brooks et al - 2011 - when does audit quality start to decline in firm audit tenure - an international analysis [mafr]

When Does Audit Quality Start to Decline in Firm Audit Tenure? – An International Analysis Li (Lily) Z Brooks Department of Accounting E.J Ourso College of Business Louisiana State University zlily424@lsu.edu C.S Agnes Cheng Department of Accounting E.J Ourso College of Business Louisiana State University acheng@lsu.edu Joseph Johnston Department of Accounting College of Business City University of Hong Kong jjohnsto@cityu.edu.hk Kenneth J Reichelt Department of Accounting E.J Ourso College of Business Louisiana State University reichelt@lsu.edu September 25, 2011 Preliminary Draft * We gratefully acknowledge the comments and suggestions of the workshop participants at Penn State University Electronic copy available at: http://ssrn.com/abstract=1933488 When Does Audit Quality Start to Decline in Audit Firm Tenure? – An International Analysis Abstract This paper investigates the decline in audit quality during an audit firm’s tenure across countries with varying degrees of legal liability We propose that audit quality can increase through a learning effect in early years but in later years it is likely to decrease due to a bonding effect Using a quadratic model, we estimate the year when audit quality, measured by earnings quality, starts to decline during an audit firm’s tenure We propose that the bonding effect should be weaker in countries with stricter legal liability regimes, which implies that the year that audit quality begins to decline should be later in countries with stricter legal liability regimes We find that it takes 14 to 16 years for countries with stronger legal liability regimes while it only takes to 10 years for countries with weaker legal liability regimes for audit quality to decline Our results are strong regardless of whether we measure legal liability from the perspective of legal origin (common or code law) or litigation risk Our findings have implications across the world for the current debate on the mandatory requirement of audit firm rotation across the world Electronic copy available at: http://ssrn.com/abstract=1933488 Introduction The purpose of our study is to examine whether the strength of the client’s country’s legal liability regime affects the decline in audit quality during an audit firm’s tenure Specifically, we examine whether a country’s strength on legal liability prolongs the point of time when the audit quality starts to decline Regulators are concerned that bonding (or lack of independence) between auditors and managers (hereafter, the ‘bonding effect’) will decrease audit quality in later years; however, firms’ and auditors’ concerns of legal liability should mitigate such a negative effect Accordingly, we propose that the legal liability regime should affect the turning point when audit quality starts to decline The empirical evidence of the ‘point’ should help regulators to determine the necessity of mandatory audit firm rotation The topic of mandatory audit firm rotation is currently being discussed by regulators such as the European Commission and the Public Company Accounting Oversight Board (hereafter PCAOB), as a potential solution to improve audit quality If regulators adopt mandatory auditor rotation, they need to decide on the appropriate term Countries that already have audit firm rotation in place all require audit firm rotation within 10 years.1 Recently, the US PCAOB is seeking comment on the proposal to limit audit firm tenure to 10 years However, it is unclear whether a 10-year term limit should apply to all countries Our paper provides a plausible explanation for varying the term limits across countries by showing that the legal liability regime mitigates the ‘bonding effect’ and thus prolongs the turning point when audit quality starts to deteriorate The debate about mandatory audit firm rotation among regulators and professional bodies has been long-standing and on-going (PricewaterhouseCoopers 2002; The Conference Board Mandatory audit firm rotation exists in Brazil (5 years), India (4 years for banks, insurance companies, and the public sector), Italy (9 years), and South Korea (6 years) 2005; European Commission 2010; Public Company Accounting Oversight Board (PCAOB) 2011) Proponents argue that long audit firm tenure induces the economic and social bonding between the auditor and the client, which can impair auditor independence and judgment Accordingly, they support using mandatory audit firm rotation to mitigate the negative bonding effect on audit quality Opponents argue that mandatory audit firm rotation is very costly to both clients and investors In addition to the high out-of-pocket switching costs, newly hired audit firms will be less effective at detecting errors due to their lack of client-specific knowledge If audit quality does not improve after the initial stage, these costs are a deadweight loss to society Many US studies tend to find evidence that audit quality is weaker when audit firm tenure is shorter (e.g., Johnson et al 2002; Chung and Kallapur 2003; Myers et al 2003; Carcello and Nagy 2004; Gul et al 2007; Stanley and DeZoort 2007) However, recent studies using US firms (Davis et al 2009; Brooks 2011) find that long audit firm tenure decreases audit quality There is also international evidence that long audit firm tenure decreases audit quality (Chi and Huang 2005) Our study extends the literature by suggesting that the legal liability regime should affect the adverse effects from bonding (or lack of independence) between auditors and clients Due to the recent financial meltdown and continuing poor audit quality, European and US regulators have renewed their interest in mandatory audit firm rotation The European Commission (EC) issued a Green paper (European Commission 2010) asking the European Union to open up debate about mandatory audit firm rotation, among other issues, in order to improve the audit quality The EC believes that improvements to audit quality will help stabilize the financial system Their concerns stem from the fact that many banks in the United Kingdom failed shortly after receiving an unqualified audit opinion (United Kingdom House of Commons Treasury Committee 2009, p.76) The US PCAOB recently issued Concept Release No 2011006 (2011) to solicit public opinion on means to improve audit quality, including mandatory audit firm rotation The PCAOB’s concern for audit quality arises from the fact that even though the PCAOB inspection process has been in place since 2004, they still find instances where auditors fail to approach the audit with the required level of independence and professional skepticism They note examples in US and foreign jurisdictions where auditors accepted management’s perspective without challenging it or developing an independent opinion The concept release notes that the audit firm tenure of the largest 100 companies averages 21 years, and asks constituents to comment on a 10 year rotation requirement Should it be years, 10 years or 15 years? If it likely that the adverse bonding effect starts at the 5th year (the turning point), then a requirement of 10 year rotation is too long and will not be able to protect investors in time If the turning point is at the 15th year, then a requirement of 10 year rotation is too short and will generate a deadweight loss to society In choosing the number of years for mandatory audit tenure rotation, regulators need to weigh these two types of costs But first, regulators need to have some idea of the “turning point” of audit quality during audit firm tenure, and whether this turning point varies across countries in different legal liability regimes We propose that a stricter legal liability regime delays the deterioration of audit quality during the audit firm’s tenure A stricter legal liability regime weakens the client-auditor bond, through the threat of higher litigation costs, thus delaying the point in time when audit quality begins to deteriorate We measure the strength of the legal liability regime by using legal origin – common law vs code law (La Porta et al 1997, 1998), and by using litigation risk (Wingate 1997) We predict that audit quality will deteriorate later in common law countries than in code law countries, and later in countries with higher litigation risk relative to countries with lower litigation risk We measure audit quality using earnings quality – the absolute value of abnormal accruals Our main sample consists of 104,758 firm-year observations from 26 countries covering the 14 year period of 1996 to 2009 We find that the turning point (when audit quality starts to deteriorate) is longer for common law countries (16 years) than for code law countries (7 years) We also find similar results when we categorize countries into high and low litigation risk To sum, we find that legal liability affects the turning point in a predicted fashion: legal liability mitigates the bonding effect, hence, longer auditor tenure can be allowed Our results are robust to an alternative measure of abnormal accruals (Francis and Wang 2008) Our paper extends at least two streams of literature We contribute to the international auditing literature by showing that the turning point in audit quality is affected by a stronger legal liability regime Francis and Wang (2008) and Choi et al (2008) show that stronger legal liability regimes are associated with higher audit quality; however, whether this audit quality varies with audit firm tenure is not apparent in these studies We find that audit quality starts to decline later in stronger legal liability regimes, suggesting that auditor-client bonding is less severe in countries with stronger legal liability laws where litigation risk is higher We also extend the one-country studies on the effect of audit tenure on audit quality, by Chi and Huang (2005), Davis et al (2009) and Brooks (2011), to an international setting Our paper provides evidence to regulators for their decision-making on the issue of mandatory audit firm rotation Our evidence suggests that the extent of litigation risk creates economic incentives for auditors to deliver high levels of audit quality for a longer period of time For countries with a stronger (weaker) legal liability regime, the requirement of mandatory rotation should be longer (shorter); this will avoid the deadweight loss to society while still preserving investor protection A limitation of our study is that we assume that audit quality is a quadratic function of audit firm tenure We use this form for the sake of convenience in estimating the turning point This form is at best an approximation of what theory suggests It assumes that audit quality increases first and then decreases in a similar degree However, the correct function could be that audit quality increases slow (or fast) but it drops fast (or slow) in an earlier (or later) stage Future research can address whether a more accurate functional form exists The remainder of the paper is organized as follows The next section presents our literature review and hypotheses The third section describes our empirical model The fourth section describes our results and the final section concludes the paper Literature Review and Hypothesis development In this section, we first review the prior literature to learn how audit quality varies over the audit firm’s tenure We next examine how the legal liability regime affects audit quality Finally, we present a hypothesis about how the extent of legal liability regime affects how audit quality varies over the audit firm’s tenure 2.1 Effect of Audit Tenure on Audit Quality The prior literature, as well as the concerns of regulators and constituents, suggests that two countervailing forces jointly determine the relation between auditor tenure and audit quality: a learning effect and a bonding effect The learning effect occurs in the initial years of the auditor’s tenure, where audit quality increases as the auditor gains a better understanding of the client’s financial reporting system, business, industry and internal controls This effect is consistent with the “learning curve” effect (Yelle 1979; Chen and Manes 1985) where new information is acquired after each successive audit engagement at a diminishing rate, until a maximum amount of information is acquired Thus, the auditor’s ability to detect material errors in accrual estimates is sharpest in early years The learning effect results in a positive relation between audit quality and audit tenure that gradually reaches a maximum level in later years Two streams of audit firm tenure literature support the learning effect The first stream examines audit failures and finds that audit failures are associated with shorter audit firm tenure For instance, Geiger and Raghunandan (2002) find that firms entering bankruptcy are less likely to have been issued a going concern audit opinion from audit firms with shorter tenure Carcello and Nagy (2004) find that fraudulent financial reporting is more likely when audit firm tenure is three years or less Stanley and DeZoort (2007) find that financial restatements are negatively related to audit firm tenure A limitation with this literature stream is that audit failures are infrequent; thus it is difficult to infer whether they are representative of the larger population A second stream of literature that supports the learning effect finds that earnings quality improves with longer audit firm tenure Chung and Kallapur (2003) and Myers et al (2003) find that discretionary accruals are negatively related to auditor tenure Similarly, Johnson et al (2002), and Gul et al (2009) find evidence of higher discretionary accruals in the early years of the audit firm’s tenure A related study by Mansi et al (2004) find a negative relation between cost of debt and audit firm tenure suggesting that perceived audit quality increases with audit firm tenure In addition to the learning effect, prior literature suggests that a second countervailing force dominates in later years of the audit firm’s tenure We coin this effect – the bonding effect We posit that the bonding effect consists of two complementary factors: an over-familiarity effect and a lack of independence effect The over-familiarity effect reduces auditor skepticism and diminishes audit quality as the auditor become more complacent and over-familiar with the client For instance, Shockley (1981) states that “complacency, lack of innovation, less rigorous audit procedures and a developed confidence in the client may arise after a long association with the client” In turn, the auditor will have a tendency to anticipate results, such as the condition of the client’s system and procedures (Hoyle 1978; Carey and Simnett 2006), and become less vigilant to more subtle anomalies (Arrunada and Paz-Ares 1997) Consequently, the ability of the auditor to detect either intentional or unintentional errors diminishes with the length of the auditor’s tenure Therefore, the over-familiarity effect results in a negative relation between audit quality and audit firm tenure The second factor of the bonding effect is the lack of independence effect Independence is the propensity of the auditor to correct material errors that they detected in the course of their audit engagement A lack of independence occurs when the auditor will not correct a material error Not correcting a material error may result when auditors develop an unwarranted trust of management’s accounting judgments (King 2002) The audit partner acts as a ‘relationship manager’ by taking steps to ensure that the client remains “happy”, in order to avoid being replaced with a more accommodating partner (McCracken et al 2008) The auditor may also socially bond with the client, and acquiesce to their client’s preferred position (Bamber and Iyer 2007) Additionally, the next partner-in-charge will try to avoid the economic loss as well as the stigma of losing a long-standing client (Doty 2011) Mautz and Sharaf (1961, p 231) state that the auditor “must be aware of the various pressures, some obvious some subtle, which tend to influence [their] attitude and thereby erode slowly but surely [their] independence.” In many cases “the greatest threat to [their] independence is a slow, gradual, almost casual erosion of [their] honest disinterestedness” (Mautz and Sharaf 1961, p 208) The close economic and social bond that develops over time suggests that the auditor’s judgment will gradually impair over time Thus, the lack of independence effect results in a negative relation between audit quality and audit firm tenure Two streams of empirical literature provide support for the bonding effect – the first stream examines perceived audit quality, and the second stream examines actual earnings quality The first stream suggests that auditors and investors perceive a bonding effect which impairs audit quality from extended audit firm tenure Kealey et al (2007) find that the successor auditor’s audit fee increases with the length of the prior auditor’s tenure, suggesting that the successor auditor views longer tenure of the predecessor auditor as lower audit quality Dao et al (2008) find that shareholders are more likely to vote against auditor reappointments when the auditor’s tenure is longer, suggesting that shareholders view longer tenure as lower audit quality Boone et al (2008) finds that cost of common equity capital decreases in early years and increases in later years Their study implies that perceived audit quality increases in early years due to a learning effect, and decreases in later years due to a bonding effect While perceptions might provide insights into the appearance of audit quality, more germane to our study is the examination of actual audit quality, such as earnings quality Several recent studies (Chi and Huang 2005; Davis et al 2009; Brooks 2011) find that earnings quality increases in the early years of audit firm tenure, and later deteriorates These studies support the view that a learning effect dominates in early years and a bonding effect dominates in later years Using Taiwanese data, Chi and Huang (2005) find that discretionary accruals decrease in the first five years and later increase Using US data, Davis et al (2009) finds that discretionary accruals to meet or beat analysts’ forecasts decrease in the first 15 years but later increase, suggesting that earnings quality increases in early years but decreases in later DeFond, M L., and J Jiambalvo 1994 Debt Covenant Violation and Manipulation of Accruals Journal of Accounting and Economics 17 (1/2):145-176 Doty, J R 2011 Rethinking the Relevance, Credibility and Transparency of Audits - Speech by PCAOB Chairman James R Doty to SEC and Financial Reporting Institute 30th Annual Conference, June Available at: http://pcaobus.org/News/Speech/Pages/06022011_DotyKeynoteAddress.aspx European Commission 2010 Green Paper - Audit Policy: Lessons from the Crisis - Com(2010) 561 Final Brussels Francis, J R., I K Khurana, and R Pereira 2003 The Role of Accounting and Auditing in Corporate Goverance and the Development of Financial Markets around the World AsiaPacific Journal of Accounting & Economics 10:1-30 Francis, J R., and D Wang 2008 The Joint Effect of Investor Protection and Big Audits on Earnings Quality around the World Contemporary Accounting Research 25 (1):157-191 Frankel, R M., M F Johnson, and K K Nelson 2002 The Relation between Auditors' Fees for Nonaudit Services and Earnings Management The Accounting Review 77 (Supplement) (4):71-105 Geiger, M A., and K Raghunandan 2002 Auditor Tenure and Audit Reporting Failures Auditing 21 (1):67 Goldwasser, D., T Arnold, and J Eickenmeyer 2008 Accountants' Liability New York, N.Y.: Practicing Law Institute Gul, F A., S Y K Fung, and B Jaggi 2009 Earnings Quality: Some Evidence on the Role of Auditor Tenure and Auditors' Industry Expertise Journal of Accounting and Economics In Press, Corrected Proof Gul, F A., B L Jaggi, and G V Krishnan 2007 Auditor Independence: Evidence on the Joint Effects of Auditor Tenure and Nonaudit Fees Auditing 26 (2):117-142 30 Hail, L., and C Leuz 2006 International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter? 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Journal of Finance 61 (1):1-32 31 La Porta, R., F Lopez-De-Silanes, A Shleifer, and R W Vishny 1997 Legal Determinants of External Finance Journal of Finance 52 (3):1131-1150 La Porta, R., F Lopez-de-Silanes, A Shleifer, and R W Vishny 1998 Law and Finance Journal of Political Economy 106 (6):1113-1155 Lennox, C S 1999 Audit Quality and Auditor Size: An Evaluation of Reputation and Deep Pockets Hypotheses Journal of Business Finance & Accounting 26 (7/8):779-805 Leuz, C., D Nanda, and P D Wysocki 2003 Earnings Management and Investor Protection: An International Comparison Journal of Financial Economics 69 (3):505-527 Mansi, S A., W F Maxwell, and D P Miller 2004 Does Auditor Quality and Tenure Matter to Investors? Evidence from the Bond Market Journal of Accounting Research 42 (4):755793 Mautz, R K., and H A Sharaf 1961 The Philosophy of Auditing Sarasota, FL: American Accounting Association McCracken, S., S E Salterio, and M Gibbins 2008 Auditor-Client Management Relationships and Roles in Negotiating Financial Reporting Accounting, Organizations and Society 33 (4-5):362-383 Myers, J N., L A Myers, and T C Omer 2003 Exploring the Term of the Auditor-Client Relationship and the Quality of Earnings: A Case for Mandatory Auditor Rotation? Accounting Review 78 (3):779-799 PricewaterhouseCoopers 2002 Mandatory Rotation of audit Firms: Will It Improve audit Quality? New York: PricewaterhouseCoopers Public Company Accounting Oversight Board (PCAOB) 2011 Concept Release on Auditor Independence and Audit Firm Rotation - PCAOB Release No 2011-06 Washington: PCAOB Shockley, R A 1981 Perceptions of Auditors' Independence: An Empirical Analysis Accounting Review 56 (4):785 32 Stanley, J D., and T F DeZoort 2007 Audit Firm Tenure and Financial Restatements: An Analysis of Industry Specialization and Fee Effects Journal of Accounting and Public Policy 26 (2):131-159 The Conference Board 2005 Findings and Recommendations of the Commission on Public Trust and Private Enterprise: The Conference Board Inc United Kingdom House of Commons Treasury Committee 2009 Banking Crisis: Reforming Corporate Governance and Pay in the City - Ninth Report of Session 2008-09 London Wingate, M L 1997 An Examination of Cultural Influence on Audit Environment Research in Accounting Regulation Supplement 1:129-148 Yelle, L E 1979 The Learning Curve: Historical Review and Comprehensive Survey Decision Sciences 10 (2):302-328 33 Figure Audit Quality (AQ) Audit Quality and Audit Firm Tenure Common Law vs Code Law Countries AQ = -0.174 + 0.467T -0.014T2 AQ = -0.216+ 0.336T + -0.011T2 1 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 -1 AQ = -0.149+ 0.102T -0.007T2 -2 -3 -4 -5 Tenure (T) -6 Code Law Countries Common Law Countries All Countries Note: the parameters for this graph come from Table The turning point for all 26 countries, common law countries, and code law countries is 15 years, 16 years and years respectively 34 Table 1: Sample Selection Number of Observations Criteria Firm-year observations from Compustat Global Vantage and Compustat North America between September of 1996 and December of 2009 379,977 Less: Missing values for dependent and independent variables (150,487) Negative book value amounts (33,960) Financial services firms (SIC 6000-6999) (36,433) Auditor changes (48,346) Countries with less than 50 firm-year observations (527) 1st and 99th percentiles and studentized residuals greater than Final Sample (5,466) 104,758 35 Country Common Law Countries United States N= Mean Std Median Australia N= Mean Std Median Hong Kong N= Mean Std Median United Kingdom N= Mean Std Median Canada N= Mean Std Median Singapore N= Mean Std Median AQ1 56,446 -0.103 0.131 -0.065 5,347 -0.113 0.123 -0.073 382 -0.047 0.044 -0.034 6,516 -0.067 0.071 -0.045 5,933 -0.088 0.096 -0.058 1,591 -0.057 0.053 -0.042 Tenure 9.719 7.812 6.528 3.275 5.840 3.179 6.400 3.721 7.258 5.510 5.311 2.933 Table 2: Descriptive Statistics by Country OCF LOGMV MtoB Age Tenure2 LITIGATE= 155.477 241.414 49 LITIGATE= 53.335 51.254 36 LITIGATE= 44.191 56.877 25 15 0.018 0.218 0.065 10 -0.072 0.267 -0.031 10 0.054 0.136 0.053 LITIGATE= 54.805 63.433 25 LITIGATE= 83.034 142.507 36 LITIGATE= 36.805 44.531 25 10 0.048 0.197 0.085 8.07 -0.028 0.235 0.012 4.82 0.054 0.120 0.057 INDG Growth 5.109 2.325 5.105 3.444 4.583 2.066 17.364 13.937 12 0.097 0.156 0.101 1.028 0.019 1.031 3.398 1.969 3.129 2.833 3.727 1.772 7.523 3.848 0.093 0.272 0.065 1.047 0.126 1.083 5.599 2.043 5.209 1.943 2.785 1.080 9.681 5.236 0.134 0.272 0.144 1.032 0.050 1.028 4.818 2.141 4.691 3.024 4.406 1.757 9.445 5.102 0.042 0.226 0.029 1.024 0.118 1.038 4.412 2.112 4.337 3.527 4.577 2.137 11.052 9.831 0.091 0.237 0.087 1.053 0.099 1.043 4.011 1.627 3.893 1.661 2.656 1.054 8.128 4.337 0.048 0.273 0.032 1.053 0.084 1.071 (continued on next page) 36 Table 2: Descriptive Statistics by Country (cont.) Country AQ1 Common Law Countries (cont.) South Africa N= 354 Mean -0.059 Std 0.060 Median -0.045 Thailand N= 414 Mean -0.054 Std 0.049 Median -0.040 India N= 3,787 Mean -0.064 Std 0.059 Median -0.048 Pakistan N= 299 Mean -0.056 Std 0.052 Median -0.044 Mean country values N= 8,107 Mean -0.071 Std 0.074 Median -0.049 Tenure2 OCF 7.823 3.517 LITIGATE= 58.921 51.201 43 LITIGATE= 61.804 64.424 36 LITIGATE= 52.551 40.462 49 LITIGATE= 73.522 57.099 64 4.82 0.088 0.125 0.081 3.61 0.105 0.117 0.104 2.42 0.075 0.121 0.073 0.098 0.132 0.079 6.944 3.976 6.200 LITIGATE= 67.445 81.320 38.800 7.00 0.044 0.167 0.058 Tenure 6.898 3.371 6.993 3.597 6.668 2.844 LOGMV MtoB Age INDG Growth 5.097 2.094 5.217 2.624 3.187 1.928 9.006 4.380 0.087 0.294 0.068 0.970 0.117 0.971 3.931 1.597 3.732 1.582 2.235 1.118 9.399 4.384 -0.036 0.200 -0.029 1.051 0.105 1.031 3.884 2.011 3.720 2.042 2.999 1.126 6.665 2.778 0.200 0.229 0.173 1.038 0.134 1.108 3.524 1.721 3.572 1.962 3.035 1.085 7.913 3.570 0.109 0.161 0.082 0.970 0.089 0.975 4.378 1.964 4.261 2.464 3.419 1.512 9.618 5.740 8.300 0.087 0.232 0.075 1.027 0.094 1.038 (continued on next page) 37 Table 2: Descriptive Statistics by Country (cont.) Code Law Countries Country France N= Mean Std Median Germany Italy Netherlands Norway Switzerland N= Mean Std Median N= Mean Std Median N= Mean Std Median N= Mean Std Median N= Mean Std Median AQ1 1,449 -0.045 0.042 -0.033 618 -0.056 0.050 -0.040 97 -0.031 0.030 -0.021 126 -0.058 0.071 -0.038 86 -0.048 0.052 -0.028 202 -0.040 0.041 -0.029 Tenure 7.552 4.160 7.694 3.886 5.144 1.826 4.691 2.018 5.814 2.476 6.624 3.707 Tenure2 LITIGATE= 74.331 83.231 49 OCF 6.22 0.063 0.107 0.073 LITIGATE= 74.280 77.091 49 LITIGATE= 29.763 27.003 25 LITIGATE= 26.040 25.152 16 LITIGATE= 39.860 42.045 25 LITIGATE= 57.545 72.634 36 6.22 0.053 0.139 0.072 6.22 0.051 0.094 0.046 6.22 0.064 0.134 0.091 6.22 0.058 0.171 0.054 6.22 0.092 0.125 0.094 LOGMV MtoB Age INDG Growth 5.068 2.172 4.740 2.335 3.008 1.616 10.460 5.045 10 0.080 0.238 0.077 1.060 0.099 1.052 4.837 2.066 4.437 2.186 2.643 1.452 10.774 4.997 11 -0.032 0.183 -0.065 1.027 0.071 1.029 5.656 1.661 5.585 1.562 1.249 1.146 10.949 4.816 11 -0.130 0.141 -0.152 1.024 0.038 1.025 5.156 2.046 4.735 2.299 2.340 1.707 11.643 4.857 12 0.095 0.168 0.125 1.063 0.092 1.037 6.055 1.669 5.993 4.361 5.916 1.863 10.151 5.637 -0.007 0.134 0.042 1.138 0.097 1.202 5.892 1.847 5.644 2.971 3.648 1.970 11.109 5.684 11 -0.012 0.167 0.020 1.040 0.087 1.079 (continued on next page) 38 Table 2: Descriptive Statistics by Country (cont.) Country AQ1 Code Law Countries (cont.) Belgium N= 94 Mean -0.042 Std 0.041 Median -0.033 Japan N= 15,573 Mean -0.031 Std 0.028 Median -0.023 Mexico N= 118 Mean -0.030 Std 0.023 Median -0.026 Spain N= 53 Mean -0.015 Std 0.016 Median -0.011 Sweden N= 221 Mean -0.059 Std 0.064 Median -0.040 Indonesia N= 64 Mean -0.058 Std 0.057 Median -0.041 Tenure 6.468 3.735 13.022 6.784 12 5.271 3.099 5.642 2.346 5.923 2.722 8.219 2.579 Tenure2 OCF LITIGATE= 55.638 76.731 36 LITIGATE= 215.584 187.967 144 LITIGATE= 37.305 44.166 16 LITIGATE= 37.226 34.164 25 LITIGATE= 42.457 42.075 25 LITIGATE= 74.094 44.580 64 4.82 0.019 0.154 0.050 4.82 0.051 0.068 0.053 4.82 0.136 0.087 0.142 4.82 0.079 0.061 0.078 4.82 -0.001 0.240 0.061 3.61 0.111 0.122 0.088 LOGMV MtoB Age INDG Growth 5.207 1.864 4.938 1.961 1.375 1.677 10.000 5.042 0.081 0.241 0.153 1.054 0.093 1.051 5.224 1.738 5.030 1.511 2.138 0.991 12.844 6.624 12 0.064 0.125 0.067 1.058 0.087 1.071 7.158 1.745 7.161 2.119 2.662 1.712 10.263 4.833 11 0.067 0.107 0.056 0.951 0.082 0.980 6.873 2.362 7.095 2.153 2.849 1.527 9.679 5.601 -0.024 0.100 -0.027 0.982 0.067 1.039 4.058 1.993 4.101 3.458 4.029 2.417 10.177 4.339 10 -0.076 0.179 -0.101 1.044 0.095 1.062 4.380 1.985 4.246 2.310 5.132 0.971 12.703 3.624 13 -0.095 0.075 -0.139 1.251 0.000 1.251 (continued on next page) 39 Table (cont.): Descriptive Statistics by Country OCF LOGMV MtoB Age Tenure Tenure2 INDG Growth Country AQ1 Code Law Countries (cont.) Philippines N= 67 LITIGATE= 3.61 Mean -0.046 10.045 114.642 0.041 4.493 3.456 11.373 -0.131 1.027 Std 0.048 3.735 75.055 0.187 1.972 7.041 3.958 0.265 0.065 Median -0.033 11 121 0.038 4.145 1.097 13 -0.108 1.045 South Korea N= 705 LITIGATE= 3.61 Mean -0.048 7.495 78.604 0.050 4.358 1.174 7.472 -0.031 1.102 Std 0.040 4.739 89.987 0.096 1.676 1.288 4.712 0.187 0.149 Median -0.037 36 0.049 4.083 0.788 -0.038 1.171 Taiwan N= 4,137 LITIGATE= 3.61 Mean -0.056 4.452 25.232 0.078 4.545 1.569 6.223 0.017 1.035 Std 0.049 2.327 26.777 0.105 1.552 1.358 2.673 0.223 0.048 Median -0.043 16 0.075 4.433 1.209 -0.012 1.007 Turkey N= 79 LITIGATE= 2.42 Mean -0.040 6.076 42.633 0.098 5.687 1.326 8.544 0.106 0.988 Std 0.043 2.406 33.572 0.104 1.230 1.050 4.203 0.124 0.224 Median -0.027 36 0.104 5.686 1.010 0.085 0.978 Mean country values N= 1,481 LITIGATE= 4.94 Mean -0.044 6.883 64.077 0.065 5.290 2.297 10.273 -0.002 1.053 Std 0.043 3.284 61.389 0.125 1.849 2.983 4.790 0.166 0.087 Median -0.031 6.313 44.938 0.073 5.128 1.447 9.938 -0.001 1.067 The sample consists of 104,758 firm-year observations for the period 1996 to 2009 for 26 countries Variable definitions are as follows: AQ1 is (-1) * the absolute value of abnormal accruals estimated from equation (2) for firm i in year t; Tenure is the number of consecutive years since 1974 that firm i has retained the auditor at year t; Tenure2 is the square of Tenure; OCF is operating cash flow scaled by average total assets for firm i in year t; LOGMV is the natural log of market value of equity for firm i in year t; MtoB is the market value divided by book value of equity i in year t; Age is the natural log of the number of years since firm i in year t first appeared in Compustat Global Vantage and Compustat North America; INDG is industry sales growth calculated as ∑ே ݈ܵܽ݁‫ݏ‬௜,௧ / ∑ே ݈ܵܽ݁‫ݏ‬௜,௧ିଵ by digit SIC industry groups for firm i in year t; Growth is annual growth in Gross Domestic Product ௜ୀଵ ௜ୀଵ (inflation adjusted); and LITIGATE is the litigation risk of a country, measured by Wingate (1997) litigation index for each country 40 Table 3: Correlation Matrix Variable AQ Tenure Tenure2 OCF LogMV Age MtoB INDG Growth Civil LITIG 0.152 AQ1 0.152 0.149 0.177 0.106 0.168 0.046 0.107 0.290 0.252 1.000 0.126 0.207 0.676 0.110 0.036 0.025 0.133 0.003# 0.126 0.207 0.676 0.110 0.036 0.025 0.133 0.003# 0.343 0.184 0.099 0.004# 0.031 0.005 0.008 0.262 0.359 0.021 0.027 0.044 0.102 0.055 0.008 0.13 0.051 0.252 0.078 0.01 0.274 0.288 0.178 0.144 0.109 0.147 0.201 Tenure 0.127 Tenure2 0.108 0.960 OCF 0.249 0.142 0.126 LogMV 0.187 0.253 0.256 0.296 Age 0.085 0.650 0.660 0.166 0.305 MtoB 0.165 0.077 0.047 0.063 0.354 0.006 INDG 0.026 0.018 0.012 0.007 0.016 0.013 0.055 Growth 0.060 0.010 0.011 0.006 0.014 0.062 0.035 0.144 Civil_Com 0.257 0.119 0.085 0.078 0.049 0.121 0.253 0.113 0.132 0.688 LITIGATE 0.255 0.030 0.063 0.067 0.084 0.285 0.285 0.068 0.128 0.719 Amounts in bold indicate significant at 0.01, and amounts with # indicate they are not significant at 0.01 The lower diagonal reports Spearman correlation coefficients, and the upper diagonal reports Pearson correlation coefficients Civil_Com is an indicator variable equal to for code law countries and equal to for common law countries All other variables are defined in Table 41 Table Regression Analysis - Turning Point of Audit Quality between Common Law and Code Law Countries Dependent Variable is AQ1 Pooled Variable Common Law Code Law Common Law vs Code Law Estimate Estimate Estimate Estimate N 104,758 81,069 23,689 AdjRSq 19.10% 15.90% 13.00% Intercept -0.157 *** -0.192 *** -0.054 Tenure 0.031 ** 0.070 *** 0.014 Tenure2 -0.016 *** -0.024 *** -0.017 *** -0.007 OCF 0.092 *** 0.091 *** 0.021 *** 0.070 *** Age 0.000 *** 0.000 *** 0.001 *** 0.000 *** LogMV 0.009 *** 0.011 *** 0.003 *** 0.008 *** MtoB -0.019 *** -0.021 *** -0.007 *** -0.015 *** INDG 0.007 *** 0.010 *** 0.001 0.009 *** Growth 0.022 *** 0.049 *** -0.006 0.055 *** Turning Point 9.625 *** 14.301 *** 4.086 10.215 *** *** -0.138 *** 0.056 Country Fixed Effects Industry Fixed Effects YES YES YES YES YES YES YES YES Year Fixed Effects YES YES YES YES *** significant at 0.01, ** significant at 0.05, * significant at 0.10 All tests are two-tailed, unless otherwise stated Turning point is defined as the ratio of the ்௘௡௨௥௘ coefficient estimates െ ଶൈ்௘௡௨௥௘ మ (note that the coefficient on Tenure2 has been multiplied by 10 for presentation purposes) All other variables are defined in Table Country, industry and year fixed effects are not reported for brevity 42 Table Regression Analysis - Turning Point of Audit Quality between Common Law and Code Law Countries Dependent Variable is AQ2 Pooled Variable Common Law Code Law Common Law vs Code Law Estimate Estimate Estimate Estimate N 119,032 88,823 30,209 AdjRSq 13.00% 11.50% 12.00% Intercept -0.216 *** -0.174 *** -0.149 *** -0.025 *** Tenure 0.336 *** 0.467 *** 0.102 *** 0.365 *** -0.111 *** -0.143 *** -0.070 *** -0.073 *** OCF 0.132 *** 0.129 *** 0.017 *** 0.112 *** Age 0.001 *** 0.001 *** 0.001 *** 0.000 *** logMV 0.016 *** 0.017 *** 0.008 *** 0.009 *** MtoB -0.034 *** -0.037 *** -0.014 *** -0.023 *** INDG -0.004 * Growth 0.000 Tenure Turning Point 15.183 0.001 0.002 -0.001 -0.062 *** 9.040 *** -0.062 *** *** 0.000 16.332 *** 7.292 *** Country Fixed Effects Industry Fixed Effects YES YES YES YES YES YES YES YES Year Fixed Effects YES YES YES YES *** significant at 0.01, ** significant at 0.05, * significant at 0.10 All tests are two-tailed, unless otherwise stated Turning point is defined as the ratio of the ்௘௡௨௥௘ coefficient estimates െ ଶൈ்௘௡௨௥௘ మ (note that the coefficient on Tenure2 has been multiplied by 10 for presentation purposes) AQ2 is accruals quality estimated by -1* actual accruals for firm i in year t less predicted accruals based on the prior year’s ratio of current accruals to sales and prior year’s ratio of depreciation to gross property plant and equipment (see text for further details) All other variables are defined in Table Country, industry and year fixed effects are not reported for brevity 43 Table Regression Analysis - Turning Point of Audit Quality between High-LIT and Low-LIT Countries Dependent Variable is AQ2 Pooled Variable High-LIT Low-LIT High-LIT vs Low-LIT Estimate Estimate Estimate Estimate N 119,032 71,511 47,521 AdjRSq 13.00% 12.10% 13.50% Intercept -0.216 *** -0.134 *** -0.173 *** 0.039 *** Tenure 0.336 *** 0.551 *** 0.180 *** 0.371 *** Tenure2 -0.111 *** -0.169 *** -0.090 *** -0.079 *** OCF 0.132 *** 0.138 *** 0.048 *** 0.091 *** Age 0.001 *** 0.001 *** 0.001 *** 0.000 *** logMV 0.016 *** 0.017 *** 0.013 *** 0.004 *** MtoB -0.034 *** -0.038 *** -0.022 *** -0.015 *** INDG -0.004 * -0.006 ** 0.010 Growth 0.000 Turning Point Country Fixed Effects Industry Fixed Effects Year Fixed Effects 15.183 0.004 -0.109 *** *** 0.000 16.333 *** 10.013 * -0.109 *** *** 6.320 *** YES YES YES YES YES YES YES YES YES YES YES YES *** significant at 0.01, ** significant at 0.05, * significant at 0.10 All tests are two-tailed, unless otherwise stated Turning point is defined as the ratio of the ்௘௡௨௥௘ coefficient estimates െ ଶൈ்௘௡௨௥௘ మ (note that the coefficient on Tenure2 has been multiplied by 10 for presentation purposes) High-LIT is defined as LITIGATE >= 10, and Low-LIT is defined as LITIGATE < 10 All other variables are defined in Table Country, industry and year fixed effects are not reported for brevity 44 .. .When Does Audit Quality Start to Decline in Audit Firm Tenure? – An International Analysis Abstract This paper investigates the decline in audit quality during an audit firm? ??s tenure across... For instance, auditors became less tolerant of accruals-based earnings management (Cohen et al 2008) in the postSOX era 14 The point in time when audit quality starts to deteriorate during an audit. .. US firms, Davis et al (2009) and Brooks (2011) find that audit quality and audit firm tenure have an inverted U function – i.e., audit quality increases in early years of the audit firm? ??s tenure