779 THE ACCOUNTING REVIEW Vol. 78, No. 3 2003 pp. 779–799 Exploring the Term of the Auditor-Client Relationship and the Quality of Earnings: A Case for Mandatory Auditor Rotation? James N. Myers Linda A. Myers University of Illinois at Urbana-Champaign Thomas C. Omer University of Illinois at Chicago ABSTRACT: In this study, we document evidence on the relation between auditor ten- ure and earnings quality using the dispersion and sign of both absolute Jones-model abnormal accruals and absolute current accruals as proxies for earnings quality. Our study is motivated by calls for ‘‘mandatory auditor rotation,’’ which are based on con- cerns that longer auditor tenure reduces earnings quality. Multivariate results, control- ling for firm age, size, industry growth, cash flows, auditor type (Big N versus non-Big N), industry, and year, generally suggest higher earnings quality with longer auditor tenure. We interpret our results as suggesting that, in the current environment, longer auditor tenure, on average, results in auditors placing greater constraints on extreme management decisions in the reporting of financial performance. Keywords: auditor tenure; earnings quality; audit quality; mandatory rotation. Data Availability: All data used in this study is publicly available. I. INTRODUCTION T he issue of earnings quality and the quality of financial statements in general has been the focus of recent Congressional, regulatory, and financial statement user dis- cussions. Recent events have focused the public’s eye on earnings quality and on audit quality in general. Numerous legislative proposals at federal and state levels would place limits on the maximum length of a given auditor-client relationship. The proposed limits are based on the notion that extended auditor tenure results in auditor complacency about and possibly complicity in the decisions that management makes regarding the pre- sentation of financial results. While the Sarbanes-Oxley Act of 2002 does not impose man- datory rotation on audit firms, it mandates a study of mandatory rotation by the Comptroller General of the United States to be completed within one year of the passage of the Act. We thank Mark Bradshaw, Mark Peecher, Marjorie Shelley, and two anonymous reviewers for their insightful comments. All errors and omissions are our own. Editor’s note: This paper was accepted by Terry Shevlin, Senior Editor. Submitted June 2002 Accepted February 2003 780 Myers, Myers, and Omer The Accounting Review, July 2003 In this study, we document the relation between earnings quality (using absolute, signed, and raw [unsigned] accruals measures as proxies for earnings quality) and auditor tenure. We assert that earnings quality can be used to draw inferences about audit quality. We do not purport to comment on audit quality in the traditional sense—compliance with Generally Accepted Auditing Standards (GAAS). Rather, we claim that when audit quality is high, auditors constrain the extreme (and presumably self-serving) choices that manage- ment would like to make in presenting the financial position of the firm. When audit quality is low, we posit that auditors do not constrain these extreme choices and that in some cases, auditors may even aid management in ‘‘pushing the boundaries’’ of Generally Accepted Accounting Principles (GAAP). 1 Proponents of mandatory rotation express the belief that poor-quality earnings are as- sociated with extended auditor tenure. Poor-quality earnings are problematic because they can mislead investors, resulting in misallocated resources. In its defense, the accounting profession has argued that mandatory rotation increases audit start-up costs and increases the risk of audit failure because the incoming auditor places increased reliance on the client’s estimates and representations in the initial years of an engagement. Over time, auditors can gain firm-specific expertise, which helps them to understand the business and allows them to rely less on management estimates. 2 Managers of firms being audited are also opposed to mandatory rotation because changing auditors is costly. These managers believe that auditors better understand their particular business with experience and man- agers have concerns about whether a new auditor will have the requisite industry expertise and/or will be able to put forth the additional effort required to audit a new client (Dunham 2002). In this paper, we provide evidence on the claim made by proponents of mandatory auditor rotation that the current voluntary rotation system is flawed. Because the push for mandatory rotation stems from the belief that extended auditor tenure impairs auditor in- dependence, we assert that understanding the relation between auditor tenure and earnings quality is central to the debate. That is, the veracity of claims made by proponents about the current system should be central to decisions made by regulators, and of interest to auditors and financial statement users. To our knowledge, this is the first broad cross- sectional study to explicitly consider the relation between auditor tenure and earnings qual- ity as proxied for by measures of accounting accruals. We assume that producing higher- quality earnings is the goal of recent legislative proposals and claim that the extent to which auditor tenure either enhances or inhibits earnings quality should be addressed before leg- islative or regulatory changes impose limits on auditor tenure. Borrowing extensively from previous research that uses accounting accruals as a proxy for earnings quality, we test for an association between auditor tenure and earnings quality for those auditor-client combi- nations where the auditor-client relationship lasts for at least five years. We do this by examining the relation between absolute, signed, and raw values of both Discretionary and Current Accruals and auditor tenure after controlling for other factors expected to affect the distribution of accruals. Although we cannot comment on whether mandatory auditor rotation would improve earnings quality, we do provide evidence inconsistent with the claim that earnings quality 1 For a more thorough discussion of audit quality and auditor independence, see Levitt (2000). 2 For example, while Chairman of the SEC, Wallman wrote that ‘‘[p]eriodically rotating the audit firms of a public company seems contrary to the notion of learning as much as possible about an audit client. It also would appear to be remarkably inefficient.’’ (See Wallman, 1996, 93.) Exploring the Term of the Auditor-Client Relationship 781 The Accounting Review, July 2003 deteriorates with extended auditor tenure under the current voluntary rotation system. After controlling for firm age, size, industry growth, cash flows, auditor type (Big N versus non- Big N), industry, and year, we find that the magnitude of both Discretionary and Current Accruals decline with longer auditor tenure. Further, we find some evidence that longer auditor tenure is associated with less extreme income-increasing accruals. 3 This suggests that as the relationship lengthens, auditors limit management’s ability to use accruals to increase current period earnings. We also find evidence that longer auditor tenure is asso- ciated with less extreme income-decreasing accruals. This suggests that as the relationship lengthens, auditors limit management’s ability to create reserves to manage future earnings. We find this result particularly interesting because income-decreasing earnings management has received a great deal of attention from regulators and the popular press as of late. 4 The remainder of the paper is organized as follows. In Section II, we summarize the arguments supporting and opposing mandatory auditor rotation and develop our hypotheses. We discuss our data and empirical results in Section III, and in Section IV we present our conclusions and the implications of our study. II. HYPOTHESIS DEVELOPMENT Arguments Supporting Mandatory Auditor Rotation Whether auditor rotation should be made mandatory is an issue that has been debated for more than 40 years in the U.S. Proponents of mandatory auditor rotation are generally concerned that auditor independence, and thus audit quality, will decrease with increased auditor tenure. Mautz and Sharaf (1961) suggest that extended auditor-client relationships could have a detrimental affect on auditor independence because an auditor’s objectivity about a client is reduced with the passage of time. Further, the Metcalf Committee states that ‘‘mandatory auditor rotation is a way to bolster auditor independence’’ (U.S. Senate 1976, 21). More recently, regulators suggest a link between auditor tenure and reductions in earnings quality, and allude to mandatory auditor rotation as a possible solution (U.S. Senate 1977; AICPA 1978; Berton 1991; SEC 1994). It has been suggested that decreased auditor independence could lead to auditors’ support for more aggressive accounting choices that ‘‘push the boundaries’’ of GAAP and could ultimately result in a failure to detect material fraud and/or misstatements. Mandatory rotation proponents argue that limiting auditor tenure reduces concerns about deteriorating independence and audit quality. 5 In response to the recent Enron/Anderson audit failure, several bills containing provisions limiting auditor tenure and mandating auditor rotation were proposed in the House and Senate as part of an effort to improve financial reporting and protect investors. 6 3 Specifically, we find a significantly negative association between tenure and Positive Current Accruals in all specifications. We also find a significantly negative association between tenure and Positive Discretionary Ac- cruals when all sample firm-years are included in our analyses, but when we omit firms with extremely positive and negative return on assets, the sign on tenure remains negative but the result is not significant. 4 See, for example, Levitt (1998). 5 Research by Deis and Giroux (1992) suggests a negative relation between auditor tenure and audit quality, consistent with concerns about the current system raised by proponents of mandatory auditor rotation. However, their results may have little bearing on the current debate because their sample includes only small CPA firms and the audit clients represent quasi-governmental entities in the public sector. 6 See, for example, the Integrity in Auditing Act of 2002 (which suggests that auditors should not be considered independent if they have audited a firm for more than seven consecutive years), the Comprehensive Investor Protection Act of 2002 (which suggests that non-independence is a problem when the auditor has consecutively audited a firm’s financial statements for more than four years), and the Truth and Accountability in Accounting Act of 2002 (which states that an auditor should not be considered independent if it has audited a firm’s financial statements for more than seven consecutive years). 782 Myers, Myers, and Omer The Accounting Review, July 2003 Arguments Opposing Mandatory Rotation Opponents of mandatory rotation suggest that along with higher audit costs, an in- creased likelihood of audit failures would result from mandated rotation. New auditors, they argue, lack sufficient knowledge regarding firm-specific risks and, as a consequence, audit failures would likely increase. This argument is consistent with research indicating that a greater proportion of audit failures occur on newly acquired clients (Berton 1991; Petty and Cuganesan 1996) and that auditors’ litigation risk is greater in the early years of an engagement (Palmrose 1986b, 1991). Further evidence on auditor tenure and audit quality is provided by the AICPA’s Quality Control Inquiry Committee of the SEC Practice Sec- tion. The Committee analyzed 406 cases of alleged audit failure between 1979 and 1991 and concluded that allegations of audit failure occur almost three times as often when an audit firm is performing its first or second audit of a given client (AICPA 1992). Fi- nally, the accounting profession argues that uncertainty regarding characteristics of the client increases the potential for audit failures early in the auditor-client relationship (PricewaterhouseCoopers 2002). 7 Accounting Accruals and Audit Quality Absent from public discussion and prior research is a cogent picture of the (in- ter)temporal relation between audit quality and auditor tenure. The results of prior studies, while informative about extreme events (for example, SEC violations and qualified opin- ions), do not address audit quality for a broad cross-section of firms. However, the relation between auditor tenure and audit quality is of interest in a broader context. By linking earnings quality and audit quality, we attempt to address this relation more generally. While we acknowledge that studying the association between auditor tenure and audit quality in the case of extreme audit failures is important, we suggest that a broader analysis of this relation should be informative to the mandatory rotation debate. To address the relation between auditor tenure and audit quality, we must first provide a plausible definition of audit quality. We borrow from an extensive prior literature to argue that accounting accruals measures are a plausible descriptor of audit quality. Numerous studies have examined the association between various measures of accruals and proxies for audit quality. These proxies include auditor litigation, qualified audit opinions, audit failures, and auditor conservatism. Results suggest that higher accruals levels are positively associated with eventual auditor litigation (Heninger 2001), the issuance of qualified audit opinions (Bartov et al. 2000), audit failures (Geiger and Raghunandan 2002), and auditor changes (DeFond and Subramanyam 1998), while lower accruals levels are associated with greater auditor conservatism, which has been interpreted as suggestive of higher-quality audits (Becker et al. 1998; Francis et al. 1999; Francis and Krishnan 1999). Based on these 7 Prior research suggests two reasons why auditors are likely to be less aggressive in their oversight of management early in an auditor’s tenure. First, Geiger and Raghunandan (2002) suggest that one reason new auditors are less aggressive in their oversight is because they are attempting to recoup losses from the competitive practice of low-balling. However, while the practice of low-balling has been documented by Simon and Francis (1988), Ettredge and Greenberg (1990), and Deis and Giroux (1996), the literature suggests that low-balling and the recouping of losses does not impair auditor independence (DeAngelo 1981, 113; Lee and Gu 1998, 534). Thus, if auditor independence is not impaired, auditor oversight of managements’ decisions should not be affected regardless of tenure. Second, Geiger and Raghunandan (2002) also suggest that new auditors are likely to be less aggressive because they lack knowledge of client-specific risks. Although they find that auditors are less likely to issue going concern opinions for new clients, this does not provide convincing evidence on either the relation between low-balling and audit quality or the lack of client-specific knowledge. That is, their result can be interpreted that the auditors failed to issue going concern opinions to increase the likelihood that they would recoup some or all of the fees lost in the initial engagement period or that new auditors were unaware of the client-specific risks and this lack of knowledge lead to the issuance of nonqualified opinions. Exploring the Term of the Auditor-Client Relationship 783 The Accounting Review, July 2003 findings, we posit that high-quality audits mitigate more extreme management reporting decisions, and suggest that accruals can be used to identify these extreme reporting decisions. Accruals measures have also been used in numerous accounting studies that consider the relation between earnings management and accruals behavior, and earnings quality and accruals behavior. Early studies used the change in Total Accruals as a measure of man- agement discretion (e.g., Healy 1985; DeAngelo 1986), while later studies adopted and modified the ‘‘Jones Model’’ (Jones 1991). 8 Thus, abnormal discretionary accruals (esti- mated using variations of the Jones Model) became the accepted proxy for extreme man- agerial discretion. Various accruals measures have also been used to study earnings quality. These studies are important to the audit quality issue because they generally find that information is contained in specific accruals and/or that earnings quality declines with extreme accruals (e.g., Sloan 1996; Thomas and Zhang 2001; Xie 2001; Dechow and Dichev 2002; Richardson et al. 2002). Both the literatures on earnings management and earnings quality provide evidence that suggests that extreme accruals are less desirable, consistent with the audit quality literature cited above. Thus, the extent to which accruals behavior is associated with auditor tenure under the current voluntary rotation system is informative to parties currently debating mandatory rotation. We follow prior literature and perform analyses of those accruals measures generally considered to be most representative of managements’ discretion in the financial reporting process—Discretionary Accruals and Current Accruals. As in prior work, we not only study the raw and absolute values of these measures, but we also posit that studying the associ- ation between auditor tenure and signed accruals is important because auditors could con- strain income-increasing accruals to a greater or lesser extent than income-decreasing ac- cruals, and auditor tenure could have differential effects on this constraint. 9 By using multiple measures, we better test the relation between auditor tenure and audit quality. We formulate the following alternative hypotheses regarding the relation between au- ditor tenure and accounting accruals: H rotation proponent : Audit quality (as measured by accounting accruals) is decreasing in auditor tenure. H rotation opponent : Audit quality (as measured by accounting accruals) is increasing in auditor tenure. We test these general hypotheses to determine which is descriptive of the relation between auditor tenure and audit quality (as we have defined it). 10 8 For an extensive review of the earnings management literature, see Healy and Wahlen (1999) and Dechow and Skinner (2000). 9 For example, the perception that litigation is more likely to occur when income is overstated might lead auditors to constrain income-increasing accruals more severely than income-decreasing accruals even if auditors become less independent of their clients as the relationship lengthens. Tests on the signed accruals rather than on their absolute values allow us to examine this possibility. 10 In related work, Davis et al. (2002) provides results suggesting that discretionary accruals increase with auditor tenure. However, differences in design (noted below) make it difficult to compare this study with ours. First, we examine the absolute value of two accruals measures and separately examine the positive and negative components of these measures. Second, we do not require that firms survive throughout our entire sample period, thus eliminating the survivorship bias in Davis et al. (2002). Third, we delete observations that limit our ability to generalize our findings. These include: (1) very young firms, so that abnormal accruals behavior associated (continued on next page) 784 Myers, Myers, and Omer The Accounting Review, July 2003 III. DATA AND EMPIRICAL RESULTS Data Our initial sample consists of all firm-years from 1988 to 2000 inclusive with sufficient data on the 2001 Compustat annual industrial and research files to estimate accruals. In addition, we require at least the six years of prior data to ensure that any abnormal accruals behavior associated with start-up firms (Teoh et al. 1998a, 1998b) is not attributed to short auditor tenure. Because Collins and Hribar (2002) show that estimating accruals is prob- lematic when firms undergo mergers and acquisitions, we also omit these observations. 11 Finally, we limit our analyses to years beginning in 1988 because cash flow from operations was not available before that date. 12 We calculate auditor tenure as the number of years that the firm has retained the given auditor, and code auditor changes attributable to audit firm mergers as a continuation of the prior auditor. We determine which observations are in the top or bottom 0.5 percent of the distribution of cash flow from operations, Current Accruals or Jones Model residuals annually and delete them to remove outliers. Note that our research question relates to the relation between the accruals (for a given firm) and auditor tenure. To guard against the possibility that observations where firms switch auditors early in the relationship differ systematically from observations where firms retain the auditor for a number of years, we eliminate all firm-year observations where the auditor-client relationship did not last at least five years. That is, when the auditor-client relationship lasts at least five years, we retain all available observations, and when the auditor-client relationship lasts for less than five years, we eliminate all of these auditor-client observations. In this way, the early and later years represent the same auditor-client combinations, thus preserving comparability. Elim- inating the quick turnover group reduces the sample size to 42,302 firm-years. In our analyses, we use two measures of accruals: Current Accruals ϭ ((⌬CA Ϫ ⌬Cash) Ϫ (⌬CL Ϫ ⌬STD)) and Discretionary Accruals ϭ Accruals Ϫ ␤ 0 ϩ ␤ 1 ⌬Revenue ϩ ␤ 2 PPE (Jones Model residuals) 13 where: ⌬CA ϭ change in current assets (Compustat annual data item 4); ⌬Cash ϭ change in cash and cash equivalents (Compustat annual date item 1); Footnote 10, continued with start-up firms (Teoh et al. 1998a, 1998b) is not attributed to short auditor tenure; (2) firms undergoing mergers and acquisitions, so that the difficulties in reliably estimating accruals for these firms (Collins and Hribar 2002) do not influence our findings; and (3) observations where firms change auditors in the first five years of an audit engagement, because their inclusion does not allow us to directly address the question of what happens to accruals with lengthy auditor tenure. 11 To identify firms that undergo mergers and acquisitions, we follow Collins and Hribar (2002) and use the footnote codes appearing in Compustat. 12 The number of new auditor-client combinations each year ranges between 306 (in 1994) and 527 (in 2000). The number of new auditor-client combinations for Big N auditors is 3,590 versus 1,561 for non-Big N auditors. 13 We estimate the residuals and the coefficients contemporaneously. That is, for each year, we estimate the model within two-digit SIC industries, and use the residuals from this regression as our estimate of discretionary accruals. Exploring the Term of the Auditor-Client Relationship 785 The Accounting Review, July 2003 ⌬CL ϭ change in current liabilities (Compustat annual data item 5); ⌬STD ϭ change in short-term notes and current portion of long-term debt (Compustat annual data item 34); ␤ i ϭ coefficient estimates from an OLS regression by industry-year, where an in- dustry is defined by its two-digit SIC code; to reduce sampling error and to be consistent with prior literature, we eliminate industry-years with fewer than eight firms; Accruals ϭ operating income after depreciation (Compustat annual data item 178) – cash flow from operations (Compustat annual data item 108); ⌬Revenue ϭ change in net sales revenue (Compustat annual data item 12); and PPE ϭ property, plant, and equipment—net (Compustat annual data item 8). We scale all variables by average total assets. Empirical Results Table 1, Panel A provides descriptive statistics for all firms in our sample where the auditor-client relationship lasts at least five years, while Panel B provides descriptive statistics for the quick-turnover firms (where the auditor-client relationship lasts for less than five years). Within each panel we present descriptive statistics during three stages of the auditor-client relationship: 1 to 2 years; 3 to 4 years; and more than 4 years (when an auditor-client relationship lasts for at least 5 years). 14 We selected these stages (or group- ings) for two reasons. First, drafts of the Congressional bills cited earlier provided a range of suggested mandatory rotation periods, and groups of 3 to 5 years and more than five years are representative of the suggested periods. Second, the argument for mandatory auditor rotation hinges, in part, on the potential for reducing extreme management reporting decisions with unbiased oversight by auditors in the initial years of an auditor-client rela- tionship, while the argument against mandatory auditor rotation hinges, in part, on the uncertainty that occurs during the initial years. Our grouping of 1 to 2 years is representative of this initial period. The quick-turnover firms are significantly different from firms where the auditor-client relationship lasts for at least five years (i.e., the sample firms). For example, for the subset of firms that are in their first or second year of the audit engagement, the quick-turnover firms have significantly smaller average ROA and Cash Flow, and are older. Results on size proxies are mixed. Table 1 also reveals that the dispersion of our two accruals measures is significantly greater (in the first two years of the audit engagement) for the quick-turnover firms than for the sample firms. For these reasons, and because including quick- turnover firms does not allow us to adequately address the possible consequences of ex- tended auditor tenure, we eliminate the quick-turnover firms in all subsequent analyses. Univariate Results In this section, we present univariate results concerning auditor tenure and our accruals measures. Specifically, in Figure 1 we graph the 90th percentile, mean, median, and 10th percentile of our two accruals measures, Discretionary Accruals and Current Accruals, by 14 Note that observations relating to a given auditor-client combination will appear in Panel A if and only if that combination lasted for at least five years. However, if the auditor-client combination lasted for ten years, the first two years will be included in the Group 1 observations, the next two years will be included in the Group 2 observations, and the final six years will be included in the Group 3 observations. Observations relating to a given auditor-client combination will appear in Panel B if and only if that combination lasted for less that five years. The groupings can be interpreted as in Panel A. 786 Myers, Myers, and Omer The Accounting Review, July 2003 TABLE 1 Descriptive Statistics by Tenure Group Tenure Group ROA Mean (Median) [n] Cash Flow Mean (Median) [n] MVE Mean (Median) [n] Assets Mean (Median) [n] Tenure Mean (Median) [n] Age Mean (Median) [n] Absolute Discretionary Accruals Mean (Median) [n] Absolute Current Accruals Mean (Median) [n] Panel A: Omitting Observations Where the Auditor-Client Relationship Lasts for Less than Five Years Group 1 1or2 years Ϫ0.0324 (0.0237) [2,637] 0.0394 (0.0635) [2,637] 781.11 (32.868) [2,174] 1,153.58 (41.201) [2,637] 1.6011 (2) [2,637] 10.7144 (10) [2,637] 0.0918 (0.0553) [2,637] 0.1582 (0.0702) [2,637] Group 2 3or4 years Ϫ0.0407 (0.0249) [3,730] 0.0293 (0.0631) [3,730] 991.15 (41.135) [3,115] 1,463.79 (49.897) [3,730] 3.5357 (4) [3,730] 11.4434 (11) [3,730] 0.0917 (0.0524) [3,730] 0.1565 (0.0677) [3,730] Group 3 Ͼ4 years Ϫ0.0193 (0.0316) [35,935] 0.0477 (0.0723) [35,935] 1,788.15 (93.283) [31,124] 2,329.66 (129.472) [35,935] 10.4634 (10) [35,935] 12.1084 (11) [35,935] 0.0812 (0.0484) [35,935] 0.1313 (0.0592) [35,935] Panel B: Observations Where the Auditor-Client Relationship Lasts for Less than Five Years Group 1 1or2 years Ϫ0.0939 (0.0077) [6,844] 0.0017 (0.0457) [6,844] 1,024.55 (29.176) [5,851] 1,721.13 (46.152) [6,844] 1.3494 (1) [6,844] 11.4566 (10) [6,844] 0.1091 (0.0622) [6,844] 0.1763 (0.0793) [6,844] Group 2 3or4 years Ϫ0.1048 (0.0043) [1,869] Ϫ0.0080 (0.0388) [1,869] 827.15 (22.586) [1,594] 1,246.54 (33.953) [1,869] 3.3087 (3) [1,869] 11.6249 (11) [1,869] 0.1163 (0.0723) [1,869] 0.1992 (0.0817) [1,869] (continued on next page) Exploring the Term of the Auditor-Client Relationship 787 The Accounting Review, July 2003 TABLE 1 (continued) Tenure Group ROA Mean (Median) [n] Cash Flow Mean (Median) [n] MVE Mean (Median) [n] Assets Mean (Median) [n] Tenure Mean (Median) [n] Age Mean (Median) [n] Absolute Discretionary Accruals Mean (Median) [n] Absolute Current Accruals Mean (Median) [n] Panel C: Tests of Differences between Observations Where the Auditor-Client Relationship Lasts at Least Five Years and Observations Where the Auditor-Client Relationship Lasts for Less than Five Years t-statistics for Tests of Differences in Means (Z-statistics for Tests of Differences in Medians) Group 1 1or2 years 7.04*** (8.65***) 7.91*** (5.90***) Ϫ1.98* (1.76) Ϫ3.13*** (Ϫ1.71) 22.59*** (22.25***) Ϫ8.84*** (Ϫ1.37) Ϫ6.55*** (Ϫ3.27)*** Ϫ2.26** (Ϫ3.64)*** Group 2 3or4 years 5.90*** (8.35***) 5.13*** (6.82***) 0.97 (6.64***) 0.83 (4.78***) 16.87*** (16.07***) Ϫ1.53 (Ϫ1.83***) Ϫ6.76*** (Ϫ7.52***) Ϫ3.62*** (Ϫ3.78***) * , **, *** Indicates significant at .10, .05, and .01, respectively, using a two-tailed test. Observations relating to a given auditor-client combination will appear in Panel A if and only if that combination lasted for at least five years. However, if the auditor- client combination lasted ten years, the first two years will be included in the Group 1 observations, the next two years will be included in Group 2 observations, and the final six years will be included in Group 3 observations. Observations relating to a given auditor-client combination will appear in Panel B if and only if that combination lasted for less that five years. The groupings can be interpreted as in Panel A. 788 Myers, Myers, and Omer The Accounting Review, July 2003 FIGURE 1 Accruals by Deciles of Tenure Panel A: Current Accruals by Deciles of Tenure Current Accruals -0.30 -0.20 -0.10 0.00 0.10 0.20 0.30 12345678910 Deciles of tenure Accruals 90 percentile Mean Median 10 percentile Panel B: Discretionary Accruals by Deciles of Tenure Discretionary Accruals -0.20 -0.10 0.00 0.10 0.20 12345678910 Deciles of tenure Accruals 90 percentile Mean Median 10 percentile Omitting observations where the auditor-client relationship lasts for less than five years. Current Accruals ϭ ((⌬CA Ϫ ⌬Cash) Ϫ (⌬CL Ϫ ⌬STD)) where: ⌬CA ϭ change in current assets (Compustat annual data item 4); ⌬Cash ϭ change in cash and cash equivalents (Compustat annual date item 1); ⌬CL ϭ change in current liabilities (Compustat annual data item 5); and ⌬STD ϭ change in short-term notes and current portion of long-term debt (Compustat annual data item 34). Discretionary Accruals ϭ Accruals Ϫ ␤ 0 ϩ ␤ 1 ⌬Revenue ϩ ␤ 2 PPE where: Accruals ϭ operating income after depreciation (Compustat annual data item 178) – cash flow from operations (Compustat annual data item 108); ␤ i ϭ coefficient estimates from an OLS regression by industry-year, where an industry is defined by its two-digit SIC code; ⌬Revenue ϭ change in net sales revenue (Compustat annual data item 12); and PPE ϭ property, plant, and equipment—net (Compustat annual data item 8). All variables are scaled by average total assets. [...]... accruals vary by industry (Barth et al 2001) and the magnitude and type could vary by year When performing our analyses, we acknowledge that auditors might require managers to record legitimate asset write-offs and/ or impairment charges in the initial year of an auditor- client relationship These write-offs and charges would create large absolute accruals and large negative accruals in the first year,... earnings quality If deteriorating earnings and/ or audit quality are the motivation for calls for mandatory rotation, then our results do not support such an argument However, our results also do not imply that forcing firms to remain with the same auditors would improve earnings quality or audit quality Rather, Johnson and Lys (1990) show that allowing auditor turnover can improve audit quality because... association between tenure and earnings quality Our specialist definition is based on that in Palmrose (198 6a) Here, we code an auditor as a (two-digit SIC code) industry specialist if the auditor audits the largest percentage of 20 Recall that this is one of the arguments against mandatory rotation The Accounting Review, July 2003 794 Myers, Myers, and Omer TABLE 3 Regressions of Accruals Measures on Auditor. .. reporting of accruals Auditing: A Journal of Practice & Theory 18 (Fall): 17–34 Frankel, R M., M F Johnson, and K K Nelson 2002 The relation between auditors’ fees for nonaudit services and earnings quality The Accounting Review 77 (Supplement): 71–105 The Accounting Review, July 2003 798 Myers, Myers, and Omer Geiger, M., and K Raghunandan 2002 Auditor tenure and audit quality Auditing: A Journal of Practice... for audit quality These measures of earnings quality are drawn from prior literature that examines how accruals vary around events such as SEC violations and qualified opinions These studies find that the level of accruals around the examined events is generally higher than in the absence of these events We investigate the extent to which auditor tenure is associated with the dispersion in accruals and. .. whether the recognition of income-increasing or income-decreasing accruals varies with auditor tenure We contribute to the literatures on earnings quality and audit quality by documenting that longer auditor tenure is generally associated with less dispersion in the distributions of Discretionary Accruals and Current Accruals and that auditors appear to place greater constraints on both income-increasing... years that the firm has retained the auditor; the number of years of data available on Compustat since 1980; the log of total assets; N i,t iϭ1 Cash Flow Auditor Type Industry Year ϭ ϭ ϭ ϭ N ͸ Sales / ͸ Sales i,tϪ1 by two-digit SIC code; iϭ1 the firm’s cash flow from operations divided by average total assets; an indicator set to 1 if the auditor is a Big N auditor, and set to 0 otherwise; a control based... auditor is a Big N auditor, and set to 0 otherwise; a control based on two-digit SIC codes (62 industries); and a control based on calendar year sales in the industry (i.e., is the lead auditor) or audits sales within 15 percent of the lead auditor Our analyses reveal no significant differences (in the association between tenure and earnings quality) for specialist versus non-specialist auditors Thus,... tenure and the level of Current Accruals However, we posit that regulators (and users of financial statements) should not be as concerned about the level of accruals as about the extremes of the distribution and the directional affect Thus, looking only at levels (in Panel C) provides a less-than-satisfactory indication of the relation between auditor tenure and audit quality In sum, the results in Panels... income-increasing and incomedecreasing accruals as the auditor- client relationship lengthens Our study also provides useful evidence to regulators, members of the accounting profession, and financial statement users as they deliberate on the costs and benefits of mandatory auditor rotation Specifically, our results suggest that under the current system, increased auditor tenure does not lead to reduced audit and earnings . annual data item 12); and PPE ϭ property, plant, and equipment—net (Compustat annual data item 8). All variables are scaled by average total assets. Exploring the Term of the Auditor- Client Relationship. uses accounting accruals as a proxy for earnings quality, we test for an association between auditor tenure and earnings quality for those auditor- client combi- nations where the auditor- client relationship. quality; audit quality; mandatory rotation. Data Availability: All data used in this study is publicly available. I. INTRODUCTION T he issue of earnings quality and the quality of financial statements