U.S. Audit Partner Rotations Henry Laurion henry_laurion@haas.berkeley.edu Alastair Lawrence* lawrence@haas.berkeley.edu James Ryans james_ryans@haas.berkeley.edu Haas School of Business University of California at Berkeley 2220 Piedmont Avenue Berkeley, CA 94720-1900 October 2014 ABSTRACT: The main purpose of audit partner rotation is to bring a “fresh look” to the audit engagement while maintaining firm continuity and overall audit quality. Despite mandatory audit partner rotation being required in the U.S. for over 35 years, to-date there has been limited empirical evidence speaking to the effectiveness of U.S. auditor partner rotations given that audit partner information is not disclosed in U.S. audit reports. Using SEC comment letter correspondences to identify U.S. audit partner rotations, we provide initial evidence among publicly-listed companies suggesting that audit partner rotation in the U.S. supports a “fresh look” at the audit engagement. Specifically, we find that audit partner rotation results in substantial increases in material restatements (129 to 135 percent) and write-downs of impaired assets (one percent of market value). Overall, these findings suggest that audit partner rotation supports auditor independence and is an important component of quality control for U.S. accounting firms. KEYWORDS: U.S. audit partner rotations; fresh look; material restatements; 10-K/As; 10- Q/As; write-downs. JEL CLASSIFICATION: M41; M42; M48. DATA AVAILABILITY: Data are publicly available from sources identified in the article. We have received valuable comments and suggestions from Hans Christensen, Sunil Dutta, Miguel Minutti-Meza, Alexander Nezlobin, Xiao-Jun Zhang, and seminar participants at the University of California at Berkeley. *Corresponding author. 1 “…we do not believe the identification of the engagement partner will provide meaningful information to financial statement users…” Center for Audit Quality Comment Letter to the PCAOB (CAQ 2014). 1. Introduction and background For over 35 years, audit partner rotation has been an important component of quality control for the vast majority of accounting firms that audit Securities and Exchange Commission (SEC) registrants. While U.S. audit partner rotation has generally reflected a compromise for full audit firm rotation, the main purpose of audit partner rotation is to bring a “fresh look” to the audit engagement while maintaining firm continuity and overall audit quality (e.g., SEC 2003). Regulators state that partner rotation requirements must balance the need to achieve a fresh look and a need for the audit engagement team to be composed of competent auditors, and hence, there has been significant tension relating to these needs in regards to who should be subject to rotation and how long the partner should remain on the engagement prior to rotating (SEC 2003). In 1978, the American Institute of Certified Public Accountants (AICPA) first introduced audit partner rotation by requiring the lead audit partner to rotate off the audit engagement of SEC registrants after seven years with a two-year time out (also known as a “cooling off”) period before the partner may return (AICPA 1978). The Sarbanes-Oxley Act of 2002 (SOX 2002) further requires both the lead partner and the concurring partner (reviewing partner) to rotate off the audit engagement of SEC registrants after five years—thus reducing the partner rotation from seven to five years. While SOX is silent concerning the time out period, the SEC adopted rules effective May 6, 2003 requiring a five-year time out period for both lead and concurring partners (SEC 2003). Thus, under current standards lead audit partners must rotate off audit engagements for SEC registrants after five years and then sit out for another five years before returning to the audit engagements. 2 Audit partner rotation addresses a concern that long-term relationships between audit partners and clients can create problems related to partner objectivity and independence. Partners who are familiar with the audit client can become complacent over the audit engagement term (e.g., Bamber and Iyer 2007) and new partners may help address such complacence by bringing a renewed sense of skepticism as well as additional insights and expertise to the engagement. On the other hand arguments and evidence have been advanced that there are costs to audit partner rotation, including that management may influence the new partner selection (Cohen, Krishnamoorthy, and Wright 2010) and that the new partner may have less industry expertise (Daugherty, Dickins, Hatfield, and Higgs 2012). Despite the perceived importance of partner rotation to the independence and quality control of U.S. accounting firms, as only audit firm and not audit partner information is disclosed in U.S. audit reports (PCAOB 2013), there has been limited evidence examining the effectiveness of partner rotation in the U.S. for publicly-listed firms. Of the evidence to-date, it generally concludes that audit partner rotation in the U.S. decreases audit quality. Specifically, using data of U.S. audit clients from 1999 to 2001 obtained from three audit firms, Manry, Mock, and Turner (2008), while not examining the direct effects of audit partner rotation, provide evidence suggesting that audit quality, measured using discretionary accruals, increases with partner tenure. Also using proprietary U.S. audit firm data—containing engagement-level information from one audit firm for 2002 and 2003—Bedard and Johnstone (2010) find that audit fee realization rates decrease in the year of audit partner rotation, suggesting that new partners invest extra time and effort during the first year on the engagement. However, they do not show any tangible benefits to audit partner rotation. Moreover, using a proxy for mandatory audit partner rotation for U.S. firms who switch audit firms, Litt, Sharma, Simpson, and Tanyi (2014) find lower financial reporting quality, measured using discretionary accruals to meet-or-beat targets and a lower frequency of issuing 3 going concern opinions, following an estimated audit partner rotation. Thus, current U.S. evidence examining the effectiveness of partner rotation for U.S. publicly-listed firms generally suggests that the fresh look reduces audit quality, supporting the view that audit partner rotation is bad for audit quality as it results in a loss of client-specific knowledge or industry expertise. Fitzgerald, Omer, and Thompson (2014) also examine the effects of audit partner rotation in the U.S. but among not-for-profit organizations. While they do not find any evidence that the likelihood of reporting internal control deficiencies increases in the year of the partner change, they do find some evidence that the likelihood of reporting internal control deficiencies increases in the second year following the partner change. In addition, there have been several international studies examining the effects of partner rotation in settings where audit partner data is publicly disclosed (e.g., Australia, China, Germany, Taiwan); however, these studies provide mixed evidence concerning the effects of partner rotation (e.g., Carey and Simnett 2006; Chi and Huang 2005; Chen, Lin, and Lin 2008; Chi, Huang, Liao, and Xie 2009; Gold, Lindscheid, Pott, and Watrin, 2012; Azizkhani, Monroe, and Shailer 2012; Firth, Rui, and Wu 2012; Lennox, Wu, and Zhang 2014) and it is uncertain as to whether the findings from these various international settings generalize to the unique features of the U.S. regulations and capital markets. In this paper, we investigate the effects of audit partner rotation among U.S. public firms. To identify auditor rotations in the United States, we turn to an unreported fact in the accounting literature that audit partners are copied on correspondences between issuers and the Securities and Exchange Commission (SEC). As stipulated by SOX, the SEC’s Division of Corporation Finance (DCF) now reviews each issuer’s filings at least once every three years, and in practice, reviews are being conducted on average every two years (SEC 2013). As a result, a majority of firms receive SEC comment letters at least once every two years. When issuers respond to SEC comment letters, they sometimes copy their audit partner in their 4 response letters and hence, we identify partner rotations by examining those firms receiving SEC comment letters where different audit partners are copied in adjacent years. This framework yields 220 U.S. audit partner rotations of 205 public-company clients from 2006 to 2013. Bamber and Bamber (2009) highlight that the effects of audit partner rotation are likely to be modest and empirical tests must be well-specified in order to detect “an economically material effect, should one exist”. In addition, their discussion highlights the importance of analyzing changes in audit quality surrounding the actual audit partner rotation (rather than using partner tenure which often lacks cross-sectional variation) and using sharper measures of audit quality (rather than the typical discretionary accrual and earnings response coefficient measures) when examining the effects of audit partner rotation. Thus, our analyses are designed with these considerations in mind, and we use measures of financial reporting quality that we believe will be influenced by the incoming audit partner to directly investigate changes in such measures surrounding the partner rotation. First, if the incoming partner does notice errors or inconsistencies with Generally Accepted Accounting Principles (GAAP) and Generally Accepted Auditing Standards (GAAS) then the frequency of material restatements (e.g., Form 8-K item 4.02) or amendments to previously issued financial statements (e.g., “10-K/A”s, “10-Q/A”s) should increase upon audit partner rotation. Moreover, the restatements and amendments should pertain to the prior engagement partner’s financial statements. Second, a significant part of the audit process is to enforce impairment standards and that the client is indeed recording timely impairments. Hence, if the prior audit partner has become complacent with regards to assessing impairment, the incoming partner will likely have concerns over the impairment of assets. Hence, we use material restatements, financial statement amendments, and write-downs of impaired assets to 5 examine the effects of audit partner rotation, as we believe that these measures will reflect the enhanced efforts and objectivity—should these benefits exist—of the incoming partner. Contrary to prior research, we provide initial evidence among U.S. publicly-listed companies suggesting that audit partner rotation in the U.S. supports a fresh look at the audit engagement. Specifically, we find evidence in the first two years following audit partner rotations suggesting that the new audit partner is responsible for substantial increases in material restatements and write-downs of impaired assets. We find that material restatements increase by approximately 129 to 135 percent, and that write-downs of impaired assets increase by one percent of market value. We find that increases in restatements following the partner change relate to asset impairments, deferred taxes, and statement of cash flow classification errors. 1 Moreover, we find that increases in write-downs are evident in settings where impairment standards suggest that assets are impaired. The foregoing increases in restatements and write-downs of impaired assets suggest that new partners may help address the complacence of the former audit partner by bringing a renewed sense of skepticism as well as additional insights and expertise. We also find increases in amendments to previously issued 10-Ks and 10-Qs of approximately 13 to 21 percent; however, these increases appear to be due to the comment letter process. As we cannot separate mandatory versus voluntary rotations, our findings reflect a combination of both mandatory and voluntary audit partner rotations. However, given that audit partner rotation is mandated at least every five years, on average we anticipate that our inferences primarily reflect the effects of mandatory auditor rotations. Conversations with U.S. audit partners from all four Big 4 firms confirm this notion as they suggest that the vast majority of partner changes are due to mandatory rotations, noting that audit firms work to make a five year commitment because the change can be disruptive to the audit process, both 1 We highlight that the increases are not related to fraud restatements. 6 from the clients’ and auditors’ perspectives, and clients do not appreciate unnecessary audit partner rotations. Partner retirements, relocations, medical emergencies, and new public-client responsibilities were stated as the other reasons for audit partner rotation although the audit partners indicated that these rotations are not very common. Hence, it appears that our main inferences are reflective of exogenous rather than endogenous audit partner rotations. We perform a series of robustness analyses to collaborate our main findings. First, the increase in restatements following the new audit partner can relate to errors missed by the former audit partner or errors missed by the new audit partner. Hence, we re-run our analyses by only including restatements that relate to restatements of the former audit partner’s financial statements, finding similar inferences suggesting that the increase in restatements in the first two years of the new audit partner appear to relate to issues missed by the former audit partner and not restatements relating to inexperience on behalf of the new audit partner. Second, we examine whether the audit partner rotations reflect the effects of switching from a non- specialist office to a specialist office. We find that our main inferences hold when only include audit partner rotations that do not involve audit office switches, suggesting that our inferences do not relate to the effects of specialist auditors. Third, we use several different control groups for our analyses to ensure that our main inferences are not a result of the comment letter process or a specific set of control firms. Taken together, the study makes the following main contributions. First, it contributes to the prior literature by providing initial public-company evidence highlighting that partner rotation in the U.S. appears to support a fresh look at the audit engagement. This evidence is based on direct measures of audit quality, including restatements and write-downs. Audit studies that use discretionary accruals as indicators of audit quality should account for the fact that abnormal accruals that arise through transactions such as write-downs may indicate that audit quality is improving instead of the assumption that such an abnormal accrual (in the 7 absolute value) indicates a decrease in audit quality. Second, this study highlights a framework for future research to identify audit partner identities and rotations in the U.S. setting using SEC comment letter correspondences. Third, the study speaks to the recent U.S. debate over audit firm turnover, highlighting that audit firm rotation is not the only solution to obtaining a fresh look for an audit engagement and that the current fresh look mechanism appears to be working to some degree. Lastly, the study’s findings relate to the PCAOB’s recent rulemaking proposals (PCAOB 2009, 2011, and 2013), which propose the disclosure of audit partner names in U.S. audit reports. Our analyses highlight that audit rotation is supports a fresh look in settings where the partners generally believe that they will not be publicly identified as the client’s auditor, and hence, our findings cannot speak to whether including audit partners names in the audit report would “prompt engagement partners to perform their duties with a heightened sense of accountability” (PCAOB 2013). However, contrary to the arguments of the Center for Audit Quality, our findings do suggest that audit partner rotations and audit partner identification does provide meaningful information which would be useful to investors, and hence supports the PCAOB’s proposal to disclose audit partner names in U.S. audit reports. The remainder of this paper is organized as follows. Section 2 summarizes the prior literature and develops the main hypotheses. Section 3 outlines our research design and data. Section 4 reports the results of our empirical analyses, and Section 5 concludes. 2. Prior Literature and Hypothesis Development 2.1 Prior Literature Efforts to improve audits have regularly considered a number of requirements designed to improve audit quality by addressing issues of transparency, accountability, and independence. Recent legislation and proposed regulations have included requirements for audit engagement partners to sign audit reports (PCAOB 2009, 2011, and 2013), for an increase in the frequency 8 of mandatory audit partner rotation in the U.S. (SOX, Section 203), and studies to consider the impact of mandatory audit firm rotation (SOX, Section 207). These three practices: audit partner identification, audit partner rotation, and audit firm rotation, are interrelated issues that have been debated and studied for decades with varying degrees of generalizability because of differing institutional factors of the countries and time periods examined. Audit firm rotation in the United States is endogenous by its voluntary nature, and because the costs and benefits of audit firm rotation differ from audit partner rotation, the net benefits of firm rotation and partner rotation are likely not directly comparable. Nevertheless, audit firm rotation has been studied both because regulators have considered the requirement in order to improve auditor independence and also because audit firm switches are observable. 2 These studies generally find that audit firm tenure improves audit quality, concluding that the costs of audit firm rotation likely outweigh the benefits. However, a notable exception to voluntary audit firm rotation in recent years in the U.S. was the dissolution of Arthur Anderson. Research examining firms switching from Arthur Anderson to other audit firms provides contrary inferences to the foregoing studies, suggesting a significant improvement in financial statement quality when firms switched auditors (e.g., Blouin, Grein, and Rountree 2007). Surveys of auditors concerning audit partner rotation provide conflicting evidence, with some studies providing evidence that audit partner rotation can provide independence and “fresh look” benefits (e.g., Bamber and Iyer 2007; Beasley, Carcello, Hermanson, and Neal 2009) while other research suggests that management may influence the audit partner rotation process (e.g., Cohen et al. 2010) and that partner rotation could actually harm audit quality as incoming partners are more likely to audit firms in unfamiliar industries (e.g., Daugherty et al. 2012) and reduce their time spent on activities related to audit quality (e.g., Winn 2014). 2 Such studies include: DeFond and Subramanyam (1998); Gieger and Raghunandan (2002); Johnson, Khurana, and Reynolds (2002); Myers, Myers, and Omer (2003); GAO (2003); Carcello and Nagy (2004); Mansi, Maxwell, and Miller (2004); Ghosh and Moon (2005); Kaplan and Mauldin (2008). 9 Very few studies have empirically examined audit partner rotation in the United States, primarily because audit partner names are not disclosed, and hence research cannot directly observe audit partner changes separately from audit firm changes. Audit partner signatures allow researchers and investors to observe changes in audit partners when there is no corresponding change in firm, but the audit partner signature can also induce reputational incentive effects on audit partner behavior. For example, Carcello and Li (2013) indicate improved audit quality through a decline in earnings management after the introduction of engagement partner signatures in the United Kingdom. To proxy for audit partner changes in the United States, where the audit partner changes are not generally observable, Litt et al. (2014) use the fifth consecutive year after an audit firm change to proxy for an audit partner change, finding lower earnings quality following a presumed partner rotation evidenced by an increased propensity to meet or beat earnings forecasts using discretionary accruals and decreased propensity to issue going-concern opinions. Because firms are selected based on having changed audit firms in order to join the sample, these results may lack generalizability. Manry, Mock, and Turner (2008) study audit partner tenure and discretionary accruals, using audit records hand collected from a sample of 90 firms, finding that discretionary accruals decline with partner tenure for small firms, but are not significant for large firms. An issue with both Litt et al. (2014) and Manry et al. (2008) is the use of accruals as the measure of audit quality, which Bamber and Bamber (2009) note are unsatisfying proxies for audit quality. One study that addresses this concern using internal control deficiencies as a measure of audit quality is Fitzgerald et al. (2014) in the United States not-for-profit setting, which also provides limited generalizability to the for-profit sector. Finally, while not looking at audit quality per se, Bedard and Johnstone (2010) use a proprietary sample from a single United States audit firm, and find that audit partners invest a significant amount of additional [...]... 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The Accounting Review 89 (5): 177 5-1 803 Litt, B., D Sharma, T Simpson, and P Tanyi 2014 Audit partner rotation and financial reporting quality Auditing: A Journal of Practice and 31 (1): 5 9-8 6 Liu, L-L., K Raghunandan, and D Rama 2009 Financial restatements and shareholder ratifications of the auditor...time following audit partner rotation, although whether the additional partner time transpires to improved audit quality remains an empirical question Studies of audit partner rotation are facilitated in countries where the audit partner is required to be identified, a factor that intertwines audit partner rotation with audit partner identification Partner identification has led to... α1 NEW_PARTNERi,t + α2 BTMDi,t-1 + α3 INTAi,t-1 + α4 BTMDi,t-1 * INTAi,t-1 (3) + α5 NEW_PARTNERi,t * BTMDi,t-1 + α6 NEW_PARTNERi,t * INTAi,t-1 + α7 NEW_PARTNERi,t * BTMDi,t-1 * INTAi,t-1 + Year Fixed Effects + εi,t , 3 In robustness tests, we find our main inferences are robust to requiring control firms to also have year-to-year SEC comment letters 4 All difference-in-differences inferences in the... of asset write-downs and goodwill impairments for firm i for fiscal year t scaled by its market capitalization as of fiscal t-1's year-end We multiply by -1 so that write-downs are positive Negative write-downs were set to zero and positive writedowns were winsorized at the 99%th quantile (-( wdpt + gdwlipt)/(cshot-1*prcc_ft-1)); and, [Var]_dt = The value of this variable for firm i minus the value for... long auditor tenure impair earnings quality? Contemporary Accounting Research 25 (2): 42 5-4 45 Chi, W., and H Huang 2005 Discretionary accruals, audit- firm tenure and audit- partner tenure: Empirical evidence from Taiwan Journal of Contemporary Accounting and Economics 1 (1): 6 5-9 2 , , Y Liao, and H Xie 2009 Mandatory audit partner rotation, audit quality, and market perception: Evidence from Taiwan Contemporary... discretion Managerial Auditing Journal 23 (2): 16 1-1 86 Firth, M., O Rui, and X Wu 2012 Rotate back or not after mandatory audit partner rotation? Journal of Accounting and Public Policy 31 (4): 35 6-3 73 Fitzgerald, B., T Omer, and A Thompson 2014 Audit partner tenure and reported internal control deficiencies: U.S evidence from the not-for-profit sector Working Paper, University of Illinois at Urbana-Champaign . write-downs. Audit studies that use discretionary accruals as indicators of audit quality should account for the fact that abnormal accruals that arise through transactions such as write-downs may indicate. audit quality. One study that addresses this concern using internal control deficiencies as a measure of audit quality is Fitzgerald et al. (2014) in the United States not-for-profit setting,. in audit quality surrounding the actual audit partner rotation (rather than using partner tenure which often lacks cross-sectional variation) and using sharper measures of audit quality (rather