1 Does Long Audit Partner Tenure Decrease Earnings Quality? Evidence from Japan Kenichi Yazawa 1 School of Business Administration, Aoyama Gakuin University Current Version March 2014 Acknowledgement: I would like to thank Roger Simnett, Gary Monroe, Peter Roebuck, Elizabeth Carson, and other participants in the 18th annual International Symposium on Audit Research for their valuable feedback on earlier versions of this paper. I also would like to Tsuyoshi Numagami, Hironori Fukukawa, Mikiharu Noma, Soo-Joon Chae, Yuan Zhang and other participants in the Hitotsubashi G-COE Research Workshop on Innovation and Management. 1 Address: 4-4-25 Sibuya, Shibuya-ku, Tokyo 150-8366, Japan Tel./Fax: +81 (3) 3409-6272 Email address: yazawa@busi.aoyama.ac.jp 2 Does Long Audit Partner Tenure Decrease Earnings Quality? Evidence from Japan Abstract: This study examines the relationship between audit partner tenure and audit quality by using data on 7,567 Japanese listed companies from 1999 to 2006. First, I find that the absolute and positive values of discretionary accruals decrease significantly with increased length of audit partner tenure. These findings are not consistent with the argument that earnings quality decreases with audit partner tenure, especially when income-increasing earnings management are the primary concern. Second, I find that positive discretionary accruals decrease significantly with audit partner tenure only after the tenure exceeds seven years. Given that half of the companies in the sample for this study have more than 50 years of business experience, these findings indicate that relatively long-term engagement is required to effectively audit a company with a longer history. Third, I find that the impact of tenure on earnings quality disappeared after the introduction of a periodic partner rotation rule in Japan in 2003. This is consistent with the argument that the purpose of audit partner rotation is to break up personal relationships between auditors and their clients and introduce fresh approaches to audits. In addition, the results of my sensitivity checks reveal the same results as those of the main tests. These findings contribute to the literature on auditor tenure and earnings quality. JEL Classification: G14; M41; M42 Key Words: Audit partner tenure; Audit partner rotation; Audit quality; Earnings management Data Availability: The data used in this paper are publicly available from the sources identified herein. 3 Does Long Audit Partner Tenure Decrease Earnings Quality? Evidence from Japan 1. Introduction In many countries around the world, periodic audit partner rotation is mandatory for businesses. An implicit assumption in a policy of mandatory audit partner rotation is that long relationships between audit partners and clients could lead to overfamiliarity and reduce earnings quality. However, this assumption has not been systematically tested in the literature, due to the lack of audit partner information in US and major country’s audit reports. In addition, some existing empirical research, which investigate firms in countries that practice the audit partner to sign the audit reports, has not provided consistent evidence as to whether long audit partner tenure reduces earnings quality (Carey and Simnett, 2006; Chen, Lin, and Lin, 2008; Manry, Mock, and Turner 2008; Chi et al., 2009). In addition, the maximum audit-partner tenure varies considerably in each country. In the 1970s, the U.S. was the first to require audit-partner rotation after seven years of tenure for Securities and Exchange Commission (SEC)-registered clients. The Sarbanes–Oxley Act of 2002 (SOX) further strengthened this requirement by mandating a five-year rotation for the lead and concurring partners (SOX Sec.203). By the end of June 2008, all 27 Member States of the European Union (EU) were required to enact the revised 8th Directive’s (2006) requirements into national law. One important detail of the Directive is key 4 audit-partner(s) rotation for seven years (2006/43/EC Article 42 .2), but each Member State has the discretion to decide how long the tenure with the audit client should be. For example, the UK rule requires rotation of the lead audit-engagement partner after five years and of other engagement partners after seven years. Germany requires seven years, France requires six years, and Greece requires four years. These facts suggest that regulation of audit partner rotation is not well underpinned by empirical findings. Regardless of the effectiveness of the audit partner rotation rule has not verified sufficiently, the European Union (EU) is currently scheduling the introduction of a new rotation rule, which mandates that European listed companies tender their audit firms (not audit partners) every 10 years and rotate auditors every 20 years. The rule will be subject to the approval of the European Parliament, which will be determined in April 2014. 2 This rule is based on the assumption that the negative impact caused by familiarity between auditors and clients is not effectively eliminated by changes of audit partner (EC green paper 2010). 3 In contrast, in the US, Public Company Accounting Oversight Board (PCAOB) Chairman James Doty told the Securities and Exchange Commission (SEC) that “we don’t have an active project or work going on within the board to move forward on a 2 Economia, 17 December 2013, Journal of Accountancy, 24 January 2014. 3 An EC green paper (2010) says that “situations where a company has appointed the same audit firm for decades seem incompatible with desirable standards of independence. Even when ‘key audit partners’ are regularly rotated as currently mandated by the Directive, the threat of familiarity persists.” 5 term limit for auditors.” 4 There are political factors behind the different approaches of the EU and the US, but the differences have primarily resulted from the fact that no clear explanation of the economic consequences of auditor rotation exist, even for audit partners. In other words, the issue of audit partner rotation is still an open one. As mentioned above, the amount of existing empirical evidence on this topic is very limited. The reason for this is that many countries do not require the signature of an audit partner in audit reports, although countries such as Taiwan and Australia are exceptions. Japan is unique in that it requires that the signature of the audit partner who is in charge appear in audit reports. In addition, Japan introduced an audit partner rotation rule similar to those of the EU and US in 2003. 5 These features make the Japanese audit market a suitable one for examining the relationship between audit partner tenure and audit quality, as well as the effects of audit partner rotation rules. In this study, I examine the relationship between audit partner tenure and audit quality by using data on 7,567 Japanese listed companies from 1999 to 2006, in order to verify the impact of long audit partner tenure on earnings quality and the economic consequence of the introduction of the periodic partner rotation rule in Japan. First, I find that the absolute 4 CFO journal, 6 February 2014. 5 As explained later, Japanese rules require all listed firms to rotate audit-engagement partners after seven years, and require clients of large audit firms to rotate lead engagement partners after five years. A “large audit firm” is defined as an audit firm that has more than 100 clients. The large audit firms are the Japanese Big 4 audit firms, and included Azusa, Shin-Nihon, Tomastu, and ChuoAoyama at the time of this study. 6 and positive values of discretionary accruals decrease significantly with increases in the length of audit partner tenure. These findings are contrary to the argument that earnings quality decreases with the length of audit partner tenure, especially when income-increasing earnings management attempts are the primary concern. Second, I find that positive discretionary accruals decrease significantly with audit partner tenure only after the tenure in question exceeds seven years. As half of the businesses in the sample used in this study have more than 50 years of business history, these findings indicate that relatively long-term engagement is required to effectively audit a company with a longer history. Third, I find that the impact of tenure on earnings quality disappeared after the introduction of the periodic rotation rule in Japan in 2003. This is consistent with the argument that the purpose of audit partner rotation is to break up personal relationships between audit partners and their clients, and to add fresh perspective to audits. In addition, these results are robust, as revealed by the results of sensitivity checks. The findings of this study contribute to the literature on auditor tenure and earnings quality by providing evidence at the audit partner level. Interestingly, the finding of this study are essentially the same as those of Chen, Lin, and Lin (2008) and Chi et al. (2009), whose studies examine Taiwanese companies, while these are not consistent with the results of Carey and Simnett (2006) and Hamilton et al. (2005), whose studies examine Australian companies, While doing so can prevent the generalization of findings, it is 7 important to consider the specific business practices of countries with regard to how they affect the impact of audit tenure on earnings quality. Japan and Taiwan belong to the Asian economic zone and have a deep historical relationship with one another. It is possible that the fact that Japanese companies prefer stable long-term relationships affects relationships between clients and audit partners. If regulators regard the tenures of audit firms as influencing earnings quality but consider the tenures of audit partners to have no effects, a reasonable explanation for this approach is needed. The rest of this paper is organized as follows. In Section 2, I discuss the institutional background of audit partner rotation in Japan and propose hypotheses. In Section 3, I explain the methodology used to test these hypotheses. In Section 4, I describe the sample used in this study and discuss the results. Finally, I provide a summary and conclusion in Section 5. 2. Background and Hypotheses Audit market and institutional background in Japan Japan has roughly 3,500 listed companies and Tokyo Stock Exchange is the third-largest capital market in the world after NYSE and NASDAQ in the US. A securities and exchange law like that of the United States was introduced in Japan in the 1950s, and the capital market developed over the next several decades. As in the audit markets of the US 8 and the EU, the innumerable small audit firms that initially operated in Japan have integrated into the four largest audit firms in the country (the Big 4) over a period of several decades. By the 2000s, the Big 4 in Japan held a market share of 80% of all accounts. The Japanese Big 4 have partnerships with the global Big 4 accounting firms, and use audit standards that are in accordance with the International Standards on Auditing (ISAs), which are issued by the International Auditing Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC). Japan introduced a periodic audit partner rotation rule similar to those of the EU and US in 2003 by the amendment of the Certified Public Accountant Law. 6 However, the rule did not come into force until March 31, 2010, because partners’ tenure was not counted retroactively. To address this problem, the Big 4 audit firms and the Japanese Institution of Certified Public Accountants (JICPA) announced on September 13 2005 that all Big 4 firms would rotate audit partners over seven years until March 2007 as a means of self-regulation. Figure 1 shows transitions in audit partner tenure in the Japanese Big 4 and small to medium-sized audit firms (non-Big 4) from 1999 to 2006. The audit partner tenure for the non-Big 4 firms has remained stable at roughly 17 years. On the other hand, the audit partner tenure for the Big 4 firms was stable at 12 years until 2002, began to decrease in 6 Certified Public Accountant Act, 24(3) 9 2003, and had reduced to six years by 2006, which is half the tenure of only four years priorago. As mentioned above, this is due to the fact that because the Big 4 have introduced a partner rotation rulesystem as a means of self-regulation from in 2003. In this study, in order to analyze the relationship between long tenure and the audit quality, the sample is has been corrected from 1999 on. In addition, in order to analyze how this relationship between them has changed with the introduction of rotation rules, the period for analysis period has been extended until 2006. Therefore, the sample period covers eight years, from 1999 to 2006, which is divided into the two periods of 1999-2002 and 2003-2006. [Insert Figure 1 about here] Theory and prior research Audit quality is defined as the joint probability that an auditor will both detect material statements and prevent or report the misstatements (DeAngelo, 1981). According to this definition, audit quality is a function of the auditor’s ability to detect material misstatements and report those detected misstatements. To detect material misstatements, auditors must have specific knowledge and skills (auditor expertise). To report detected misstatements, auditors must be independent in both fact and appearance (auditor independence). The debate on auditor rotation has always centered on a key question. What makes audits 10 more effective: a fresh pair of eyes (independence effect) or deep knowledge of the ins and outs of a complex company (expertise effect)? With an increase in audit-partner tenure, the relationship between the auditor and her or his client might introduce a so-called “familiarity threat” to auditor independence (IFAC Code of Ethics ED 2008, para.100.13). 7 This threat could result in a decline in the audit partner’s ability to judge the company’s performance accurately. On the other hand, audit quality could be considered to increase with auditor tenure, because of the accumulation of client-specific information and knowledge. Thus, the net effect of auditor tenure on earnings quality is determined by the magnitude of the independence and expertise effects. However, only a few studies examine the impact of audit partner tenure and rotation on the earnings quality. The reason for this is that audit reports in most major countries record only the auditing firm’s signature, and not the audit-engagement partner’s name. Therefore, prior research has focused on a limited number of countries in which this is not the case, such as Australia, Germany, and Taiwan. In addition, the findings of that research have been mixed. Carey and Simnett (2006) investigate the relationship between audit partner tenure and earnings quality by using 1,021 Australian companies listed in 1995. They find no evidence of a relationship between audit partner tenure and abnormal working capital accruals. Chen, 7 The IFAC Code of Ethics ED states that a “familiarity threat occurs when, by virtue of a close relationship with an assurance client, its directors, officers or employees, a firm or a member of the assurance team becomes too sympathetic to the client’s interests (IFAC Code of Ethics ED 2008: 18).” [...]... Audit partner tenure and audit quality , The Accounting Review, Vol.81, No.3, pp.65 3-6 76 Chen, C.-Y., C.-J Lin, and Y.-C Lin (2008), Audit partner tenure, audit firm tenure and discretionary accruals: Does long auditor tenure impair earnings quality? ’, Contemporary Accounting Research, Vol.25, No.2, pp.41 5-4 45 Chi, W., H Huang, Y Liao, and H Xie (2009), ‘Mandatory audit partner rotation, audit quality. .. the quality of earnings is high Tenure of audit partner In Japan, two or three partners typically sign each audit report, which means that several audit partners influence and have responsibility for the audit Based on the idea that length of tenure would have a negative effect on the audit quality, it can be assumed that an audit partner with the longest tenure has the greatest impact over the audit. .. measures of audit partner tenure As explained above, in Japan, two or three audit partners typically sign each audit report The analysis in this study was based on the assumption that the audit partner with 26 the longest tenure has the greatest influence on the client However, audit judgment can be influenced not only by the audit partner with the longest partner tenure, but also by the other audit partners... implicit assumption of the audit partner rotation regulations that have been introduced in developed countries is that the long tenure of an audit partner has a negative effect on audit quality Thus, a basic hypothesis can be created, which states that earnings quality decreases with audit partner tenure (H1) 12 The maximum tenure of audit partners is set in the periodic audit partner rotation rules of... relationship between audit partner tenure and earnings quality for a sample of Japanese listed companies First, I find that the absolute and positive values of discretionary accruals decrease significantly with audit partner tenure These findings are not consistent with the argument that earnings quality decreases with the length of audit partner tenure, especially when income-increasing earnings management... -0 .047 * * -0 .039 * 0.225 8 -0 .007 -0 .018 ** -0 .291 * -0 .024* * 0.101** 0.197** * 0.016 ** * 0.132 -0 .064 7 * 0.182** * * 0.132 0.063 ** * 0.019 -0 .127 -0 .160 * 5 ** -0 .143 * 0.150 -0 .109 * -0 .033* -0 .024 * * 7 CHG_FST * 0.001 -0 .265* 0.018 * -0 .117* -0 .033* -0 .011 * -0 .025* 0.011 * 0.109** * 0.008 0.091** 1 See variable definitions in table 1 0.010 0.006 0.070** -0 .075* -0 .075* * 2 Pearson (Spearman)... relationship between audit partner tenure and reduced earnings quality They find evidence that for small companies, regardless of their level of engagement risk, earnings quality may actually increase as audit partner tenure increases Hamilton et al (2005) use a sample of 3,621 firm-years between 1998 and 2003 from Australian-domiciled companies, and report that among these companies, audit- partner changes that... impact of audit- engagement partner tenure on audit quality by using the regression model below: 𝐴𝐴 = 𝛽! + 𝛽! 𝑇𝑁𝑅𝐸 + 𝛽! 𝐴𝑆𝑆𝐸𝑇 + 𝛽! 𝐺𝑅𝑂𝑊𝑇𝐻 + 𝛽! 𝐶𝐹𝑂 + 𝛽! 𝐴𝐺𝐸 + 𝛽! 𝐶𝐻𝐺_𝐹𝑆𝑇 + 𝛽! 𝐶𝐻𝐺_𝐿𝑆𝑇 + 𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦&𝑌𝑒𝑎𝑟_𝑒𝑓𝑓𝑒𝑐𝑡 + 𝜀   (1) Audit quality Prior research has examined the impact of audit- related factors on audit quality by testing whether the audit- related factors are systematically associated with earnings quality, ... accruals as proxies for audit quality Lindscheid, Pott, and Wartin (2009) use a sample of 457 firm-years from German companies and investigate the effects of both audit- engagement and review -partner switches They find evidence that earnings increase more in the case of audit review -partner switches However, they do not find an effect on any accrual measures when audit- engagement partners change Hypotheses... change auditors at the Less: Number of firm-year observations for which financial data were not fiscal year-end Sub-total available Audit- related data (221) (168) (2,002) 13,245 Less: Number of firm-year observations for which audit data were not (3,363) Less: Non-Big 4 audit firms available Less: Audits by a single auditor (1,640) (11) Less: Audits by joint-auditors (314) Less: Changes in audit firms . yazawa@ busi.aoyama.ac.jp 2 Does Long Audit Partner Tenure Decrease Earnings Quality? Evidence from Japan Abstract: This study examines the relationship between audit partner tenure and audit quality by using. Does Long Audit Partner Tenure Decrease Earnings Quality? Evidence from Japan Kenichi Yazawa 1 School of Business Administration, Aoyama Gakuin University Current Version March 2014. identified herein. 3 Does Long Audit Partner Tenure Decrease Earnings Quality? Evidence from Japan 1. Introduction In many countries around the world, periodic audit partner rotation is mandatory