ghosh and moon - 2005 - auditor tenure and audit quality [mar]

Auditor Tenure and Perceptions of Audit Quality Author(s): Aloke Ghosh and Doocheol Moon Source: The Accounting Review, Vol. 80, No. 2 (Apr., 2005), pp. 585-612 Published by: American Accounting Association Stable URL: http://www.jstor.org/stable/4093070 . Accessed: 28/09/2013 18:13 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. . American Accounting Association is collaborating with JSTOR to digitize, preserve and extend access to The Accounting Review. http://www.jstor.org This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions THE ACCOUNTING REVIEW Vol. 80, No. 2 2005 pp. 585-612 Auditor Tenure and Perceptions of Audit Quality Aloke Ghosh U.S. Securities and Exchange Commission and Baruch College-The City University of New York Doocheol Moon State University of New York at Old Westbury ABSTRACT: We analyze how investors and information intermediaries perceive auditor tenure. Using earnings response coefficients from returns-earnings regressions as a proxy for investor perceptions of earnings quality, we document a positive association between investor perceptions of earnings quality and tenure. Further, we find that the influence of reported earnings on stock rankings becomes larger with extended tenure, although the association between debt ratings and reported earnings does not vary with tenure. Finally, we find that the influence of past earnings on one-year-ahead earnings forecasts becomes greater as tenure increases. In general, our results are consistent with the hypothesis that investors and information intermediaries perceive auditor tenure as improving audit quality. One implication of our study is that imposing mandatory limits on the duration of the auditor-client relationship might impose unintended costs on capital market participants. Keywords: auditor tenure; auditor independence; audit quality; earnings quality; mandatory auditor rotation; capital market perceptions. Data Availability: All data used in this study are available from public sources. We thank Ashiq Ali, Mark Beasley, Marti Benis, Donal Byard, Masako Darrough, Paquita Davis-Friday, Anita Dennis, Zeng Deng, Rajib Doogar, Amy Edwards, Mary Greenawalt, Zhaoyang Gu, Larry Harris, Prem Jain, Joe Kerstein, Ying Li, Steve Lilien, Steve Lustgarten, Darius Miller, two anonymous referees, Srini Sankaraguruswamy, Bharat Sarath, Dave Smith, Jonathan Sokobin, Jan Sweeney, Tony Tinker, Joe Weintrop, and Jimmy Ye for their helpful comments. This paper was previously titled: "Does Auditor Tenure Impair Audit Quality?" We acknowledge financial support from the Robert Zicklin Center for Corporate Integrity of Baruch College. The Securities and Exchange Commission disclaims responsibility for any private publication or statement by any SEC employee or commissioner. This paper expresses the authors' views and does not necessarily reflect those of the Commission, the commissioners, or other members of the staff. Editor's note: This paper was accepted by Terry Shevlin, Senior Editor. Submitted August 2002 Accepted August 2004 585 This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions 586 Ghosh and Moon I. INTRODUCTION he recent rise in accounting irregularities has reopened questions about auditor tenure, independence, and audit quality (Bricker 2002).' Recent studies provide valuable insights into the debate surrounding auditor tenure by examining the association between tenure and (1) accounting accruals, (2) analysts' forecast errors, and (3) the cost of debt. Myers et al. (2003) conclude that longer auditor tenure constrains managerial discretion with accounting accruals, which suggests high audit quality. Johnson et al. (2002) also find that accruals are larger and less persistent for firms with short auditor tenure relative to those with medium or long tenure. Using credit spreads between bond yields and matched Treasury yields as the cost of debt, Mansi et al. (2004) find that the cost of debt declines with longer tenure, which suggests bondholders perceive audit quality as improving with extended tenure. In contrast, Davis et al. (2002) conclude that audit quality declines with extended tenure because, as tenure increases, client firms have greater reporting flexibility and earnings forecast errors decline. This study focuses on how investors and information intermediaries perceive auditor tenure. Using earnings response coefficients from returns-earnings regressions as a proxy for investor perceptions of earnings quality, we analyze whether investors perceive earnings quality as being affected by tenure. Given the importance of information intermediaries who receive and process financial information for investors, we also analyze whether independent rating agencies and financial analysts incorporate the potential effects of tenure on earnings quality. Specifically, we examine whether tenure affects the relationship between reported earnings and (1) stock rankings, (2) debt ratings, and (3) analysts' earnings forecasts. A key distinction between our study and those of Davis et al. (2002) and Mansi et al. (2004) is the difference in the research design. We examine whether the extent to which analysts rely on past reported earnings to predict future earnings varies with tenure, whereas Davis et al. (2002) explore the association between forecast errors and tenure. Our research design might be better suited because it is difficult to draw unambiguous inferences about analysts' perceptions from an association between forecast errors and tenure. Lower forecast errors with longer tenure might suggest that earnings quality is perceived as improving with tenure because earnings are more predictable. However, it could also suggest lower earnings quality if managers increasingly guide earnings forecasts as auditor tenure lengthens. Fur- ther, Mansi et al. (2004) investigate the influence of tenure on the cost of debt, whereas we examine whether the influence of reported earnings on debt ratings varies with tenure. Although Mansi et al. (2004) examine the effect of tenure on debt ratings, their primary aim is to purge (orthogonalize) the information effects of tenure and other control variables related to debt ratings and ultimately examine the insurance role of tenure on the cost of debt. In contrast, our emphasis is on the informational role of tenure. Our fundamental objective is to provide insights into any changes in the perceived credibility of reported earnings with extended auditor tenure. Emphasis on capital market perceptions of independence and audit quality is consistent with the Financial Accounting Standards Board's (FASB) conceptual framework for financial reporting and principles of auditor independence (Carmichael 1999). According to the Regulators express concerns that pressure to retain client firms and the "comfort level" created between auditors and management over time impair auditor independence, which adversely affects audit quality (U.S. Government Accounting Office [GAO] 2003). The accounting profession, on the other hand, claims that the likelihood of audit failures is greater during the initial period of an auditor-client relationship because of lack of information about client-specific risks (PricewaterhouseCoopers 2002). The Accounting Review, April 2005 This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions Auditor Tenure and Perceptions of Audit Quality 587 Statement of Financial Accounting Concepts (SFAC No. 1, FASB 1978), "financial statements are often audited by independent accountants for the purpose of enhancing confidence in their reliability." The AICPA (1994) also acknowledges the importance of considering investor perceptions of auditor independence. A former chairman of AICPA, Elliott (2000) says "[The AICPA] believe[s] that appearances are very important and capital markets require confidence in financial statements and audit reports, and the member firms of the AICPA are basing their business of auditing on their reputations, and that is heavily affected by appearance." Other things remaining constant, audited financial statements are less reliable (or of lower perceived quality) for investment and credit decisions if users of financial statements view lengthy tenure as having an adverse effect on auditor independence and audit quality. Alternatively, investors and information intermediaries are more likely to rely on reported accounting numbers if they perceive that greater auditor expertise from longer tenure im- proves independence and audit quality. We assert that the relationship between perceptions of earnings quality and auditor tenure provides insights into how capital market participants view auditor tenure as affecting audit quality. We use earnings response coefficients (ERCs) from contemporaneous returns-earnings regressions to measure investor perceptions of earnings quality. After controlling for the other determinants of ERC-such as the age of the firm, the quality of auditors, growth, earnings persistence, earnings volatility, systematic risk, firm size, financial leverage, and regulatory environment-we find that the magnitude of the ERC increases as the auditor- client relationship lengthens. One concern is that if the market anticipates a portion of current earnings more than one-year-ahead of the earnings release, then the estimated ERC might be biased downward (Kothari 1992; Kothari and Sloan 1992). Additionally, if the market is more likely to anticipate current earnings for firms with longer tenure, then the bias might be associated with tenure. Consistent with the premise that prices lead earnings, the estimated ERC for firms with extended tenure is larger when we increase the returns measurement window or when we use non-market metrics, such as total assets, to deflate earnings. Thus, the ERC-based findings are consistent with the hypothesis that investors perceive auditor tenure as enhancing earnings quality. Further, controlling for the other determinants of stock rankings, we find that the influence of reported earnings on Standard & Poor's (S&P) common stock rankings becomes larger with extended tenure. In contrast, the association between S&P debt ratings and reported earnings does not vary with tenure. Thus, our results provide modest evidence that independent rating agencies perceive reported earnings as being more reliable for firms with longer tenure. Finally, after controlling for factors that affect analysts' earnings forecasts, we find that the influence of past earnings on one-year-ahead earnings forecasts becomes larger over extended auditor-client relationships. All else equal, analysts are more likely to rely on reported earnings to predict future earnings with longer tenure. Thus, the results from analyst earnings forecasts also suggest that analysts perceive earnings quality as improving with longer auditor tenure. While our results are based on a large sample of firms spanning 11 years, there is one concern with our dataset. If auditor tenure is endogenous to audit quality, then the results are also consistent with an alternative hypothesis that auditor turnover is high for firms with low earnings quality. In other words, high-quality auditors might terminate engagements with client firms that prefer low-quality financial statements (DeFond and Subramanyam 1998). We address potential concerns about frequent auditor turnover by constructing a subsample for which the auditor-client relationship lasts for at least five The Accounting Review, April 2005 This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions 588 Ghosh and Moon years, as in Myers et al. (2003). When we use this subsample, our inferences remain unchanged for all our tests. In sum, our results are generally consistent with the hypothesis that reported earnings are perceived as being more reliable as auditor tenure increases. One implication of our results is that capital market participants view longer auditor tenure as having a favorable impact on audit quality. Our results suggest that imposing mandatory limits on the duration of the auditor-client relationship might impose unintended costs on capital markets. How- ever, results from a regime without auditor term limits may not be applicable to a regulated environment because of differences in economic incentives for both auditors and clients. The rest of the paper is organized as follows. Section II establishes the links between tenure, independence, and perceptions of audit quality. Section III discusses the research design, and Section IV describes the sample selection procedure. Section V reports the results of the association between tenure and perceptions of earnings quality. Section VI concludes the paper. II. TENURE, INDEPENDENCE, AND PERCEPTIONS OF AUDIT QUALITY Independent auditors are considered the "gatekeepers" of the public securities markets (SEC 2001, III.A). However, the recent rash of accounting irregularities has led many to question auditor independence (Wall Street Journal 2002a, 2002b). One perception is that auditors are more likely to agree with managers on important reporting decisions as the length of the audit engagement increases (Ryan et al. 2001; Farmer et al. 1987). Therefore, imposing mandatory limits on auditor tenure is expected to improve audit quality by reducing client firms' influence over auditors (Turner 2002; Brody and Moscove 1998; SEC 1994; AICPA 1978; U.S. Senate 1977; Mautz and Sharaf 1961). An opposing viewpoint is that problem audits occur more frequently for newer clients because auditors have less information about these firms (AICPA 1992). Client-specific knowledge of items such as operations, accounting system, and internal control structure is crucial for auditors to detect material errors and misstatements. In particular, Johnson et al. (2002) argue that lack of adequate client-specific knowledge during the early years of engagement decreases the likelihood of detecting material errors and misstatements. As the auditor-client relationship lengthens, firm-specific expertise allows auditors to rely less on managerial estimates and become more independent of management (Solomon et al. 1999). The crux of the debate rests on how tenure affects auditor independence. Proponents of mandatory auditor rotation claim that lengthy auditor tenure erodes independence, which in turn impairs audit quality. Others argue that independence and audit quality increase with longer tenure because of improved auditor expertise from superior client-specific knowledge.2 Since independence is not observable, regulators, practitioners, and academics often rely on the appearance dimension to define auditor independence (Dopuch et al. 2003; Kinney 1999). Our study investigates whether capital market participants perceive longer tenure as affecting audit quality. Insights from a market-based approach are important along at least two dimensions. First, academics often emphasize the need to understand capital market perceptions of auditor independence and audit quality because ultimately the value of auditing services depends on perceptions of independence (Dopuch et al. 2003; Shockley 2 Expert knowledge gained through years of on-the-job experience increases the likelihood that auditors will detect errors in financial statements (Ashton 1991; Libby and Frederick 1990). In contrast, industry specialization, another frequently used proxy for auditor expertise, is based on training and practical experience gained from auditing in a particular industry (Gramling and Stone 2001; Solomon et al. 1999; Hogan and Jeter 1999; Craswell et al. 1995). The Accounting Review, April 2005 This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions Auditor Tenure and Perceptions of Audit Quality 589 1981). Second, regulatory institutions such as the FASB (SFAC No. 1) and SEC (2000) emphasize the importance of capital market perceptions of auditor independence. A perception that the auditors' work is more objective and independent inspires greater confidence in auditor opinion, which increases the perceived reliability or quality of reported accounting numbers (Ryan et al. 2001; Elliott and Jacobson 1998). Independent auditors increase the reliability of financial statements because (1) they are more likely to prevent or detect and correct material misstatements/omissions, and (2) they ensure that financial statements comply with generally accepted accounting principles (Carmichael 1999). There- fore, to the extent that capital market participants view tenure as improving independence and audit quality, financial statements are perceived as more reliable for financial decisions as tenure lengthens. In this study, we focus on the perceptions of investors because they are the principal users of financial statements. In its Conceptual Framework, the FASB defines "quality" in relation to the usefulness of financial statements to investors and links "usefulness" in turn to constructs such as relevance and reliability (SFACs No. 1 [FASB 1978] and No. 2 [FASB 1980]). To draw inferences about investors' perceptions of earnings quality, researchers tend to use stock-market-based metrics such as earnings response coefficients from regressions of returns on earnings (Schipper and Vincent 2003; Warfield et al. 1995). Prior studies document that investors pay a larger premium for "high-quality" earnings because high- quality earnings are viewed as sustainable (Schipper and Vincent 2003; Teoh and Wong 1993). Thus, examining the influence of auditor tenure on the pricing of earnings is likely to provide valuable insights into investors' views of the association between the length of the auditor-client relationship and earnings quality. Given that information intermediaries constitute an integral part of the capital market by providing stock recommendations, debt ratings, and earnings forecasts (Lang and Lundholm 1996), we also analyze how independent rating agencies and financial analysts view auditor tenure. Hunt (2002) states that independent rating agencies provide information about the creditworthiness of issuers and that credit ratings play a significant role in investment decisions. Extant research finds links between earnings and debt ratings/stock rankings issued by independent rating agencies (Bhojraj and Sengupta 2003; Ziebart and Reiter 1992; Van Horne 1992; Kaplan and Urwitz 1979), suggesting that perceptions of earnings quality could be an important input in determining rankings/ratings. Similarly, financial analysts also play a prominent role as information intermediaries in capital markets because of their ability to incorporate value-relevant information in their published reports, which impacts security prices (Francis and Soffer 1997; Schipper 1991; Lys and Sohn 1990; Brown et al. 1987). Prior research finds that analysts rely on earnings releases to estimate future earnings (Kasznik and McNichols 2002; Barron et al. 2002; Stickel 1989), which suggests that the extent to which analysts depend on reported earnings to make earnings forecasts might vary with perceptions of earnings quality. Extending this line of research, we examine the association between auditor tenure and (1) stock rankings, (2) debt ratings, and (3) analysts' forecasts of earnings per share. Ad- ditionally, we analyze how auditor tenure affects the association between reported earnings and rankings, ratings, and earnings forecasts. If auditor tenure is perceived as enhancing earnings quality, then, all else equal, the influence of reported earnings on rankings/ratings and earnings forecasts is expected to become larger with longer auditor tenure because reported earnings are viewed as more informative about future earnings. The converse is true if information intermediaries perceive longer auditor tenure as eroding earnings quality. Based on the association between our proxy measures for perceptions of earnings quality and auditor tenure, we infer how investors and information intermediaries view auditor The Accounting Review, April 2005 This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions 590 Ghosh and Moon tenure as affecting audit quality. A positive relationship between the proxies for perceptions of earnings quality and auditor tenure is consistent with the hypothesis that longer tenure is perceived as improving independence and audit quality. In contrast, a negative relationship is consistent with the hypothesis that lengthy tenure is viewed as eroding independence and audit quality. III. RESEARCH DESIGN We use the following basic regression framework to analyze whether investors, independent rating agencies, and financial analysts perceive earnings quality as being affected by auditor tenure: Dependent variable = ac + PE + P2AE + 13E*Tenure + r4AE*Tenure 9 + 35Tenure + P36+2(j-1)E*Control variable. j=1 9 + 137+2(j- ) AE*Control variable. j=1 9 + E 323+jControl variablej + E. (1) j=1 E and AE are reported earnings and changes in reported earnings, respectively. Tenure is the duration of the auditor-client relationship (calculated using Compustat #149) in years, starting from 1982 (audit firm mergers are considered as a continuation of the prior auditor). Subscriptj represents the number of control variables (1 to 9). Each of the control variables is interacted with E/AE and is also included as a separate independent variable. Details on the dependent and control variables are provided in subsequent subsections. The sum of earnings levels and changes coefficients (p, + 132) or the "earnings response coefficient" (ERC) is our proxy for capital markets' perceptions of earnings quality. Our interest is in the sum of the E*Tenure and AE*Tenure coefficients (P3 + 14). If investors, rating agencies, and analysts perceive earnings quality as improving (declining) with longer auditor tenure, 133 + 34 is expected to differ from zero. Perceptions of Investors and Auditor Tenure We measure investor perceptions of earnings quality using 12-month (ending three months after the fiscal year-end) cumulative market-adjusted returns (CAR) as the dependent variable in Equation (1). Market-adjusted returns are the difference between raw returns and value-weighted CRSP market returns. We include earnings changes and earnings levels in the same regression because including both increases the explanatory power and magnitude of earnings response coefficients when earnings contain both transitory and permanent components (Easton and Harris 1991; Ali and Zarowin 1992). E is income before extraordinary items (Compustat #18) and AE is the difference between income before extraordinary items for the current year and that of last year. Both E and AE are deflated by market value of equity (Compustat #25 x #199) at the beginning of the year. We include various control variables because the ERC is associated with other firm characteristics (Warfield et al. 1995; Dhaliwal and Reynolds 1994; Collins and Kothari 1989), which, in turn, might be associated with tenure. The control variables are defined as follows: FirmAge, computed using the beginning and end dates as reported in CRSP, The Accounting Review, April 2005 This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions Auditor Tenure and Perceptions of Audit Quality 591 measures the number of years that the firm has been publicly traded as of the fiscal year- end; Big4 is an indicator variable that equals 1 when the client's auditor is a large accounting firm (Compustat #149); Growth is the sum of the market value of equity (Compustat #25 x #199) and the book value of debt (Compustat #9 + #34) scaled by the book value of total assets (Compustat #6); Persistence (Volatility) is the first-order autocorrelation (standard deviation) of income before extraordinary items per share (Compustat Quarterly #8/ Quarterly #61) for the past 16 quarters;3 Beta is systematic risk computed using the past 60 monthly stock returns; Size is the logarithmic transformation of the fiscal year-end market value of equity (Compustat #25 x #199) of the prior year; Leverage is the ratio of total debt (Compustat #9 + #34) to total assets (Compustat #6); and Regulation is an indicator variable that equals 1 for firms in a regulated industry with two-digit standard industry classification codes between 40 and 49 or between 60 and 63. We include FirmAge for two reasons: (1) older firms are more likely to be stable with less information asymmetry problems, which suggests higher ERCs; and (2) Tenure and FirmAge are positively correlated. We control for Big4 because large auditors are generally associated with high-quality audits (Becker et al. 1998; Teoh and Wong 1993). The inclusion of Growth, Persistence, Volatility, and Beta is primarily motivated by valuation considerations (Warfield et al. 1995). The inclusion of Size is motivated by the political cost theory: managers of large, politically sensitive firms are more likely to exploit the latitude in accounting to reduce political costs, which affects earnings quality. We include Leverage because of contracting considerations: firms with high leverage are more likely to use the latitude in accounting to avoid possible debt-covenant violations (DeFond and Jiambalvo 1994). Finally, the quality of earnings is affected in a regulated environment (Regulation) because managers have limited scope for opportunistic behavior (Warfield et al. 1995). Perceptions of Information Intermediaries and Auditor Tenure Independent Rating Agencies Our analysis of how tenure affects independent rating agencies' perceptions of earnings quality is based on estimates from Equation (1) using Standard & Poor's (S&P) common stock rankings (Stock Rankings) and senior debt ratings (Debt Ratings) as dependent variables. Stock Rankings represent numerical values of 1 to 7, corresponding to S&P common stock rankings (Compustat #282). A value of 1 is assigned if a firm's common stock ranking is rated as A+ and as S&P common stock rankings decline, the numerical value increases by 1.4 Similarly, Debt Ratings are assigned a value of I if a firm's S&P senior debt (Com- pustat #280) is rated as AAA. As S&P debt ratings decline from AAA (the highest) to D (payment default), the numerical value increases by 1. We include Growth, Volatility, Beta, Size, and Leverage to control for cross-sectional differences in firm quality and riskiness (Bhojraj and Sengupta 2003; Van Home 1992; Ziebart and Reiter 1992; Kaplan and Urwitz 1979). Growing firms with high earnings volatility tend to be more risky, Beta controls for both operating and financial risk, large firms tend to be less risky, and firms with higher leverage have greater financial risk. We also include FirmAge, Big4, Persistence, and Regulation because the association between reported earnings and rankings/ratings might depend on the firm's life-cycle, whether firms SSince Persistence and Volatility measures are computed using time-series income per share numbers, we adjust for stock-splits and stock dividends that occur subsequent to the end of a given period using the adjustment factor reported in Compustat (Quarterly #17). 4 For instance, values 2 through 7 correspond to the S&P common stock rankings of A, A-, B+, B, B-, and C, respectively. We do not include S&P common stock rankings of D (in reorganization) and LIQ (liquidation) for our sample because of going-concern issues. The Accounting Review, April 2005 This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions 592 Ghosh and Moon use big audit firms, whether earnings are persistent, and whether firms are in a regulated environment. In a recent study, Mansi et al. (2004) find that longer tenure lowers the rate of return required by bondholders and that the impact is larger for "information-sensitive" securities such as non-investment grade bonds (debt ratings less than BBB-). Therefore, we also separately estimate the effects of tenure on investment and non-investment grade debt ratings. Financial Analysts Finally, our analysis of whether tenure influences financial analysts' perceptions of earnings quality is based on the estimates from Equation (1) using earnings forecasts (FEPS,) as the dependent variable. FEPS, is the consensus analyst forecasts of annual earnings per share from the Institutional Brokers Estimation System (I/B/E/S) database. Our proxy for consensus forecasts is the mean one-year-ahead forecast for year t issued immediately following the earnings announcement for year t- 1 (earnings announcement dates are obtained from Compustat).5 We restrict the forecasts to those issued immediately following earnings announcements, as in Kasznik and McNichols (2002) and Barron et al. (2002), because (1) any change in analysts' perceptions of earnings quality is more likely to be updated following earnings releases (Barron et al. 2002), (2) it excludes stale forecasts since forecast revisions are more common following earnings announcements (Stickel 1989), and (3) it conditions the forecasts on the same set of publicly disclosed information. Reported earnings per share (EPS,_, and AEPS,_,) are used as measures for E and AE in Equation (1). EPS,_, is annual earnings per share reported for year t- 1, and AEPS,_, is the absolute change in earnings per share for year t- 1 defined as the difference in annual earnings per share in year t- I and that in year t-2 (IEPS,_, - EPS,_-2), both obtained from the I/B/E/S database. As in Barron et al. (2002), we include the absolute value of changes in earnings because a larger earnings surprise tends to be temporary, which reduces the potential usefulness of past earnings in predicting future earnings. Since prior studies find that analysts' incentives to acquire information about future earnings are affected by firm characteristics (DeFond and Hung 2003; Barron et al. 2002; Lang and Lundholm 1996), we include the following control variables: FirmAge because older firms are more likely to be stable and consequently earnings might be easier to predict; auditor type (Big4) because analysts might perceive earnings quality as improving for firms with big auditors; Growth because high-growth firms tend to generate greater demand for private information, thereby reducing the reliance on reported earnings (Barron et al. 2002; Lang and Lundholm 1996); Volatility because analysts are more likely to attach lower importance on reported earnings for firms with higher earnings volatility (DeFond and Hung 2003); risk using a market-based measure (Beta) and a balance-sheet-based measure (Lev- erage); Size because prior studies find that firm size is associated with risk and the information environment, which affects earnings predictability (DeFond and Hung 2003; Barron et al. 2002); Regulation because the predictability of earnings might vary between industries (O'Brien 1990); and the number of analysts (Analysts) providing annual earnings per share SWe prefer consensus forecasts to individual forecasts because prior research finds that consensus forecasts are more accurate than the individual forecasts underlying the consensus. One explanation for this result is that the forecast errors made by individual analysts are less than perfectly correlated and therefore in the process of aggregation, the individual forecast errors offset each other (see Brown et al. 11985] for related papers). The results are similar when we use either the mean or the median forecast. The Accounting Review, April 2005 This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions Auditor Tenure and Perceptions of Audit Quality 593 forecasts for a firm (Lang and Lundholm 1996). All the control variables including Tenure are measured at the end of year t- 1. In a recent study, Davis et al. (2002) find that forecast errors decline as tenure increases.6 However, it is difficult to draw unambiguous inferences about perceptions of analysts from an association between forecast errors and tenure. Lower forecast errors might suggest that analysts perceive earnings quality as improving with tenure because earnings are more predictable. Alternatively, lower forecast errors with longer tenure might suggest lower earnings quality if managers are more likely to guide earnings forecasts as auditor tenure lengthens.7 Hence, we do not focus on earnings forecast attributes such as forecast errors and dispersion. IV. DATA We construct a sample from the list of publicly traded firms in the 2001 Compustat annual files (active and research). Since the 2001 Compustat files cover 20 years of data, and financial data are available from 1982, auditor tenure is 1 for the first year by construc- tion. The analysis begins with 1990 to provide some variation for auditor tenure and excludes the year 2001 because of possible missing and incomplete data.8 Stock return and firm age data are obtained from the 2001 CRSP files. We get earnings forecast data from the 2001 Institutional Brokers Estimation System (I/B/E/S) Summary Estimates. We impose the following restrictions on the sample: (1) we delete the top and bottom 1 percent of observations for the level of earnings (E), changes in earnings (AE), annual earnings per share (EPS), and the absolute change in annual earnings per share (AEPS); (2) we remove all observations with the absolute value of cumulative market-adjusted returns (CAR) greater than 100 percent; and (3) we also winsorize the top and bottom 1 percent of observations for Growth, Persistence, Volatility, Beta, and Leverage.9 This sample selection procedure results in a maximum of 38,794 observations for the "full" sample over the years 1990 through 2000. Some concerns remain with the full sample. Firms might frequently switch auditors either because of "opinion shopping" (SEC 1988) or because of auditors' preference for conservative accounting choices (DeFond and Subramanyam 1998). Alternatively, high- quality auditors might end engagements with clients that prefer low quality of financial 6 Researchers frequently use forecast errors and dispersion among forecasts as proxies for the uncertainty among analysts about the quality of accounting information (Hope 2003; Duru and Reeb 2002; Ashbaugh and Pincus 2001; Barron et al. 1998; Lang and Lundholm 1996). 7 Managers have strong incentives to avoid negative earnings surprises because of the large stock-price reactions to negative earnings (see Ghosh et al. 2005; Bartov et al. 2002; Myers and Skinner 2002; Skinner and Sloan 2002; Barth et al. 1999). Firms can avoid earnings surprises by manipulating earnings to meet expectations or by guiding analyst expectations to avoid overly optimistic forecasts. Although existing studies suggest that earnings management declines with longer auditor tenure (Myers et al. 2003; Johnson et al. 2002), we do not know whether tenure affects managers' propensity to guide analysts' expectations. 8 Our computation of Tenure will understate the actual length of auditor tenure because Tenure is 1 for firms in 1982 even if the auditor was the same for the prior years. However, when we replicate our analysis computing Tenure from 1974 using information about the client's auditor as reported in Compustat backfiles, similar to Mansi et al. (2004), our conclusions remain unaffected. 9 The use of alternative cut-off points such as 0.5 percent also yields similar results, but it retains extreme observations. For instance, the minimum of E is -541 percent and the maximum of AE is 629 percent when we delete the top and bottom 0.5 percent. We delete observations with absolute CARs greater than 100 percent to reduce the impact of major corporate restructuring activities such as mergers, bankruptcies, spin-offs, etc. However, when we delete the top and bottom 1 percent of CAR, we get similar results. The results on tenure are unaffected when we truncate the top and bottom 1 percent of observations for the control variables. The Accounting Review, April 2005 This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions [...]... (P315) -0 .117 (-2 .11)** 0.023 (1.35) (,33) -0 .002 (-1 .71) -0 .296 (-4 .21)*** -0 .061 (-1 .38) 0.001 (4.58)*** 0.047 (4.00)*** 0.023 (5.41)*** 0.014 (1.93)* -0 .025 (-7 .75)*** -0 .005 (-0 .18) -0 .005 (-1 .23) -0 .018 (-0 .71) 0.045 (4.01)*** -0 .051 (-1 .27) 0.001 (4.47)*** 0.041 (3.43)*** 0.024 (5.60)*** 0.015 (2.28)** -0 .025 (-8 .53)*** -0 .003 (-0 .10) -0 .005 (-1 .39) -0 .014 (-0 .53) 0.044 (3.72)*** 2,89 7-3 ,803 0.10 9-0 .369... 0.140 (7.17)*** -0 .235 (-2 .18)** -0 .225 (-1 .99)* -0 .041 (-1 .26) -0 .034 (-1 .04) -0 .013 0.003 0.028 -0 .003 0.138 -0 .004 -0 .048 0.174 -0 .014 0.004 0.034 -0 .003 0.138 -0 .002 -0 .050 0.168 (-3 .85)*** (4.92)*** (1.39) (-0 .91) (3.04)*** (-0 .28) (-1 2.29)*** (5.06)*** (-4 .20)*** (4.95)*** (1.54) (-1 .00) (2.86)*** (-0 .18) (-1 2.99)*** (4.41)*** 0.020 (0.89) 0.013 (0.55) 1,10 0-1 ,855 0.002 (1.82)* 1,10 0-1 ,855 0.002... significant (-0 .216, t-statistic = -1 .98; t-statisticAc = -1 .85) for the full sample, it is insignificant (-0 .240, t-statistic = S-1.66; t-statisticAc -1 .62) for the restrictedsample On the other hand, P, remains and significant for the full sample (-0 .065, t-statistic = -4 .78; t-statisticAC negative = -2 .70) and the restricted = sample (-0 .067, t-statistic = -4 .51; t-statisticAc -2 .70) Thus, althoughlonger tenureis... Rankings and Perceptions of Information Intermediaries Full Sample Variables (Coefficients) 5.746 (100.31)*** Intercept (a) E AE (P31) (P2) (P1 + E *Tenure AE *Tenure Tenure 32) (13) (N4) (13 + 14) (Ps) -0 .366 (-1 .01) -0 .030 (-0 .08) -0 .396 (-1 .84)* -0 .100 (-3 .80)*** 0.046 (2.39)** -0 .054 (-3 .76)*** -0 .068 (-6 .05)*** -0 .061 (-5 .16)*** 0.021 (1.93)* -0 .040 (-3 .31)*** -0 .023 (-9 .33)*** -0 .063 (-5 .87)***... EPS,_, *Tenure AEPS,_, *Tenure (p, + 32) -0 .068 (-0 .66) 0.464 (4.62)*** -0 .074 (-0 .70) 0.456 (4.49)*** (133) 0.005 (1.75) 0.005 (1.79) 0.005 (1.54) (34) 0.014 (2.00)** 0.011 (2.11)** 0.011 (1.95)* 0.016 (2.51)** -0 .002 (-0 .76) + (136 P7) -0 .004 (-2 .83)*** -0 .004 (-2 .90)*** (13 + 13) -0 .060 (-1 .29) -0 .077 (-1 .49) (A3o+ 3,,) Tenure ControlVariables 0.016 (2.90)*** -0 .003 (-1 .16) -0 .008 (-0 .33) -0 .010 (-0 .41)... negative (-0 .040) and significant (t-statistic = -3 .31; t-statisticA = -3 .31) 13 is also negative (-0 .023) and significant (t-statistic = -9 .33; t-statisticAC= -6 .59) The results are very similar when we use the restrictedsample (reportedin the last column) P3 + 134is negative (-0 .040) and significant(t-statistic = -2 .97; t-statisticAC -2 .97), and P, is highly significant (-0 .024, t-statistic = -9 .79; = t-statisticAC=... W., and S P Kothari 1989 An analysis of intertemporal and cross-sectional determinants of earnings response coefficient Journal of Accounting and Economics 11: 14 3-1 81 Craswell, A T., J R Francis, and S L Taylor 1995 Auditor brand name reputations and industry specialization Journal of Accounting and Economics 20: 29 7-3 22 Davis, L R., B Soo, and G Trompeter 2002 Auditor tenure, auditor independence and. .. 3.20) andthe restricted = 2.90) sample (0.016, t-statistic VI CONCLUSIONS This study provides insights into the recent debate surrounding auditortenure, indebetween auditortenureand audit pendence ,and auditquality by analyzingthe relationship TheAccountingReview,April 2005 This content downloaded from 205.133.226.104 on Sat, 28 Sep 2013 18:13:51 PM All use subject to JSTOR Terms and Conditions AuditorTenure... (130) Regulation (- 1.94)* (4.78)*** (7.55)*** (12.12)*** -1 .087 (-3 1.65)*** (127) (129) 3.676 (13.00)*** (131) - 1.025 (- 10.18)*** (332) YearlyObservations AdjustedR2 1.914 (3.80)*** -0 .102 0.306 0.254 1.359 (328) Size Leverage -0 .014 (-7 .13)*** 1.473 (3.13)*** (326) Volatility Beta -1 .271 (-1 .99)* -1 .127 (-1 .84)* -0 .014 (-7 .46)*** 60 3-1 ,124 0.13 2-0 .245 -0 .108 0.305 0.223 1.333 (-1 .98)* (4.60)***... anticipatecurrent-year earningsmore thanone year ahead of the earningsrelease for firms with extendedauditor-client relationships Overall,the resultsfromTables3 and 4 are consistentwith the hypothesisthatinvestors perceive earningsquality as improvingwith longer auditortenure.Our results suggest that investorsview audit quality as improvingwith auditortenure P3 Perceptions of Information Intermediaries and Auditor . (P31) -1 .969 (-5 .25)*** -0 .208 (-0 .91) -0 .366 (-1 .01) AE (P2) 1.314 (4.77)*** -0 .148 (-0 .58) -0 .030 (-0 .08) (P1 + 32) -0 .655 (-5 .25)*** -0 .356 (-2 .03)** -0 .396 (-1 .84)* E *Tenure. (1328) -0 .025 (-7 .75)*** -0 .025 (-8 .53)*** Beta (129) -0 .005 (-0 .18) -0 .003 (-0 .10) Size (030) -0 .005 (-1 .23) -0 .005 (-1 .39) Leverage (P31) -0 .018 (-0 .71) -0 .014 (-0 .53). -0 .100 (-3 .80)*** -0 .061 (-5 .16)*** -0 .063 (-5 .87)*** AE *Tenure (N4) 0.046 (2.39)** 0.021 (1.93)* 0.023 (1.96)* (13 + 14) -0 .054 (-3 .76)*** -0 .040 (-3 .31)*** -0 .040 (-2 .97)*** Tenure

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