chi et al - 2011 - the effects of audit partner pre-client and client-specific experience on earnings quality and on perceptions of audit quality

The Effects of Audit Partner Pre-Client and Client-Specific Experience on Earnings Quality and on Perceptions of Audit Quality Wuchun Chi Department of Accounting National Chengchi University Taipei, Taiwan Email: wchi@nccu.edu.tw Linda A. Myers Department of Accounting University of Arkansas Fayetteville, Arkansas 72701 Email: lmyers@walton.uark.edu Thomas C. Omer Department of Accounting Texas A&M University College Station, Texas 77843 Email: tomer@mays.tamu.edu Hong Xie Von Allmen School of Accountancy University of Kentucky Lexington, Kentucky 40506 Email: hongxie98@uky.edu November 2011 We thank Brian Bratten, Monika Causholli, Guojin Gong, Ole-Kristian Hope, Yue Li, Linda McDaniel, James Myers, Robert Ramsay, Steven Salterio, Marjorie Shelley, Shui-Liang Tung, Chung-Fern Wu, Minlei Ye, David Ziebart, participants at the 2 nd Symposium of China Journal of Accounting Research, the 2010 CAPANA Conference, and the 2011 European Accounting Association conference, as well as workshop participants at National Taiwan University and at the University of Kentucky for helpful comments and suggestions. Wuchun Chi gratefully acknowledges the financial support from National Science Council (Project No. NSC 94-2416-H-004- 036). Linda Myers gratefully acknowledges financial support from the Garrison/Wilson Chair at the University of Arkansas. Thomas Omer gratefully acknowledges financial support from Ernst & Young. Hong Xie gratefully acknowledges financial support from the Von Allmen Research Support endowment and the PWC fellowship endowment at the University of Kentucky. The Effects of Audit Partner Pre-Client and Client-Specific Experience on Earnings Quality and on Perceptions of Audit Quality SUMMARY: We examine the effects of auditors‘ pre-client and client-specific experience on earnings quality and on perceptions of audit quality for both public and private companies using audit data from Taiwan, where the names of signing audit partners are disclosed and both public and large private companies are required to publish audited financial statements. We use discretionary accruals to proxy for earnings quality and the bank loan interest rate spread to proxy for creditor perceptions of audit quality. We find that for public companies, an audit partner‘s pre-client experience enhances earnings quality, but the effect of pre-client experience on earnings quality is smaller than that of client-specific experience, suggesting a transition cost in terms of earnings quality associated with mandatory auditor rotation. For private companies, we find some evidence that pre-client experience improves earnings quality and that client- specific experience improves earnings quality, thus extending our understanding of the benefits of audit partner and audit firm tenure from public to private companies. Finally, we find that both pre-client experience and client-specific experience improve creditor perceptions of audit quality for both private and public companies. Our findings are important because they reveal the effects of more finely parsed measures of auditor experience (tenure) on earnings quality and on creditor perceptions of audit quality for both public and private companies. Our study is timely in light of the Public Company Accounting Oversight Board‘s 2011 call for comments on mandatory auditor rotation. In addition, our findings provides evidence consistent with the beliefs underlying the Public Company Accounting Oversight Board‘s proposal to disclose the name of the engagement partner in the audit report – that the disclosure of the engagement audit partner could provide useful information to investors. Keywords: Audit partner experience; Auditor rotation; Earnings quality; Audit quality Data Availability: Data are available from public sources identified in the text. - 1 - INTRODUCTION The effect of auditor tenure on earnings quality and on perceptions of audit quality has been the focus of intense debate and research in the recent accounting literature. Prior studies using U.S. data measure auditor tenure at the audit firm level (e.g., Myers et al. 2003; Mansi et al. 2004) while studies using non-U.S. data measure auditor tenure at the audit partner level (e.g., Carey and Simnett 2006; Chen et al. 2008). As such, these studies examine the effects of auditors‘ client-specific experience, as captured by audit firm tenure and/or audit partner tenure, on earnings quality and on various measures of the cost of debt (which proxies for creditor perceptions of audit quality). These studies generally find that longer tenure is associated with higher earnings quality and with a lower cost of debt (so higher perceived audit quality). However, an audit partner‘s pre-client experience (the number of years as the signing partner for other clients prior to the current client) can also play an important role, especially when clients experience audit firm or audit partner turnover, and whether pre-client experience affects earnings quality and/or perceptions of audit quality is unexplored in the extant literature. Studying the effect of pre-client experience is important and timely because of ongoing arguments for and against audit partner (and audit firm) rotation that center on the potential detriments associated with longer tenure, as well as the potential benefits from bringing a ―fresh look‖ to the audit engagement. The issue of mandatory auditor rotation is once again in the spotlight with the 2011 Public Company Accounting Oversight Board (PCAOB) call for comments on their concept release proposing mandatory audit firm rotation (Cohn 2011a; Cohn 2011b). 1 A more complete analysis of the issues surrounding mandatory audit firm rotation should include a consideration of whether the pre-client experience of an incoming audit partner compensates for the loss of client-specific experience of an outgoing partner. While the benefits 1 Also see ―Accounting board to seek comments on rotating auditors‖ in the New York Times (August 17, 2011). - 2 - and detriments to audit quality from long (audit firm and audit partner) tenure have been tested in numerous studies in the U.S. and international settings, the benefits of an incoming audit partner‘s pre-client experience are unexplored. 2 Thus, our focus on the effects of an audit partner‘s pre-client experience can add to the discussion of the relative costs and benefits of an incoming partner‘s ―fresh look.‖ Moreover, our examination of an audit partner‘s pre-client and client-specific experience can also shed light on the potential benefits of recent PCAOB concept releases that call for disclosure of an audit partner‘s identity in the audit report (PCAOB 2009; PCAOB 2011). In this paper, we examine the effects of auditors‘ pre-client and client-specific experience on earnings quality and on creditor perceptions of audit quality using samples of public and private companies in Taiwan. 3 Unlike in the U.S., audit reports in Taiwan contain not only the audit opinion and audit firm name but also the names of the two signing audit partners. In addition, large private companies were required, like public companies, to file and publish their audited financial statements before 2002. These distinctive features of the Taiwanese audit market allow us to develop a more complete set of auditor experience measures than are examined in prior literature. In particular, we measure the audit partner‘s pre-client experience for both public and private companies as the cumulative number of years from the first year that the auditor became a signing partner for any company to the first year that he became a signing partner for the current client. Our client experience measures allow us to estimate the potential impact on earnings quality and on perceptions of audit quality of an incumbent audit partner‘s 2 Studies that address audit firm tenure address the potential benefits of a ―fresh look‖ to some extent but do not consider pre-client experience of the incoming audit partner. Thus, we argue that studying the effects of a ―fresh look‖ at the audit firm level may be necessary but not sufficient. 3 Public companies are those whose shares are traded on the Taiwan Stock Exchange Corporation or on the GreTai Securities Market, which are analogous to the New York Stock Exchange and National Association of Securities Dealers Automated Quotation System, respectively, in the U.S. Private companies are those whose shares are not listed (publicly traded) on any stock exchange. - 3 - client-specific experience and of a successor audit partner‘s pre-client experience. Results using our pre-client experience measure suggest that the level of auditor pre-client experience is likely to be important under a mandatory rotation system. Our measures of the audit partner‘s client-specific experience differ somewhat between public and private companies. For public companies, we separate audit partner tenure, and audit firm tenure, into two periods: (1) the period before the company‘s initial public offering (IPO); and (2) the period after the IPO. Specifically, we measure the cumulative number of years in which the audit partner audited the company while it was still private, as well as the cumulative number of years in which the audit partner audited the company once it had gone public. We label the former pre-listing audit partner tenure and the latter post-listing audit partner tenure. We define pre-listing audit firm tenure and post-listing audit firm tenure similarly. Our post- listing audit partner tenure and post-listing audit firm tenure measures correspond to audit partner tenure and audit firm tenure in prior studies (e.g., Chen et al. (2008) and Myers et al. (2003), respectively) but our pre-listing audit partner tenure and pre-listing audit firm tenure measures are not examined in prior literature. For private companies, we use audit partner tenure (i.e., the cumulative number of years that the auditor has been a signing partner in the current client-partner relationship) and audit firm tenure (i.e., the number of consecutive years that the current client-firm relationship has existed) as our measures of client-specific experience. We address several research questions in this paper. First, we investigate the effect of auditors‘ pre-client experience (taking into account the effect of client-specific experience) on earnings quality and on creditor perceptions of audit quality for public companies. An implicit assumption underlying mandatory audit partner rotation is that the incoming audit partner‘s lack of client-specific experience can be alleviated by his pre-client experience so that when this pre- - 4 - client experience is coupled with (presumably) enhanced auditor independence, mandatory partner rotation enhances earnings quality and perceptions of audit quality. Zerni (2011) finds that perceptions of higher audit quality associated with individual partners‘ industry specialization (even after controlling for audit firm industry specialization) influence audit fees for industry specialist auditors. He suggests that audit partner identity is important to the market‘s perceptions of ex ante audit quality. However, whether pre-client experience enhances earnings quality (and is as effective as client-specific experience in enhancing earnings quality) or affects perceptions of audit quality is unexplored in the extant literature. 4 Our findings can shed light on these important issues. Second, we examine the effects of pre-listing audit partner tenure and pre-listing audit firm tenure on earnings quality and on creditor perceptions of audit quality for public companies. Here, we examine whether client-specific experience accumulated over the years during which a public company was still private can benefit the auditor‘s work for that company once it has gone public. This also allows us to test whether market pressures faced by public companies affect auditor oversight. The effects of pre-listing experience on earnings quality and on creditor perceptions of audit quality are also unexplored in the literature. Finally, we also examine the effects of auditors‘ pre-client experience (taking into account the effect of client-specific experience) on earnings quality and on creditor perceptions of audit quality for private companies. Although private companies make up a large portion of the economy and audit firms do much of their work for private clients (especially those seeking debt financing), little is known about the financial reporting practices of private companies (Hope and Langli 2010; Chen et al. 2011) and very little of the extant literature provides 4 The extant literature provides evidence that client-specific experience as captured by audit firm tenure (e.g., Myers et al. (2003)) or as captured by audit partner tenure (e.g., Chen et al. (2008) and Chi et al. (2011)) is important for earnings quality. However, it does not consider the effect of pre-client experience. - 5 - evidence about how auditor experience affects earnings quality or creditor perceptions of audit quality (and hence the cost of debt) for private companies. The exception is Chi et al. (2011). In concurrent work, Chi et al. (2011) use samples of public and private Taiwanese companies to investigate whether client importance, measured at the audit partner level, impairs auditor independence. 5 Although their variable of interest is partner-level client importance, they control for audit partner tenure but they do not consider the effect of audit firm tenure so the incremental effect of audit partner tenure cannot be determined. In addition, they do not separately investigate the effects of pre-client experience and do not study creditor perceptions of audit quality (cost of debt). Thus, our study contributes to the literature because extant literature has not examined the effects of pre-client experience and audit partner tenure, after controlling for audit firm tenure, on the earnings quality of private companies, nor the effects of pre-client and client-specific experience on creditor perceptions of audit quality for private companies. Following a long line of research (e.g., Chen et al. 2008; Francis and Yu 2009; Prawitt et al. 2010; among others), we measure earnings quality using performance-adjusted, modified Jones model-estimated discretionary accruals. For public companies, we find that pre-client experience reduces the magnitude (i.e., the absolute value) of discretionary accruals and constrains extreme negative discretionary accruals (but not extreme positive discretionary accruals). Regarding client-specific experience, we find that pre-listing partner tenure constrains the magnitude of discretionary accruals as well as extreme negative discretionary accruals. Pre- listing audit firm tenure also constrains extreme negative discretionary accruals. 6 Our post- 5 Chi et al. (2011) measure client importance measure as the natural logarithm of client sales divided by the sum of the natural logarithm of sales for all of the audit partner‘s clients. They proxy for auditor independence using performance-adjusted discretionary accruals, the auditor‘s propensity to issue modified audit opinions, and the client‘s probability of meeting or just beating earnings benchmarks. 6 Note that previous studies using samples of public companies find that audit firm tenure constrains both positive and negative accruals but these studies do not consider pre-listing experience (i.e., they consider only post-listing experience). - 6 - listing partner tenure and post-listing firm tenure results are consistent with those in Chen et al. (2008) in that earnings quality tends to increase in both post-listing partner tenure and post- listing firm tenure. Finally, our tests suggest that the effect of pre-client experience on earnings quality is smaller than that of client-specific experience. This implies that the loss of the outgoing partner‘s client-specific experience cannot be fully compensated for by the incoming partner‘s non-client-specific experience in a mandatory audit partner rotation regime. For private companies, we find that greater pre-client experience reduces extreme positive discretionary accruals but does not affect the magnitude of discretionary accruals or negative discretionary accruals. This finding is somewhat similar to our findings for public companies in that greater pre-client experience enhances earnings quality but for public companies we find a constraint on absolute and negative rather than positive accruals. In addition, we find that for private companies, discretionary accruals become less extreme and that both negative and positive discretionary accruals are constrained as audit partner tenure increases, consistent with Chi et al. (2011). We also find that discretionary accruals become less extreme and positive discretionary accruals are constrained as audit firm tenure increases. Finally, similar to our findings for public companies, we find that for private companies, the effect of pre-client experience on earnings quality is smaller than that of client-specific experience so the loss of the outgoing partner‘s client-specific experience cannot be fully compensated for by the incoming partner‘s non-client-specific experience. Similar to Mansi et al. (2004), we use bank loan pricing to proxy for creditor perceptions of audit quality, and use this proxy for both public and private companies. 7 For public companies, we find a negative association between pre-client experience and the bank loan 7 Mansi et al. (2004) study the relation between audit firm tenure (equivalent to our post-listing audit firm tenure) and the cost of debt for public companies in the U.S. - 7 - interest rate spread, suggesting greater perceived audit quality with increased pre-client experience. In addition, the interest rate spread is lower for all of our measures of client-specific experience—pre-listing audit partner tenure, pre-listing audit firm tenure, post-listing audit partner tenure, and post-listing audit firm tenure. For private companies, we find that pre-client experience and client-specific partner tenure lower the interest rate spread. However, we find no incremental effect of client-specific audit firm tenure on the interest rate spread. Finally, for both public and private companies, we find that the effect of pre-client experience on creditor perceptions of audit quality is indistinguishable from that of client-specific experience. We conjecture that our measures of pre-client experience and client-specific experience affect creditor perceptions of audit quality for both public and private companies because creditors in our study (who are primarily Taiwanese banks) likely have greater confidence in audit partners with more auditing experience, regardless of whether that experience is accumulated with the current client or with prior clients Our study contributes to the auditing literature by examining the effects of a more complete set of auditor experience measures (both pre-client and client-specific) on earnings quality and on perceptions of audit quality for both public and private companies. Our examination of these effects for private companies is among the first in the literature. We also contribute to the auditing literature by separating perceptions of the audit quality associated with the audit partner versus the audit firm. We document that pre-client experience has an incremental positive impact on earnings quality and on perceptions of audit quality but its effect on earnings quality is smaller than the effect of client-specific experience. This implies a net transition cost associated with mandatory audit partner rotation, although the transition cost is decreasing in audit partner pre-client experience. Moreover, we document that client-specific - 8 - experience accumulated at the audit partner and audit firm levels during the years in which a public company was still private (i.e., the pre-listing audit partner tenure and pre-listing audit firm tenure) has an incremental positive impact on earnings quality and on perceived audit quality, even after controlling for client-specific audit partner tenure and audit firm tenure following the client‘s IPO. These findings have a number of implications. First, prior studies suggest that mandatory partner rotation does not enhance earnings quality (Chi et al. 2009) or is unlikely to enhance earnings quality (Chen et al. 2008). Our findings imply that using an incoming audit partner with greater pre-client experience to replace the outgoing audit partner (who has greater client- specific experience) can partially, albeit not fully, mitigate the detrimental effects on earnings quality of audit partner rotation. Second, on July 28, 2009, the PCAOB issued a concept release seeking public comments on its proposal to require that the engagement audit partner sign the audit report. 8 On October 11, 2011, the PCAOB issued a new proposal for public comment that would require the engagement partner‘s name be disclosed in the audit report, making the engagement partner‘s name readily available to audit report users. 9 Underlying the Board‘s position is a belief that audit partner disclosure identity ―would increase transparency about who is responsible for performing the audit, which could provide useful information to investors‖ (PCAOB 2009, 5). Our finding that creditors in Taiwan perceive audit quality to be higher when audit partners with more experience sign financial statements provides evidence consistent with the Board‘s belief. 8 This is consistent with actions in foreign countries. For example, in 2006, the European Union (EU) issued the Eighth Company Law Directive, which requires member states, under Article 28, to adopt a mandate requiring the engagement audit partner to sign the audit report. In addition, proposals requiring mandatory audit firm are currently being discussed in the EU (see ―EU to propose audit-only firms and mandatory rotation‖ in Accountancy Age (September 26, 2011)). 9 See ―PCAOB proposes disclosure of engagement partner name‖ in Accounting Today (October 11, 2011) and PCAOB Proposes Amendments to Improve Transparency through Disclosure of Engagement Partner and Certain Other Participants in Audits at http://pcaobus.org/News/Releases/Pages/10112011_OpenBoardMeeting.aspx. [...]... mandatory auditor rotation and can aid the PCAOB‘s deliberation of this issue We also investigate the effects of our various measures of pre-client and client-specific experience on perceptions of audit quality using the interest rate spread to proxy for creditor perceptions In prior work, Mansi et al (2004) use audit firm tenure to proxy for audit quality - 33 - and investigate the relation between audit quality. .. section, we describe how we derive our bank loan pricing sample from this discretionary accruals sample, and we use the bank loan pricing sample to examine the effects of pre-client experience and client-specific experience on creditor perceptions of audit quality EMPIRICAL MODELS AND RESULTS In this section, we examine the effects of auditors‘ pre-client and client-specific experience on earnings quality. .. individual audit partner experience (either pre-client experience or client-specific experience) and perceptions of audit quality (and so the cost of debt) because of data limitations in the U.S setting We posit that a signing partner with substantial pre-client experience and/ or client-specific experience is more likely to be known to creditors in the Taiwanese market, and that, all else equal, an audit partner. .. tenure, and post-listing audit firm tenure to measure client-specific experience for public companies, and use audit partner tenure and audit firm tenure to measure client-specific experience for private companies Our client experience measures allow us to estimate the potential impact on earnings quality and on perceptions of audit quality of an incumbent audit partner s client-specific experience and of. .. longer audit partner tenure enhances perceptions of audit quality but longer audit firm tenure has no incremental effect on perceived audit quality Overall, our results suggest that auditor experience, accumulated with the current client or with other clients, enhances earnings quality and creditor perceptions audit quality This is consistent in spirit with Myers et al (2003) and Chen et al (2008) and. .. audit quality and investigate whether bondholders require lower returns from clients with larger or longer tenured audit firms We extend their study by investigating perceptions of audit quality based on individual (either incoming or current) audit partner experience This allows us to separate perceptions of audit firm quality from perceptions of audit quality associated with individual engagement partners... summarize, the results in Table 5 suggest that clients of audit partners with more preclient and client-specific experience enjoy more favorable loan pricing, consistent with lenders perceiving these partners as providing higher audit quality than less experienced partners CONCLUSION This study investigates the effects of audit partners‘ pre-client and client-specific experience on earnings quality and on perceptions. .. more experience will be perceived as a providing higher audit quality To summarize, we investigate the effects of auditors‘ pre-client and client-specific experience on earnings quality and on perceptions of audit quality for both public and private companies in Taiwan Our hypotheses, stated in the alternative, are as follows: 13 Interestingly, the PCAOB also acknowledges the importance of auditor experience. .. successor audit partner s pre-client experience Results using our pre-client experience measure suggest that the level of auditor pre-client experience is likely to be important under a mandatory rotation system We investigate the effects of our various measures of pre-client and client-specific experience on earnings quality using performance-adjusted, modified Jones model-estimated discretionary accruals... discretionary accruals (Johnson et al 2002; Myers et al 2003), restatements (Stanley and DeZoort 2007), and fraudulent financial reporting (Carcello and Nagy 2004) to proxy for earnings quality Studies investigating the relation between audit firm tenure and perceptions of audit quality include Mansi et al (2004), which uses the cost of debt financing to proxy for creditor perceptions of audit quality, and . on Earnings Quality and on Perceptions of Audit Quality SUMMARY: We examine the effects of auditors‘ pre-client and client-specific experience on earnings quality and on perceptions of. The Effects of Audit Partner Pre-Client and Client-Specific Experience on Earnings Quality and on Perceptions of Audit Quality Wuchun Chi Department of Accounting National Chengchi. complete set of auditor experience measures (both pre-client and client-specific) on earnings quality and on perceptions of audit quality for both public and private companies. Our examination of