chu et al - 2012 - does long tenure erode auditor independence

Does Long Tenure Erode Auditor Independence? Ling Chu School of Business and Economics Wilfrid Laurier University Waterloo, ON N2L 3C5 lchu@wlu.ca Bryan K. Church 800 West Peachtree Street College of Management Georgia Tech Atlanta, GA 30308-0520 404.894.3907 bryan.church@mgt.gatech.edu Ping Zhang Rotman School of Management University of Toronto Toronto, ON M5S 3E6 416-946-5655 pzhang@rotman.utoronto.ca January 2012 2 Does Long Tenure Erode Auditor Independence? Abstract Regulators have shown a renewed interest in considering the merits of mandatory auditor rotation. A fundamental concern is that long tenure may undermine auditor independence. We conduct a study to investigate the effects of long tenure on companies’ allowance for bad debts (ABD). We focus on ABD, as opposed to total accruals, because it allows us to hone in on the effect of auditor tenure on a specific accrual. By examining ABD, we are able to conduct a more direct and powerful test and avoid some of the measurement error and noise associated with total accruals (e.g., discretionary or abnormal). We find evidence of a negative association between auditor tenure and estimated ABD. The finding holds across a series of robustness tests. Further analyses suggest that long tenure (around 15 years) is associated with downward bias in estimated ABD. With long tenure, the auditor endorses an estimate of ABD that is too aggressive. This result is consistent with the argument that long tenure leads to compromised independence. Our findings suggest that a term limit of 10 years, which has been suggested elsewhere (e.g., PCAOB 2010; Chasan 2011), is sufficient to preserve auditor independence. JEL classification: M41 Does Long Tenure Erode Auditor Independence? 1. Introduction Regulators are once again considering the merits of mandatory audit firm rotation. Under Section 207 of the Sarbanes-Oxley Act of 2002 (SOX), the Comptroller General of the United States was directed to study the potential effects of requiring firm rotation. The General Accounting Office (GAO) completed a report in the fall of 2003 and concluded that, in light of other reforms enacted as a result of SOX, it was not cost beneficial to mandate audit firm rotation (GAO 2003). But, the GAO’s report states that further experience is necessary to evaluate the effect of other SOX reforms to gauge the implications for auditor independence and audit quality: that is, to determine whether other SOX reforms are sufficient. In the years since the GAO’s study, pundits (e.g., Sikka 2009; Rapoport 2010) have claimed that auditors played a role in the global financial crisis, willingly turning a blind eye to clients’ questionable accounting tactics (leading to inflated asset values). The PCAOB also has gathered data through its inspection process, with inspection reports often suggesting that auditors lacked sufficient professional skepticism (PCAOB 2008). Hence, regulators have a renewed interest in taking actions to strengthen auditor independence. On August 16, 2011, the Public Company Accounting Oversight Board (PCAOB) issued Concept Release on Auditor Independence and Audit Firm Rotation, which revisits imposing term limits on auditor-client relations. The Board is particularly interested in relationships that extend beyond ten years (PCAOB 2011, 20). The European Commission (EC) also is actively considering firm rotation and various proposals have suggested term limits of nine years and six years (EC 2010; Barker and Hughes 2011; Journal of Accountancy 2011). With long tenure, the auditor may face significant pressure to preserve client relationships, which may encourage the 2 auditor to acquiesce to client demands, undermining independence. The practical implications of such concerns cannot be underestimated. The average auditor tenure of the 500 (100) largest companies in the U.S., based on market capitalization, is 21 (28) years (PCAOB 2011, 20). 1 Academic research has examined the association between auditor tenure and various proxies for audit/financial reporting quality. Researchers have commonly used proxies based on unexpected accruals (signed and unsigned), with the findings being decidedly mixed, particularly with respect to long tenure. Some studies find that quality is not affected by long tenure (e.g., Johnson et al. 2002; Gul et al. 2007); others find that quality improves with long tenure (e.g., Myers et al. 2003; Srinidhi et al. 2010); and still others find that quality diminishes with long tenure (e.g., Raghunathan 1994; Davis et al. 2009). The mixed findings may be attributable, in part, to the measurement error inherent in estimating total accruals (see e.g., McNichols and Wilson 1988; Healy and Wahlen 1999). A fundamental concern with unexpected accruals is that, across a range of accounts, the potential for a noisy measure is magnified. Furthermore, if unexpected accruals change over time, measurement error may be compounded due to the reversing nature of accruals (Chu et al. 2011). In the current paper, we take a different approach and focus on one specific accrual, companies’ allowance for bad debts (ABD). As compared to total accruals, ABD is little affected by accounting estimates in prior periods: it is an offset to accounts receivable (a current asset), and, thus, valuation issues (the accuracy of the accrual) typically are resolved within a one-year time frame. Our approach permits a more precise measurement of the related accrual, though we readily acknowledge a tradeoff (i.e., financial reporting quality encompasses a broad array of accruals). Healy and Wahlen (1999) suggest that a focus on specific accruals is a fruitful area for future research, as it may allow for more direct and powerful tests. We examine ABD because 1 The Board notes that average tenure would be even longer if Andersen had not failed. 3 (1) it directly affects the valuation of accounts receivable, which is a fundamental component of operating working capital; (2) it is subject to discretion and, thus, can be used to manage earnings (e.g., McNichols and Wilson 1988; Teoh et al. 1998); (3) it is associated with revenues (i.e., credit sales), which often are involved in fraudulent financial reporting (e.g., Beasley et al. 1999; Beasley et al. 2010); 2 and (4) professional standards (AS No. 12) require auditors to consider revenues, specifically, in identifying and assessing the risks of material misstatement (PCAOB 2010). We examine ABD to gauge its association with auditor tenure at any given point in time. We find evidence of a negative association between auditor tenure and estimated ABD. The finding holds across a series of robustness tests. Further analyses suggest that long tenure is associated with a downward bias in estimated ABD. The downward bias appears with auditor tenure of around 15 years. With long tenure, the auditor endorses an estimate of ABD that is too aggressive. This result is consistent with the argument that long tenure leads to compromised independence. Our findings suggest that a term limit of 10 years, which has been suggested elsewhere (e.g., PCAOB 2010; Chasan 2011), is sufficient to preserve auditor independence. The remainder of the paper is organized as follows. Next, we provide a framework, including our research hypothesis. Subsequently, we describe the research design and then present the empirical findings. Lastly, we offer concluding remarks. 2. Framework The auditor conducts an examination to collect evidence on a company’s financial data, most notably its earnings. The audit examination provides insight into the distribution of 2 Brazel et al. (2010) examine financial fraud cases that involve revenues and find that accounts receivable/allowance for bad debts are involved in 66 percent of the cases. 4 accounting earnings. The auditor learns a distribution, rather than an exact value, because financial data depend on the application of accounting principles and significant estimates, both of which require professional judgment. The auditor’s best assessment of earnings is the mean of the earnings distribution. The auditor opines on accounting earnings, which are announced and publicly disclosed. The auditor may incur various costs if accounting earnings are misstated, including increased legal exposure and client frictions. From the perspective of the auditing firm (the national office), the costs of legal exposure may be paramount. The overall firm may prefer to report conservatively in order to minimize the expected litigation cost, especially if the legal regime is strict. As such, the auditing firm may prefer to endorse an accounting value that is biased downward: that is, a value that falls below the mean of the earnings distribution. The engagement partner, on the other hand, may be more focused on the costs of client frictions, which arise when client relations are strained. The partner’s performance evaluation, compensation, and professional status may be tied directly to his or her ability to cultivate and maintain client relations. Thus, the partner may be incentivized to acquiesce to client demands (e.g., Francis 2004; Knechel et al. 2011). The client, on average, may prefer to report aggressively, with the aim being to create a more favorable financial picture (e.g., to secure better credit terms or to bolster stock prices). The engagement partner, in turn, may feel compelled to support the client’s position. Moore et al. (2006) suggest that an unconscious, self- serving bias may make the partner susceptible to the client’s arguments and demands, undermining objectivity. Likewise, the PCAOB has expressed concern that audit partners “may have a bias toward accepting management's perspective, rather than developing an independent view or challenging management's conclusions” (PCAOB 2011, 7). Accordingly, the 5 engagement partner may be predisposed to endorse an accounting value that is biased upward: that is, a value that exceeds the mean of the earnings distribution. The engagement partner’s (audit team’s) bias may be magnified as auditor tenure increases. In the early years of an engagement, bias may subtly creep into auditors’ judgment, providing a ready means to foster client relations. Bazerman et al. (2002, 100) assert that the auditor may unknowingly adapt to “small imperfections in a client’s financial practices.” Over time, the auditor’s objectivity may deteriorate, ever so gradually, to the point that larger imperfections are accepted, which may have significant implications for financial reporting quality (e.g., Bazerman et al. 1997; Bazerman et al. 2002; Moore et al. 2006). In turn, the potential negative consequences of rejecting the client’s position may increase as auditor tenure increases, with any backlash realized immediately. In cases of long tenure, the auditor may come to interpret evidence from a partisan perspective (Moore et al. 2006). Ongoing relations may cause the auditor to more closely identify with the client, making it more likely that the auditor will endorse the client’s position (e.g., Bamber and Iyer 2007). Simply put, long tenure may undercut objectivity. For our purposes, long tenure increases the possibility that the auditor approves of more aggressive accounting estimates, effectively increasing earnings. We are interested in the auditor’s assessment of ABD, as it gives ample room for discretion. Examples of companies’ that have understated ABD, under the auditor’s watchful eye, are plentiful including Friedman’s Jewelers (http://www.sec.gov/litigation/complaints/comp19477.pdf), Satyam (Kahn 2009), Advocat (Mulford and Comiskey 2002, 241), Miniscribe (Albrecht et al. 2009, 144), and NextCard (Knapp 2010, 78), just to name a few. With long tenure, the auditor may come to embrace the client’s perspective, wanting to believe that the assessment is correct. Hence, we 6 posit that as tenure increases, the auditor more readily accepts the client’s estimate of ABD, which on average is too aggressive (too low). Formally stated, our research hypothesis is as follows. Hypothesis: Ceteris paribus, the allowance for bad debts (ABD) is a decreasing function of auditor tenure. 3. Research Design We examine clients’ ABD over time to test for an association with auditor tenure. As discussed above, the audit firm (national office) prefers to report conservatively, whereas the engagement partner (local office) prefers to report aggressively. Because the engagement partner makes the reporting decision, the partner’s preferences may prevail. We conduct empirical tests to examine this issue. We consider the following regression model. ܣܤܦ ௜௧ = ߙ + ߚ ଵ ܶܧܷܴܰܧ ௜௧ + ߚ ଶ ܣܩܧ + ߚ ଷ ∆ܵܣܮܧܵ ௜௧ + ߚ ସ ܥܨܱ + ߚ ହ ܵܫܼܧ ௜௧ + ߚ ଺ ܵܫܼܧ ௜௧ ଶ + ߚ ଻ ܵܫܼܧ ௜௧ ଷ + ߚ ଼ ܴܱܣ ௜௧ + ߚ ଽ ܴܱܣ_ܵܦ ௜௧ + ߚ ଵ଴ ܮܱܵܵ ௜௧ + ߚ ଵଵ ܮܧܸ +ߚ ଵଶ ܥܴ ௜௧ + ߚ ଵଷ ܫܰܦܩܴܱܹ + ߚ ଵସ ܨܫܴܯܩܴܱܹ + ߚ ଵହ ܤܫܩ + ߚ ଵ଺ ܵܲܧܥܫܣܮ + ߚ ଵ଻ ܶܧܷܴܰܧ_ܵܲܧܥܫܣܮ + ܫ݊݀ݑݏݐݎݕܦݑ݉݉ݕ + ܻ݁ܽݎܦݑ݉݉ݕ + ߳ ௜௧ . The dependent variable, ABD, is measured as the estimated bad debts scaled by total accounts receivable. The primary independent variable of interest is auditor tenure (TENURE), measured as the number of consecutive years that the auditor is engaged with the same client. 3 Other independent variables are defined as follows: AGE number of years the firm exists on the Compustat database; 3 The change of auditor due to audit firm mergers is treated as a continuation of the predecessor auditor. 7 ∆SALE change of sales from year t-1 to year t scaled by the beginning total assets ((data12 t – data12 t-1 )/data6 t-1 ); CFO cash flow from operations scaled by the beginning total assets (data308 t /data6 t-1 ); SIZE log transformation of the year-end market value of equity (ln(data25 t *data199 t )); ROA net income scaled by the beginning total assets (data172 t /data6 t-1 ); ROA_SD standard deviation of ROA for the last three years; LOSS an indicator variable that equals to 1 if data172 t < 0 and 0 otherwise; LEV total liabilities to total assets ratio (data181 t /data6 t ); CR ratio of current assets to current liabilities (data4 t /data5 t ); INDGROW growth in sales in an industry ( ∑ ݀ܽݐܽ12 ௜௧௜ / ∑ ݀ܽݐܽ12 ௜௧ିଵ௜ ); FIRMGROW growth in sales of a firm (data12 t /data12 t-1 ); BIG an indicator variable that equals 1 when the auditor is a Big 4 firm and 0 otherwise; SPECIAL an indicator variable that equals 1 when the auditor audits the largest portion of total assets in an industry and 0 otherwise; and TENURE_SPECIAL an interactive variable that equals the product of TENURE and SPECIAL. Because accrual recognition varies across industries and time, we include two-digit SIC codes to capture industry fixed effects and indicators for years to capture time fixed effects. The control variables are similar to those in Myers et al. (2003) and Gul et al. (2009). Firm age (AGE) is included to mitigate the possible confounding effects of firm maturity and to control for differences associated with different firms’ life cycles (Anthony and Ramesh 1992). Other variables associated with accruals also are included. We control for the change in revenues (∆SALES), as it may directly impact ABD; cash flow (CFO) because prior studies show 8 an association between cash flow and accruals (e.g., Dechow 1994); and firm market value (SIZE, SIZE 2 , and SIZE 3 ) because larger firms have more stable accruals (Dechow and Dichev 2002) and the size effect is non-linear (Gul et al. 2009). We also control for growth (INDGROW, FIRMGROW) because firms in expanding or contracting industries may have different accrual behavior (Gul et al. 2009); leverage (LEV, CR) as there are documented associations between leverage and accruals (e.g., Butler et al. 2004); performance (LOSS, ROA, and ROA_SD) because it is associated with accruals; and finally auditor size and specialization (BIG, SPECIAL, and TENURE_SPECIAL) because auditors’ specialization is associated with accruals (e.g., Gul et al. 2009). 4. Data and Empirical Findings 4.1. Sample Composition and Descriptive Statistics The initial sample consists of all firms for the years from 1988 to 2006 in the Compustat database. We restrict our analyses to this time period because reported operating cash flows as per SFAS No. 95 (FASB 1987) are only available since 1988. We exclude firms in the financial services industries (SIC codes between 6000-6999). The firm’s age and the auditor tenure variables are calculated from all available data in Compustat. We delete firms with negative total assets, sales, debt, and market values of equity because such observations introduce noise into the analyses. To mitigate problems caused by extreme observations in cash flows and ABD, we exclude observations in the top and bottom 0.5 percentile. To avoid the confounding effects of start-up firms, we drop observations of all firms in their first five years of existence. Firms that switch auditors in the first five years also are left out because such firms may differ systematically from other firms (Myers et al. 2003). [...]... *** 0.0814 4.68 *** -0 .0007 -3 .35 0.0308 *** 3.37 *** -0 .0024 -3 .15 -0 .0001 -0 .73 -0 .0059 * -1 .88 0.0546 *** 5.81 *** -0 .0186 -2 .89 ** 0.0024 2.04 -0 .0001 -1 .43 -0 .0955 *** -7 .54 0.0058 1.32 *** 0.0089 2.85 0.0020 0.69 0.0006 0.89 -0 .0010 -0 .31 -0 .0026 -0 .63 0.0052 1.20 -0 .0032 -0 .78 0.0001 0.56 Yes Yes 15,226 0.167 Indicate significance at the 0.10, 0.05, and 0.01 levels, using two-tailed tests This... Variable = ABD Coef t-stat 0.0865 *** 4.95 *** -0 .0007 -3 .75 -0 .0001 -0 .81 -0 .0055 * -1 .80 *** 0.0508 5.40 -0 .0206 *** -3 .16 0.0027 ** 2.28 * -0 .0001 -1 .66 -0 .0985 *** -7 .79 0.0067 1.38 *** 0.0083 2.66 0.0015 0.51 0.0006 0.85 -0 .0012 -0 .36 -0 .0024 -0 .57 0.0057 1.31 -0 .0033 -0 .81 0.0002 0.60 Yes Yes 15,226 0.164 Indicate significance at the 0.10, 0.05, and 0.01 levels, using two-tailed tests This table... 0.000 -0 .053 0.000 -0 .088 0.000 0.062 0.000 -0 .1 81 0.000 1 000 -0 .043 0.000 -0 .067 0.000 -0 .090 0.000 0.009 0.297 -0 .061 0.000 -0 .1 90 0.000 0.037 0.000 -0 .309 0.000 1 000 0.032 0.000 -0 .038 0.000 -0 .036 0.000 0.040 0.000 0.01 9 0.021 -0 .053 0.000 0.01 3 0.1 9 1 0.020 0.01 2 -0 .024 0.003 1 000 FIRMGROW -0 .025 0.002 -0 .089 0.000 -0 .098 0.000 0.373 0.000 -0 .093 0.000 -0 .030 0.000 -0 .01 3 0.1 9 1 -0 .047... 0.0856 O _TENURE -0 .0046 *** -3 .74 AGE -0 .0003 *** -3 .77 -0 .0055 * -1 .80 ∆SALE *** t-stat 4.90 0.0508 SIZE SIZE 2 SIZE ROA 3 *** 5.40 -0 .0206 CFO *** -3 .16 0.0027 ** 2.28 -0 .0001 * -1 .66 -0 .0985 *** -7 .79 ROA_SD 0.0067 LOSS 0.0083 LEV 0.0015 0.51 CR 0.0006 0.85 INDGROW -0 .0012 -0 .36 FIRMGROW -0 .0024 -0 .57 0.0057 1.31 -0 .0033 -0 .81 BIG SPEICAL TENURE_ SPECIAL Year Fixed Effect Industry Fixed Effect No of Observations... relationship between auditor tenure and current allowance for bad debts The t-statistics are calculated using clustered standard errors by firm for the multivariate analyses a The sample consists of all firm-years from 1988 to 2006 from Compustat We delete firms in the financial services industries (SIC codes between 600 0-6 999) We delete firms with negative total assets, sales, and market values of equity... relationship between auditor tenure and current allowance for bad debts using orthogonal auditor tenure to firm age Specifically, the orthogonal audit value is the residual of the regression of audit tenure on firm age The t-statistics are calculated using clustered standard errors by firm for the multivariate analyses a The sample consists of all firm-years from 1988 to 2006 from Compustat We delete firms... following period on the current period’s allowance for bad debts with various years of auditor tenure The F-statistics are generated using the Wald method 25 a The sample consists of all firm-years from 1988 to 2006 from Compustat We delete firms in the financial services industries (SIC codes between 600 0-6 999) We delete firms with negative total assets, sales, and market values of equity We exclude 0.5% of... challenges that arise in examining total accruals (discretionary or abnormal) We want to gain insight into whether long tenure undermines auditor independence Regulators assert that long tenure incentivizes the auditor (engagement partner) to focus on preserving client relations, perhaps to the detriment of audit quality The primary concern is that long tenure may cause the auditor to more readily acquiesce... 0.031 0.000 1 000 BIG -0 .047 0.000 0.1 53 0.000 0.050 0.000 0.005 0.547 0.095 0.000 0.389 0.000 0.070 0.000 0.005 0.563 -0 .042 0.000 -0 .01 1 0.1 61 -0 .01 4 0.096 1 000 LOSS 0.1 45 0.000 -0 .1 41 0.000 -0 .1 55 0.000 -0 .1 83 0.000 -0 .442 0.000 -0 .222 0.000 -0 .61 6 0.000 0.1 59 0.000 -0 .033 0.000 -0 .01 4 0.087 -0 .040 0.000 -0 .059 0.000 1 000 SPECIAL -0 .01 3 0.097 0.095 0.000 0.036 0.000 -0 .009 0.289 0.041... observations The F-statistics are generated by the Wald method a The sample consists of all firm-years from 1988 to 2006 from Compustat We delete firms in the financial services industries (SIC codes between 600 0-6 999) We delete firms with negative total assets, sales, and market values of equity We exclude 0.5% of the cash flow and ABD at each extreme Finally, we exclude observations of auditors that . long tenure. Some studies find that quality is not affected by long tenure (e.g., Johnson et al. 2002; Gul et al. 2007); others find that quality improves with long tenure (e.g., Myers et al. . total accruals (discretionary or abnormal). We want to gain insight into whether long tenure undermines auditor independence. Regulators assert that long tenure incentivizes the auditor (engagement. the total marginal impact of new equity financing with various years of auditor tenure are shown in Table 6. For each given value of auditor tenure ( 1-2 7), we compute the total marginal impact