introduction of rotation rules, the period for analysis period has been extended until 2006 Therefore, the sample period covers eight years, from

1999 to 2006, which is divided into the two periods of 1999-2002 and 2003-2006

[Insert Figure 1 about here]

Theory and prior research

Audit quality is defined as the joint probability that an auditor will both detect material statements and prevent or report the misstatements (DeAngelo, 1981) According to this definition, audit quality is a function of the auditor’s ability to detect material misstatements and report those detected misstatements To detect material misstatements, auditors must have specific knowledge and skills (auditor expertise) To report detected misstatements, auditors must be independent in both fact and appearance (auditor independence)

The debate on auditor rotation has always centered on a key question What makes audits

more effective: a fresh pair of eyes (independence effect) or deep knowledge of the ins and outs of a complex company (expertise effect)? With an increase in audit-partner tenure, the relationship between the auditor and her or his client might introduce a so-called

“familiarity threat” to auditor independence (IFAC Code of Ethics ED 2008, para.100.13).7This threat could result in a decline in the audit partner’s ability to judge the company’s performance accurately On the other hand, audit quality could be considered to increase with auditor tenure, because of the accumulation of client-specific information and knowledge Thus, the net effect of auditor tenure on earnings quality is determined by the magnitude of the independence and expertise effects However, only a few studies examine the impact of audit partner tenure and rotation on the earnings quality The reason for this

is that audit reports in most major countries record only the auditing firm’s signature, and not the audit-engagement partner’s name Therefore, prior research has focused on a limited number of countries in which this is not the case, such as Australia, Germany, and Taiwan In addition, the findings of that research have been mixed

Carey and Simnett (2006) investigate the relationship between audit partner tenure and earnings quality by using 1,021 Australian companies listed in 1995 They find no evidence

of a relationship between audit partner tenure and abnormal working capital accruals Chen,

7 The IFAC Code of Ethics ED 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 Code of Ethics ED 2008: 18).”

Lin, and Lin (2008) use a sample of 5,213 firm-years between 1990 and 2001 from Taiwanese companies They find that the absolute and positive values of discretionary accruals decrease significantly with audit partner tenure These findings are not consistent with the argument that earnings quality decreases with audit partner tenure By focusing on

a specific client, Manry, Mock, and Turner (2008) examine whether there is a relationship between audit partner tenure and reduced earnings quality They find evidence that for small companies, regardless of their level of engagement risk, earnings quality may actually increase as audit partner tenure increases

Hamilton et al (2005) use a sample of 3,621 firm-years between 1998 and 2003 from Australian-domiciled companies, and report that among these companies, audit-partner changes that are most likely to reflect partner rotation (when the company is not due for a switch of audit firm) are associated with lower signed discretionary accruals They conclude that this result is consistent with the more conservative reporting following an auditor rotation, and furthermore, find that this explanation is supported by evidence that suggests that a significant increase in the asymmetrically timed recognition of economic losses occurs when firms change audit partners Chi et al (2009) investigate whether the mandatory audit-partner rotation regime implemented in 2004 in Taiwan has had a positive influence on audit quality They find that, in 2004, audit quality was higher for companies that were subject to the mandatory rotation regime than for firms that were not The authors

use absolute and signed discretionary accruals and abnormal working capital accruals as proxies for audit quality Lindscheid, Pott, and Wartin (2009) use a sample of 457 firm-years from German companies and investigate the effects of both audit-engagement and review-partner switches They find evidence that earnings increase more in the case of audit review-partner switches However, they do not find an effect on any accrual measures when audit-engagement partners change

Hypotheses

As described above, the net effect of audit partner tenure on earnings quality can be theoretically determined depending on the magnitude of both the expertise effect and the entrenchment effect However, consistent results regarding this matter have not been obtained by prior researchers As such, it is difficult to construct a hypothesis only from empirical and theoretical perspectives Therefore, in this study, I create hypotheses by also applying an institutional point of view This approach is reasonable because one of the purposes of this study is to investigate the economic consequences of regulation The implicit assumption of the audit partner rotation regulations that have been introduced in developed countries is that the long tenure of an audit partner has a negative effect on audit quality Thus, a basic hypothesis can be created, which states that earnings quality decreases with audit partner tenure (H1)

The maximum tenure of audit partners is set in the periodic audit partner rotation rules of major countries This assumes that the positive effects of accumulating knowledge and experience will be greater than the negative effects of familiarity until a certain number of years have passed, after which the negative effects of familiarity become greater than the positive effects In other words, it can be said that audit partner tenure and earnings quality

do not have a linear relationship to each other, and may be in a non-linear relationship that

is convex at a certain level Thus, a second hypothesis can be put forward, which states that earnings quality increases (decreases) with audit partner tenure up to (beyond) a certain level (H2)

The number of years needed for a positive relationship to become a negative one must also be determined Rotation rules in many countries set the turning point in this relationship at five or seven years As mentioned above, Japanese rule requires five year rotation for lead audit partners It is similar to the US, which requires a five-year rotation for the lead audit partners In addition, the revised 8th Directive’s of EU (2006) requires seven year rotation for the key audit partners Based on the points discussed above, this study sets the turning point at five years On the other hand, Chen et al (2008), who analyze the audit partner tenures of Taiwanese companies, define long tenures as those lasting more than five or 10 years So, it needs to be checked for sensitivity

As mentioned above, periodic partner rotation requirements were introduced in Japan in

2003, as a means of self-regulation New audit partners not only make independent judgments, but can also improve audit quality with fresh perspectives If longer audit partner tenures compromise auditor independence, auditors with long tenures may fail to prevent clients from pursuing aggressive accounting policies If so, audit partner rotation will enhance auditor independence, and could control client aggressiveness Thus, the third hypothesis in this study is that the negative effects of tenure are (not) observed before (after) the introduction of rotation rules (H3)

3 Research Design

Main regression model

I examine the impact of audit-engagement partner tenure on audit quality by using the regression model below:

a cross-sectional version of a modified Jones (1995) model (Dechow, Sloan, and Sweeney, 1995) to estimate discretionary accruals I control for the company’s lagged rate of return

on assets (ROA) and compute discretionary accruals (DA) as follows:

𝐴𝐴 = 𝑇𝐴 − 𝑎 + 𝛽! 𝛥𝑅𝐸𝑉 − 𝛥𝑅𝐸𝐶 + 𝛽!𝑃𝑃𝐸 + 𝛽!𝑅𝑂𝐴!!!    (2)

where

TA = Earnings before extraordinary items - net cash flow from operations ΔREV = Change in net sales

ΔREC = Change in net accounts receivable

PPE = Net property, plant, and equipment

ROAt-1 = Net profit t-1 divided by total assetst-2

TA, REV, and PPE are scaled by lagged total assets

The coefficients α, β1, β2, and β3, are those gained by estimating the following model by industry-year, as is consistent with DeFond and Jiambalvo (1994) and Subramanyam (1996) Prior research has found that the discretionary accruals of Big 4 audit firms’ clients are smaller than those of non-Big 4 clients (Becker et al., 1998; Francis and Krishnan, 1999; Francis and Wang, 2008) This means that Big 4 auditors employ conservative accounting policies, and so are likely to detect income-increasing earnings management and request appropriate adjustments from clients (Nelson et al., 2002) In Japan, Yazawa (2010) has examined the relationship between auditor size and discretionary accruals by using data on 7,127 firm years among Japanese listed companies from 2004 to 2007 He finds that the discretionary accruals of Big 4 auditors are smaller than those of non-Big 4

auditors This study analyzes the relationship between partner tenure and discretionary accruals by using absolute and signed value in a sub-sample dividing the negative and positive values of DA In any case, It is possible to interpret that where DA is small, the quality of earnings is high

Tenure of audit partner

In Japan, two or three partners typically sign each audit report, which means that several audit partners influence and have responsibility for the audit Based on the idea that length

of tenure would have a negative effect on the audit quality, it can be assumed that an audit partner with the longest tenure has the greatest impact over the audit judgment Thus, this study defines TNRE as the natural logarithm of the longest audit partner's tenure If a longer tenure compromises auditor independence, then an auditor with long tenure may lose the ability to combat the aggressive accounting policies of a client As a result, discretionary accruals and auditor’s tenure are shown to have a positive correlation In addition, this study examines the effect of other alternative audit partner tenure measures in its sensitivity check

Control variables

Based on prior research, I include several control variables for other known determinants

of discretionary accruals in my model First, I control for the size of a company (ASSET), which determines earnings-management behavior in the sense that larger companies face higher political costs (Watts and Zimmerman, 1986) and higher litigation risks (Lang and Lundholm, 1993) Additionally, larger companies tend to report larger and more stable accruals (Dechow and Dichev, 2002) I also control for the growth rate of a company’s sales (GROWTH), which is likely to increase the absolute value of accruals Dechow (1994) also suggests that accruals and cash flow are negatively correlated, so I include cash flow from operations (CFO) in my controls Company age (AGE) is used to control for the level of business experience of a company

This study also controls for the first year after the audit partner with top tenure in an audit team is replaced (CHG_FST) and the last year before the audit partner with top tenure

in an audit team is replaced (CHG_LST).In the first year, a successor audit partner may not make decisions properly, because of a shortage of client-specific knowledge In this case,

DA should be higher In the last year of tenure, a partner change will occur in the subsequent year For a given length of partner tenure, if a partner change is more likely when the company is facing more risk, then DA should be higher in cases of partner change

[Insert Table 1 about here]

4 Results

Data

The sample in this study is composed of data on listed companies in Japan from 1999 to

2006 As mentioned earlier, the reason that sample period has been set until 2006 is to verify the influence of long tenure in the before and after the introduction of rotation rule Since the Big 4 auditing firms introduced the partner rotation rule as a means of self-regulation in 2003, the sample has been divided into two sub-samples, which are for the periods before the introduction of the rule (b2003) and after its introduction (a2003) Our data source for accounting variables is the NIKKEI NEEDS–Financial Quest by Nikkei Media Marketing The name of the audit firm and signature of each audit partner were obtained from the audit reports of each company Information on the sample selection

is shown in Table 2 The initial sample included data on 15,636 Japanese listed companies from 1999 to 2006 Companies that use US-GAAP, that conduct M&A, and for which adequate financial data were not available were then deleted, leaving 13,245 firm-year observations In order to control for the effect that audit firm tenure has on the tenure of audit partners, this study analyses companies that did not change their audit firm for more than 10 years After companies that are audited by non-Big 4 auditors, that are audited by two audit firms in joint audits, or for which adequate auditor data is not available were all eliminated, a final sample was left that consists of 7,567 firm-year observations

[Insert Table 2 about here]

Descriptive statistics and correlations

Descriptive statistics on the variables in this study are presented in Table 3 The mean (median) of absolute DA equals 0.30% (0.22%) of the total assets The mean and median of audit partner tenure are 2.211 (about 9 years) and 2.303 (about 10 years), respectively The tenures of audit partners in Japan are relatively long, compared to those of audit partners in other countries For example, Carey and Simnett (2006) report that the average tenure of audit partners in Australia is 3.75 years, while Chen et al (2008) report that the average (median) tenure of audit partners in Taiwan is six years (five years) Note that the above means and medians do not indicate that the relationships between clients and auditors are significantly longer in Japan than in other countries The mean value of AGE is 4.023 (56 years), which is double the mean for Taiwanese companies (22 years) This suggests that the average company age in this study is relatively old, and that the years of audit partnership are longer as a result In the first year, 30.5% of audit partners changed (CHG_FST), and in the last year (CHG_LST) 30.5% changed also, meaning that over 30%

of the total number of longest-standing audit partners changed during the eight years addressed in this study

[Insert Table 3 about here]

Table 4 presents the correlations of variables Pearson (Spearman) correlations are shown above (below) the diagonal TNRE is positively associated with ASSET and AGE, and negatively associated with GROWTH, CFO, and CHG_FST The positive correlation between TNRE, ASSET, and AGE suggests that the accumulation of client-specific knowledge is required for companies that are large and have long histories The highest correlation coefficient in the sample is 29%, for CHG_FST and TNRE, which is not at a level that suggests multicollinearity

[Insert Table 4 about here]

Univariate analysis

First, this study constructs 10 portfolios related to audit partner tenure, and examines the distribution of DA in each portfolio The results are shown in Figure 2 There is no clear pattern in the mean (median) of DA by portfolio rankings of TNRE, but the pattern is clear for extreme values of positive DA The 90th percentile of DA is the highest for portfolio 2 and it becomes less positive as the portfolio ranking increases On the other hand, the 10th percentile of DA is almost constant in each portfolio In addition, this trend is clearer in the period prior to the introduction of the partner rotation rule, and cannot be observed after its introduction, as can be seen in Panels A and B of Figure 3 In sum, the results suggest that companies are less likely to record extreme values of income-increasing discretionary