Contemporary Accounting Research Vol. 19 No. 4 (Winter 2002) pp. 637–60 © CAAA Audit-Firm Tenure and the Quality of Financial Reports* VAN E. JOHNSON, Georgia State University INDER K. KHURANA, University of Missouri-Columbia J. KENNETH REYNOLDS, Louisiana State University Abstract This study examines whether the length of the relationship between a company and an audit firm (audit-firm tenure) is associated with financial-reporting quality. Using two proxies for financial-reporting quality and a sample of Big 6 clients matched on industry and size, we find that relative to medium audit-firm tenures of four to eight years, short audit-firm tenures of two to three years are associated with lower-quality financial reports. In contrast, we find no evidence of reduced financial-reporting quality for longer audit-firm tenures of nine or more years. Overall, our results provide empirical evidence pertinent to the recurring debate regarding mandatory audit-firm rotation — a debate that has, to date, relied on anecdotal evidence and isolated cases. Keywords Audit-firm tenure; Audit quality; Financial-reporting quality; Mandatory auditor rotation Condensé Les auteurs étudient l’incidence de la durée du mandat des cabinets d’expertise comptable sur la qualité de l’information financière. Les rapports financiers sont l’un des principaux outils de communication de l’information financière aux tiers. Il existe une asymétrie de l’information et des facteurs de motivation conflictuels entre les gestionnaires qui ont la res- ponsabilité de préparer les rapports et les utilisateurs de ces rapports, et la vérification des états financiers contribue à réduire l’incidence de ces conflits en améliorant la qualité de l’information communiquée par les gestionnaires. Pourtant, la vérification n’améliore la qualité de l’information que si elle réduit l’occurrence d’inexactitudes dans les états financiers. La capacité de la vérification de réduire ces inexactitudes est généralement considérée comme une fonction dépendant de deux variables : la capacité du vérificateur de déceler les inexactitudes (soit la compétence du vérificateur) et son comportement subséquent, c’est-à- dire le fait qu’il s’assure que les correctifs nécessaires soient apportés aux inexactitudes décelées (soit le comportement de communication du vérificateur). *Accepted by Dan Simunic. We thank Dick Dietrich, Mike Ettredge, Jere Francis, Tom Linsmeier, Earl Wilson, two anonymous reviewers, participants at the 1999 American Accounting Associa- tion midyear auditing section meeting, the central states accounting research workshop, and workshop participants at University of Illinois, University of Kansas, University of Missouri, and University of North Texas for their valuable comments on this paper. 638 Contemporary Accounting Research CAR Vol. 19 No. 4 (Winter 2002) L’on a souvent supposé que la durée des mandats des cabinets d’expertise comptable avait des répercussions négatives sur la compétence des vérificateurs, leur comportement de communication ou les deux. La durée du mandat est la période pendant laquelle est maintenue la relation entre une société et ses vérificateurs. Ceux qui débattent de la question de la rotation des vérificateurs invoquent des arguments antagonistes relatifs aux conséquences positives ou négatives de relations prolongées entre une société et ses vérificateurs. En apparence, les arguments des deux camps se défendent, bien que la majorité des preuves invoquées jusqu’à maintenant dans les discussions tiennent essentiellement de l’anecdote et de la conjecture. Il existe peu de données empiriques relatives à l’incidence de la durée des mandats des cabinets d’expertise comptable sur l’information financière. La présente étude vise à combler ce vide et à contribuer à faire avancer le débat sur la durée des mandats des cabinets d’expertise comptable. Dans leur analyse empirique, les auteurs classent la durée des mandats des cabinets d’expertise comptable selon qu’elle est courte, moyenne ou longue. Suivant leur définition, un mandat de courte durée est une relation vérificateur-client de deux à trois ans, un mandat de durée moyenne, une relation de quatre à huit ans, et un mandat de longue durée, une relation de neuf ans ou plus ; les tests effectués par les auteurs ne sont cependant pas sensibles aux autres découpages possibles. Les auteurs formulent l’hypothèse selon laquelle les durées courte et longue seraient toutes deux associées à une qualité d’information financière inférieure à celle qui correspond à la durée moyenne. Les auteurs s’attendent à ce que les mandats de courte durée aient une incidence négative sur la qualité de l’information, principalement parce que la société faisant l’objet de la vérification est peu familière aux vérificateurs. Bon nombre d’études ont invariablement démontré que les vérificateurs ont tendance à fournir un travail légèrement moins efficace au cours des deux premières années de leur mandat qu’au cours des années subséquentes. Outre cette lacune, le vérificateur peut également faire face à différents facteurs de motivation durant les premières années du mandat, comparativement aux années subséquentes. Il devra, en effet, trouver un compromis entre le désir de tirer parti des possibilités commerciales qu’offre le client et celui de préserver la réputation du cabinet et d’éviter les litiges onéreux. Les facteurs de motivation initiaux du vérificateur peuvent être partiellement modifiés par l’impératif du maintien de la relation avec le client pendant la période nécessaire au recouvre- ment des coûts lorsqu’il y a sous-facturation systématique des services (ce que l’on appelle la pratique du leurre-prix), au cours des premières années du mandat, dans le but d’attirer le client. Les auteurs s’attendent à ce que les mandats de longue durée aient une incidence négative sur la qualité de l’information, principalement en raison de problèmes de motivation. Plus le vérificateur accumule d’expérience en travaillant auprès du client, moins il est sensible au risque de litige ou de préjudice à la réputation et plus ses motivations s’orientent vers la fidélisation du client et ce qu’il peut rapporter. De plus, le vérificateur risque de devenir moins vigilant dans la détection des inexactitudes en raison de la confiance qu’il a cultivée au fil de ses relations prolongées avec le client. Pour déterminer l’incidence de la durée des mandats d’un cabinet d’expertise comptable sur la qualité de l’information financière, les auteurs évaluent cette qualité à l’aide de deux mesures. Premièrement, ils utilisent la valeur absolue des ajustements imprévus à titre de sub- stitut à l’ampleur des interventions de la direction dans les résultats déclarés. La comptabilité Audit-Firm Tenure and the Quality of Financial Reports 639 CAR Vol. 19 No. 4 (Winter 2002) d’exercice donne aux gestionnaires une grande latitude dans la détermination des résultats. Les recherches précédentes ont fait ressortir que cette latitude peut être exploitée de façon opportuniste, ce qui risque de réduire la qualité des rapports financiers. En l’absence d’attentes précises a priori en ce qui a trait aux facteurs de motivation des gestionnaires, les chercheurs ont généralement utilisé la valeur absolue des ajustements imprévus pour cerner le comportement interventionniste de la direction. Deuxièmement, les auteurs étudient la mesure dans laquelle les ajustements d’un exercice persistent dans les résultats de l’exercice subséquent. L’utilisation opportuniste des ajustements aura tendance à augmenter la portion transitoire des résultats de l’exercice, ce qui en diminue la persistance. Les auteurs bornent leur analyse empirique aux clients des Six Grands cabinets d’expertise comptable, étant donné que les recherches précédentes ont révélé d’importantes différences entre les vérificateurs des Six Grands cabinets et les autres vérificateurs. À chacun des cabinets appartenant au groupe de ceux dont la durée des mandats est courte (le plus petit des trois groupes), les auteurs associent des cabinets de taille comparable et du même secteur, appartenant aux groupes de ceux dont la durée des mandats est moyenne et longue, afin d’éliminer les différences dans la qualité de l’information financière attribuables à des facteurs autres que la durée des mandats. En utilisant les échantillons finals résultant des combinaisons de 2 463 pour le test de la valeur absolue des ajustements et de 2 280 pour le test de la persistance des ajustements, ils constatent uniformément que les mandats de courte durée des cabinets d’expertise comptable sont associés à des rapports financiers de qualité inférieure. En revanche, pour les deux tests, les auteurs ne relèvent rien qui permette de conclure à une diminution de la qualité de l’information financière pour les mandats de durée plus longue. Les résultats obtenus par les auteurs viennent enrichir le fonds croissant des travaux sur la qualité de la vérification. En utilisant un échantillon de sociétés clientes des services de vérification des Six Grands cabinets d’expertise comptable, les auteurs démontrent que l’on peut observer des variations de qualité de l’information financière — et, par déduction, des variations de qualité de la vérification — dans les missions de vérification exécutées par les Six Grands. Les résultats augmentent aussi la documentation relative à la qualité de l’infor- mation financière. Dans l’optique selon laquelle les rapports financiers sont le résultat du travail effectué de concert par la société et ses vérificateurs, les auteurs démontrent qu’il pourrait être important de prendre en considération le vérificateur dans les prochaines analyses de la qualité des rapports financiers. Enfin, les auteurs abordent la question de la rotation des vérificateurs dans une perspective empirique. Leurs constatations viennent confirmer les échos selon lesquels la qualité de l’information est inférieure pendant les premières années de la relation vérificateur-client, mais elles ne permettent pas de conclure que, dans les années subséquentes, les rapports sont de qualité inférieure, tout au moins sous le régime de réglementation actuel. 1. Introduction Congress and regulators periodically turn their attention to the role that auditors play in the financial-reporting process (U.S. Governmental Accounting Office (GAO) 1996). During these periods, which often follow high-profile frauds or bankruptcies, the closeness of audit-firm–client relationships is frequently scrutinized 640 Contemporary Accounting Research CAR Vol. 19 No. 4 (Winter 2002) (cf. McClaren 1958; Winters 1976; United States Senate (Metcalf committee) 1976; Hoyle 1978; GAO 1991). Also during these periods, mandatory audit-firm rotation is offered as a possible means of improving the quality of financial reporting. 1 There is limited empirical evidence regarding the relationship between audit- firm tenure (the length of the auditor–client relationship) and financial-reporting quality. Thus, it is not clear whether the problem that mandatory rotation is intended to solve is real or illusory. In this paper, we examine whether short and long audit tenures are associated with the issuance of lower-quality financial reports using two proxies for financial-reporting quality. First, we use the absolute value of unexpected accruals to proxy for the extent of management interventions in reported earnings numbers. Second, we investigate the extent to which current accruals persist into earnings in the subsequent year as a proxy for the quality of accruals reported in current period earnings. Based on an industry- and size-matched sample of publicly traded companies audited by Big 6 audit firms, our results suggest that short audit-firm–client rela- tionships (two to three years) are associated with lower-quality financial reports relative to medium audit-firm–client relationships (four to eight years). We observe evidence of greater management intervention in reported earnings and lower-quality accruals (current accruals that are less likely to persist in one-period-ahead earn- ings) for short audit-firm tenures. In contrast to the results for short audit-firm tenures, the same tests do not pro- vide evidence that long audit-firm–client relationships (nine years or longer) are associated with reduced financial-reporting quality relative to medium audit-firm– client relationships. We are unable to detect statistically significant differences in management interventions in reported earnings or accrual quality for long audit- firm tenures. Our results provide needed empirical evidence pertinent to the recurring debate regarding mandatory audit-firm rotation — a debate that has, until recently, relied on anecdotal evidence and isolated cases. This study, when combined with other recent research, such as Dopuch, King, and Schwartz 2001 and Geiger and Raghunandan 2002, can be used to move the debate forward. Our results document lower financial-reporting quality for short audit tenures, but not for long audit ten- ures. It is important to note that our results are based on the current regulatory regime, and cannot be generalized to a regime in which audit-firm rotation is man- datory. Under such a regime, where the horizon for the relationship between the client and the firm is known, auditor incentives may differ significantly. Our results also add to the growing body of literature on audit quality. Several prior studies have investigated whether Big 6 auditors provide higher-quality audits than non–Big 6 auditors (cf. DeAngelo 1981; Teoh and Wong 1993; Becker, DeFond, Jiambalvo, and Subramanyam 1998; Francis, Maydew, and Sparks 1999). We investigate audit tenure, a factor that varies within auditor size class rather than across auditor size classes. Given the relative dominance of the Big 6 in the audits of publicly listed companies, our study highlights quality differences within the Big 6 class. More importantly, we demonstrate that auditor tenure may be an additional variable influencing financial-reporting outcomes. Our results are also consistent Audit-Firm Tenure and the Quality of Financial Reports 641 CAR Vol. 19 No. 4 (Winter 2002) with prior work (e.g., Knapp 1991; O’Keefe, King, and Gaver 1994) that has iden- tified the importance of client-specific knowledge to audit quality. The remainder of the paper is organized as follows. In section 2, we develop our hypotheses. In section 3, we discuss specific research design issues associated with the methodology used, and describe sample selection. Results are presented in section 4, and conclusions are presented in the final section of the paper. 2. Hypotheses development Financial reports are a principal means of communicating financial information to those outside an entity. Given the existence of information asymmetries and the potential for conflicts of interest between company management and outside users of financial information, an audit of financial reports by a third party (or alternative monitoring arrangements) can enhance the quality of the financial information reported by management (Dopuch and Simunic 1982; Watts and Zimmerman 1986) and improve the quality of information that investors have about the value of traded securities (Ronnen 1996). Recognizing the importance of auditing in the financial-reporting process, Antle and Nalebuff (1991) suggest that financial statements should be viewed as a joint statement from the audit firm and company management. In general, the abil- ity of the audit function to enhance financial-reporting quality is dependent on both the likelihood that the audit will detect a material misstatement or omission (henceforth auditor competence) and the auditor’s behavior subsequent to the detection of a material misstatement (henceforth, auditor-reporting behavior). If material misstatements are detected and corrected (or revealed), the quality of the financial report is improved. Alternatively, a failure to detect material misstate- ments or a failure to require that they be corrected before issuing a clean audit report would not improve the quality of the financial report. Prior work has documented that Big 5/6/8 audit firms are associated with superior financial reporting outcomes (cf. Teoh and Wong 1993; Beasley and Petroni 1996; Becker et al. 1998; Francis et al. 1999). The explanations offered for the superiority of the larger firms generally focus on advantages in (1) perceived competence (by virtue of their heavy spending on auditor-training facilities and pro- grams), and (2) perceived independence in reporting (by virtue of their size and large portfolio of clients, which presumably gives them the financial strength to stand up to, or walk away from, a client if necessary). We investigate the potential effects of audit tenure on financial-reporting quality by considering how changes in auditor knowledge and incentives may impact financial-reporting quality as audit tenure changes. Short audit-firm tenure Knowledge is a critical input to the auditor’s ability to detect material misstatements. A great deal of knowledge necessary to the audit (such as knowledge of the client’s accounting system and internal control structure) is client-specific. 2 Although auditors use other types of knowledge (such as general knowledge and industry knowledge) to produce an audit, the importance of client-specific knowledge 642 Contemporary Accounting Research CAR Vol. 19 No. 4 (Winter 2002) creates a significant learning curve for new auditors (Knapp 1991) and results in significant start-up costs (DeAngelo 1981). Less client-specific knowledge in the early years of an engagement may result in a lower likelihood of detecting material misstatements, thereby giving auditors a comparative advantage in detecting errors over time as they obtain a deeper understanding of the client’s business (Beck, Frecka, and Solomon 1988). 3 An initial lack of client-specific knowledge on an engagement may not be associated with lower financial-reporting quality if it is possible to overcome the lack of knowledge by employing additional effort on new engagements. 4 However, knowledge and effort may not be perfect substitutes for one another. Arrunada and Paz-Ares (1997) suggest that there may be a technological limit to the replacement of client-specific assets; that many, if not most, of them cannot be replaced immedi- ately. Thus, financial-reporting quality is expected to increase as client-specific knowledge increases in the early years of an audit engagement. Prior research also suggests that auditor incentives may differ in the early years of an audit engagement. Generally, auditor incentives are traded off between the auditor’s desire to maintain and profit from the auditor–client relationship (Chow and Rice 1982; Citron and Taffler 1992) and the desire to protect the firm’s reputation (brand name) and to avoid costly litigation (Balachandran and Nagara- jan 1987; DeJong 1985; Melumad and Thoman 1990; Narayanan 1994; Nelson, Ronen, and White 1988). DeAngelo (1981) noted that client-specific assets (such as knowledge) along with transactions costs allow the incumbent auditor to earn quasi rents from maintaining existing client relationships. Financial-reporting quality could be reduced in early engagement years if the existence of quasi rents skews the auditor’s incentives toward maintaining the client relationship. Geiger and Raghunandan (2002) suggest that the competitive practice of low balling may further skew the auditor’s incentives and cause the auditor to employ less effort or be more accommodating to the client in the early years of an engagement in an attempt to limit losses on the current engagement and to ensure a repeat engagement. The above discussion leads to the following hypothesis (stated in the alternative form). H YPOTHESIS 1. The quality of financial reports issued by a company will be lower when the audit firm’s tenure is short than when the audit firm’s tenure is medium. Long audit-firm tenure Most arguments surrounding audit tenure and incentives have suggested that ceteris paribus, over time, the auditor’s incentives shift toward maintaining and profiting from the client and the auditor becomes less concerned with litigation relating to the client. Accordingly, the auditor may become less objective and apply less effort toward the detection of material misstatements (Hoyle 1978; Arrunada and Paz- Ares 1997). 5 Given the increased client-specific knowledge obtained from multiple repeat engagements, some reduction in effort would be expected without threaten- ing audit quality. However, arguments regarding the detrimental effects of long Audit-Firm Tenure and the Quality of Financial Reports 643 CAR Vol. 19 No. 4 (Winter 2002) audit-firm tenures implicitly assume that reductions in effort will exceed an opti- mal level. Shockley (1981) characterizes this situation as the audit firm having a “learned confidence” in the client as a result of the long relationship and suggests that this learned confidence may result in the audit firm using less strenuous and less innovative audit procedures. 6 These arguments lead to the following hypothesis. H YPOTHESIS 2. The quality of financial reports issued by a company will be lower when the audit firm’s tenure is long than when the audit firm’s tenure is medium. The available empirical evidence regarding both hypotheses is limited. After investigating 406 alleged cases of audit failures involving Securities and Exchange Commission (SEC) clients, an AICPA quality control committee concluded that audit failures are 3 times more likely in the first 2 years of an engagement than in subsequent years (AICPA 1992). Two studies examining lawsuits involving audi- tors found that audit failures are more common when audit tenure is 3 years or less (St. Pierre and Anderson 1984; Stice 1991). Knapp (1991) varied audit tenure in an experimental setting and found that experienced audit committee members per- ceived that auditors with a 5-year tenure were more likely to detect errors than auditors in the first year of an engagement or auditors with an audit tenure of 20 years. Most recently, Geiger and Raghunandan (2002) found that long-tenure audi- tors were more likely than short-tenure auditors to issue going-concern opinions for clients that subsequently declared bankruptcy. A series of studies examining governmental audits consistently documented a negative correlation between audit quality (measured as compliance with audit standards) and audit tenure (cf. Deis and Giroux 1992; Giroux, Deis, and Bryan 1995; Deis and Giroux 1996; Copley and Doucet 1993). To date, there is limited empirical evidence regarding the associa- tion between short or long audit tenures and the quality of financial information issued by publicly traded companies. This study is intended as a first step toward providing such evidence. 3. Method To investigate whether audit-firm tenure is associated with financial-reporting quality, we use two empirical proxies for financial-reporting quality. These two proxies, the measurement of audit-firm tenure, the control variables used in the investigation, and the sample selection methods are discussed below. Proxies for financial-reporting quality Absolute value of unexpected accruals Dechow (1994) highlights the potential timing and matching problems associated with the use of cash flows as a short-term performance measure. Accrual-based earnings under generally accepted accounting principles (GAAP) contain accruals and deferrals to overcome the inherent limitations of cash flows. However, GAAP 644 Contemporary Accounting Research CAR Vol. 19 No. 4 (Winter 2002) also affords management substantial flexibility in reporting accrual-based earnings. Prior research has noted that management may use this flexibility to opportunistically manage earnings. Such opportunistic use of accruals by management will result in lower-quality financial reports. Several papers have used unexpected accruals as a proxy for management’s active intervention in reporting earnings. The decision to use directional unex- pected accruals or the absolute value of unexpected accruals is driven by the nature of the study; specifically, whether there is an a priori expectation regarding manage- ment’s incentives. For example, Jones (1991) expected that import relief investigations would motivate managers to decrease earnings during the investigation period. Accordingly, the tests were designed to detect significant income-decreasing unex- pected accruals. Teoh, Welch, and Wong (1998) hypothesized that upcoming stock issues would motivate managers to prefer higher income levels. They designed tests to detect significant income-increasing unexpected accruals. When a researcher has an a priori expectation of management’s incentives, directional unexpected accruals represent a more powerful test. Alternatively, several papers have examined the impact of factors that are not associated with a clear directional management incentive. For example Warfield, Wild, and Wild (1995) examine the association between managerial ownership and earnings management. Klein (2002) examines the association between corporate governance mechanisms and earnings management. In each study, the data is pooled over a long time period. Because they do not have a priori directional expectations regarding management’s motivation for particular firm-year observa- tions, both Warfield et al. and Klein use the absolute value of unexpected accruals to capture management’s intervention behavior, noting that the magnitude of dis- cretionary accrual adjustments serves to measure the extent to which managers intervene in reporting accounting earnings numbers. Similarly, Bartov, Gul, and Tsui (2000) interpret a positive association between the absolute value of a firm’s unexpected accruals and the likelihood of receiving a qualified audit report as evi- dence that unexpected accruals capture the extent of earnings management behavior. Following prior research, we use the absolute value of unexpected accruals as a proxy for financial reporting quality. 7 The magnitude of absolute value of unex- pected accruals measures a company’s success in managing earnings either up or down, as needed, depending on year-specific situations (Reynolds and Francis 2000). In general, using unexpected accruals as a proxy for financial-reporting quality is a joint test of earnings management and the model of expected accruals used. 8 The persistence of the accrual components of earnings As a second proxy for financial-reporting quality, we examine the relationship between current-period accruals and future income. The time series properties of earnings have been studied extensively in accounting (cf. Freeman, Ohlson, and Penman 1984; Sloan 1996). One approach used in prior research is to estimate the following regression equation Earnings t + 1 = α 0 + α 1 Earnings t + ∈ t + 1 (1). Audit-Firm Tenure and the Quality of Financial Reports 645 CAR Vol. 19 No. 4 (Winter 2002) The slope coefficient, α 1 , represents the extent to which earnings performance in time t is expected to persist in subsequent-period earnings. A slope coefficient equal to zero suggests that current-period earnings are purely transitory whereas a slope coefficient equal to one suggests that earnings follow a random walk. Prior research has generally found the slope coefficient to be between zero and one, sug- gesting that earnings are mean reverting. The extent to which current-period earnings persist or are purely transitory (as reflected by the magnitude of the slope coefficient α 1 ) is not independent of the accounting choices of management. The opportunistic use of accruals tends to reduce the slope coefficient, while the use of accruals to signal private information tends to increase it. As an example, consider a manager with private information that collection periods are increasing and several large customers are in financial distress. This information suggests that future earnings may be negatively affected. The manager may signal this information by increasing the size of the reserve for doubtful accounts, or he or she may choose to postpone any adjustment to the net realizable value of receivables. The two choices generally have quite different effects on the extent to which current-period earnings persist in the future, with the former choice resulting in a larger slope coefficient than the latter. Measurement of audit-firm tenure Audit-firm tenure is the length of the audit-firm–client relationship as of the fiscal year-end covered by the audited financial statements. 9 Auditor data are available on the 1995 annual COMPUSTAT files beginning in 1976. Accordingly, the initia- tion date of the auditor–client relationship is censored on the left in some cases because we do not have auditor data before 1976. Firms that are added to the COMPUSTAT data base over time are included in the sample subject to the con- straint that audit tenure can be computed accurately (i.e., if the initiation date of the auditor–client relationship is available, or if the company has had the same auditor for nine or more years). Following prior research (e.g., St. Pierre and Anderson 1984; Stice 1991), we define audit tenure as short when the same auditor has audited the financial state- ments of a company for two or three years (as discussed below, we omit the year of the auditor change to control for potential confounds). 10 We define audit tenure as long when the same auditor has audited the financial statements of a company for nine or more years. 11 On the basis of the definition of short and long tenure, we define audit tenure as medium when the same auditor has audited the financial statements for four to eight years. However, given the data-availability constraint on the initiation date of the auditor–client relationship and our definition of audit tenure (short is two to three years, medium is four to eight years, and long is nine or more years), we can accurately (without measurement error) classify observa- tions as of 1986 (the beginning of our sample period). Sample selection The set of initial candidates for inclusion in the sample was all U.S. corporations on the COMPUSTAT full coverage and research files that did not change fiscal 646 Contemporary Accounting Research CAR Vol. 19 No. 4 (Winter 2002) year-ends in the 10-year test period 1986–95. We then deleted individual firm-year observations for the following reasons: 1. Data considerations : Observations were deleted if (a) financial data were not available on COMPUSTAT; or (b) the auditor could not be determined from the annual COMPUSTAT tapes. 12 2. Auditor considerations : Observations were deleted if (a) the company was not audited by a Big 6 auditor; (b) the company received a modified audit opinion within two years before or after the fiscal year-end; or (c) the company changed auditors within one year before or after the fiscal year-end. These screens resulted in 11,148 firm-year observations. 13 The screens relat- ing to data considerations are obvious; however, the screens relating to auditor considerations warrant some discussion. First, we restricted our investigation to Big 6 auditors. Prior research suggests that audit quality and perceptions of audit quality differ for companies audited by Big 6 auditors versus those audited by non–Big 6 auditors (Becker et al. 1998; Francis et al. 1999; Teoh and Wong 1993). As discussed previously, restricting our sample to Big 6 auditors avoids a potential confound and allows us to study an observable auditor characteristic that varies within a particular size class. The screens relating to opinion qualifications and auditor changes are also used to avoid potentially confounding factors. Prior research has documented that the market’s responsiveness to earnings announce- ments is significantly lower in periods before and after the issuance of qualified audit reports (Choi and Jeter 1992; Subramanyam and Wild 1996). Similarly, prior research has found that auditor behavior may differ in the year before and after an auditor change (DeFond and Subramanyam 1998). In an attempt to enhance our ability to attribute differences in financial report- ing quality to audit-firm tenure, we also match on industry and size. Matching on industry can rule out alternative explanations because companies from the same industry are more likely to face similar supply and demand uncertainties, to engage in similar transactions, and to use similar accounting methods (Teoh and Wong 1993). Prior research has conjectured that the ability of companies to use discre- tionary accruals in financial reporting (Francis et al. 1999) may vary across industries. Matching on company size can rule out the alternative explanation of auditor independence because larger clients generally represent a greater potential loss of revenue to the auditor if the client switches to a different auditor. Prior research (Haskins and Williams 1990; Krishnan 1994) has also documented a neg- ative relation between client size and auditor switching. We selected the industry- and size-matched sample in the following manner. Companies audited by short-tenure audit firms were selected and matched with companies audited by medium-tenure and long-tenure audit firms in the same fis- cal year and four, three, and two-digit Standard Industrial Classification (SIC) code, depending on data availability, and that are closest in size (defined in terms of book value of total assets). The sample is further restricted to exclude observa- tions falling in the extreme 1 percent of the entire distribution of variables used to test Hypothesis 1 and Hypothesis 2. This procedure yielded a matched sample of [...]... capital/total assets) + 1.4*(retained earnings/total assets) + 3.3*(earnings before interest and taxes/total assets) + 0.6*(market value of equity/book value of total debt) + 1.0*(sales/total assets) BETA is the value-weighted beta estimated over the fiscal year ROA is the ratio of operating income to total assets AGE is the number of years since listing date ∆CFO is the change in operating cash flows scaled... to those of clients with medium -tenure auditors Like the evidence on the unexpected accruals, this result is also inconsistent with the prediction under Hypothesis 2 We are unable to find evidence of reduced financial-reporting quality associated with long audit-firm tenures CAR Vol 19 No 4 (Winter 2002) Audit-Firm Tenure and the Quality of Financial Reports 653 Sensitivity analysis A further analysis is... We also changed the cutoff for medium to 2 and 4 years Again, our primary result of lower financial-reporting quality for the short -tenure group relative to the medium -tenure group was unaffected by the change in cutoff dates to 4 years However, the decline in financial-reporting quality of the shorttenure group relative to the medium -tenure group was not significant when the CAR Vol 19 No 4 (Winter 2002) ... insignificant (p-value > 0.10) We also changed the cutoff for medium to 2 and 4 years Again, our primary result of lower financial reporting quality for the short -tenure group relative to the medium -tenure group was unaffected by the change in cutoff dates to 4 years However, the decline in financial reporting quality of the short -tenure group relative to the mediumtenure group was not significant when the cutoff... assets GROWTH is the one-year growth in assets ∆ACQN is the change in acquisition expenditures scaled by assets ∆TIE is the change in times interest earned scaled by assets ∆FIN is the change in new financing scaled by assets SI is one if a firm reported a special item, zero otherwise CAR Vol 19 No 4 (Winter 2002) Audit-Firm Tenure and the Quality of Financial Reports 649 4 Empirical results Level of. .. to three years of audit-client relationship † Four to eight years of audit-client relationship ‡ Nine or more years of audit-client relationship § Significantly different from the medium group ( p-value < 0.01) MB is the ratio of the market-to-book value of common equity SIZE is the total assets in millions of dollars LEV is the ratio of total liabilities to total assets FC is the Altman-Z computed as... years The lack of significance may be partially attributed to the small sample size in the short -tenure group as a result of a change in the cutoff date 5 Conclusions The research question in this study is whether audit-firm tenure is related to financialreporting quality An audit of financial reports by a third party can enhance the quality of the financial information reported by management (Dopuch and. .. 657 16 The elements of the Z-score with their associated weightings (in parentheses) are as follows (Altman and McGough 1974): working capital/total assets (1.2), retained earnings/total assets (1.4), earnings before interest and taxes/total assets (3.3), market value of equity/book value of total debt (0.6), and sales/total assets (1.0) A lower Zscore indicates greater financial distress 17 We also reestimated... longtenure group The effect is to make the long- and medium -tenure groups more alike, and to reduce the likelihood of detecting the actual difference 19 We also reestimated (5) separately for the upper and lower half of client size (split at the median values of total assets) The reestimation of (5) shows that the coefficient on [(TAit /Ait − 1)*SHORTit ] remains negatively associated with one-year-ahead... using the log of the age variable (instead of the age variable) as a control variable, with results essentially the same as those reported Analysis was also performed using the absolute value of operating cash flows rather than the signed cash flows as a control variable and results were similar to those reported in the paper CAR Vol 19 No 4 (Winter 2002) Audit-Firm Tenure and the Quality of Financial Reports . financial-reporting quality associated with long audit-firm tenures. Audit-Firm Tenure and the Quality of Financial Reports 653 CAR Vol. 19 No. 4 (Winter 2002) Sensitivity analysis A further analysis. to the properties of accruals used as proxies for financial-reporting quality in this study. Finally, the Audit-Firm Tenure and the Quality of Financial Reports 655 CAR Vol. 19 No. 4 (Winter 2002) proposed. threaten- ing audit quality. However, arguments regarding the detrimental effects of long Audit-Firm Tenure and the Quality of Financial Reports 643 CAR Vol. 19 No. 4 (Winter 2002) audit-firm