Mandatory audit partner rotation, actual
audit quality and perceived audit quality:
Evidence from China
Erasmus School of Economics
Master: Accounting, Auditing & Control
Master’s Thesis Accounting and Auditing
Name: Cheng Liu
Student Number: 366954
Subject: Master’s Thesis Accounting and Auditing
Supervisor Erasmus University: Dr. C.D. Knoops
Co-reader Erasmus University: Drs. R. van der Wal RA
Date: 13 August 2014
Abstract
Mandatory audit partner rotation is required by many countries (for example
Australia, China, Taiwan, Germany, The Netherlands and the United States) based on
the assumption that mandatory audit partner rotation enhances actual and
perceived audit quality. This study investigates the association between mandatory
audit partner rotation and actual and perceived audit quality using the data from
China. I also investigate the association between audit firm tenure and actual and
perceived audit quality after controlling for audit partner rotation. Most previous
studies investigate the effects of audit partner rotation through the length of audit
partner tenure. However, this study directly examines the effects of mandatory audit
partner rotation. I use performance-adjusted accruals as the proxy for actual audit
quality and Earnings Response Coefficients as the proxy for perceived audit quality. I
find that there is no significant relation between mandatory audit partner rotation
and actual and perceived audit quality. And there is no significant relation between
audit firm tenure and actual and perceived audit quality after controlling for audit
partner rotation. This suggests that mandatory audit partner rotation cannot
enhance actual and perceived audit quality as expected by regulators and requiring
mandatory audit partner rotation for audit profession might be unnecessary.
Moreover, there is no need to require mandatory audit firm rotation in addition to
audit partner rotation since long audit firm tenure does not deteriorate actual and
perceived audit quality.
Keywords: mandatory audit partner rotation, audit firm tenure, actual audit quality,
perceived audit quality.
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Table of Contents
Abstract.............................................................................................................................................1Foreword and Acknowledgements:..................................................................................................4Chapter 1: Introduction....................................................................................................................6
1.1 Introduction to main theme................................................................................................61.2 Difference between actual audit quality and perceived audit quality................................71.3 Motivation...........................................................................................................................81.4 Research question.............................................................................................................111.5 Structure of the paper......................................................................................................121.6 Summary...........................................................................................................................12
Chapter 2: Background...................................................................................................................142.1 Introduction......................................................................................................................142.2 Institutional settings in the world.....................................................................................142.3 Institutional settings in China............................................................................................162.4 Summary...........................................................................................................................17
Chapter 3: Theoretical Concepts.....................................................................................................193.1 Introduction......................................................................................................................193.2 Difference between audit partner tenure and audit partner rotation..............................193.3 Audit quality and earnings quality....................................................................................203.4 Actual earnings quality and discretionary accruals...........................................................213.5 Actual audit quality and discretionary accruals................................................................223.6 Perceived earnings quality and earnings response coefficient.........................................223.7 Summary...........................................................................................................................23
Chapter 4: Literature Review..........................................................................................................244.1 Introduction......................................................................................................................244.2 Audit partner rotation/tenure and audit quality..............................................................24
4.2.1 Audit partner rotation/tenure and actual audit quality.........................................244.2.2 Audit partner rotation/tenure and perceived audit quality...................................28
4.3 Audit firm rotation/tenure and audit quality....................................................................304.3.1 Audit firm rotation/tenure and actual audit quality..............................................304.3.2 Audit firm rotation/tenure and perceived audit quality........................................32
4.4 Literature used for hypotheses.........................................................................................334.5 Summary...........................................................................................................................35
Chapter 5: Hypotheses...................................................................................................................365.1 Introduction......................................................................................................................365.2 Hypotheses development.................................................................................................36
5.2.1 Hypothesis for actual audit quality........................................................................365.2.2 Hypothesis for perceived audit quality..................................................................375.2.3 Additional hypothesis............................................................................................37
5.3 Summary...........................................................................................................................38Chapter 6: Research Design............................................................................................................39
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6.1 Introduction......................................................................................................................396.2 Research method..............................................................................................................39
6.2.1 Measurement of audit partner rotation and audit firm tenure.............................396.2.2 Measurement of actual earnings quality...............................................................406.2.3 Measurement of perceived earnings quality.........................................................43
6.3 Regression model..............................................................................................................456.3.1 Regression model for actual earnings quality........................................................456.3.2 Regression model for perceived earnings quality..................................................46
6.4 Libby boxes........................................................................................................................486.4.1 Libby boxes for actual earnings quality..................................................................486.4.2 Libby box for perceived earnings quality...............................................................48
6.5 Sample selection and data................................................................................................496.6 Summary...........................................................................................................................50
Chapter 7: Results...........................................................................................................................517.1 Introduction......................................................................................................................517.2 Descriptive statistics..........................................................................................................51
7.2.1 Descriptive statistics for actual audit quality.........................................................517.2.2 Descriptive statistics for perceived audit quality...................................................53
7.3 Empirical findings based on performance-adjusted abnormal accruals...........................557.4 Empirical findings based on earnings response coefficients.............................................597.5 Summary...........................................................................................................................63
Chapter 8: Analysis.........................................................................................................................648.1 Introduction......................................................................................................................648.2 The effects of mandatory audit partner rotation on actual audit quality.........................648.3 The effects of mandatory audit partner rotation on perceived audit quality...................678.4 The effects of audit firm tenure on actual and perceived audit quality............................698.5 Summary...........................................................................................................................71
Chapter 9: Conclusion.....................................................................................................................729.1 Introduction......................................................................................................................729.2 Main conclusions and implications of findings.................................................................729.3 Limitations and recommendations for future research....................................................739.4 Summary...........................................................................................................................74
Bibliography....................................................................................................................................75Appendix.........................................................................................................................................81
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Foreword and Acknowledgements:
This thesis is written in order to complete the Master Accounting and Auditing, at
Erasmus University Rotterdam. And this thesis is partly based on my course paper for
Seminar Financial Accounting Research. I have chosen the topic of audit partner
rotation, which falls within the scope of auditing theory. The main reason for
choosing this topic is that there are many debates about whether mandatory audit
partner rotation is able to enhance auditor independence and audit quality. Previous
studies have no consistent conclusion for the association between mandatory audit
partner rotation and audit quality. Besides, the data for audit partner rotation is not
publicly available in most of the countries. However, in China, audit partners are
required to sign the audit reports. Therefore, I contribute to the debate by providing
the empirical evidence using the data from China.
Since May of this year, I have been conducting research on this topic. I have
experienced an intensive, but interesting time when writing my master’s thesis. At
the beginning, I had little knowledge about the data collection and statistical tests.
But I learned a lot afterwards. In addition, the Chinese database only shows the
names of audit partner and audit firm for each audit report. The data for audit
partner rotation and audit firm tenure are not directly available in the database.
Therefore, I have to hand collect the data for audit partner rotation and audit firm
tenure based on those names. I am satisfied with all the results I have achieved.
However, I didn’t write my master’s thesis completely by my own. I would not finish
my master’s thesis without several people’s help. I would like to thank my thesis
supervisor from the University, Dr C.D. Knoops. He always gave me directions when I
have doubts for my research design. He provided me guidance for the structure of
my thesis. Besides, he gave me many valuable comments, which helped me a lot to
keep a critical mind. After several discussions with Dr C.D. Knoops, I have a better
understanding for the theoretical concepts part in my master’s thesis.
4
Lastly, I would like to thank my mom and friends for their supports during the period
of writing my master’s thesis. My mom helped me a lot in hand collecting the data of
audit partner rotation and audit firm tenure. My friends taught me a lot for statistics.
I would like to thank all the people who have supported me in this period.
Rotterdam, August 2014
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Chapter 1: Introduction
1.1 Introduction to main theme
Recently, a great number of financial scandals throughout the world (Enron,
WorldCom, Xerox and Sunbeam) have drawn public attention on audit quality.
Auditor independence is a determining factor of audit quality. Therefore, investors
start to doubt the auditor independence as the auditors fail to inform them the
threats of financial scandals in time.
Previous studies (Benston & Hartgraves, 2002; Lyke & Jickling, 2002; Seipp, Kinsella,
& Lindberg, 2011) find that the common characteristic of companies involved in
financial scandals is that the companies all maintain a very long relationship with the
same audit firms. Enron has been audited by Arthur Andersen since the company
was founded in 1985 (Benston & Hartgraves, 2002). Moreover, Arthur Andersen has
audited WorldCom since the company was founded in 1989 (Lyke & Jickling, 2002).
Until the end of 2002, KPMG has maintained the relationship with Xerox for 40 years
(Seipp et al., 2011). Many studies (Dies & Giroux, 1992; Beck, Frecka, & Solomon,
1988) have suggested that excessive length of auditor-client tenure may damage
auditor independence and audit quality. Auditor independence is believed to be one
of the cornerstones of the audit profession. The development of the audit profession
has to face a big challenge nowadays as auditor’s “societal usefulness” becomes in
question. Later in 2002, Sarbanes-Oxley Act (SOX) is issued aimed to maintain auditor
independence and restore the confidence of investors. In Section 203 of SOX, the
requirement of mandatory audit partner rotation is restricted from every 7 years to
every 5 years for all American public company audits. Regulators in USA stated that
mandatory audit partner rotation may avoid the “too familiarity” between auditors
and clients, thereby enhancing auditor independence and audit quality (General
Accounting Office [GAO], 2003). However, the relation between audit partner
rotation and audit quality has not been widely investigated by previous studies due
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to the lack of information on audit partners in the United States.
After the issuance of SOX in 2002, the Chinese Institute of Certified Public
Accountants (CICPA) issues the Code of Ethics for Chinese Certified Public
Accountants in the same year. In this Code of Ethics, for the first time, the concept of
mandatory partner rotation is introduced in China by CICPA to maintain auditor
independence. Since 2003, China Securities Regulatory Commission (CSRC) officially
requires mandatory audit partner rotation for every 5 years for all the listed
companies in China, which is consistent with the requirement in the United States.
However, unlike in the United States, audit reports in China are required to be signed
by two audit partners. Since the information on audit partners is publicly available in
China, it enables us to identify companies that are subject to mandatory audit
partner rotation and companies that are not subject to partner rotation. In China,
mandatory audit partner rotation takes effect since 2003. Thus, mandatory partner
rotation can be observed in the 2003 annual audit reports for the first time in China.
By focusing on the mandatory partner rotation in 2003, this study will investigate
whether mandatory audit partner rotation enhances audit quality as expected by
regulators using data from China.
In addition, the economy in China is growing rapidly nowadays. Therefore the
international investors are now paying more and more attention on Chinese stock
market. My research results will have important implications on Chinese regulators,
auditors, audit quality and users of financial reports.
1.2 Difference between actual audit quality and perceived audit
quality
Investors are willing to rely on auditor’s opinion because they expect an unbiased
viewpoint from auditors. Several studies (Sinnett, 2004; Moore, Tetlock, Tanlu, &
Bazerman, 2006; Raiborn, Schorg, & Massoud, 2006) argue that the potentially
impaired auditor independence due to long auditor-client relationship is the major
threat in audit quality. However, the American Institute of Certified Public
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Accountants (AICPA) Code of Professional Conduct and the International Ethics
Standards Board for Accountants (IESBA) Code of Ethics for Professional Conduct
define two types of independence: independence of mind and independence in
appearance. “Independence of mind reflects the auditor’s state of mind that permits
the audit to be performed with an unbiased attitude. Independence in appearance is
the result of others’ interpretations of this independence (Arens, Elder, & Beasley,
2014)”. Therefore, audit quality can also be viewed from two perspectives: actual
audit quality and perceived audit quality (Taylor, 2005). Actual audit quality is
affected by independence of mind, while perceived audit quality is affected by
independence in appearance. Actual audit quality is the extent to which auditors fail
to discover and disclose a breach in the client’s financial reports. Perceived audit
quality is the extent to which investors believe there is no material mistakes in the
client’s audited financial reports.
The Commission on Public Trust and Private Enterprise (2003) outlines in its report
that mandatory audit partner rotation not only enhances auditor independence, but
also restores investor’s confidence in the capital market. Only when investors have
more confidence in auditor’s work, the perceived audit quality could be high. Elliott
(2000), a former chairman of the AICPA, highlights the importance of independence
in appearance. AICPA believes the smooth operation of capital markets is based on
the investor’s confidence in audited financial reports. And the confidence of investors
is heavily determined by auditor independence in appearance. Thus, it is necessary
for this study to evaluate audit quality from both actual and perceived viewpoints.
1.3 Motivation
DeAngelo (1981) defines audit quality from two perspectives. First, auditors should
have enough competence to discover a breach in annual reports of clients. Second,
auditors should be an independent third party and therefore willing to disclose the
breach they have found earlier to the public. Long auditor-client relationship is
believed to be a threat to both auditor independence and auditor competence. To
solve this problem, many countries, for example the United States, the United
8
Kingdom, the Netherlands, Brazil and China, have proposed mandatory auditor
rotation at the partner level or firm level. The purpose of mandatory audit
partner/firm rotation is to limit the allowed audit partner/firm tenure and thereby
enhance audit quality from both independence and competence perspectives.
Mandatory auditor rotation could be at the partner level or the firm level. But the
rationales behind the cost-benefit analysis about mandatory rotation are the same.
Therefore, I will explain the arguments for and against mandatory auditor rotation
together, which means both audit partner rotation and audit firm rotation.
James R. Doty, the Chairman of the five-member Public Company Accounting
Oversight Board (PCAOB), highlights the benefits of mandatory auditor rotation – a
means of enhancing auditor independence, objectivity and professional skepticism
(Bates, Waldrup, Jaeger, & Shea, 2012). This shows us again that one of the major
concerns driving mandatory auditor rotation is the notion that an excessive long and
too close auditor-client relationship negatively affects the independence and
objectivity of auditors. If auditors get too familiar with their clients, audit partners
will feel they are on the same side with clients and audit firms will turn to be a
business partner or subsidiary of their clients (Herrick & Barrionuevo, 2002). Then,
audit partners or audit firms will have difficulty acting as an isolated independent
examiner. Implementing mandatory auditor rotation could enhance auditor
independence by avoiding this too familiar relationship. Besides, mandatory auditor
rotation could also provide a “fresh viewpoint” by new auditors (Cadbury Committee,
1992). Auditors always treat the same clients with the same way of analysis every
year. If auditors have served the same clients for a long time, it will be difficult for
them to discover any new problem as auditors simply repeat their analysis in the old
way. However, new auditors with caution will invest more time and efforts to analyze
clients’ reports in a more thorough way. This “fresh viewpoint” by new auditors could
enhance auditor’s competence to find the potential breach in the client’s audit
reports.
On the contrary, many studies (Geiger & Raghunandan, 2002; Carcello & Nagy, 2004;
9
Daugherty, Dickens, & Higgs, 2010) argue that mandatory auditor rotation initiates
costs from unexperienced audit successor as well. First, new auditors lack of client
specific knowledge and therefore are more likely to result in audit failure. Geiger and
Raghunandan (2002) find a higher rate of Type 2 error (auditors fail to detect
companies that are unable to continue as a going concern) for auditors who are in
the early phase of auditor tenure. More specifically, those new auditors fail to issue a
qualified going concern opinion immediately before the client firms are filed for
bankruptcy. The results by Geiger and Raghunandan (2002) show that new auditors
tend to make unintentional mistakes due to lack of experience. Second, mandatory
auditor rotation costs new auditors more time and efforts to understand the
background information and operation process of client companies. Client specific
knowledge is a crucial element for new auditors to detect material mistakes in
financial reports. And there exists a learning curve for new auditors to gain this
knowledge (Knapp, 1991). Besides, more audit hours mean more audit fees paid by
client companies. Johnson (2012) reports that: “in 2003, it was estimated that a
change in auditors can add 20 percent to the initial cost of an audit”. In sum, on the
one hand, client companies have to suffer more audit fees from mandatory auditor
rotation. On the other hand, investors need to bear the risk of potentially deceased
auditor competence due to lack of client specific knowledge.
The adoption of mandatory audit partner/firm rotation by many countries suggests
that the regulators believe the benefits outweigh the costs of mandatory rotation.
But not all politicians agree on that. In the United States, Representative Michael
Fitzpatrick introduced a legislation in 2012 that would prohibit the implementing of
mandatory audit partner rotation or mandatory audit firm rotation (Bates et al.,
2012).
Besides regulators, previous researches (Dopuch, King, & Schwartz, 2001; Gietzmann
& Sen, 2002; Carey & Simnett, 2006) have no consistent conclusion about the cost-
benefit efficiency of mandatory auditor rotation as well. Through a between-subjects
experiment with auditors, Dopuch et al. (2001) find that auditors are less likely to
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issue a biased audit report with the imposition of mandatory auditor rotation.
Dopuch et al. (2001) argue that without the pressure from legal requirements,
auditors feel free to cooperate with client management in order to maintain a good
business relationship and gain economic benefits. This leads to a win-win situation
for both clients and auditors in the short term. Gietzmann and Sen (2002) find that
mandatory auditor rotation has a positive net benefit in certain situations where few
large client companies are available in the market. When certain client companies
contribute a large element of auditor’s income, auditors will have stronger incentives
to cooperate with client management in such a thin market.
However, several empirical studies (Carey & Simnett, 2006; Chen, Lin, & Lin, 2008;
Myers, Myers, & Omer, 2008; Chi, Huang, Liao, & Xie, 2009) find the opposite
conclusion. Carey and Simnett (2006) and Chen et al. (2008) find no significant
association between audit partner tenure and audit quality measured by accruals.
Myers et al. (2003) find longer audit firm tenure significantly increases audit quality.
Chi et al. (2009) directly examine the effects of mandatory audit partner rotation
instead of audit partner tenure and they find both the actual and perceived audit
quality are not significantly increased by mandatory rotation.
Many regulation setters (Bates et al., 2012) and researches (Carey & Simnett, 2006;
Chen et al., 2008; Myers et al., 2008; Chi et al., 2009) doubt the cost-benefit
efficiency of mandatory auditor rotation. The relation between auditor rotation and
audit quality is still not clear. Mandatory audit partner rotation has been widely
accepted by many countries already, while mandatory audit firm rotation in addition
to partner rotation is still being discussed in most places. In China, only mandatory
audit partner rotation is required for all listed companies. Therefore, in this study, I
will focus on the effects of mandatory audit partner rotation. I investigate whether
the belief is true that mandatory audit partner rotation will enhance actual or
perceived audit quality and whether audit firm tenure will still have effects on audit
quality after controlling for audit partner rotation.
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1.4 Research question
Based on the discussion above, my research question is as follows:
What is the association between mandatory audit partner rotation and audit
quality?
To investigate the research question further, two sub research questions are designed
as follows:
1. What is the association between mandatory audit partner rotation and actual
audit quality?
2. What is the association between mandatory audit partner rotation and perceived
audit quality?
The additional research question is as follows:
1. What is the association between audit firm tenure and actual audit quality after
controlling for audit partner rotation?
2. What is the association between audit firm tenure and perceived audit quality
after controlling for audit partner rotation?
1.5 Structure of the paper
The remainder of this paper is organized as follows. The next chapter introduces the
institutional background of mandatory audit partner rotation and audit firm rotation.
Chapter 3 explains several important concepts that will be used in this study. Chapter
4 reviews previous literature related to my research question. Chapter 5 develops the
hypotheses based on my expectation on research question. Chapter 6 describes the
research design and sample selection, which are used to test the hypotheses.
Chapter 7 presents the main empirical results from the regression model in Chapter
6. Chapter 8 answers the research question based on the empirical results. Chapter 9
summarizes the main findings, discusses the research limitations, and recommends
for future studies.
1.6 Summary
Mandatory audit partner rotation has been adopted by many countries, while
12
mandatory audit firm rotation is still being discussed in many places. Mandatory
audit partner rotation is believed as a means to enhance auditor independence and
audit quality. However, the cost-benefit efficiency of mandatory audit partner
rotation is doubted by many previous literatures. It is still an empirical question of
whether mandatory rotation is positively associated with audit quality. Both actual
and perceived audit quality are important. If auditors are independent in fact but
investors don’t believe it, most of the value of the audit function is lost. In this study,
I investigate the relation between mandatory audit partner rotation and audit quality
and examine audit quality from both actual and perceived perspectives. The
association between audit firm tenure and audit quality will be examined as well.
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Chapter 2: Background
2.1 Introduction
In this chapter, background information and institutional settings about mandatory
auditor rotation will be provided. Auditor rotation could be audit partner rotation or
audit firm rotation. Audit partner rotation requires the audit partners to be rotated
after certain years, while audit firm rotation requires rotation in the firm level. This
chapter will elaborate on the regulation and discussion for both partner rotation and
firm rotation. I will first describe the emergence and development of mandatory
audit partner/firm rotation across the world. Then I will elaborate the mandatory
audit partner/firm rotation in China since the statistical test is based on the Chinese
database in this study.
2.2 Institutional settings in the world
Many countries in the world have implemented mandatory audit partner rotation for
the listed companies to enhance auditor independence. In the United States,
mandatory audit partner rotation has been required by the American Institute of
Certified Public Accountants (AICPA) since 1970s. For all companies registered at
Securities and Exchange Commission (SEC), the audit partners in charge should be
rotated in every 7 years. In 2002, mandatory audit partner rotation is emphasized
again by SOX, and the allowed audit partner tenure is restricted from 7 years to 5
years in the United States. Although mandatory auditor rotation in the United States
is required at the partner level instead of firm level, audit reports of listed companies
are not required to be signed with the name of audit partner. In the United States,
only the name of audit firm is available in the audit reports. This explains why most
studies (Geiger & Raghunandan, 2002; Johnson, Khurana, & Reynolds, 2002; Myers
et al., 2003) based on American database only investigate the effects of audit firm
rotation/tenure on audit quality, instead of audit partner rotation/tenure.
In Australia, legal requirement for audit partner rotation takes effect since 2001. In
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2001, the Australian profession’s independence standard mandates audit partner
rotation for every 7 years. After that, the predetermined partner tenure is then
reduced to 5 years in 2004 in Australia. Regulations in Taiwan require mandatory
audit partner rotation for every 5 years since 2003. Before 2003, no legal or
professional audit partner rotation is required in Taiwan. In both Australia and
Taiwan, the audit partner’s name should be disclosed in the audit reports, together
with the name of audit firms (Carey & Simnett, 2006; Chen et al., 2008). Similar with
the United States, the partner rotation period has been reduced from 7 years to 5
years in United Kingdom as well. In 2003, the Department of Trade and Industry and
the UK Treasury recommend the tenure of audit partner should be limited within 5
years. Internationally, mandatory audit partner rotation has also been adopted in
Singapore, Japan, France, the Netherlands and Germany.
Regulators from different countries have different opinions about the various forms
of auditor rotation. Some countries (for example United States, United Kingdom,
Australia, Taiwan and the Netherlands) require mandatory audit partner rotation,
while some (for example Brazil, Italy, India and South Korea) choose to require
mandatory rotation at the firm level.
In the United States, the Congress considered audit firm rotation before, but they
choose to mandate audit partner rotation in SOX in the end. Mandatory audit firm
rotation was given up at that time because the Congress believe more time is needed
to analyze the costs and benefits of mandatory audit firm rotation before it is
included into the legislation (Bates et al., 2012). Recently, Arthur Levitt, former SEC
head, emphasizes the benefits of audit firm rotation by suggesting in a recent Wall
Street Journal interview that audit firm should be rotated in every ten years (Chasan,
2011). Besides, the European Commission (2010) underlines mandatory audit firm
rotation and states that “the mandatory rotation of audit firms, not just of audit
partners, should be considered…with a view to instilling and maintaining objectivity
and dynamism in the audit market.” Although audit firm rotation is not required,
many regulators are still considering it. More researches and discussions are needed
15
on audit firm rotation or audit firm tenure. Therefore, the impact of audit firm tenure
will be examined in this study as well.
2.3 Institutional settings in China
In China, the audit profession is regulated by both the Chinese Securities Regulatory
Commission (CSRC) and the Ministry of Finance (MOF). Inspired by SOX, the Chinese
Institute of Certified Public Accountants (CICPA), in the Code of Ethics for Chinese
Certified Public Accountant in 2002, suggests audit partner rotation aimed to
maintain auditor independence. This is the first time when audit partner rotation is
introduced in China. However, the Code of Ethics has no legal effects and audit
partner rotation is not required as a mandatory rule in 2002. After that, CSRC and
MOF jointly adopted a set of rules in October of 2003 and officially require
mandatory audit partner rotation for Chinese listed companies. In China, audit
partners responsible for listed company audits should be rotated at least every five
years. Besides, the policy issued by CSRC and MOF requires that “signing auditors
must not provide audit services for the same initial public offering (IPO) entity for
more than two consecutive years after the IPO (Firth, Rui, & Wu, 2010)”. These rules
became fully effective since the end of 2003 for all annual audit reports of Chinese
listed companies. Before 2003, audit partner rotation in China was entirely voluntary.
Thus, 2003 year-end audit reports are where the information about mandatory audit
partner rotation can be identified for the first time in China. I will investigate the
effects of mandatory audit partner rotation in China based on 2003 annual audit
reports.
Unlike in the United States, audit reports in China are required to be signed by two
certified public accountants. One of the two signing audit partners is responsible for
the related audit work as a leader. The other audit partner is responsible for
reviewing the audit work that the lead audit partner has done. The engagement
audit partner has stronger effects on audit quality than the reviewing audit partner.
Unfortunately, I cannot distinguish these two audit partners from China Stock Market
and Accounting Research (CSMAR) Database as two names are shown equally in the
16
database. However, both of the two audit partners undertake the same legal
liabilities according to the policy issued by CSRC and MOF.
In China, there are some companies funded by the Chinese government. They are
called State-Owned Enterprises (SOEs). SOEs usually have a more powerful position
than auditors in their auditor-client relationship. Auditor independence is more likely
to be impaired due to the threat of being dismissed by issuing qualified audit
opinions to SOEs (Ye, Xu, & Han, 2013). Thus, the State-owned Assets Supervision
and Administration Commission of the State Council (SASAC) of China established
more strict rules for SOEs. In 2005, mandatory audit firm rotation in addition to
mandatory audit partner rotation is required by SASAC for all SOEs under its
jurisdiction. Since 2005, SOEs must rotate both audit partners and audit firms after
the service of 5 consecutive years. For other listed companies except SOEs, only
mandatory audit partner rotation is required in every five years.
According to the official comments by CSRC, Chinese regulators believe auditor’s
incompetence is not the major reason for corporate scandals. The excessive long
auditor-client relationship is the major threat to auditor independence and audit
quality. Mandatory audit partner rotation can not only enhance auditor
independence by restricting the length of audit partner tenure, but also provide a
fresh perspective by new auditors to discover new problems (Firth et al., 2010). CSRC
has considered audit firm rotation as well. However, the regulators think audit firm
rotation will increase the probability of audit failure due to the lack of client specific
knowledge by new auditors (Firth et al., 2010). And the benefit, if there is any, of
mandatory audit firm rotation is still not clear.
2.4 Summary
Internationally, audit partner rotation has been implemented in many countries, for
example in the United States, the United Kingdom, the Netherlands, Australia,
Taiwan and Germany. Audit firm rotation in addition to audit partner rotation is
called for more discussion in both the United States and Europe. In Australia and
Taiwan, information on audit partner rotation or tenure is publicly available, while
17
most other countries do not require disclosure of audit partner’s name in the audit
reports. So far, mandatory audit firm rotation is only required for SOEs in China. For
ordinary Chinese listed companies, only mandatory audit partner rotation is
required. Similar to Australia and Taiwan, Chinese audit partners are also required to
sign in the audit reports. Thus, this study will mainly focus on the effects of
mandatory audit partner rotation on both actual and perceived audit quality based
on data from China.
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Chapter 3: Theoretical Concepts
3.1 Introduction
In this chapter, theoretical constructs are firstly explained before the literature
review in the following chapter. Discretionary accruals and earnings response
coefficient are widely accepted by previous studies (Myers et al., 2003; Chi & Huang,
2005; Chen & Xia, 2006; Ghosh & Moon, 2005) as the measures for actual audit
quality and perceived audit quality respectively. But it is not clear to what extent
those proxies can capture the concept of audit quality. Thus, the rationales behind
those measurements are explained in this chapter.
3.2 Difference between audit partner tenure and audit partner
rotation
Some studies (Chi & Huang, 2005; Carey & Simnett, 2006; Chen et al., 2008) examine
the effects of audit partner tenure on audit quality, while some studies (Chi et al.,
2009; Firth et al., 2010) directly examine the effects of mandatory audit partner
rotation on audit quality.
In fact, audit partner tenure and audit partner rotation are two closely related
concepts. If audit partners have maintained a very long relationship with the same
clients, audit partners are more likely to ignore the problems in their client’s financial
statements because of “too familiarity”. Or audit partners are more reluctant to issue
a qualified audit opinion to an “old friend”. This implies that the audit quality might
be impaired by long audit partner tenure. To solve this potential problem, mandatory
audit partner rotation is required in certain years. Therefore, the purpose of
mandatory audit partner rotation is to enhance the audit quality by limiting the audit
partner tenure within a short term. In sum, audit partner tenure is a time period,
while audit partner rotation is an action to limit the length of this period. Mandatory
audit partner rotation is based on the assumption that long audit partner tenure
19
deteriorates audit quality. Both of them can be used to investigate the relation with
audit quality.
3.3 Audit quality and earnings quality
Earnings quality is used as a proxy for audit quality in this study. Traditionally, high
audit quality means completely compliance with Generally Accepted Auditing
Standards (GAAS). In this study, audit quality is measured by the outcome of
auditor’s work – audited financial statements. Based on the agency theory, client
management is not the owner of the company, but they have superior information
about the company’s performance than the owners. Because of this information
asymmetry, auditors are needed to examine the quality of financial statements as an
independent third party. Therefore, client management and auditors have a joint
responsibility for the quality of financial statements (Antle & Nalebuff, 1991).
Managers of client companies are responsible for the ultimate quality of reported
financial statements. Auditor’s work is to assure the true and fair representation of
client company’s operating performance in the financial statements. Earnings are
stated by managers as the most important financial measure reported to outsiders
(Graham, Harvey, & Rajgopal, 2005). When the quality of financial statements is poor,
earnings reported in the financial statements might be artificially managed upward
or downward to meet (beat) the targets or conserve for the future targets.
In sum, the quality of financial statements can be determined by audit quality since
client management and auditors have a joint responsibility for the quality of financial
statements (Antle & Nalebuff, 1991). At the same time, earnings quality can be
determined by the quality of financial statements since earnings are stated by
managers as the most important financial measure reported to outsiders (Graham et
al., 2005). Therefore, earnings quality can be used as a proxy for audit quality.
However, there is limitation in this study as I use proxy for proxy in the research
design. The internal validity of this study is largely dependent on the ability of
earnings quality to capture the concept of financial statement quality and the ability
of financial statement quality to capture the concept of audit quality. For example,
20
earnings restatement could also be a proxy for audit quality. However, this will result
in a very small sample size in my study considering the limited sample size of
companies that are subject to mandatory audit partner rotation in year 2003. I will
explain more on the research limitations in Chapter 9.
3.4 Actual earnings quality and discretionary accruals
Actual earnings quality is a measure for actual audit quality. And discretionary
accruals are a measure of actual earnings quality in this study. There are two ways to
present the operational performance of a company in accounting: cash based
accounting versus accrual based accounting. Under cash based accounting,
companies record the revenues or costs when cash is received or paid. Cash flow is
deemed to be a more reliable line item to reflect business performance of client
companies. But cash flow has significant timing and matching problems. Accruals-
based accounting can perfectly solve these two problems and thereby is widely
adopted by both Generally Accepted Accounting Principles (GAAP) and International
Financial Reporting Standards (IFRS). Accruals based accounting records the revenues
and costs when the transaction occurs. Sometimes, managers’ prediction about
future cash flows is needed to estimate accruals. This flexibility provides the ability
for client management to communicate inside information to outsiders, but also
gives them opportunity to manipulate earnings in order to achieve some specific
objectives. Richardson, Tuna and Wu (2002) find that companies with large amount
of accruals are more likely to restate their reported earnings in the financial
statements. Earnings are the sum of accruals and cash flows. Accruals are the sum of
discretionary accruals and non-discretionary accruals. The part of earnings that is
manipulated by client management through accruals to achieve any specific
objective is called discretionary accruals. Client management has more flexibility in
overstating or understating earnings through accruals. Thus, higher level of
discretionary accruals indicates lower level of earnings quality or audit quality.
There are several forms of earnings management: accruals earnings management
and real earnings management. I recognize that both real activities manipulation and
21
accruals manipulation could affect the earnings management. Real activities
manipulation, for example cutting R&D expense and advertising expense, will
negatively affect the client firms’ long-term profits. But this will not affect the quality
of auditors’ work. Auditors only care about the true and fair disclosure of client
company’s performance. Thus it is sufficient for this study to only focus on the
accruals manipulation part.
3.5 Actual audit quality and discretionary accruals
According to section 3.3, actual earnings quality is a proxy for actual audit quality.
Section 3.4 introduces that discretionary accruals are used to measure actual
earnings quality. Thus, discretionary accruals can be used as a proxy for actual audit
quality. Several studies (Geiger & Raghunandan, 2002; Bartov, Gul, & Tsui, 2000) have
examined the association between discretionary accruals and audit quality. Geiger
and Raghunandan (2002) find that higher level of accruals is an indicator for audit
failure. Bartov et al. (2000) find that auditors issue a qualified audit opinion when
accruals level is high. Thus, a higher level of discretionary accruals implies a lower
level of actual audit quality. Besides, performance-adjusted accruals based on the
model by Kothari, Leone and Wasley (2005) has been widely accepted by many
studies (Myers et al., 2003; Chen et al., 2008; Chi et al., 2009) as the proxy for actual
earnings quality or actual audit quality.
3.6 Perceived earnings quality and earnings response coefficient
Perceived earnings quality can reflect perceived audit quality. Earnings Response
Coefficient (ERC) is used by many studies (Ghosh & Moon, 2005; Chi et al., 2009) to
measure perceived earnings quality. ERC is measured by Scott (2012) as follows:
“An earnings response coefficient measures the extent of a security’s abnormal
market return in response to the unexpected component of reported earnings of the
firm issuing that security.”
ERC measures the extent to which investors react to the earnings information.
Investors only react to the information when they perceive the information is
22
credible. Higher perceived earnings quality or audit quality facilitates investors to
invest more in specific client companies as the investors trust the credibility of
earnings information. Previous studies (Schipper & Vincent, 2003; Teoh & Wong,
1993) find that investors are willing to pay a premium for client companies with high-
quality earnings because the earnings are more persistent in the future. Thus, the
effects of mandatory audit partner rotation on perceived earnings quality can be
examined through the price of earnings that investors are willing to pay, which is ERC.
3.7 Summary
Audited financial statement is a joint outcome of both client management and
auditors. The quality of reported earnings in the audited financial statement is
therefore able to reflect audit quality. Audit quality can be divided into actual audit
quality and perceived audit quality. Actual earnings quality reflects actual audit
quality, while perceived earnings quality reflects perceived audit quality. Manages
are more likely to manipulate earnings to achieve any specific objectives through
accruals. Thus, the level of discretionary accruals can be a proxy for actual earnings
quality. ERC reflect the investor’s reaction to earnings information and therefore can
be used to measure the investor’s perception about earnings quality.
23
Chapter 4: Literature Review
4.1 Introduction
In this chapter, previous studies about mandatory audit partner or firm rotation are
introduced. The effectiveness of mandatory rotation is sometimes investigated
through partner tenure or firm tenure. The regulation of mandatory audit
partner/firm rotation is proposed based on the common cognition that excessive
long audit partner/firm tenure deteriorates audit quality as auditor independence is
undermined. In addition, audit quality affected by mandatory audit partner/firm
rotation is examined from two aspects: actual audit quality and perceived audit
quality. Thus, I am going to summarize the previous findings through 4 aspects: audit
partner rotation/tenure and actual audit quality; audit partner rotation/tenure and
perceived audit quality; audit firm rotation/tenure and actual audit quality; audit
firm rotation/tenure and perceived audit quality. A list of previous studies discussed
in this chapter will be provided later in Table 1 and Table 2 under Appendix.
4.2 Audit partner rotation/tenure and audit quality
Although most of the countries around the world require mandatory partner rotation
instead of mandatory firm rotation, few studies have directly investigated the
relation between audit partner tenure and audit quality. Chen et al. (2008)
mentioned that this might be caused by lack of data on audit partner tenure. Many
countries do not require disclosing the audit partner’s name when issuing an audit
report. Thus, the data on audit partner tenure is not publicly available for academic
research in most of the countries. The previous literatures about audit partner
rotation/ tenure discussed below are all listed in Table 1 under Appendix.
4.2.1 Audit partner rotation/tenure and actual audit quality
Chen et al. (2008) examine the relation between audit partner tenure and earnings
quality based on a sample from 1990 to 2001, which is selected from a Taiwanese
24
database. In Taiwan, all the audit reports for the listed companies need to be signed
by two audit partners from the same audit firm. Therefore, the audit partner’s name
can be accessed through the audit reports. This special regulation enables them to
count the audit partner tenure by hand. Chen et al. (2008) use performance-adjusted
discretionary accruals based on the model by Kothari et al. (2005) as the proxy for
earnings quality in their research. However, several proxies are used to measure the
audit partner tenure. Since there are two names in each audit report every year, it is
almost impossible to know which of the two has greater influence on maintaining
auditor-client relationship. In the primary analysis, the tenure of the partner with the
longest tenure is used based on the assumption that the longest-tenure partner is
more likely to determine the relationship with clients. When absolute or positive
values of discretionary accruals are used as dependent variables, the results show
that earnings quality increases significantly with longer audit partner tenure. When
raw or negative values of discretionary accruals are used, no significant results are
found in the test. Besides, Chen et al. (2008) also examine whether this relation is
conditional on the length of audit partner tenure. Since many countries, for example
Taiwan, China, United States and United Kingdom, require mandatory audit partner
rotation for every five years, the relation between partner tenure and earnings
quality might be different when the partner tenure is less than or in excess of 5 years.
However, the results show that the absolute values of discretionary accruals
decrease significantly both before and after the tenure exceeds 5 years. And long
partner tenure (PT > 10) doesn’t indicate higher discretionary accruals, neither. Thus,
there is no evidence which supports the argument that longer audit partner tenure
deteriorates audit quality based on Taiwanese market.
Contrary to the findings by Chen et al. (2008), Chi and Huang (2005) find that
earnings quality first increase with longer audit partner tenure and then decreases
after a turning point. This turning point is around 5 years of partner tenure. Chi and
Huang (2005) investigate the relation between audit partner tenure and the level of
discretionary accruals through a non-linear regression model, which is based on the
25
sample from 1990 to 2001 of a Taiwanese database. Chi and Huang (2005) measure
the discretionary accruals based on the model proposed by Dechow, Richardson and
Tuna (2003). And the sample size used in Chi and Huang (2005) is smaller than that in
Chen et al. (2008).
Later on, Chi et al. (2009) investigate the relation between mandatory audit partner
rotation and audit quality using Taiwanese database again. Different with Chi and
Huang (2005) and Chen et al. (2008), Chi et al. (2009) directly investigate the effects
of mandatory audit partner rotation instead of audit partner tenure. They only focus
on the data in year 2004, when the Taiwanese government requires mandatory
partner rotation for the first time. Chi et al. (2009) first identify a group of companies
whose audit partners were rotated in 2004 due to the requirements of mandatory
audit partner rotation. This group is called mandatory rotation sample (MROTA).
Then, MROTA is compared with three other benchmark groups: 1) non-mandatory
rotation sample (NROTA): all the other companies except MROTA; 2) mandatory
rotation sample itself in the prior year (MBEFR): same companies with MROTA, but in
different year; 3) voluntary rotation (VROTA): companies whose audit partners were
rotated before 2003 voluntarily. Similar with Chen et al. (2008), Chi et al. (2009) also
use both absolute and signed values of discretionary accruals based on the model by
Kothari et al. (2005) as the proxies for audit quality. When compared to MBEFR, they
find the level of performance-adjusted abnormal accruals is higher in MROTA.
Nevertheless, the level of abnormal accruals in MROTA is not significantly different
from that in NROTA or VROTA. Thus, there is no evidence that supports that
implementation of mandatory audit partner rotation enhances the earnings quality
or audit quality. And the earnings quality of companies in the mandatory rotation
sample group is even impaired compared to the prior year, which is consistent with
the main finding in Chen et al. (2008) that earnings quality increases with longer
audit partner tenure.
Similar to Taiwan, audit reports are also required to be signed with both the name of
audit partner and the name of audit firm in Australia. Carey and Simnett (2006)
26
investigate the relation between audit partner tenure and audit quality by focusing
on the data of year 1995 in Australia. The policy for mandatory audit partner rotation
takes into effect from year 2001 in Australia. But, the Big 6 firms in Australia start
discussing and voluntarily implementing audit partner rotation since year 1997. Thus,
1995 is the most recent year when there is enough data for long audit partner
tenure. Carey and Simnett (2006) define long audit partner tenure as the tenure
which is more than 7 years and define short audit partner tenure as the tenure which
is up to 2 years. And they use 3 proxies to measure audit quality: 1) the auditor’s
propensity to issue a going-concern opinion; 2) absolute and signed values of
abnormal working capital accruals; 3) the extent of earnings management. Following
the approach of DeFond, Raghunandan and Subramanyam (2002), Carey and Simnett
(2006) use the audit opinion received by client companies (dummy variable) to stand
for auditor’s propensity to issue a going-concern opinion and regress it to dummy
variables of short and long audit partner tenure. The coefficient of long audit partner
tenure is significantly negative, which means that audit partners with a long tenure
are less likely to issue a going-concern opinion (lower audit quality). Abnormal
working capital accruals (AWCA) is defined as “the difference between realized
working capital and an expected level of working capital needed to support a current
sales level” by DeFond and Park (2001). For both absolute and signed values of
AWCA, the coefficient of long audit partner tenure is not significant in the regression
analysis. Thus, audit quality measured by AWCA is not associated with long audit
partner tenure. Lastly, Carey and Simnett (2006) use two benchmarks to define the
extent of earnings management. They classify a company as engaging in earnings
management if its profit or loss is less than 2 percent of its total assets or the
company’s increase/decrease in profit/loss over last year is less than 2 percent of
total assets. The main reason for using these two benchmarks is that companies with
reported earnings around the targets are regarded as suspects of engaging in
earnings management. Carey and Simnett (2006) only find significant results when
using the breakeven performance as the benchmark, suggesting the client company
27
with long audit partner tenure has a high probability to artificially beat targets (lower
audit quality). In general, Carey and Simnett (2006) provide some evidence which
supports mandatory audit partner rotation as long audit partner tenure deteriorates
audit quality in Australia.
Firth et al. (2010) examine the effects of various forms of auditor rotation on audit
quality based on a Chinese database. All the observations in the sample from 1997 to
2005 are classified into five groups: mandatory partner rotation, mandatory firm
rotation, voluntary partner rotation, voluntary firm rotation and non-rotation.
Modified audit opinion is used as a manifestation of high audit quality. Firth et al.
(2010) find that companies in mandatory partner rotation group have a higher
probability to receive a modified audit opinion compared to the companies in the
non-rotation group. This suggests that mandatory audit partner rotation has effects
on enhancing auditor independence and therefore audit quality.
4.2.2 Audit partner rotation/tenure and perceived audit quality
As is stated before, perceived audit quality is as important as actual audit quality
when evaluating the effects on audit quality (Taylor, 2005). Limperg’s Theory of
Inspired Confidence confirms the importance of perceived audit quality. According to
Limperg’s Theory, the appearance of auditors is based on the needs of the
community. The responsibility of the auditors is therefore to meet the needs of
society. Thus, the existence of auditors relies heavily on the confidence through
assurance work. If society loses its confidence in auditor’s work and the issued audit
opinion, the social usefulness of auditors will be lost. Of course, investors’ confidence
is not only dependent on the actual audit quality, but also largely determined by
what the investors think about the quality of auditor’s work.
Due to the difficulty in measuring an individual’s interpretation about audit quality,
many previous studies (Teoh & Lim, 1996; Goodwin & Seow, 2002; Gates, Lowe, &
Reckers, 2007; Kaplan & Mauldin, 2008; Daniels & Booker, 2011; Dart, 2011) conduct
experiments to examine the association between audit partner rotation/tenure and
perceived audit quality. Gates et al. (2007) and Kaplan and Mauldin (2008) both
28
invite MBA students to act as the real-world investors in their experiments. Gates et
al. (2007) examine the investor’s confidence in company’s reported earnings under
three different conditions (audit firm rotation; audit partner rotation; non-audit
rotation). Based on the responses from MBA students, Gates et al. (2007) find that
requiring audit firm rotation significantly increases investor’s confidence in
company’s reported earnings, while audit partner rotation has little help in restoring
investor’s confidence. In addition, Gates et al. (2007) also invite law students to
conduct the same experiment. Law students stand in the supervisory role. And the
responses by law students show that they are more likely to trust in the companies
under the condition of audit firm rotation than audit partner rotation, which is
consistent with the responses by MBA students. Kaplan and Mauldin (2008) conduct
two experiments and ask MBA students to estimate the income-decreasing audit
difference for each experiment. The first experiment is set under the condition of 5
years auditor-client relationship, while the second is set as 26 years. On the contrary,
Kaplan and Mauldin (2008) find that investors do not perceive any difference
between the condition of audit firm or partner rotation when evaluating credibility of
reported earnings and auditor independence. The appropriateness of using MBA
students to represent investors is questionable itself. MBA students may simply
respond in a way that they learn in business schools. The results extracted from
experiments relying on MBA students can only show us what the business students
believe instead of what the real-world investors will judge.
Very few empirical studies (Ghosh & Moon, 2005; Chi et al., 2009) investigate the
relation between audit firm or partner rotation and perceived audit quality. Ghosh
and Moon (2005) focus on audit firm tenure, while Chi et al. (2009) focus on audit
partner rotation. I will discuss Ghosh and Moon (2005) later in section 4.3.2. Next to
actual audit quality, Chi et al. (2009) also examine the effects of mandatory partner
rotation on perceived audit quality measured by Earnings Response Coefficient (ERC).
As I have explained in section 4.2.1, Chi et al. (2009) compare the mandatory rotation
sample with three other benchmark groups. Following the regression model used in
29
Ghosh and Moon (2005), Chi et al. (2009) find that ERC is not significantly different
between two compared samples, which are mandatory rotation sample versus non-
rotation sample and mandatory rotation sample versus mandatory rotation sample in
prior year. But the ERC in mandatory rotation sample is significantly larger than that
in voluntary rotation sample. Thus, two of the three comparison samples fail to
provide any evidence on that mandatory audit partner rotation could improve
investor’s perception about auditor independence or audit quality.
4.3 Audit firm rotation/tenure and audit quality
When the audit firm is switched, the audit partner will be changed too. Even if most
governments require mandatory partner rotation, data on audit firm rotation can still
reflect the situation in audit partner rotation in some extent. Besides, some
countries, for example USA, Australia and China, are calling for discussion about
whether to require mandatory audit firm rotation in addition to mandatory partner
rotation. Thus, it is still interesting to examine the effects of audit firm
rotation/tenure on audit quality. The previous literatures about audit firm rotation/
tenure discussed below are all listed in Table 2 under Appendix.
4.3.1 Audit firm rotation/tenure and actual audit quality
To examine the potential association between audit firm tenure and audit reporting
failure, Geiger and Raghunandan (2002) select a sample which only contains the
companies that are filed for bankruptcy during 1996-1998 in America. A going
concern modified audit opinion received immediately prior to bankruptcy is regarded
as an indicator of high audit quality. Geiger and Raghunandan (2002) find that long
audit firm tenure may not be the major cause of audit failures, while auditors are
more likely to involve in audit failures at the early stage of audit firm tenure. The
result suggests that auditor’s learning curve matters as the new auditors lack specific
knowledge or experience for their new client companies in the earlier years of audit
engagement.
Besides the propensity to issue a going concern opinion, earnings quality is also used
quite often by previous studies to represent audit quality. Johnson et al. (2002) use
30
absolute values of unexpected accruals and accruals persistence as proxies for audit
quality to examine the effects of audit firm tenure. Expected accruals are estimated
based on a cross-sectional version of modified Jones 1991 model. The results by
Johnson et al. (2002) show that short audit firm tenure (2-3 years) is significantly
associated with a higher level of discretionary accruals and lower level of accruals
persistence. However, no significant results are found for medium (4-8 years) or long
audit firm tenure (more than 9 years). This means the requirement of mandatory
audit firm rotation for every 5 or 7 years may have limited benefits on improving
audit quality. Similarly, Myers et al. (2003) examine the relation between audit firm
tenure and earnings quality as well. Instead of focusing on short or long tenure by
Johnson et al. (2002), Myers et al. (2003) investigate the effects of the magnitude of
audit firm tenure on earnings quality. And they use absolute, raw and signed values
of both discretionary accruals based on Jones model and current accruals as proxies
for earnings quality. In general, the regression analysis by Myers et al. (2003) shows
that longer audit firm tenure significantly decreases the level of both discretionary
accruals and current accruals for both income-increasing and income-decreasing
accruals. This finding again doubts the necessity of requiring mandatory audit firm
rotation.
Jackson, Moldrich and Roebuck (2008) combine the methods from previous studies
(Geiger & Raghunandan, 2002; Johnson et al., 2002; Myers et al., 2003) and test the
effects of audit firm tenure on both the propensity to issue a going concern opinion
and the level of discretionary accruals using a sample of listed companies in
Australia. If a qualified audit opinion is issued, we consider it as a positive signal of
high audit quality. And lower level of performance-adjusted discretionary accruals
based on Kothari et al. (2005) indicates higher level of audit quality as well. The
results by Jackson et al. (2008) find that client firms with longer audit firm-client
relationship are more likely to receive a qualified audit opinion. And the actual audit
quality measured by discretionary accruals is not significantly affected by audit firm
tenure. Considering the potential high firm switching costs, it is hard to conclude any
31
benefits of mandatory audit firm rotation on enhancing audit quality in Australia.
Together with the effects of audit partner tenure, Chi and Huang (2005) and Chen et
al. (2008) examine the effects of audit firm tenure on earning quality in Taiwan as
well. By replacing the audit partner tenure with audit firm tenure in the non-linear
regression model introduced in section 4.2.1, Chi and Huang (2005) find a “U” shape
in the relation between audit firm tenure and discretionary accruals, which means
the earnings quality first increases with longer audit firm tenure, and then goes down
with excessive long tenure. The cut-off point is 5 years which is consistent with the
findings for audit partner tenure. Moreover, Chi and Huang (2005) find audit firm
tenure has stronger effects on earnings quality when including both partner and firm
tenure in the regression model. Chen et al. (2008) add audit firm tenure to the
existing regression model designed for audit partner tenure and examine the effects
of firm tenure on earnings quality after controlling for audit partner tenure. It is
found by Chen et al. (2008) that longer audit firm tenure lowers the level of
discretionary accruals and therefore improves audit quality. And requiring mandatory
firm rotation in addition to partner rotation is not able to further benefit the earnings
quality or audit quality.
Following the method by Chi and Huang (2005), Chen and Xia (2006) conduct the
quadratic regression analysis to examine the non-linear relation between audit firm
tenure and earnings quality based on the data of Chinese listed companies. Chen and
Xia (2006) exclude all the firm year observations with qualified audit opinion. They
only investigate the discretionary accruals in companies which receive unqualified
audit opinion. By this way, Chen and Xia (2006) believe that the level of discretionary
accruals can better reflect the actual audit quality since auditors have confirmed that
there are no material misstatements in those financial reports. The result found by
Chen and Xia (2006) is similar with that by Chi and Huang (2005). In China, longer
audit firm tenure first improves and then deteriorates the earnings quality measured
by discretionary accruals from the Jones model. But the cut-off point found by Chen
and Xia (2006) based on Chinese database is around 6 years instead of 5 years.
32
4.3.2 Audit firm rotation/tenure and perceived audit quality
To mitigate the limitation of using MBA students in the experiment as I have
discussed before in section 4.2.2, Dart (2011) directly sends questionnaires to real
institutional and private investors in UK to get a more targeted response. Dart (2011)
examines the effects of audit firm tenure alone rather than the comparison with
audit partner tenure. It is found that the investors in UK do not consider long audit
firm-client relationship as a major threat that will damage auditor independence or
audit quality based on the results from the survey (Dart, 2011).
Investors could be shareholders, but also debt-holders. Daniels and Booker (2011)
explore loan officer’s perception about auditor independence and audit quality
affected by audit firm rotation or audit firm tenure. In their experiment, the
questions about perceived auditor independence and perceived audit quality are
asked separately. After a case experiment, Daniels and Booker (2011) find that audit
firm rotation can significantly improve loan officer’s perception about auditor
independence, but cannot affect the perceived audit quality. In addition, loan officers
do not perceive any significant difference in auditor independence or audit quality
under different length of audit firm tenure (Daniels and Booker, 2011).
Ghosh and Moon (2005) classify financial statement users into three categories:
investors, independent rating agencies and financial analysts, and examine the
perceived audit quality in each group. Ghosh and Moon (2005) mainly focus on the
research in investors because investors are the principal users. Investors respond
differently to various firms’ earnings information depending on different earnings
quality. In the capital market, investors tend to buy or sell more stocks when the
issued earnings information is perceived to be of high quality. Thus, Ghosh and Moon
(2005) use earnings response coefficient (ERC) from return-earnings regression as the
measure of investor’s perception of auditor independence and audit quality. The
results show that all financial statement users view longer audit firm-client
relationship as favorable for perceived earnings quality and audit quality (Ghosh &
Moon, 2005). All the evidences unanimously approve that mandatory audit firm
33
rotation cannot help in improving both investors’ and information intermediaries’
perception about audit quality.
4.4 Literature used for hypotheses
First, this study will focus on audit partner rotation instead of audit firm rotation.
Many studies (Geiger & Raghunandan, 2002; Johnson et al., 2002; Myers et al., 2003;
Chi & Huang, 2005; Chen & Xia, 2006; Jackson et al., 2008) investigate the association
between audit firm tenure and actual audit quality. Previous studies (Geiger &
Raghunandan, 2002; Johnson et al., 2002; Myers et al., 2003) find that short audit
firm tenure is associated with lower audit quality based on data from the United
States. The explanation of this finding is the lack of client specific knowledge by new
auditors. Therefore, previous studies (Geiger & Raghunandan, 2002; Johnson et al.,
2002; Myers et al., 2003) conclude that there is limited benefit, if there is any, of
mandatory auditor rotation. However, in the United States, mandatory audit partner
rotation is implemented instead of mandatory audit firm rotation. The loss of client
specific knowledge might not take place when audit partners are rotated within the
same audit firm. The information on audit partner rotation is not publicly available in
the United States. However, the audit partner information is available in the Chinese
database. Audit reports in China are required to be signed by both audit partners’
name and audit firm’s name. It is possible to identify the audit partner tenure or
audit partner rotation in the Chinese database. Moreover, only mandatory audit
partner rotation is required for all the listed companies in China. Thus, the effects of
audit partner rotation will be investigated in this study instead of audit firm rotation.
Second, this study will directly examine the effect of audit partner rotation instead of
audit partner tenure. Some studies (Chi & Huang, 2005; Carey & Simnett, 2006;
Chen, et al., 2008) have investigated the association between audit partner tenure
and audit quality. To ensure the variation in audit partner tenure for the test,
previous studies (Chi & Huang, 2005; Carey & Simnett, 2006; Chen, et al., 2008) use
the data before the mandatory audit partner rotation is required in the legislation.
However, the data selected from the period when audit partner rotation is voluntary
34
cannot directly reflect the change in audit quality when audit partner rotation is
mandatorily required. Thus, in this study, 2003 annual audit reports are selected to
directly examine the effects of mandatory audit partner rotation as this is the first
year when mandatory audit partner rotation takes effect in China.
Third, this study investigates the effects of mandatory audit partner rotation on both
actual audit quality and perceived audit quality. Most studies (Chi & Huang, 2005;
Carey & Simnett, 2006; Chen, et al., 2008) only explore actual audit quality. As is
explained before, mandatory audit partner rotation is implemented to enhance
auditor independence and restore investor’s confidence. Higher auditor
independence improves actual audit quality, while investor’s confidence can only be
restored when the perceived credibility of reported earnings is high. Very few studies
(Gates et al., 2007; Kaplan & Mauldin, 2008; Chi et al., 2009) have explored the
informational role of mandatory audit partner rotation. Thus, this study will
supplement the research on perceived audit quality by using the data from China.
Following the method by Ghosh and Moon (2005), ERC is used as the proxy for
perceived audit quality. Following the method by Chen et al. (2008), performance-
adjusted discretionary accruals is used to measure actual audit quality.
4.5 Summary
The results about the effects of audit firm/partner rotation are mixed. Some studies
(Myers et al., 2003; Chen et al., 2008) are against of mandatory audit firm/partner
rotation as longer audit firm/partner tenure significantly deteriorates actual earnings
quality. Some (Chi & Huang, 2005; Chen & Xia, 2006; Firth et al., 2010) are in support
of mandatory audit firm/partner rotation as they find a cut-off point in the relation
between audit firm/partner tenure and actual earnings quality. Other studies
(Johnson et al., 2002; Jackson et al., 2008) find there is no harm, but also no benefit,
of mandatory audit firm/partner rotation as no significant association is found in the
test. Most previous studies (Gates et al., 2007; Kaplan & Mauldin, 2008; Dart, 2011;
Daniels & Booker, 2011) on perceived audit quality are examined by experiments or
surveys, because it is hard to measure investor’s interpretation about audit quality
35
with numbers. To my knowledge, only two archival researches (Ghosh & Moon, 2005;
Chi et al., 2009) are found on perceived audit quality and both of them use ERC to
represent investor’s perception. Results are again mixed on perceived audit quality
measured by different proxies.
36
Chapter 5: Hypotheses
5.1 Introduction
In this chapter, hypotheses for both actual audit quality and perceived audit quality
are developed based on the literature review discussed in previous chapter.
5.2 Hypotheses development
5.2.1 Hypothesis for actual audit quality
When the propensity to issue a going concern opinion is used as the proxy for actual
audit quality, previous studies (Carey & Simnett, 2006; Firth et al., 2010) find positive
impacts of mandatory audit partner rotation. The results by Carey and Simnett
(2006) show that longer audit partner tenure is significantly associated with lower
actual audit quality. Firth et al. (2010) concludes that mandatory audit partner
rotation significantly enhances actual audit quality. The ability of the propensity to
issue a going concern opinion to capture actual audit quality is based on the
assumption that an unqualified audit opinion issued by audit partners stands for
lower actual audit quality. This will result in greater type I error, which means the
true null hypothesis of no earnings management is rejected. Issuing an unqualified
audit opinion might be simply because of the fair representation of financial
statements. When investigating the actual audit quality measured by discretionary
accruals, conflict evidences are provided by previous studies (Chi & Huang, 2005;
Chen et al., 2008; Chi et al., 2009). Chi and Huang (2005) supports mandatory audit
partner rotation based on the finding that longer audit partner tenure strengthens
actual audit quality, but excessive long partner tenure deteriorates actual audit
quality. On the contrary, Chen et al. (2008) find actual audit quality continuously
increases with longer auditor tenure and thereby oppose mandatory audit partner
rotation. Chi et al. (2009) believe there is no harm, but also no benefit, in
implementing mandatory audit partner rotation. As is explained before, most studies
37
(Chi & Huang, 2005; Carey & Simnett, 2006; Chen et al., 2008) focus on audit partner
tenure instead of mandatory audit partner rotation using the data from the period
when the audit partner rotation is still voluntary. This study directly explores the
effects of mandatory audit partner rotation by using the data from 2003 annual audit
reports in China, when the audit partner rotation is mandatorily required. Auditor’s
incentives and behavior might be significantly changed when mandatory audit
partner rotation is included in the legislation.
Previous studies (Chi & Huang, 2005; Chen et al., 2008; Chi et al., 2009) have no
consistent conclusion about the cost-benefit efficiency of mandatory audit partner
rotation. However, the adoption of mandatory audit partner rotation in China implies
that Chinese regulators believe mandatory audit partner rotation can enhance actual
audit quality. Thus, the hypothesis for actual audit quality is expected as follows:
H1: Companies that have mandatorily rotated audit partners have higher actual
audit quality than companies that have not mandatorily rotated audit partners.
5.2.2 Hypothesis for perceived audit quality
Even if the previous studies show no positive association between mandatory audit
partner rotation and actual audit quality, partner rotation may nevertheless improve
investors’ perceived audit quality. Although Chi et al. (2009) find there is no
significant difference in perceived audit quality between mandatory audit partner
rotation sample and non-rotation sample based on the data from Taiwan. This might
not be the case in Chinese capital market. Since very few empirical studies have
investigated the relation between audit partner rotation and perceived audit quality,
I will still expect positive effects on perceived audit quality. The hypothesis for
perceived audit quality is expected as follows:
H2: Companies that have mandatorily rotated audit partners have higher perceived
audit quality than companies that have not mandatorily rotated audit partners.
5.2.3 Additional hypothesis
First, many regulators believe mandatory audit firm rotation can further strengthen
actual audit quality. In both the United States and Europe, regulators have suggested
38
mandatory audit firm rotation in addition to partner rotation (Bates et al., 2012;
European Commission, 2010). Audit firm rotation is also being discussed in China
(Firth et al., 2010). Second, mandatory audit firm rotation might be more visible for
investors than partner rotation. Gates et al. (2007) find investor’s perception about
audit quality is significantly improved by audit firm rotation, but not audit partner
rotation. These two beliefs are both based on the assumption that long audit firm
tenure deteriorates actual or perceived audit quality. In 2003, mandatory audit firm
rotation is not required by legislation in China. Therefore, I can only investigate the
effects of audit firm tenure instead of mandatory audit firm rotation on audit quality.
The additional hypothesis about the effects of audit firm tenure is as follows:
H3a: Longer audit firm tenure is negatively related to actual audit quality after
controlling for audit partner rotation.
H3b: Longer audit firm tenure is negatively related to perceived audit quality after
controlling for audit partner rotation.
5.3 Summary
Based on the literature review and background information discussed above, three
hypotheses are developed as the initial answers for my main research question and
additional research question. I expect mandatory audit partner rotation will enhance
both actual audit quality and perceived audit quality. And I expect longer audit firm
tenure will deteriorate actual and perceived audit quality even after controlling for
audit partner rotation.
39
Chapter 6: Research Design
6.1 Introduction
In this chapter, measurement of audit partner rotation, firm tenure, actual earnings
quality and perceived audit quality are respectively explained. The regression models
for examining the effects of mandatory audit partner rotation on both actual and
perceived audit quality are elaborated. Libby boxes are provided after the
explanation of regression models. In the end, the sample selection process and the
selected data will be explained.
6.2 Research method
6.2.1 Measurement of audit partner rotation and audit firm tenure
To examine the effects of mandatory audit partner rotation in China, I firstly identify
a group of companies which are subject to mandatory audit partner rotation in year
2003 – mandatory partner rotation group (MPR). Then, MPR group is compared with
other three benchmark groups. In this study, I use the same benchmarks defined by
Chi et al. (2009). The first benchmark group contains companies that are not subject
to audit partner rotation in year 2003 – non-rotation group (NPR). The second
benchmark group contains companies that are subject to voluntary audit partner
rotation in year 2003 – voluntary rotation group (VPR). The third benchmark group
contains the same companies with MPR, but earnings quality in year 2002 is
investigated in this group – mandatory partner rotation in prior year (MPRPY). In this
study, I separate the non-rotation sample from voluntary rotation sample. The main
reason is that voluntary rotation might be related to “opinion shopping”. Therefore,
voluntary rotation sample might have lower audit quality compared to non-rotation
sample. The first two benchmarks are used to compare the audit quality between
different companies. The third benchmark is used to compare the audit quality
within the same companies over time.
40
According to the policy in China, the requirement of mandatory audit partner
rotation takes effect since 2003. Besides, two audit partners need to sign the audit
reports and the names of partners are publicly available in China Stock Market
Accounting Research (CSMAR) database. One of the two audit partner is the leader
of the audit work. The other audit partner is the reviewer. Unfortunately, there is no
way to distinguish these two audit partners in CSMAR database. I will assume both of
them have the same level of influence on audit quality. For each company, if the
audit partners in year 2003 are not the same with partners in year 2002 and at least
one of them has consecutively served this company for more than 5 years till 2002,
then this company is classified into MPR group. If the company has changed its audit
partners in 2003, but none of them have maintained the relationship with this
company for more than 5 years, then this company is classified into VPR group. If the
company has the same two audit partners in year 2003 with that in year 2002, then
the company is classified into NPR group. In the CSMAR database, it only shows
names of audit partners and audit firms. Thus, I classify all the companies by hand. In
addition, I also count the firm tenure for each company in year 2003. The amount of
firm tenure is simply judged by how many consecutive years the same audit firm has
served the company till year 2003.
6.2.2 Measurement of actual earnings quality
As is explained before in Chapter 3, earnings quality is a proxy for audit quality and
discretionary accruals is a proxy for actual earnings quality. However, discretionary
accruals are unobservable and can only be estimated. There are various models
designed for estimating discretionary accruals according to Ronen and Yaari (2008).
To estimate discretionary accruals, most of the models firstly use several
independent variables to estimate the amount of non-discretionary accruals. Then
the discretionary accruals part can be calculated based on the residual in the
regression models. The key point in each model is which independent variables
should be included in the regression model to estimate non-discretionary accruals.
Dechow, Sloan and Sweeney (1995) compare the rate of Type II errors (companies
41
that have engaged in earnings management are not detected by the model) in 5
different models, and then find the modified Jones model exhibits the most power in
detecting earnings management.
The original Jones model of non-discretionary accruals is developed by Jones (1991).
Jones (1991) creates a model in which she uses three variables to estimate non-
discretionary accruals in a company. All the independent variables she uses in the
model can be easily found from financial statements. The first step is to estimate the
coefficients using the time series model or cross sectional model. Then the non-
discretionary accruals for each company and each year can be calculated from the
estimated coefficients and items from financial statements. The original Jones model
is as below:
NDAT=α1(1/ At−1)+α 2(∆ REV t)+α3 ¿)
Where
NDAT= Non-discretionary accruals in year t;
∆ REV t= Revenues in year t less revenues in year t-1 scaled by total assets at t-1;
PPEt= Gross property plant and equipment in year t scaled by total assets at t-1;
At−1= Total assets at t-1;
α 1α2α3= Firm-specific parameters.
In this model, changes in revenue and property, plant and equipment (PPE) are used
to estimate the normal accruals. Changes in revenue stand for changes in working
capital accruals, while PPE stands for depreciation expense. The final objective of
Jones model is to estimate discretionary accruals, not non-discretionary accruals.
However, the estimated discretionary accruals can be calculated by subtracting non-
discretionary accruals part from total accruals. Here is the regression model for total
accruals:
TAt=α 1(1
A t−1)+α 2(∆ REV t)+α3(PPE t)+v t
Where
TAt= Total accruals scaled by lagged total assets.
Total accruals are publicly available in the financial statements. The residual part in
42
this regression model stands for discretionary accruals.
Nevertheless, there is an obvious problem in the original model. Jones (1991)
assumes that all the amounts of changes in revenue as non-discretionary accruals.
Non-discretionary accruals are overstated in the original Jones model as client
management may boost earnings by booking credit sales in advance. Thus, the cross-
sectional modified Jones model by Dechow et al. (1995) makes the following
adjustment:
TAt=α 1(1
A t−1)+α 2(∆ REV t−∆ ARt)+α3(PPE t)+v t
Where
∆ ARt= Accounts receivable in year t less account receivable in year t-1 scaled by
total assets at t-1.
In this model (Dechow et al., 1995), change in total sales is replaced by change in
cash sales when estimating the part of non-discretionary accruals. Dechow et al.
(1995) believe the managed credit sales will bias the estimate of non-discretionary
accruals part.
Following the method by previous studies (Myers et al., 2003; Chi & Huang, 2005;
Chen et al., 2008; Carey & Simnett, 2006), both signed and absolute values of
performance-adjusted discretionary accruals based on Kothari et al. (2005) are used
to measure the actual earnings quality in this study. This model (Kothari et al., 2005)
makes another two adjustments based on the modified Jones model (Dechow et al.,
1995). The performance-matching model is as follows:
TA¿
A ¿−1=α 1+ β1( 1
A¿−1 )+β2( ∆REV ¿−∆ AR¿
A ¿−1)+β3(
PPE¿
A ¿−1)+β4(ROA¿−1)+DAC¿
Where
ROA¿−1= Net income/ total assets (return on assets for firm i in year t-1);
DAC¿=The residual which is used as a proxy for discretionary accruals.
Kothari et al., (2005) add two independent variables to modified Jones model by
Dechow et al. (1995), which are an intercept and the lagged rate of return on assets.
43
The intercept solves the problem of heteroskedasticity, while the lagged rate of
return on assets includes a performance factor in estimating accruals (Kothari et al.,
2005). Sometimes the estimated discretionary accruals are high simply because the
performance of client company is superior. Both of these two modifications enhance
the power of test for type I error (Ronen & Yaari, 2008). Type I error means the
innocent company is judged as having involved in earnings management.
In this study, I firstly estimate the coefficients in the performance-adjusted Jones
model for each industry in China using cross sectional model. Then I calculate the
raw discretionary accruals for each company in 2003 using the industry based
coefficients. Earnings could be managed upward to meet or beat the financial
analyst’s earnings targets when the performance of client company is poor, but
earnings could also be managed downward to be reserved for the following year
when the client is outperformed. So, the higher absolute value of discretionary
accruals implies poor earnings quality or audit quality. I investigate the signed values
of discretionary accruals as well. Some investors may have more interests in
overstated earnings which are manipulated by income-increasing discretionary
accruals. Auditors are more likely to require adjustments for overstated earnings
rather than understated earnings due to conservatism (Nelson, Elliott, & Tarpley,
2002). Moreover, a large amount of income-decreasing discretionary accruals could
simply be the result of severe conservative accounting policy required for the client
company. Thus, both absolute and signed valued of discretionary accruals should be
analyzed to examine the relation between mandatory audit partner rotation and
actual earnings quality or actual audit quality.
6.2.3 Measurement of perceived earnings quality
As is explained before in Chapter 3, reported earnings with less noise have higher
Earnings Response Coefficients (ERC) (Teoh & Wong, 1993). Following the method by
Ghosh and Moon (2005) and Chi et al. (2009), ERC is used to measure the perceived
earnings quality in this study as follows:
CAR=α+β1E+β2∆ E+ε
44
Where
CAR= Cumulative abnormal return over one year during April – March in the
following year;
E= Reported earnings before extraordinary items, scaled by market value of equity in
the end of previous year;
∆ E= Changes in reported earnings before extraordinary items, scaled by market
value of equity in the end of previous year.
Previous studies (Easton & Harris, 1991; Ali & Zarowin, 1992) find that including both
earnings and changes in earnings can increase the explanatory power of ERC when
there is transitory part in earnings. I estimate β1 and β2 in the above mentioned
equation and then ERC can be estimated based on these two estimated coefficients:
ERC=β1+β2
To estimate ERC, the first step is to calculate abnormal return. In this study, I define
the abnormal return as the difference between daily actual and expected return of a
company’s stock. The daily actual return (Ri) and expected return (Rm) are defined
respectively as follows:
Ri=Closing Stock Pricet−Closing Stock Pricet−1
Closing Stock Pricet−1
Rm=Market Indext−Market Index t−1
Market Indext−1
The Closing Stock Price is the daily stock price for each company. The Market Index
here is the weighted average stock price of Chinese stock market, where the
distinction is made between Shanghai Stock Exchange (SSE) index and Shenzhen
Stock Exchange (SZSE) index, dependent on which index the company is listed on. In
this study, I cumulate the daily difference between actual and expected stock return
for 12 months, which start from April in the first year and end up in March in the
following year. The sum of the daily difference is called Cumulative Abnormal Return
(CAR), which is defined as follows:
45
CAR=∑ (Ri ,t−Rm, t)
Where
Ri , t= The actual return of company i at day t;
Rm, t= The value-weighted market-adjusted return of the index of stock i at day t.
6.3 Regression model
6.3.1 Regression model for actual earnings quality
Following the method by Myers et al. (2003) and Chi et al. (2009), the regression
model used for examining the relation between mandatory audit partner rotation
and actual audit quality is built as follows:
DiscAccr=α+β1BMK+β2 Age+ β3 ¿ β¿4 IndGrowth+β5CFO+ β6Big4+β7FTenure+ε
Where
DiscAccr= Performance-adjusted discretionary accruals;
BMK= A dummy variable equal to 1 if observations are subject to any benchmark
samples (NPR, VPR or MPRPY), and equal to 0 otherwise;
Age= The number of years that the firm has been publicly traded;
¿¿= Logarithmic transformation of previous year-end book value of total assets;
IndGrowth= Industry growth rate of net sales over the previous year;
CFO= Cash flow from operations, scaled by last year’s total assets;
Big4= A dummy variable equal to 1 if the company is audited by Big 4, and equal to
0 otherwise; and
FTenure= Audit firm tenure.
The key independent variable in this regression model is BMK . My first hypothesis
predicts a positive relation between mandatory audit partner rotation and actual
audit quality. Actual audit quality is high when the level of discretionary accruals is
low. Thus, I expect the discretionary accruals in the benchmark sample should be
higher than that in the MPR sample. When the absolute value of discretionary
accruals is used, a positive β1 is expected. When the positive (negative) value of
discretionary accruals is used, a positive (negative) β1 is expected.
46
Following the previous studies (Myers et al., 2003; Chen et al., 2008), several control
variables are included in the regression model. First, Age is included as the level of
discretionary accruals varies with different years in the company’s life cycle (Anthony
& Ramesh, 1992). A negative β2 is expected as the discretionary accruals decrease
with longer company’s age. Second, a negative coefficient of ¿¿ is expected as larger
companies tend to disclose more stable accruals (Dechow & Dichev, 2002). Third, a
positive β4 is expected. The level of discretionary accruals increases with the level of
sales growth within the industry (Myers et al., 2003). Fourth, CFO is included to
predict negative effects on accruals. Accruals and cash flows are negatively related to
each other (Dechow, 1994). More cash flow from operations implies less
discretionary accruals. Thus, a negative β5 is expected. Fifth, a dummy variable of
Big4 is included. Previous studies (Becker, DeFond, Jiambalvo, & Subramanyam,
1998; Francis & Krishnan, 1999) find the large audit firms are more conservative and
are less likely to allow extreme accruals. Therefore, a negative β6 is expected as big 4
audit firms provide higher audit quality. Finally, FTenure is included to examine the
effects of audit firm tenure on actual audit quality after controlling for audit partner
rotation. Longer audit firm tenure might deteriorate auditor independence and is
therefore related to higher level of discretionary accruals (Chi & Huang, 2005). A
positive coefficient of firm tenure is expected.
6.3.2 Regression model for perceived earnings quality
Based on the research method used by Ghosh and Moon (2005), I use the following
regression model to examine the relation between mandatory audit partner rotation
and perceived audit quality in this study:
CAR=α+β1E+β2∆ E+β3BMK+β4 E×BMK+β5∆ E×BMK+∑j=1
9
β6+2 ( j−1)E×Controlvariable j+∑j=1
9
β7+2( j−1)∆ E×Control variable j+∑j=1
9
β23+ jControl variable j+ε
Where
BMK= A dummy variable equal to 1 if observations are subject to any benchmark
samples (NPR, VPR or MPRPY), and equal to 0 otherwise;
FTenure= Audit firm tenure.
47
The most important coefficients are the sum of β4 and β5 (β4+β5). My second
hypothesis predicts a positive relation between mandatory audit partner rotation
and perceived audit quality. Thus, the benchmark sample should have lower ERC
than MPR sample. The sum of coefficients (β4+β5) represents the incremental ERC
for benchmark sample compared to the MPR sample. I predict a negative
incremental ERC and the sum of coefficients (β4+β5) should be smaller than zero.
All the nine control variables are interacted with earnings and changes in earnings.
Following the previous studies (Ghosh & Moon, 2005; Chi et al., 2009), I include 9
control variables in the regression model. The nine control variables are shown as
follows:
1. Age: The number of years that the firm has been publicly traded (discussed
above);
2. Big4: A dummy variable equal to 1 if the company is audited by Big 4, and equal
to 0 otherwise (discussed above);
3. Growth: (Market value of equity + Book value of debt)/Book value of total assets
at the end of year t;
4. Persist : First-order autocorrelation of earnings per share for the past 16 quarters;
5. Volatility: Standard deviation of earnings per share for the past 16 quarters;
6. Beta: Systematic risk calculated with 60 months stock returns;
7. ¿¿: Logarithmic transformation of market value of equity at the end of year t;
8. Leverage: Total debt/total assets at the end of year t;
9. FTenure: Audit firm tenure (discussed above).
Growth, Persist , Volatility and Beta are included as the control variables for the
considerations of valuation (Warfield, Wild, & Wild, 1995). ¿¿ is included based on
the political cost theory (Ghosh & Moon, 2005). Managers of large companies have
incentives to manage earnings in order to reduce the political costs. Leverage is
included based on contracting considerations. Companies with higher leverage are
more likely to manipulate earnings in order to avoid debt-covenant violations
(DeFond & Jiambalvo, 1994).
48
6.4 Libby boxes
6.4.1 Libby boxes for actual earnings quality
The Libby boxes for the regression model on the relation between mandatory audit
partner rotation and actual audit quality are as follows:
Figure 1: Libby boxes for actual earnings quality
6.4.2 Libby box for perceived earnings quality
The Libby boxes for the regression model on the relation between mandatory audit
partner rotation and perceived audit quality are as follows:
Figure 2: Libby boxes for perceived earnings quality
49
6.5 Sample selection and data
In China, mandatory audit partner rotation is required since 2003. Thus, the first
mandatory audit partner rotation can be observed through the 2003 annual audit
reports. I investigate the effects of mandatory audit partner rotation when the
regulation takes effects for the first year. Therefore, I will focus on Chinese listed
companies in year 2003. To identify the companies that changed their audit partners
due to mandatory requirement in 2003, I need to judge if the company has
consecutively maintained the relationship with the same audit partners for 5 years
till 2002. Therefore, I need data for audit partners from year 1998 to year 2003 for
each listed company.
Data for this study are collected from CSMAR database for all the companied listed
on SSE or SZSE. First, my original sample contains all the companies listed on Chinese
stock market, which are 1290 companies. I delete 43 companies which belong to
financial industry and 232 companies which have incomplete data for audit partners.
By focusing on the 2003 data, I obtain a preliminary sample of 1015 companies in
total.
Second, I classify these 1015 companies into three groups. 111 companies (MPR) are
found to have mandatorily rotated their audit partner in year 2003. 426 companies
(VPR) voluntarily rotated their audit partners in year 2003. And the other 478
companies (NPR) did not change their audit partners in year 2003. After that, I delete
64 companies that are delisted in or before 2003. In the end, I obtain a final sample
of 951 companies, which are 109 companies for MPR sample, 439 companies for NPR
sample and 403 companies for VPR sample. The selection process for MPR, NPR and
VPR is summarized in Table 3 under Appendix.
The actual and perceived audit quality in MPR is compared with other three
benchmark groups: VPR, NPR and MPRPY. MPRPY contains the same companies with
MPR, but with different years. Thus, I collect all the data again for those 109
companies, but in year 2002, for example audit firm tenure in 2002 and discretionary
accruals in 2002.
50
To estimate the discretionary accruals, I use the cross-sectional industry model by
Kothari et al. (2005). China Securities Regulatory Commission (CSRC) defined 17
industries in China in 2012. I obtained all the companies for each industry except
financial industry. The coefficients for each industry in the model by Kothari et al.
(2005) are estimated by 8 years data from 2000 to 2007. I start from year 2000
because most of the data for cash flow from operations are missing before 2000.
Data for daily stock return are obtained from WIND database. I obtained both daily
closing stock price and daily market index from 1st of April in 2003 till 31st of March in
2004 for those 951 companies. Due the missing data for daily stock price, I delete
one company for my second regression analysis for NPR sample. Thus, when using
ERC as the measure for perceived audit quality, I obtain 109 companies for MPR
sample, 403 companies for VPR sample and 438 companies for NPR sample.
6.6 Summary
In this chapter, research method for this study is discussed. I hand-collect the data
for audit partner rotation and audit firm tenure. I use discretionary accruals
estimated by Kothari et al. (2005) model to measure the actual audit quality. And I
use ERC as the proxy for perceived audit quality. To examine the relation between
audit partner rotation and discretionary accruals, another 6 control variables are
included in the regression model. To examine the relation between audit partner
rotation and ERC, another 9 control variables are included in the second regression
model. Data are collected from both CSMAR and WIND database. In the end, I
obtained 109 companies for MPR, 403 companies for VPR and 439 (438) companies
for NPR.
51
Chapter 7: Results
7.1 Introduction
In this chapter, I will present the statistical results for regression analyses on both
actual and perceived audit quality. Before the regression analyses, I will first provide
the descriptive statistics and comparisons of means. The results for univariate test
will be presented in section 7.2, while the results for multivariate test will be briefly
discussed in section 7.3 and 7.4. Section 7.3 presents the results based on both
absolute and signed values of discretionary accruals. Section 7.4 presents the results
for perceived audit quality. And I will explain the results for three comparisons
separately, which are MPR vs. NPR, MPR vs. VPR and MPR vs. MPRPY.
7.2 Descriptive statistics
7.2.1 Descriptive statistics for actual audit quality
Descriptive statistics for variables in the regression model of actual audit quality are
shown in Table 4 under Appendix. Firstly, I compare the level of discretionary
accruals between MPR sample and NPR sample. Based on Panel A and Panel B of
Table 4, the mean of │DA│ is 0.064 in MPR sample, while the mean is 0.055 in NPR
sample. Before checking whether the difference in │DA│ is significant between these
two groups, I first examine whether │DA│ is normally distributed in my sample.
Based on the results from Panel A of Table 5 under Appendix, the dependent
variable is not normally distributed. Thus, I will run both parametric and
nonparametric test to examine the mean difference. Table 6 shows the results of
two-tailed t-tests. The results in Panel A of Table 6 suggest that the mean difference
between MPR sample and NPR sample is not significantly different from zero. In
addition, Table 7 shows the results of two-tailed nonparametric Wilcoxon z-tests.
The results in Panel A of Table 7 suggest that the mean of │DA│ in MPR sample is not
significantly different from that in NPR sample. Therefore, the univariate
52
comparisons of mean of │DA│ between MPR sample and NPR sample shows that
there is no significant difference in earnings quality or actual audit quality between
the companies that are subject to mandatory audit partner rotation and companies
that retain the same audit partners, which fails to support Hypothesis 1. Turning to
other 6 control variables, all the mean differences are insignificant between MPR
and NPR samples except for AGE and FTenure. The mean of AGE is 7.321 in MPR
sample, while the mean of AGE is 6.337 in NPR sample based on the results in Table
4. Both the two-tailed t-test and two-tailed nonparametric Wilcoxon z-test show the
mean difference of AGE is significantly different in MPR and NPR samples. The mean
of FTenure in MPR sample is 4.183, while the mean of FTenure in NPR sample is
3.597. The results from both the two-tailed t-test and two-tailed nonparametric
Wilcoxon z-test suggest that the mean of FTenure in MPR sample is significantly
larger than that in NPR sample.
Secondly, I compare the earning quality or actual audit quality between MPR sample
and VPR sample. The mean for │DA│ in MPR sample is 0.064, while the mean for
│DA│ in VPR sample is 0.055. The results of two-tailed t-test in Panel B of Table 6
show that the mean of │DA│ in MPR sample is not significantly different from that in
VPR sample. The two-tailed nonparametric Wilcoxon z-test in Panel B of Table 7
shows that the difference of │DA│ between MPR and VPR samples is not significant
as well. The findings suggest that the actual audit quality in MPR sample is not
significantly different from that in VPR sample. Turning to the mean difference of
control variables, all the mean differences are insignificant except for AGE and
FTenure. The mean of AGE in MPR sample is 7.321, and the mean of AGE in VPR
sample is 6.092. The difference of 1.229 is significant based on the results from both
parametric and nonparametric tests. The mean of FTenure in MPR sample is 4.183,
while the mean of FTenure in VPR sample is 3.295. According to both two-tailed t-
test and two-tailed nonparametric Wilcoxon z-test, the mean of FTenure in MPR
sample is significantly larger than that in VPR sample.
Thirdly, I compare the actual audit quality in companies that are subject to
53
mandatory audit partner rotation in year 2003 with the audit quality in the same
companies, but in year 2002. By this way of comparison, I test whether the
mandatory audit partner rotation is able to increase the actual audit quality in the
same company over time. Based on Panel A and Panel D of Table 4, the mean of
│DA│ in MPRPY sample is 0.055, which is different from the mean of │DA│ in MPR
sample. This mean difference is insignificant according to the results from Panel C of
Table 6 and Table 7. Both two-tailed t-test and two-tailed nonparametric Wilcoxon z-
test show that the actual audit quality is not significantly increased after the
implementation of mandatory audit partner rotation for the same company over
time. All the mean differences in control variables are insignificant except for AGE.
The mean of AGE in MPRPY sample is 6.321, which is significantly from 7.321 in MPR
sample based on both parametric and nonparametric tests.
7.2.2 Descriptive statistics for perceived audit quality
Additional variables are needed for the second regression model to examine the
effects of mandatory audit partner rotation on perceived audit quality. Due to the
missing data for CAR, the sample size is reduced. For the regression analysis on
perceived audit quality, I obtain 109 companies for MPR sample, 403 companies for
VPR sample and 438 companies for NPR sample respectively.
Table 8 under Appendix shows the results for descriptive statistics for perceived audit
quality. Similar with the analysis on actual audit quality, I compare the stock reaction
in MPR sample with the stock reaction in three other benchmark samples.
Firstly, I compare mandatory partner rotation sample with non-rotation sample.
From Panel A and Panel B of Table 8, I find the mean of CAR in MPR sample is -0.395
and the mean of CAR in NPR sample is -0.420. The results in Panel A of Table 9 show
that CAR is not normally distributed under the comparison of “MPR vs. NPR”. A two-
tailed t-test shown in Panel A of Table 10 suggests the difference in CAR means is not
significant. And the two-tailed nonparametric Wilcoxon z-test from Panel A of Table
11 also suggests an insignificant difference in CAR means. Therefore, the univariate
tests show there is no significant difference in CAR between MPR sample and NPR
54
sample. Turning to control variables, all the mean differences are insignificant except
for AGE, Beta and FTenure when comparing MPR sample with NPR sample. The mean
of AGE in MPR sample is 7.321, while the mean of AGE in NPR sample is 6.345. Both
two-tailed t-test and nonparametric Wilcoxon z-test show this mean difference is
significant, which suggests that mandatory audit partner rotation sample include
more old companies. The two tailed t-test shows NPR sample has larger Beta than
MPR sample, which means companies in NPR sample are more risky. I will discuss
FTenure later in this section.
Secondly, I compare MPR sample with VPR sample. The mean of CAR in VPR sample
is -0.414, which is different from -0.395 in MPR sample. Both parametric and
nonparametric tests show that this mean difference is not significant, which means
the CAR in MPR sample is indifferent from the CAR in VPR sample generally. The
control variable of AGE shows a significant difference in mean between MPR and VPR
samples. This finding suggests that companies that are subject to mandatory audit
partner rotation are generally older than companies that are subject to voluntary
audit partner rotation.
Thirdly, I compare CAR in mandatory partner rotation sample with CAR in the same
sample, but in prior year. Based on the two-tailed t-test in Panel C of Table 10 and the
nonparametric test in Panel C of Table 11, the mean difference of 0.248 in CAR is
significant between mandatory audit partner rotation sample and mandatory
rotation sample in prior year. Both parametric and nonparametric tests show that
companies that are subject to mandatory audit partner rotation sample have
significant larger CAR than the same companies in prior year. The two-tailed t-tests
show that the mean differences in AGE and Growth are significant, while the
nonparametric tests show that the mean differences in AGE, Growth, Size and
FTenure are all significant. The nonparametric Wilcoxon z-tests find the mean
differences in FTenure are all significant for all the three comparisons (MPR vs. NPR,
MPR vs. VPR and MPR vs. MPRPY). In general, companies that are subject to
mandatory audit partner rotation have longer audit firm tenure than other
55
benchmark companies.
7.3 Empirical findings based on performance-adjusted abnormal
accruals
All the findings based on univariate tests are inconsistent with the expectation in
Hypothesis 1. Next to univariate tests, I examine the effects of mandatory audit
partner rotation on actual audit quality again with multivariate tests. Table 12 shows
the results of the regression analysis for actual audit quality. Panel A of Table 12
reports the findings using absolute values of performance-adjusted discretionary
accruals as the dependent variable. Firstly, I find that the coefficient of BMK is
insignificant (-0.009, t = -1.390) under the column of “MPR vs. NPR”. This suggests
that │DA│ in MPR sample is not significantly different from that in NPR sample even
after controlling for other 6 common determinants of discretionary accruals based
on the regression model explained in section 6.3.1. Secondly, the coefficient of BMK
is insignificant (-0.008, t = -1.154) under column “MPR vs. VPR”, which means the
difference of │DA│ between MPR and VPR samples is insignificant. Thirdly, the
coefficient of BMK is insignificant (-0.007, t = -0.769) when comparing the MPR
sample with MPRPY sample. This result suggests that the level of │DA│ in companies
that are subject to mandatory audit partner rotation in year 2003 is indifferent with
the level of │DA│ in the same companies one year earlier with old audit partners.
Table 12: Performance-adjusted discretionary accruals and mandatory audit partner rotation
Panel A: Absolute performance-adjusted discretionary accruals (│DA│) resultsVariable Exp.sign MPR vs. NPR MPR vs. VPR MPR vs. MPRPY(Constant) ? 0.362* 0.141* 0.316* (5.583) (2.204) (2.666) BMK +¿ -0.009 -0.008 -0.007 (-1.390) (-1.154) (-0.769) AGE −¿ 0.001 0.002 0.000 (1.140) (1.423) (0.042) SIZE −¿ -0.034* -0.010 -0.030* (-4.798) (-1.394) (-2.342) IndGrowth +¿ -0.007 0.004 -0.002 (-1.197) (0.675) (-0.664)
56
CFO −¿ 0.054 -0.044 0.110* (1.857) (-1.456) (2.316) Big4 −¿ -0.001 0.003 -0.001 (-0.131) (0.276) (-0.061) FTenure +¿ 0.000 0.000 0.004 (0.250) (0.087) (1.381) Adj.R2 0.045 0.005 0.034 n 548 512 218 (The table is continued.)
Following the method by previous studies (Myers et al., 2003; Chi & Huang, 2005;
Chen et al., 2008; Carey & Simnett, 2006), both signed and absolute values of
performance-adjusted discretionary accruals based on Kothari et al. (2005) are used
to measure the actual earnings quality in this study. The results using signed values
of performance-adjusted discretionary accruals as dependent variable are reported
in Panel B and Panel C of Table 12. Firstly, the coefficients of BMK are all insignificant
(-0.005, t = -1.408; -0.002, t = -0.462; -0.007, t = -1.669) for income-increasing
accruals in Panel B. These findings suggest that the level of income-increasing
accruals in MPR is indifferent with that in other three benchmark samples (NPR, VPR
and MPRPY). Secondly, the coefficients of BMK are all insignificant (0.002, t = 0.534;
0.005, t = 0.976; -0.007, t = -0.973) for income-decreasing accruals in Panel C. These
findings suggest that the levels of income-decreasing accruals are not significantly
different between MPR and benchmark samples (NPR, VPR and MPRPY).
In sum, the coefficients of BMK are all insignificant when using absolute value or
signed value of performance-adjusted discretionary accruals as the dependent
variable. All the findings suggest that the actual audit quality in mandatory audit
partner rotation sample is indifferent with the actual audit quality in non-rotation
sample, voluntary audit partner rotation sample or mandatory audit partner rotation
sample in prior year. In addition, when the absolute value of accruals or positive
discretionary accruals is used, the coefficient of BMK is negative (Panel A and Panel B
of Table 12), which is contrary to my expectation of a positive relationship in
Hypothesis 1. When negative discretionary accruals are used, the coefficient of BMK
is insignificantly negative under the column “MPR vs. MPRPY”, which is consistent
57
with the expectation of a negative relationship. But for comparisons of “MPR vs.
NPR” and “MPR vs. VPR”, the coefficients of BMK are positive. A negative relationship
between BMK and absolute value of positive value of discretionary accruals means
that the actual audit quality in mandatory audit partner rotation sample is lower
than the actual audit quality in other benchmark samples (NPR, VPR or MPRPY). A
positive relationship between BMK and income-decreasing accruals suggests that the
actual audit quality is lower in mandatory audit partner rotation sample than other
benchmark samples (NPR or VPR).
Table 12: (Continued)Panel B: Positive performance-adjusted discretionary accruals (DA+¿ ¿) resultsVariable Exp.sign MPR vs. NPR MPR vs. VPR MPR vs. MPRPY(Constant) ? 0.049 0.056 0.132* (1.409) (1.353) (2.031) BMK +¿ -0.005 -0.002 -0.007 (-1.408) (-0.462) (-1.669) AGE −¿ -0.001 -0.001 -0.002* (-1.865) (-1.485) (-2.135) SIZE −¿ 0.002 -4.221E-5 -0.008 (0.544) (-0.009) (-1.105) IndGrowth +¿ -0.001 0.003 0.001 (-0.277) (0.934) (0.636) CFO −¿ -0.782* -0.831* -0.783* (-37.823) (-34.540) (-24.981) Big4 −¿ 0.002 0.005 0.008 (0.341) (0.689) (1.128) FTenure +¿ -0.001 0.001 0.002* (-1.069) (1.430) (1.983) Adj.R2 0.827 0.830 0.863n 314 256 113 (The table is continued.)
Table 12: (Continued)Panel C: Negative performance-adjusted discretionary accruals (DA−¿ ¿) resultsVariable Exp.sign MPR vs. NPR MPR vs. VPR MPR vs. MPRPY(Constant) ? -0.173* -0.065 -0.057 (-3.719) (-1.469) (-0.762) BMK −¿ 0.002 0.005 -0.007 (0.534) (0.976) (-0.973)
58
AGE +¿ -0.002* -0.002* -0.002 (-2.836) (-2.741) (-1.081) SIZE +¿ 0.023* 0.009 0.010 (4.749) (1.945) (1.265) IndGrowth −¿ 0.010* 0.007 0.002 (2.183) (1.534) (0.847) CFO −¿ -0.815* -0.730* -0.812* (-32.331) (-25.071) (-20.930) Big4 +¿ -0.003 0.011 0.019 (-0.365) (1.687) (1.059) FTenure −¿ -0.001 0.002* 0.001 (-0.502) (2.136) (0.482) Adj.R2 0.831 0.717 0.811n 234 256 105
Notes:
BMK is a dummy variable equal to 1 if observations are belong to any benchmark
samples (NPR, VPR or MPRPY), and equal to 0 otherwise.
* Significant at the 0.05 level based on a two-tailed t-test (in parentheses).
Turning to control variables, the results in Panel A of Table 12 show that SIZE is
significantly negatively (-0.034, t = -4.798) related to the absolute value of
discretionary accruals when comparing the mandatory audit partner rotation sample
with non-rotation sample. Under column “MPR vs. VPR” of Panel A in Table 12, all
the coefficients of control variables are insignificant when using the absolute value of
discretionary accruals as the dependent variable. Under column “MPR vs. MPRPY” of
Panel A in Table 12, the coefficient of SIZE is significantly negative (-0.030, t = -2.342)
when using absolute value of discretionary accruals in the regression analysis. These
findings are consistent with my expectations and suggest that companies with larger
size have less discretionary accruals, therefore are related to higher actual audit
quality. When income-increasing accruals are used as the dependent variable, the
coefficients of CFO are found to be significantly negative (-0.782, t = -37. 823; -0.831,
t = -34.540; -0.783, t = -24.981) when comparing the MPR sample with three other
benchmark samples (NPR, VPR or MPRPY). This is consistent with the expectation
59
that companies with more cash flow from operations have less income-increasing
accruals and thereby higher actual audit quality. In Panel B of Table 12, the results
show that AGE is significantly negatively (-0.002, t = -2.135) related to income-
increasing discretionary accruals when comparing the mandatory audit partner
rotation sample with mandatory rotation sample in prior year. This means older
companies generally have less income-increasing accruals and thereby have higher
actual audit quality. When the negative value of performance-adjusted discretionary
accruals are used as the dependent variable, the results from Panel C of Table 12
show that the coefficients of CFO are significantly negative (-0.815, t = -32.331; -
0.731, t = -25.071; -0.812, t = -20.930) under all the three columns. The results for
CFO suggest that companies with large amount of cash flow from operations have
more income-decreasing accruals. Under both the columns of “MPR vs. NPR” and
“MPR vs. VPR”, AGE is found to be significantly negatively (-0.002, t = -2.836; -0.002, t
= -2.741) related to the negative values of discretionary accruals based on Panel C of
Table 12. This means older companies generally have more income-decreasing
accruals. This might be caused by the more conservative accounting rules in older
companies. When comparing MPR sample with NPR sample using negative value of
discretionary accruals, the coefficients of SIZE (0.023, t = 4.749) and IndGrowth
(0.010, t = 2.183) are both significantly positive. Based on the results shown in Panel
C of Table 12, it is found that companies with larger size or larger industry growth
have less income-decreasing accruals.
Besides the relation between mandatory audit partner rotation and actual audit
quality, Table 12 also provides some evidence for the effects of audit firm tenure. In
Panel B of Table 12, FTenure is significantly positively (0.002, t = 1.983) related to
income-increasing accruals under the column of “MPR vs. MPRPY”. In Panel C of
Table 12, FTenure is significantly positively (0.002, t = 2.136) related to income-
decreasing accruals under the column of “MPR vs. VPR”. The findings for FTenure
suggest that companies with longer firm tenure have more income-increasing
accruals, but less income-decreasing accruals.
60
7.4 Empirical findings based on earnings response coefficients
The univariate tests presented in section 7.2.2 show that there is no significant
difference in mean of CAR when comparing the mandatory audit partner rotation
sample with other two benchmark samples, which are non-rotation sample and
voluntary audit partner rotation sample. However, I find that CAR in companies that
are subject to mandatory audit partner rotation sample is significantly larger than
CAR in prior year within the same companies. The findings provide some evidence to
support Hypothesis 2 as mandatory audit partner rotation has positive effects on
perceived audit quality. In this part, I will conduct the multivariate test to obtain
more evidence for the relation between mandatory audit partner rotation and
perceived audit quality. Table 13 shows the regression analysis for perceived audit
quality measured by ERC.
Table 13: Earnings response coefficients and mandatory audit partner rotation
Variable
Coefficient (Exp.sign)
MPR vs. NPR
MPR vs. VPR
MPR vs. MPRPY
(Constant) α -3.632* -2.889* -2.014* (-9.649) (-8.474) (-3.358)E β1 20.760* 9.632 -33.919 (2.409) (1.253) (-1.937)ΔE β2 -17.484 -4.910 -15.741
(-1.726) (-0.673) (-
1.684)
ERC β1+ β2 3.276 4.722 -
49.660*
(1.298) (1.305) (-
2.331)BMK β3 -0.012 -0.017 -0.196*
(-0.482) (-0.655) (-
6.066)E*BMK β4 0.470 -0.367 -3.258*
(−¿) (0.748) (-0.583) (-
3.320)ΔE*BMK β5 -0.686 -0.430 1.244 (−¿) (-0.950) (-0.722) (1.333) ERC BMK β4+β5 -0.216 -0.797* -2.013 (−¿) (0.014) (-2.166) (-
61
0.378)Control variables:E*FTenure(β6)/ΔE*FTenure(β7) β6+β7 -0.141 -0.035 -0.480
(−¿) (0.155) (0.729) (-
0.034)E*Age(β8)/ΔE*Age(β9) β8+β9 -0.356* -0.051* -0.442*
(+¿) (-3.159) (-2.609) (-
1.970)E*Big4(β10)/ΔE*Big4(β11) β10+ β11 2.945 2.113 5.501 (+¿) (0.421) (1.921) (1.949)E*Growth(β12)/ΔE*Growth(β13) β12+β13 0.701 0.136 0.148 (+¿) (1.341) (0.906) (0.678)E*Persist(β14)/ΔE*Persist(β15) β14+β15 -0.747 -1.151 6.288 (+¿) (-1.168) (-0.860) (0.274)E*Volatility(β16)/ΔE*Volatility(β17) β16+ β17 -2.025 -1.172* -4.916
(−¿) (-0.932) (-1.989) (-
1.757)E*Beta(β18)/ΔE*Beta(β19) β18+ β19 -1.461 -1.256 -1.467
(−¿) (-0.873) (-1.510) (-
0.781)E*Size(β20)/ΔE*Size(β21) β20+ β21 0.365 -0.032 4.725* (+¿) (-0.673) (-0.509) (2.749)E*Leverage(β22)/ΔE*Leverage(β23) β22+β23 -0.511 -0.433 2.572 (−¿) (-1.098) (-0.541) (0.193)FTenure β24 0.002 0.006 0.019* (−¿) (0.358) (0.938) (2.342)Age β25 0.005 -0.006 -0.005
(+¿) (1.033) (-1.389) (-
0.653)Big4 β26 0.036 0.041 -0.047
(+¿) (0.692) (0.785) (-
0.409)Growth β27 -0.016 -0.001 0.014 (+¿) (-1.690) (-0.153) (0.954)Persist β28 0.086 0.084 -0.207
(+¿) (1.249) (1.239) (-
1.450)Volatility β29 -0.041 -0.021 0.203 (−¿) (-0.328) (-0.167) (0.876)Beta β30 0.066 0.026 0.037 (−¿) (1.321) (0.588) (0.707)Size β31 0.334* 0.268* 0.143*
62
(+¿) (8.202) (7.073) (2.151)Leverage β32 0.083 0.000 0.186* (−¿) (1.538) (0.012) (2.232)Adj.R2 0.367 0.341 0.470n 547 512 218
Notes:
ERC is calculated by taking the sum of the individual coefficients of E and ΔE.
* Significant at the 0.05 level based on a two-tailed t-test (in parentheses).
I find that the sum of the individual coefficients of E and ΔE is not significant when
comparing the MPR sample with NPR or VPR samples. But ERC (β1+ β2) is significantly
negative (-49.660, t = -2.331) under the column of “MPR vs. MPRPY”. The coefficient
of interest in this study is the incremental ERC (β4+β5) for benchmark samples. I find
that the incremental ERC is indifferent from zero under the column of “MPR vs. NPR”
and “MPR vs. MPRPY”. This means ERC in mandatory audit partner rotation sample is
not significantly different from the ERC in Non-rotation sample or mandatory
rotation sample in prior year, which fails to support my expectation in Hypothesis 2.
However, the incremental ERC for voluntary audit partner rotation sample is
significantly negative (-0.797, t = -2.166). This finding suggests that ERC in mandatory
audit partner rotation sample is significantly larger than ERC in voluntary audit
partner rotation sample, which provides some evidence to support Hypothesis 2.
When using VPR as the benchmark sample, investors’ perception about audit quality
is increased in mandatory audit partner rotation sample.
Following the method by Ghosh and Moon (2005), I present the sum of the two
interaction coefficients for each control variable in Table 13, instead of the individual
coefficient on each control variable. Based on the results shown in Table 13, I find
consistent evidence under all the three comparisons that Age is significantly negative
(-0.356, t = -3.159; -0.051, t = -2.609; -0.442, t = -1.970), which suggests that older
companies have lower perceived audit quality. This finding about Age is consistent
with the findings by Chi et al. (2009) using the data from Taiwan. The results also
63
provide some evidence on Volatility and Size. ERC increases with company size, while
decreases with Volatility. Unfortunately, I do not find any significant results for audit
firm tenure after controlling for audit partner rotation and other factors which could
affect the ERC. This means investors’ perception about audit quality is not
significantly decreased by longer audit firm tenure after controlling for the audit
partner rotation, which is again consistent with the findings by Chi et al. (2009)
based on the Taiwanese database.
In sum, under three comparisons, only one of them shows significant result that is in
support of Hypothesis 2. Therefore, I find no consistent evidence to support my
expectation that mandatory audit partner rotation enhances perceived audit quality
by investors. All the sums of interaction coefficients are insignificant except for Age,
Volatility and Size. Based on the regression analysis in Table 13, I fail to find any
evidence to support Hypothesis 3, which expects longer firm tenure deteriorates
perceived audit quality after controlling for audit partner rotation. The sums of
coefficients (β6+β7) are negative, but not significant under all the three comparisons
shown in Table 13.
7.5 Summary
In this chapter, I examine the effects of mandatory audit partner rotation on actual
and perceived audit quality through both univariate and multivariate tests. Firstly, for
actual audit quality, all the findings based on univariate tests are inconsistent with
my expectation in Hypothesis 1. The regression analysis on actual audit quality finds
no significant results using both absolute and signed values of discretionary accruals
as the dependent variable. I conclude that no evidence is found to support the
expectation in Hypothesis 1 that mandatory audit partner rotation enhances actual
audit quality. Secondly, for perceived audit quality, the univariate tests find some
evidence that supports Hypothesis 2. I find that CAR in companies that are subject to
mandatory audit partner rotation sample is significantly larger than CAR in prior year
within the same companies. The multivariate tests find that only one (MPR vs. VPR)
of the three comparisons has significant result that is in support of Hypothesis 2.
64
Thus, I conclude that there is no consistent evidence to support the expectation in
Hypothesis 2 that mandatory audit partner rotation enhances perceived audit
quality. In addition, I do not find consistent evidence that supports Hypothesis 3,
which suggests that audit firm tenure has no significant effects on actual and
perceived audit quality after controlling for other determinants of discretionary
accruals or ERC.
65
Chapter 8: Analysis
8.1 Introduction
In this chapter, I will elaborate the results from my regression analyses shown in my
previous chapter. Both main research questions and additional research question
issued in Chapter 1 will be answered. The corresponding 3 hypotheses will be
discussed as well. Based on the findings from my empirical results, I will explain why
the outcomes differ from my expectation before and from prior literatures.
8.2 The effects of mandatory audit partner rotation on actual
audit quality
In this section, I will try to answer one of the main research questions stated in
Chapter 1, which is whether the mandatory audit partner rotation has effects on
earnings quality or actual audit quality. Previous studies (Chi & Huang, 2005; Chen et
al., 2008; Chi et al., 2009) find conflicting results when investigating the effects of
mandatory audit partner rotation or audit partner tenure on earnings quality
measured by discretionary accruals. Most studies (Chi & Huang, 2005; Carey &
Simnett, 2006; Chen et al., 2008) focus on audit partner tenure instead of mandatory
audit partner rotation using the data from the period when the audit partner
rotation is still voluntary. However, this study directly explores the effects of
mandatory audit partner rotation. Auditor’s incentives and behavior might be
significantly changed when mandatory audit partner rotation is included in the
legislation. In addition, the adoption of mandatory audit partner rotation in China
implies that Chinese regulators believe mandatory audit partner rotation can
enhance actual audit quality. Thus, I hypothesized that companies that have
mandatorily rotated audit partners have higher actual audit quality than companies
that haven’t mandatorily rotated audit partners.
To examine the effects of mandatory audit partner rotation on earnings quality or
66
actual audit quality based on the sample in China, I compare the level of
performance-adjusted discretionary accruals in mandatory audit partner rotation
sample with other three benchmark samples, which are non-rotation sample,
voluntary audit partner rotation sample and mandatory rotation sample in prior year.
The results for regression analysis shown in Table 12 suggest that mandatory audit
partner rotation has no significant effects on earnings quality or actual audit quality.
From panel A of Table 12, it is found that mandatory audit partner rotation has no
significant effects on absolute values of performance-adjusted discretionary accruals.
Moreover, from Panel B and Panel C of Table 12, it is found that mandatory audit
partner rotation has no effects on either positive or negative values of discretionary
accruals. Thus, all the findings provide no evidence to support Hypothesis 1. My
empirical results suggest that there is no association between mandatory audit
partner rotation and earnings quality or actual audit quality.
There could be several reasons that result in these insignificant effects of mandatory
audit partner rotation on earnings quality. As I have explained before in Chapter 1,
the introduction of mandatory audit partner rotation may solve the problem of long
audit partner tenure. Mandatory audit partner rotation not only enhances auditor
independence, but also provides a “fresh viewpoint” which could enhance auditor’s
competence to find the potential breach in the client’s audit reports. At the same
time, mandatory audit partner rotation could also bring a negative effect on actual
audit quality. Mandatory audit partner rotation initiates costs from unexperienced
audit successor. Based on the regression analysis for actual audit quality, the
insignificant results suggest that the costs of mandatory audit partner rotation have
offset most parts of the benefits from increased auditor independence and “fresh
viewpoints”. The adoption of mandatory audit partner rotation by many countries
suggests that the regulators believe the benefits outweigh costs of mandatory
rotation. However, the main findings in this study suggest that the actual effects of
mandatory audit partner rotation on earnings quality might be overestimated by
those regulators or prior studies.
67
In addition, many other factors could affect the actual audit quality besides
mandatory audit partner rotation. These factors might reduce the effects of
mandatory audit partner rotation. Firstly, audit partners are not the only ones who
can affect the quality of audit work. Although the audit partners have the final
responsibility for audit quality, it is the whole audit team who is doing the audit work
and preparing the audit files. Mandatory audit partner rotation only requires the
rotation of audit partners, not the whole audit team. Thus, it is possible that the
same audit team members are doing the actual audit work even after the partners
are changed, which could still deteriorate audit quality after a long time.
Secondly, client management and auditors have a joint responsibility for the quality
of financial statements (Antle & Nalebuff, 1991). Managers of client companies are
responsible for the ultimate quality of reported financial statements. This means
earnings quality is not only determined by auditors, but also the client management.
For example, managers could affect the quality of reported earnings through internal
control or accounting systems designed for the company. Companies with good
internal control environment or well-designed accounting systems are less likely to
get involved in earnings management. And the client management might have
stronger influence on earnings quality than audit partners. This explains why auditor
partner rotation has no significant effects on earnings quality.
Thirdly, auditors also concern about the litigation risk and audit firm’s reputation.
Even under a long client-auditor relationship, auditors still have strong motivation to
maintain auditor independence due to the potential litigation costs for audit failure.
Auditors add credibility to financial reports, so that their reputation is also a key
factor in assurance work. These two concerns about litigation costs and reputation
could increase the actual audit quality, therefore limiting the influence by mandatory
audit partner rotation. This could also explain the reason for the insignificant results
regarding the effects of mandatory audit partner rotation.
In sum, based on the data from China, my empirical results suggest no association
between mandatory audit partner rotation and earnings quality. However, these
68
insignificant results could also be caused by the missing control variables in the
regression model, which might have some important effects on earnings quality as
well. Firstly, the other members in the audit team might have more influences on
audit quality than audit partners. Secondly, managers in the client companies are
jointly responsible for earnings quality together with audit partners. At last, audit
partners’ concerns about the potential litigation costs and their reputation also
encourage them to maintain the auditor independence and audit quality. Not
including these factors into the regression model may reduce the effects of
mandatory audit partner rotation, which might explain the insignificant results in my
empirical analyses in some extent.
8.3 The effects of mandatory audit partner rotation on perceived
audit quality
In this section, I will try to answer the other main research question stated in the first
chapter, which is whether the mandatory audit partner rotation has effects on ERC or
perceived audit quality. Very few empirical studies have investigated the relation
between audit partner rotation and perceived audit quality. Chi et al. (2009) find
there is no significant difference in perceived audit quality between mandatory audit
partner rotation sample and non-rotation sample based on the data from Taiwan.
However, this might not be the case in Chinese capital market. Therefore, I still
hypothesized that companies that have mandatorily rotated audit partners have
higher perceived audit quality than companies that haven’t mandatorily rotated
audit partners.
To examine the effects of mandatory audit partner rotation on perceived audit
quality, I compare ERC in mandatory audit partner rotation sample with other three
benchmark samples, which are non-rotation sample, voluntary audit partner rotation
sample and mandatory rotation sample in prior year. The regression analysis shown
in Table 13 suggests that the incremental ERC in voluntary audit partner rotation
sample is significantly negative compared to ERC in mandatory audit partner rotation
69
sample. However, the sum of the two interaction coefficients is insignificant under
the column “MPR vs. NPR” or “MPR vs. MPRPY”. This means ERC in mandatory audit
partner rotation sample is not significantly different from ERC in non-rotation sample
or mandatory audit partner rotation sample in prior year, which is inconsistent with
the expectation in Hypothesis 2. In the end, I conclude that there is no consistent
evidence which supports that mandatory audit partner rotation enhances perceived
audit quality. My empirical results suggest there is no association between
mandatory audit partner rotation and perceived audit quality.
There could be several reasons which explain the insignificant results on perceived
audit quality. Firstly, most investors may not notice the rotation of audit partners in
the audit report. Even if the investors notice the audit partner rotation, there are still
several other factors they will take into consider when assessing the earnings quality.
The efficiency of internal control process, corporate governance and accounting
systems are all crucial factors which will determine the investor’s perception about
earnings quality or audit quality. And these factors might be more important than
audit partner rotation in investor’s mind when assessing the earnings quality.
Therefore, the effects of mandatory audit partner rotation become insignificant due
to those more important determinants on earnings quality or audit quality.
Secondly, it is possible that investors do not perceive the mandatory audit partner
rotation as a signal of higher audit quality at all. And the benefits of restoring
investor’s confidence through mandatory audit partner rotation might be
overestimated by government and prior literatures. As I have explained before in
section 8.2, the audit work is finished by the whole audit team instead of only two
audit partners. Investors may also notice this fact and they do not believe the change
of one or two audit partners will materially affect the earnings quality or audit
quality. Therefore, investors will not take mandatory audit partner rotation as a
determinant for the estimation of earnings quality or audit quality.
At last, I do find a significant larger ERC in mandatory audit partner rotation sample
than ERC in voluntary audit partner rotation sample. This suggests that investors may
70
view voluntary audit partner rotation as a way of “audit opinion shopping” by
companies. Therefore, investors perceive lower earnings quality for companies that
voluntarily rotate their audit partners and react less in the stock market to those
companies’ stocks.
In sum, my empirical results find no association between mandatory audit partner
rotation and perceived audit quality using the Chinese database. There could be
several reasons for these insignificant results. Firstly, there are many other factors
which may determine investors’ assessment of earnings quality or audit quality.
These other factors might be more important than mandatory audit partner rotation
to investors, which reduce the effects of audit partner rotation. Secondly, investors
may not believe the change of audit partners will materially affect the earnings
quality or audit quality.
8.4 The effects of audit firm tenure on actual and perceived audit
quality
In this section, additional research question about the effects of audit firm tenure
will be answered. And the corresponding Hypothesis 3 will be analyzed. In the first
chapter, an additional research question is issued to examine the effects of audit firm
tenure on actual and perceived audit quality after controlling for audit partner
rotation. First, many regulators believe mandatory audit firm rotation can further
strengthen actual audit quality (Bates et al., 2012; European Commission, 2010).
Second, mandatory audit firm rotation might be more visible to investors compared
to mandatory audit partner rotation (Gates et al., 2007). These two beliefs are both
based on the assumption that long audit firm tenure deteriorates actual or perceived
audit quality. Therefore, I hypothesized that longer audit firm tenure is negatively
related to actual and perceived audit quality after controlling for audit partner
rotation.
When using discretionary accruals as the dependent variable, Table 12 shows the
results for the effects of audit firm tenure on actual audit quality after controlling for
71
audit partner rotation. Panel A of Table 12 finds no significant results for the effects
of audit firm tenure on the absolute value of discretionary accruals. Panel B of Table
12 suggests that the income-increasing discretionary accruals in mandatory audit
partner rotation sample is significantly lower than that in prior year. Panel C of Table
12 finds that companies that are subject to mandatory audit partner rotation have
more income-decreasing accruals than companies that are subject to voluntary audit
partner rotation sample. The findings for the effects of audit firm tenure on actual
audit quality are mixed in my empirical results. Therefore, I conclude that there is no
association between audit firm tenure and actual audit quality after controlling for
audit partner tenure.
When using ERC as the dependent variable, Table 13 shows the results for the effects
of audit firm tenure on perceived audit quality after controlling for audit partner
rotation. I focus on the sum of the two interaction coefficients for audit firm tenure
instead of individual coefficients in this part. Table 13 finds that the coefficients (
β6+β7) are all insignificantly negative under three comparisons. These findings
suggest that longer audit firm tenure does not significantly affect ERC after
controlling for audit partner rotation. Therefore, I conclude that there is no
association between audit firm tenure and perceived audit quality after controlling
for audit partner rotation.
There are several reasons for these insignificant findings. Firstly, audit firm tenure
may not materially affect actual and perceived audit quality. This is consistent with
the findings by Johnson et al. (2003) that long audit firm tenure is not associated
with accruals quality. The benefits of mandatory audit firm rotation are
overestimated by regulators and previous studies. Besides, investors may not notice
the length of audit firm tenure. And there are always several more important factors
than audit firm tenure that investors will take into consider when assessing the
earnings quality or audit quality. Those factors might reduce the effects of audit firm
tenure.
Secondly, litigation and reputation concerns by audit firms could also motivate the
72
auditors to maintain their audit quality. Audit firms, for example big 4, heavily rely on
their reputation for business. Therefore, audit firms will not sacrifice the audit quality
even under a long client-auditor relationship.
Thirdly, audit service provided by the same audit firm does not mean the service
provided by the same audit team. Sometimes, it is possible that audit members or
audit partners are rotated within the same audit firm. In this case, audit partner
rotation is already enough to maintain auditor independence and audit quality. At
the same time, different audit partners could also share the knowledge and
experience with the previous audit partners within the same audit firm. Investors
may also believe the rotation of audit partners is already enough to maintain auditor
independence. And investors will not perceive long audit firm tenure as a negative
effect on audit quality. Therefore, actual or perceived audit quality is not significantly
affected by audit firm tenure if audit partners are rotated within the audit firm. After
controlling for audit partner rotation, the effects of audit firm tenure are thereby
reduced.
In sum, the empirical results show no association between audit firm tenure and
actual and perceived audit quality after controlling for audit partner rotation. On the
one hand, the reason for these insignificant results could be that audit firm tenure
has no effects on actual and perceived audit quality due to investor’s ignorance,
auditor’s litigation and reputation concerns. On the other hand, the effects of audit
firm tenure might be reduced by audit partner rotation or other determinants for
audit quality in investors’ mind.
8.5 Summary
In this chapter, I have answered all the main research question and additional
research question. I find there is no association between mandatory audit partner
rotation and actual and perceived audit quality. And there is also no association
between audit firm tenure and actual and perceived audit quality after controlling for
audit partner rotation. For actual audit quality, there might be some missing control
variables that have stronger influence on discretionary accruals other than audit
73
partner rotation or audit firm tenure. And it is the whole audit engagement team,
instead of audit partner or audit firm, that will determine the actual audit quality. For
perceived audit quality, investors may not notice the audit partner rotation or audit
firm tenure and thereby do not adjust their assessment of audit quality. Besides,
there are several other factors that investors will consider when assessing the audit
quality, which thereby reduce the effects of mandatory audit partner rotation or
audit firm tenure on perceived audit quality.
Chapter 9: Conclusion
9.1 Introduction
In this chapter, the main findings in this study will be summarized and the
implications of the findings on both literature and audit profession will be discussed.
After the conclusions, limitations in this study will be analyzed and I will also
recommend some corresponding solutions for future researches on the topic of audit
partner rotation.
9.2 Main conclusions and implications of findings
The empirical results in this study show that there is no relation between mandatory
audit partner rotation and actual and perceived audit quality. When using
performance-adjusted discretionary accruals as the proxy for actual audit quality, I
find that there is no significant relation between mandatory audit partner rotation
and actual audit quality. When using ERC as the proxy for perceived audit quality, I
find that the perceived audit quality in mandatory audit partner rotation sample is
significantly higher than that in voluntary audit partner rotation sample. However, no
significant results are found for perceived audit quality when using the other two
benchmarks (NPR and MPRPY). In the end, I conclude that there is no consistent
evidence which supports that mandatory audit partner rotation enhances actual and
perceived audit quality.
The main findings in this study have several implications. Firstly, I contribute to the
74
literature on audit partner rotation and audit quality. Mandatory audit partner
rotation has been restricted from every 7 years to every 5 years by SOX in 2002.
Besides the United States, many other countries (for example Australia, Germany,
Japan, Singapore and China) also require mandatory audit partner rotation. The
requirement is based on the assumption that mandatory audit partner rotation
enhances actual and perceived audit quality. However, many previous studies only
investigate the relation between audit partner tenure and actual and perceived audit
quality. Only the study by Chi et al. (2009) directly investigates the effects of
mandatory audit partner rotation using the data from Taiwan. This study follows the
method by Chi et al. (2009), but using the data from China. By examining the relation
between mandatory audit partner rotation and actual and perceived audit quality, I
find that there is limited evidence which supports mandatory audit partner rotation.
The main findings in this study are inconsistent with the assumption that mandatory
audit partner rotation enhances actual and perceived audit quality.
Secondly, I contribute to the literature on audit firm tenure and audit quality. In my
additional research question, I test the relation between audit firm tenure and actual
and perceived audit quality after controlling for audit partner rotation. In many
countries, regulators are still considering the requirement of audit firm rotation in
addition to audit partner rotation. The main reason for requiring audit firm rotation
is that long audit firm tenure deteriorates actual and perceived audit quality.
Previous studies have no consistent conclusion about the effects of audit firm tenure.
This study finds that longer audit firm tenure is not related to lower actual and
perceived audit quality after controlling for audit partner rotation.
Lastly, this study has an implication on audit profession as well. The implementation
of mandatory audit partner/firm rotation is costly based on the analysis in Chapter 1.
And this study fails to find any benefits from mandatory audit partner/firm rotation.
Therefore, the requirement of mandatory audit partner/firm rotation might be
unnecessary for audit profession based on the findings in this study.
75
9.3 Limitations and recommendations for future research
The external validity of this study is relatively high since the sample size is large.
However, the internal validity of this study is relatively low. The effectiveness of the
main findings in this study is largely dependent on the ability of performance-
adjusted discretionary accruals and ERC to capture the concepts of actual and
perceived audit quality respectively. As is explained in Chapter 3, discretionary
accruals are the proxy for actual earnings quality, while ERC is the proxy for perceived
earnings quality in this study. And earnings quality is a proxy for audit quality.
Therefore, I am using proxy for proxy in my research design. Although those proxies
are widely used in previous studies as discussed in Chapter 4, they are still noisy. The
audit quality is a wider concept than earnings quality. For example, Audit opinion
issued in the audit reports can also be an indicator of audit quality. Besides the level
of discretionary accruals, earnings quality can also be reflected by earnings
persistence, earnings volatility. Moreover, investors could be stockholders, as well as
debt-holders. Earning Response Coefficients can only measure the reaction by
stockholders, but not debt-holders. Therefore, cost of debts can also be used to
measure the perceived audit quality. There are many other proxies that could be
used to measure the actual and perceived audit quality. The future research could
use those alternative proxies for actual and perceived audit quality to investigate the
association between mandatory audit partner rotation and actual and perceived
audit quality.
9.4 Summary
Based on the results in this study, I find limited evidence which supports that
mandatory audit partner rotation enhances actual and perceived audit quality. And
there is no significant relation between audit firm tenure and actual and perceived
audit quality after controlling for audit partner rotation. The main findings in this
study contribute to the literature on both audit partner rotation and audit firm
tenure. The requirement of mandatory audit partner/firm rotation for audit
76
profession might not be necessary. However, there are some limitations in this study.
The internal validity of this study is relatively low since the proxies I use in this study
cannot fully capture the concepts of actual and perceived audit quality. More
alternative proxies for actual and perceived audit quality are suggested for future
researches.
77
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Appendix
Table 1: Literature review on audit partner rotation/tenure and audit quality
Authors Object of
study
Sample Method Outcome
Actual audit quality:
Chi and Huang (2005)
X: audit partner tenure
Y: earnings quality
1337 firm year observations from 1998 to
2001 in Taiwan
Archival: non-linear regression analysis between audit partner tenure and discretionary accruals.
Longer audit partner tenure helps to produce higher earnings quality, but
extreme long audit partner tenure results in lower earnings quality. The cut-off
point of audit partner tenure is nearly 5 years.
Carey and Simnett (2006)
X: audit partner tenureY: audit quality
1021 companies in 1995 in Australia
Archival: regression analysis between audit partner tenure and three measures of audit quality (the auditor’s propensity to issue a
going-concern opinion; absolute and signed values of abnormal working capital accruals; the
extent of earnings management).
Audit partners with a long tenure are less likely to issue a going-concern opinion. Audit quality measured by AWCA is not significantly associated with long audit
partner tenure. Client company with long audit partner tenure has a high
probability to artificially beat targets
84
Chen, Lin and Lin (2008)
X: audit partner tenure
Y: earnings quality
5213 firm year observations from 1990 to
2001 in Taiwan
Archival: regression analysis between audit partner tenure and performance adjusted
discretionary accruals.
When absolute or positive values of discretionary accruals are used, the results show that earnings quality
increases significantly with longer audit partner tenure. When raw or negative
values of discretionary accruals are used, results are not significant.
Chi, Huang, Liao and
Xie (2009)
X: audit partner rotationY: audit quality
1131 firm year observations in 2004 in Taiwan
Archival: Compare performance matched abnormal accruals in mandatory audit partner
rotation group with three other benchmark groups
There is no significant difference in audit quality between mandatory rotation
group and non-mandatory rotation group or voluntary rotation group. The audit quality in mandatory rotation group is
significantly lower than itself in prior year.
Firth, Rui and Wu (2010)
X: different forms of auditor rotationY: audit quality
8560 firm year observations from 1997 to 2005 in China
Archival: Compare auditors’ propensity to issue a modified audit opinion among various forms
of auditor rotation (mandatory/voluntary partner rotation, mandatory/voluntary firm
rotation, non-rotation).
Companies in mandatory partner rotation group have a higher probability to receive a modified audit opinion compared to the
companies in non-rotation group.
85
Perceived audit quality:
Gates, Lowe and Reckers (2007)
X: audit firm rotation and audit partner rotation
Y: public confidence in earnings quality
79 MBA students and 92 law
students in USA
Experiment: two separate behavioral studies on MBA
and Law students: a between-subjects design with one-way analysis of variance for each
study.
Audit firm rotation significantly increases investor’s confidence in company’s reported
earnings, while audit partner rotation has little help in restoring investor’s confidence
Kaplan and Mauldin (2008)
X: audit firm rotation and audit partner rotation
Y: non-professional investors’ perceived
auditor independence
236 MBA students in USA
Experiment: two experiments on MBA students: a 2×2
between-subjects design that manipulates auditor rotation
and audit committee strength.
With audit partner rotation in place, audit firm rotation does not further strengthen perceived
auditor independence. And investors value strong audit committee.
Chi, Huang, Liao and
Xie (2009)
X: audit partner rotation
Y: perceived audit quality
1634 firm year comparison
observations in 2004 in Taiwan
Archival: Compare ERC in mandatory audit partner rotation group with three other benchmark groups
ERC is not significantly different between 2 comparison samples, which are mandatory
rotation sample versus non-rotation sample or mandatory rotation sample in prior year. But the ERC in mandatory rotation sample is significantly
larger than that in voluntary rotation sample.
86
Table 2: Literature review on audit firm rotation/tenure and audit quality
Authors Object of
study
Sample Method Outcome
Actual audit quality:
Geiger and Raghunandan
(2002)
X: audit firm tenure
Y: audit reporting
failure
117 companies entering into bankruptcy during 1996-1998
in USA
Archival: regression analysis between audit opinions (dummy
variable) issued before bankruptcy and audit firm
tenure.
There are more audit reporting failures in the earlier years of audit firm tenure.
Johnson, Khurana and
Reynolds (2002)
X: audit firm tenureY: earnings
quality
2463 (2280) firm year observations for the unexpected accruals
(persistence) test from Big 6 clients during 1986-1995 in
USA
Archival: regression analysis between audit firm tenure and absolute values of unexpected
accruals or persistence of accruals.
Short audit firm tenure results in decreased accruals quality, while
medium or long auditor tenure is not associated with accruals quality.
Myers, Myers and Omer (2003)
X: audit firm tenureY: earnings
quality
42302 firm year observations during 1988-2000 in USA
Archival: regression analysis between audit firm tenure and absolute, signed and raw values of both discretionary accruals
and current accruals.
Longer audit firm tenure significantly decreases the level of both
discretionary accruals and current accruals.
87
Chi and Huang (2005)
X: audit firm tenureY: earnings
quality
1337 firm year observations during 1998-2001 in Taiwan
Archival: non-linear regression analysis between audit firm
tenure and discretionary accruals.
Longer audit firm tenure helps to produce higher earnings quality, but
extreme long audit firm tenure results in lower earnings quality. The cut-off point of audit firm tenure is nearly 5
years.Chen and Xia
(2006)X: audit
firm tenureY: earnings
quality
2667 firm year observations during 2000-2002 in China
Archival: non-linear regression analysis between audit firm
tenure and discretionary accruals.
Longer audit firm tenure helps to produce higher earnings quality, but
extreme long audit firm tenure results in lower earnings quality. The cut-off point of audit firm tenure is nearly 6
years.Jackson,
Moldrich and Roebuck (2008)
X: audit firm tenure
Y: audit quality
1750 firm year observations during 1995-2003 in Australia
Archival: regression analysis between audit firm tenure and
propensity to issue a going-concern opinion or discretionary
accruals.
Longer auditor tenure will increase auditors’ propensity to issue a going-
concern opinion, but has no significant effects on accruals quality.
Chen, Lin and Lin (2008)
X: audit firm tenureY: earnings
quality
5213 firm year observations from 1990 to 2001 in Taiwan
Archival: regression analysis between audit firm tenure and
performance adjusted discretionary accruals after
controlling for partner tenure.
Longer audit firm tenure increases the earnings quality. Adding mandatory firm rotation to mandatory partner
rotation has no positive effects on audit quality.
88
Perceived audit quality:
Ghosh and
Moon (2005)
X: audit firm tenureY: public confidence in earnings quality
38794 firm-year observations
during 1990-2000 in USA
Archival: regression analysis between audit firm tenure and
ERC (stock/debt rankings or analyst’s earnings forecast).
Both investors’ and information intermediaries’ perception about earnings
quality is positively associated with audit firm tenure.
Dart (2011)
X: audit firm tenureY: investor’s
perception about auditor
independence
113 institutional investors and 254
private investors in UK
Experiment: a questionnaire-based study.
Investors in UK are relatively unconcerned about the threat of long audit firm tenure compared to other threats in the survey.
Daniels and
Booker (2011)
X: audit firm rotation and audit firm tenure
Y: loan officer’s perception of auditor
independence and audit quality
207 bank loan officers in USA
Experiment: a between-subject design. The versions of the case are different only as it relates to the rotation policy and length of tenure within the rotation policy.
Audit firm rotation improves loan officer’s perception about auditor independence, but does not affect perceived audit quality. Audit firm tenure is not significantly associated with
both perceived auditor independence and perceived audit quality.
89
Table 3: Sample selection
MPR, NPR and VPR sample selection
Companies listed on SSE or SZSE in 2003 from CSMAR database
1290
Less Companies with missing audit partner information (232) Companies belong to financial industry (43)Preliminary sample 1015Sample label MPR NPR VPRPreliminary sample
111 478 426
LessCompanies delisted in or before 2003
(2) (39) (23)
Final sample for the first regression
109 439 403
Less Companies with missing daily stock price information
(0) (1) (0)
Final sample for the second regression
109 438 403
90
Table 4: Descriptive statistics for actual audit quality
Panel A: Mandatory partner rotation sample (MPR, n=109)
Variable Minimum Maximum Mean Std. Deviation│DA│ 0.000 0.395 0.064 0.070 AGE 3.000 13.000 7.321 2.063 SIZE 8.023 9.992 9.174 0.371 IndGrowth -1.094 0.966 0.592 0.462 CFO -0.256 0.457 0.058 0.101 Big4 0.000 1.000 0.055 0.229 FTenure 1.000 11.000 4.183 2.065 Panel B: Non-rotation sample (NPR, n=439)
Variable Minimum Maximum Mean Std. Deviation│DA│ 0.000 0.482 0.055 0.058 AGE 1.000 13.000 6.337 2.594 SIZE 7.849 10.271 9.125 0.372 IndGrowth -1.094 0.966 0.606 0.448 CFO -0.290 0.486 0.047 0.084 Big4 0.000 1.000 0.062 0.241 FTenure 1.000 11.000 3.597 1.398 Panel C: Voluntary partner rotation sample (VPR, n=403)
Variable Minimum Maximum Mean Std. Deviation│DA│ 0.000 0.382 0.055 0.055 AGE 2.000 13.000 6.092 2.552 SIZE 7.770 10.789 9.154 0.402 IndGrowth -3.865 0.966 0.596 0.492 CFO -0.314 0.362 0.050 0.083 Big4 0.000 1.000 0.099 0.299 FTenure 1.000 11.000 3.295 1.657 Panel D: Mandatory partner rotation in prior year (MPRPY, n=109)
Minimum Maximum Mean Std. Deviation│DA│ 0.000 0.385 0.055 0.066 AGE 2.000 12.000 6.321 2.063 SIZE 8.179 9.939 9.137 0.353 IndGrowth -0.393 14.095 0.479 2.058
91
CFO -0.356 0.436 0.049 0.090 Big4 0.000 1.000 0.092 0.290 FTenure 1.000 10.000 3.706 1.553
92
Table 5: Tests of Normality for actual audit quality
Panel A: MPR vs. NPR
Kolmogorov-Smirnova Shapiro-WilkStatistic df Sig. Statistic df Sig.
│DA│ .175 548 .000 .743 548 .000a. Lilliefors Significance Correction
Panel B: MPR vs. VPR
Kolmogorov-Smirnova Shapiro-WilkStatistic df Sig. Statistic df Sig.
│DA│ .165 512 .000 .760 512 .000a. Lilliefors Significance Correction
Panel C: MPR vs. MPRPY
Kolmogorov-Smirnova Shapiro-WilkStatistic df Sig. Statistic df Sig.
│DA│ .192 218 .000 .725 218 .000a. Lilliefors Significance Correction
93
Table 6: Independent samples test for actual audit quality
Panel A: MPR vs. NPR
Levene's Test for Equality of Variances t-test for Equality of Means
F Sig. t dfSig. (2-tailed)
Mean Differenc
e
Std. Error Differenc
e
95% Confidence Interval of the
DifferenceLower Upper
│DA│ Equal variances assumed
2.072 0.151 -1.470 546 0.142 -0.009 0.006 -0.022 0.003
Equal variances not assumed
-1.307 146.249 0.193 -0.009 0.007 -0.024 0.005
Panel B: MPR vs. VPR
Levene's Test for Equality of Variances t-test for Equality of Means
F Sig. t df Sig. (2-tailed)
Mean Differenc
e
Std. Error Differenc
e
95% Confidence Interval of the
Difference
94
Lower Upper│DA│ Equal
variances assumed
2.607 0.107 -1.411 510 0.159 -0.009 0.006 -0.021 0.003
Equal variances not assumed
-1.228 145.705 0.221 -0.009 0.007 -0.023 0.005
Panel C: MPR vs. MPRPY
Levene's Test for Equality of Variances t-test for Equality of Means
F Sig. t dfSig. (2-tailed)
Mean Differenc
e
Std. Error Differenc
e
95% Confidence Interval of the
DifferenceLower Upper
│DA│ Equal variances assumed
0.023 0.880 -0.958 216 0.339 -0.009 0.009 -0.027 0.009
Equal variances not assumed
-0.958 215.220 0.339 -0.009 0.009 -0.027 0.009
95
Table 7: Test statistics for actual audit quality
Panel A: MPR vs. NPR
│DA│Mann-Whitney U
21965.000
Wilcoxon W
118545.000
Z -1.325Asymp. Sig. (2-tailed)
.185
a. Grouping Variable: BMK
Panel B: MPR vs. VPR
│DA│Mann-Whitney U
20558.500
Wilcoxon W
101964.500
Z -1.025Asymp. Sig. (2-tailed)
.305
a. Grouping Variable: BMK
Panel C: MPR vs. MPRPY
│DA│Mann-Whitney U
5163.000
Wilcoxon W
11158.000
Z -1.670Asymp. Sig. (2-tailed)
.095
a. Grouping Variable: BMK
96
97
Table 8: Descriptive statistics for perceived audit quality
Panel A: Mandatory partner rotation sample (MPR, n=109)
Variable Minimum Maximum Mean Std. DeviationCAR -1.218 0.698 -0.395 0.273 E -0.222 0.189 0.015 0.051 ΔE -0.243 1.198 0.020 0.133 AGE 3.000 13.000 7.321 2.063 Big4 0.000 1.000 0.055 0.229 Growth 1.056 6.536 1.903 0.874 Persist -0.683 0.247 -0.267 0.218 Volatility 0.009 2.751 0.159 0.273 Beta 0.000 1.368 0.941 0.306 Size 8.528 10.217 9.289 0.334 Leverage 0.073 4.343 0.547 0.427 FTenure 1.000 11.000 4.183 2.065
Panel B: Non-rotation sample (NPR, n=438)
Variable Minimum Maximum Mean Std. DeviationCAR -1.589 0.561 -0.420 0.264 E -0.376 0.288 0.017 0.049 ΔE -0.168 0.381 0.007 0.046 AGE 1.000 13.000 6.345 2.592 Big4 0.000 1.000 0.059 0.237 Growth 0.989 15.163 1.957 1.156 Persist -0.814 0.339 -0.277 0.190 Volatility 0.008 0.962 0.132 0.105 Beta 0.000 2.235 1.007 0.212 Size 8.508 10.540 9.257 0.325 Leverage 0.011 4.883 0.512 0.301 FTenure 1.000 11.000 3.600 1.397 Panle C： Voluntary partner rotation sample (VPR, n=403)
Variable Minimum Maximum Mean Std. DeviationCAR -1.134 0.594 -0.414 0.265 E -0.569 0.165 0.013 0.066 ΔE -0.531 1.000 0.006 0.085 AGE 2.000 13.000 6.092 2.552 Big4 0.000 1.000 0.099 0.299 Growth 0.911 24.719 2.054 1.489
98
Persist -0.677 0.838 -0.265 0.202 Volatility 0.008 0.928 0.141 0.121 Beta -0.126 1.408 0.967 0.236 Size 8.542 10.947 9.310 0.378 Leverage 0.027 4.229 0.510 0.334 FTenure 1.000 11.000 3.295 1.657 Panel D: Mandatory partner rotation in prior year (MPRPY, n=109)
Variable Minimum Maximum Mean Std. DeviationCAR -1.281 0.020 -0.643 0.192 E -0.675 0.101 0.002 0.075 ΔE -0.654 0.132 -0.008 0.074 AGE 2.000 12.000 6.321 2.063 Big4 0.000 1.000 0.092 0.290 Growth 1.087 11.262 2.408 1.488 Persist -0.527 0.084 -0.252 0.160 Volatility 0.006 2.748 0.157 0.263 Beta 0.000 1.369 0.951 0.293 Size 8.748 9.992 9.362 0.273 Leverage 0.083 5.948 0.540 0.561 FTenure 1.000 10.000 3.706 1.553
99
Table 9: Tests of Normality for perceived audit quality
Panel A: MPR vs. NPR
Kolmogorov-Smirnova Shapiro-Wilk
Statistic df Sig. Statistic df Sig.
CAR .048 547 .004 .980 547 .000
a. Lilliefors Significance Correction
Panel B: MPR vs. VPR
Kolmogorov-Smirnova Shapiro-Wilk
Statistic df Sig. Statistic df Sig.
CAR .046 512 .011 .988 512 .000
a. Lilliefors Significance Correction
Panel C: MPR vs. MPRPY
Kolmogorov-Smirnova Shapiro-Wilk
Statistic df Sig. Statistic df Sig.
CAR .071 218 .010 .969 218 .000
a. Lilliefors Significance Correction
100
Table 10: Independent samples test for perceived audit quality
Panel A: MPR vs. NPR
Levene's Test for Equality of Variances t-test for Equality of Means
F Sig. t dfSig. (2-tailed)
Mean Differenc
e
Std. Error Differenc
e
95% Confidence Interval of the
DifferenceLower Upper
CAR Equal variances assumed
0.018 0.893 -0.885 545 0.376 -0.025 0.028 -0.081 0.031
Equal variances not assumed
-0.868 161.953 0.387 -0.025 0.029 -0.082 0.032
Panel B: MPR vs. VPR
Levene's Test for Equality of Variances t-test for Equality of Means
F Sig. t df Sig. (2-tailed)
Mean Differenc
e
Std. Error Differenc
e
95% Confidence Interval of the
Difference
101
Lower UpperCAR Equal
variances assumed
0.071 0.790 -0.664 510 0.507 -0.019 0.029 -0.076 0.037
Equal variances not assumed
-0.653 167.289 0.515 -0.019 0.029 -0.077 0.039
Panel C: MPR vs. MPRPY
Levene's Test for Equality of Variances t-test for Equality of Means
F Sig. t dfSig. (2-tailed)
Mean Differenc
e
Std. Error Differenc
e
95% Confidence Interval of the
DifferenceLower Upper
CAR Equal variances assumed
9.038 0.003 -7.751 216 0.000 -0.248 0.032 -0.310 -0.185
Equal variances not assumed
-7.751 193.763 0.000 -0.248 0.032 -0.311 -0.185
102
Table 11: Test statistics for perceived audit quality
Panel A: MPR vs. NPR
CARMann-Whitney U
22473.000
Wilcoxon W
118614.000
Z -.947Asymp. Sig. (2-tailed)
.344
a. Grouping Variable: BMK
Panel B: MPR vs. VPR
CARMann-Whitney U
20928.000
Wilcoxon W
102334.000
Z -.756Asymp. Sig. (2-tailed)
.450
a. Grouping Variable: BMK
Panel C: MPR vs. MPRPY
CARMann-Whitney U
2438.000
Wilcoxon W
8433.000
Z -7.522Asymp. Sig. (2-tailed)
.000
a. Grouping Variable: BMK
103
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