Audit Tenure Partner

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Effect of audit
The effect of audit partner partner tenure
tenure on client managers’
accounting discretion
161
Neil Fargher
Macquarie University, Sydney, Australia
Ho-Young Lee
Yonsei University, Seoul, South Korea, and
Vivek Mande
California State University-Fullerton, Fullerton, California, USA
Abstract
Purpose – This paper aims to examine the effect of audit partner tenure (PARTEN) on client
managers’ accounting discretion.
Design/methodology/approach – The authors contend that, when a new audit partner is from the
same audit firm as the outgoing audit partner (audit partner rotation), audit quality increases because
the new audit partner brings “fresh eyes” to the engagement.
Findings – The results confirm this conjecture. The authors find that, in the initial years of tenure of
a new audit partner, client managers’ accounting discretion decreases when the new partner is from
the same audit firm as the outgoing partner. However, when the new audit partner is from a different
audit firm as the outgoing partner (audit firm rotation), it is found that client managers’ accounting
discretion increases in those initial years.
Originality/value – The results provide support for recent legislation in the US restricting audit
PARTEN and should be of interest to other regulatory bodies contemplating mandatory audit partner
rotation.
Keywords Auditors, Financial reporting
Paper type General review
Introduction
The purpose of this paper is to examine the effect of audit partner tenure (PARTEN) on
client managers’ accounting discretion. Following recent high-profile audit failures
such as Enron and WorldCom, the effect of lengthy auditor tenure on audit quality has
become the subject of extensive public debate in the USA. As early as 1999, the US
Securities and Exchange Commission (SEC) had begun to express concerns about the
effects of long auditor tenure on auditor independence[1]. Then Chief Accountant of the
SEC, Lynn Turner called on academics to investigate whether the quality of financial
reporting deteriorated as client managers developed long-lasting relationship with
their auditors (Turner, 1999). Arthur Levitt, the Chairman of the SEC in 2000, echoed
the anxiety of his Chief Accountant that auditor judgment was impaired when auditors
remained on an engagement for a lengthy period of time (Levitt, 2000). Later, Levitt Managerial Auditing Journal
Vol. 23 No. 2, 2008
(2002) testified before the Senate Committee on Governmental Affairs that: pp. 161-186
q Emerald Group Publishing Limited
0268-6902
The data used are from public sources identified in the paper. DOI 10.1108/02686900810839857
MAJ . . . serious consideration be given to requiring companies to change their audit firm – not just
the partners – every 5-7 years to ensure that fresh and skeptical eyes are always looking at
23,2 the numbers.
However, these views expressed above are not universally accepted. Opposed to auditor
rotation is the auditing profession which has argued that as auditor tenure increases, so
does an auditor’s understanding of the client’s business, control risks and other factors
162 that contribute to audit failures (AICPA, 1992; PricewaterhouseCoopers, 2002)[2].
Given the conflicting views on auditor tenure, Congress in 2002, decided not to require
the mandatory rotation of audit firms. Instead, it directed the General Accounting Office
(GAO)[3] to conduct research on the potential effects of mandatory audit firm rotation on
audit quality. The GAO’s (2003) study of the largest public accounting firms and their
Fortune 1000 publicly traded client-companies concluded that “mandatory audit firm
rotation may not be the most efficient way to strengthen auditor independence and
improve audit quality.”
In 2002, Congress also considered the issue of whether lengthy audit PARTEN
adversely affected audit quality. Contrary to the case of audit firm rotation,
Congress decided that it was necessary to require mandatory partner rotation every
five years to increase audit quality. Section 203 of the Sarbanes-Oxley Act (2002)
provides that it is:
. . . unlawful for a registered public accounting firm to provide audit services to an issuer if
the lead audit partner (having primary responsibility for the audit) or the audit partner
responsible for reviewing the audit that is assigned to perform those audit services has
performed audit services for that issuer in each of the five previous fiscal years of that
issuer[4].
Following Sarbanes-Oxley, the SEC (2003) issued its rules on audit partner rotation
in 2003.
Several recent published US studies have examined the effect of audit firm tenure
(AUDTEN) on audit quality (Ghosh and Moon, 2005; Carcello and Nagy, 2004; Myers
et al., 2003; Johnson et al., 2002; Geiger and Raghunandan, 2002). The results of these
studies are generally supportive of the GAO’s conclusions that as AUDTEN increases,
audit quality also increases. They show that audit failures are most likely to occur in the
first few years of tenure of an audit firm. However, there have only been a few studies
that have examined whether audit partner rotation also adversely affects audit quality.
As with audit firm rotation, rotation of audit partners can increase the risk of audit
failures during a partner’s initial years on an engagement if rotation creates a steep
learning curve about the client’s operations for the new partner[5].
Our study contributes to the literature by providing some of the first evidence on the
relationship between audit PARTEN and audit quality. Specifically, our paper examines
the effect of audit PARTEN on client managers’ accounting discretion. We test our
hypothesis using tenure data on Australian audit partners. Unlike US rules which only
require the audit firm’s name to be disclosed underneath the auditor’s opinion,
Australian law requires the auditor’s report to be signed by the partner-in-charge of the
audit engagement[6]. Two papers have examined the effect of audit PARTEN on audit
quality in the Australian context. Carey and Simnett (2006) find a negative association
between Australian audit PARTEN and audit report qualifications which supports the
case for mandatory rotation. Concurrent research by Hamilton et al. (2005) find that audit
partner changes are associated with lower unexpected accruals (ACC) consistent with Effect of audit
arguments in support of audit partner rotation. Unlike our study their tests focus on partner tenure
cross-sectional comparison of firms with auditor partner changes to all firms. Their
results are however generally consistent with results reported in this study.
The results of this study show that as audit PARTEN increases, managers’
accounting discretion increases. We find that in the first years of an engagement, client
managers’ discretionary accruals (jDACCRj) are smaller than in the later years but 163
only if the new audit partner is from the same audit firm as the outgoing partner
(audit partner rotation). In contrast, client managers’ accounting jDACCRj are larger in
the initial years when the new audit partner is from a different audit firm as the
outgoing audit partner (audit firm rotation). These findings suggest that new partners
from the same audit firm bring “fresh eyes” to an engagement increasing audit quality,
while new partners from a different audit firm (although they also bring fresh eyes)
face a very steep learning curve regarding the client’s operations as a result of which
audit quality suffers. Our results support recent regulatory policy, for example in the
USA, requiring the rotation of audit partners but not audit firms.
The next section provides background on the Australian context, followed by a
section on the development of our hypothesis. This is followed by a discussion of our
research design and data collection methods. Results are presented next, followed by
our conclusion.
Background
The International Federation of Accountants Code of Ethics (IFAC, 2003) recognizes that
prolonged use of the same lead engagement partner on an audit may create a “familiarity
threat” that by virtue of a close relationship with an assurance client, its directors,
officers or employees, a member of the assurance team becomes too sympathetic to the
clients’ interests. The code proposed that the lead engagement partner be rotated after a
pre-defined period, normally no more than seven years.
Countries that have adopted a mandatory rotation policy include: Austria,
Australia, Brazil, Greece, India, Italy, Israel, Singapore, South Korea, Taiwan and the
USA (Catanach and Walker, 1999; Kim et al., 2004; Cameran et al., 2005; Chi and Huang,
2005; Chi et al., 2005; Carey and Simnett, 2006). Spain adopted mandatory rotation and
since abandoned the policy (Cameran et al., 2005).
The Australian profession’s standard on independence was revised in line with the
IFAC Code of Ethics during 2001. The first mandatory requirement for auditor rotation
in Australia was issued in May 2002, Professional Statement F1 Professional
Independence (Professional Statement F1) (Institute of Chartered Accountants in
Australia (ICAA, 2002)). The effective date was December 31, 2003 with the partner
rotation requirement impacting fiscal periods ending in 2004. Professional Statement
F1 introduced the mandatory rotation of the lead engagement partner and the review
partner on an engagement for publicly listed companies. With limited exceptions, the
requirement was for the lead engagement partner to be rotated after a pre-defined
period, no longer than seven years for audits of listed public companies. A partner
rotating after a pre-defined period should not resume the lead engagement role until a
further period of time, no less than two years has elapsed.
Prior to the introduction of Professional Statement F1 there was no specific
requirement for audit partner rotation in Australia. Carey and Simnett (2006) note that
MAJ between 1997 and 2001 Arthur Andersen had a policy of mandatory partner rotation
23,2 after seven years. The other Big 6 firms were aware of the issue and undertook partner
rotation but not on a mandatory basis. Subsequent to the period of this study further
reforms were adopted in Australia: Corporate Law Economic Reform Program (Audit
Reform and Corporate Disclosure) Act 2004 (Cth) (CLERP 9). CLERP 9 requires
mandatory partner rotation every five years. The legislation became effective from
164 July 1, 2004 however the audit partner rotation requirements did not come into effect
until after the period examined in this study.
Hypothesis development
Proponents of mandatory auditor rotation have argued that extended auditor tenure
leads to low-quality audits. Low-quality audits can mislead investors and result in
misallocated resources. In several class-action lawsuits, institutional investors have
charged that a long relationship between the client and its auditor resulted in lower
scrutiny by the auditor over the company’s improper accounting practices (Accounting
Today, 2004). As the regulator of US capital markets, the SEC has a keen interest in
knowing whether the quality of financial reports deteriorates as client managers
develop long-lasting relationships with their auditors (Turner, 1999). In 2002, following
a series of several high-profile audit failures, Congress passed the Sarbanes-Oxley Act.
Congress considered the issue of the effect of auditor tenure on audit quality and
directed the GAO to study whether rotation of audit firms should be required.
Opponents of mandatory auditor changes include the public accounting firms
which have argued that that mandatory auditor rotation increases audit start-up costs
and the risk of audit failure in the initial years of an engagement because the incoming
auditor is forced to place a higher level of reliance on the client’s estimates and
representations (PricewaterhouseCoopers, 2002). They have argued that as tenure
increases, an auditor is able to gain firm-specific expertise and a better understanding
of the client’s business[7].
Several prior US studies have attempted to shed light on the debate about auditor
tenure. Deis and Giroux (1992) find that audit quality decreases as auditor tenure
increases[8]. In contrast, St Pierre and Andersen (1984) find that auditors of new clients
(three years or less on the engagement) commit more errors and experience higher legal
risk than auditors with a tenure greater than three years. Based on audit committee
members’ responses to a survey, Knapp (1991) also concludes that as auditors gain
more experience with individual clients, the likelihood of discovering material errors
increases.
More recently, Geiger and Raghunandan (2002) find that long-tenured auditors are
more efficient in the collection and evaluation of evidence than short-tenured auditors.
Their results are consistent with long-tenured auditors having a more in-depth
knowledge of their clients’ financial status and operating systems than short-tenured
auditors. Carcello and Nagy (2004) find that fraudulent financial reporting is more likely
to occur in the first three years of an audit. In addition, they find no evidence of greater
fraudulent financial reporting by clients of long-tenured auditors. Finally, Myers et al.
(2003) test for the association between auditor tenure and earnings quality where the
auditor-client relationship lasted for at least five years. They find that the magnitude of
both discretionary and current ACC declines with longer auditor tenure. They also find
evidence that lengthier auditor tenure is associated with less extreme ACC. Their results
suggest that as the relationship between the auditor and client lengthens, the auditor is Effect of audit
able to limit management’s ability to use ACC to manage earnings. partner tenure
However, the above research has only examined the effect of AUDTEN on audit
quality. It has not examined how audit PARTEN on an engagement affects the quality of
an audit. To the extent that an audit partner’s knowledge of a client’s business increases
with his/her tenure on the audit, audit partner rotation, like audit firm rotation, can
arguably lead to a decrease in audit quality. Also, similar to audit firm rotation, audit 165
partner rotation can lead to the most qualified audit partner on an engagement being
replaced by a partner who is less qualified. The SEC (2003) acknowledges that the quality
of the engagement audit team could, in fact, decrease as a result of its rules mandating
audit partner rotation. This suggests that in some circumstances audit partner rotation
can be tantamount to audit firm rotation, reducing audit quality and increasing the
likelihood of audit failures in the initial years of a partner on an engagement.
However, there are important differences between audit firm rotation and audit
partner rotation which in turn lead to different predictions about the effect of tenure on
audit quality. Unlike the case of a new audit firm on an engagement, there may be less
likelihood of significant deterioration in audit quality in the first years of an engagement
if the new audit partner was from the same audit firm as the outgoing audit partner.
Audit firms have processes in place for managing the transition from one engagement
partner to another[9]. As a result, a new lead partner from the same audit firm is likely to
be more familiar with the client’s business and risks than a new partner from a different
audit firm. A new partner should also find it easier to consult with a former partner on
the engagement if the former partner was from the same audit firm. Therefore, the
learning curve for an incoming audit partner from the same audit firm is likely to be less
steep than if the incoming audit partner were from a different audit firm. Indeed, it is
possible that by bringing “fresh eyes” to the engagement, a new audit partner from the
same audit firm might actually increase the quality of the audit. That is, the tradeoff
between bringing fresh eyes to an engagement and the potential loss in the quality of the
engagement team may favor audit partner rotation but not audit firm rotation.
In addition, the incentives facing an audit partner are likely to be different from those
facing an audit firm which can also lead to a different relationship of tenure with audit
quality[10]. As the length of time on an engagement increases the economic incentives to
bond with the client may be more strongly present at the partner level than at the audit
firm level. Audit partners have compensation incentives that are related to the fees
received from client-firms (Trompeter, 1994)[11]. Failure to keep a client satisfied can
lead to a client’s dismissal of the audit firm. Loss of a client affects an audit partner more
directly than the audit firm because the latter is able to diversify its revenues over its
existing and future client base. Loss of a valued client can lead to an audit partner’s
dismissal or limit future opportunities offered to that partner by the audit firm[12]. As an
audit partner’s tenure on an engagement increases, the economic incentives to bond with
the client may become stronger. For these reasons, it is possible that the quality of an
audit suffers as the tenure of the audit partner on an engagement increases.
In summary, this paper suggests that a policy of rotation of audit partners on an
engagement may have the potential to increase audit quality. Although audit partner
rotation creates a new learning curve for the incoming partner, it also brings fresh and
skeptical eyes into the audit. Importantly, the audit firm can continue to build its
relationship with the client and provide high-quality client service while accumulating
MAJ knowledge about the client’s operations. Therefore, in contrast to audit firm rotation,
the benefits of bringing new blood to an engagement may be greater than the potential
23,2 loss of audit quality due to changing the engagement team. As tenure increases,
however, the incentives to bond with a client may be more strongly evident at the audit
partner level than the audit firm level. Therefore, in contrast to AUDTEN, lengthy
audit PARTEN may, in fact, decrease audit quality.
166 We examine three related hypotheses regarding the effect of a rotation of audit
partners on client managers’ accounting discretion. First, we examine whether client
managers’ accounting discretion increases as audit PARTEN increases. An increase in
client managers’ accounting discretion with audit PARTEN would be supportive of a
policy requiring the rotation of audit partners on an engagement[13]. This hypothesis
is stated below in the null form:
H1. All else constant, there is no change in client managers’ accounting discretion
as audit PARTEN on an engagement increases.
Our next hypotheses contrast audit quality in the initial years of a new audit partner on
an engagement with that in the later years of the partner’s tenure. As discussed, prior
US research indicates that in the initial years of a new partner being engaged there is a
significant deterioration in audit quality when the new partner is from a different audit
firm[14]. However, this research has not examined whether audit quality is low in the
first years of a new audit partner when the new auditor is from the same firm. Prior US
studies also find that audit quality is higher in firms whose auditors have lengthy
tenure. Again, these studies do not control for audit PARTEN. They treat an audit firm
with a lengthy tenure and frequent audit partner rotation the same as an audit firm
with a lengthy tenure and infrequent audit partner rotation[15].
Following the method in Carcello and Nagy (2004) our hypotheses compare audit
quality associated with short- and long-tenured audit partners with audit quality
associated with medium-tenured audit partners. The hypotheses are stated below in
the null form:
H2. All else constant, there is no difference in client managers’ accounting
discretion across short- and medium-tenured audit partners.
H3. All else constant, there is no difference in client managers’ accounting
discretion across medium- and long-tenured audit partners.
Research design
Models used to test the hypotheses
The following regression models are used to test the hypotheses:
.
Model A:
jDACCRjit ¼ a0 þ b1 PARTENit þ b2 AUDTENit þ b3 FIRMAGEit þ b4 LNSIZEit
þ b5 INDGROWit þ b6 BIGFIVEit þ b7 ROAit þ b8 ROAPLUSit
þ b9 OCFit þ b10 OCFPLUSit þ b11 ACCit þ b12 ACCPLUSit
X
þ b13 ISSUEit þ b14 LEVit þ a INDDUMkit
k k
X
þ a YEARDUMlit þ 1it
l l
.
Model B: Effect of audit
jDACCRjit ¼ a0 þ b121 PARTEN – SHORTit þ b122 PARTEN – LONGit
partner tenure
þ b2 AUDTENit þ b3 FIRMAGEit þ b4 LNSIZEit þ b5 INDGROWit
þ b6 BIGFIVEit þ b7 ROAit þ b8 ROAPLUSit þ b9 OCFit
þ b10 OCFPLUSit þ b11 ACCit þ b12 ACCPLUSit þ b13 ISSUEit 167
X X
þ b14 LEVit þ k
a k INDDUM kit þ a YEARDUMlit þ 1it
l l
where, jDACCRj, absolute value of discretionary accruals; PARTEN, audit PARTEN;

PARTEN-SHORT, indicator variable which is 1 if PARTEN is less than three years,
and 0 otherwise; PARTEN-LONG, indicator variable which is 1 if PARTEN is greater
than six years and 0 otherwise; AUDTEN, audit firm tenure; FIRMAGE, length of
years since the ASX listing year; LNSIZE, natural log of total assets measured in
dollars; INDGROW:
!
XN X
N
Salesi;t 2 Salesi;t21
i¼1 i¼1
X
N
Salesi;t21
i¼1
by industry code; BIGFIVE, indicator variable which is equal to 1 if the new auditor is
one of the Big 5, and 0 otherwise; ROA, net income in year-1 divided by total assets in
year-2; ROAPLUS, 0 if ROA is less than zero and ROA if ROA is greater than or equal
to zero; OCF, cash flow from operations divided by average total assets; OCFPLUS, 0 if
OCF is less than zero and OCF if OCF is greater than or equal to zero; ACC, total
accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less than
zero and ACC if ACC is greater than or equal to zero; ISSUE, indicator variable which is
1 if the number of shares outstanding is increased more than 10 percent and
0 otherwise; LEV, total liabilities divided by total assets; INDDUM, industry indicator
variables; and YEARDUM, year indicator variables.
Measuring discretionary accruals
We measure client managers’ accounting discretion using absolute jDACCRj based on
the Cross Sectional Modified Jones-model. The use of absolute jDACCRj is consistent
with client managers using positive jDACCRj to manage current earnings upward and
negative jDACCRj for building “cookie jar reserves” for increasing earnings in
subsequent years. Our proxy for jDACCRj follows the method used by Myers et al.
(2003), Johnson et al. (2002) and others. In addition to using the absolute value of
jDACCRj we also use their signed raw values. Additionally, we separately estimate our
models for income increasing ACC and income decreasing ACC[16].
Measuring audit partner tenure

We measure audit PARTEN as the number of consecutive years an audit partner
serves as the signing partner on an engagement. A positive and significant coefficient
on PARTEN in Model A would support the argument that client managers’ accounting
discretion increases as PARTEN increases. Model B replaces PARTEN with two
MAJ dummy variables, PARTEN-SHORT and PARTEN-LONG, which are intended to test
23,2 the association of client managers’ accounting discretion with short- and long-tenured
audit partners, respectively. A negative (positive) coefficient on PARTEN-SHORT
(PARTEN-LONG) would support the argument that client managers’ accounting
discretion decreases (increases) in the initial (later) years of tenure of an audit partner.
168 Measuring audit firm tenure

While the primary purpose of this paper is to measure the effect of audit PARTEN on
client managers’ accounting discretion, we also need to measure AUDTEN for this
sample of firms. We use AUDTEN as a control variable in our regression model[17].
We measure AUDTEN in the following way:
.
for client firms that engaged an audit firm in our sample for the first time during
our sample period, AUDTEN is the number of consecutive years the audit firm
was retained by the client (47 percent of observations);
.
for client firms that first listed on the Australian Stock Exchange (ASX) during
our sample period, we compute AUDTEN assuming the year of the listing is the
audit firm’s first year of tenure (19 percent of observations); and
.
for all remaining client firms we compute AUDTEN assuming 1990, the first
year of coverage on the database used in this study, is the first year of
AUDTEN[18].
We acknowledge that this approach does not measure AUDTEN accurately in certain
cases, however, we attempt to alleviate this concern by conducting additional tests for
robustness of the results (see “additional analyses”).
Measuring other control variables

We control for factors found by previous work to impact client managers’ jDACCRj.
Based on Myers et al. (2003), we include client-firm age (FIRMAGE) which is measured
as the number of years since the client firm was first listed on the ASX. Industry growth
(INDGROW) is included because this variable has been shown to be positively
associated with the jDACCRj (Myers et al., 2003). Because large client firms tend to
record more stable ACC (Dechow and Dichev, 2002; Lee and Mande, 2003), we include the
natural log of total assets (LNSIZE). Past return on assets (ROA) and current operating
cash flows (OCF) are included because these variables have been shown to affect the
magnitude of jDACCRj (Dechow et al., 1995; Chung and Kallapur, 2003). Leverage (LEV)
ratio is included because prior studies find that client managers of high-LEV firms have
greater incentives to manage earnings to avoid violating debt covenants (DeFond and
Jiambalvo, 1994; DeAngelo et al., 1994; Becker et al., 1998; Frankel et al., 2002). A variable
representing past total ACC is included in the regression to control for the normal
relation between ACC of past years and ACC of successive years. Similar to Chung and
Kallapur (2003) we interact ROA, OCF and ACC with indicator variables denoting the
signs of ROA, OCF and ACC. Using these indicator variables allows for different
coefficients on negative and positive ROA, OCF and ACC. Consistent with prior studies
showing that stock issuances (ISSUE) are associated with the amount of abnormal ACC
(Firth, 1997; DeFond and Subramanyam, 1998; Chung and Kallapur, 2003), we include a
control for shares issued by the client firm. Auditor type (BIGFIVE) is included because
prior studies suggest that, when compared to small audit firms, large audit firms tend to
be more conservative and limit extreme client jDACCRj to a greater extent (Becker et al., Effect of audit
1998; Francis et al., 1999; Francis and Krishnan, 1999). We also include dummy variables partner tenure
representing industry and year because the magnitude of ACC has been shown to vary
by industry (Barth et al., 2001) and year (Myers et al., 2003).
Sample selection
Our initial sample consists of the population of publicly traded Australian firms that 169
were publicly traded on the ASX for which annual reports were available to us over the
period 1990-2004 (14 years). The annual reports were obtained from DatAnalysis, a
database produced by Aspect Huntley Pty. Ltd, that provides annual reports for most
companies listed, or formerly listed, on the ASX. Annual reports were available on the
database for 1,311 Australian firms for at least one year during the period 1990
through 2004[19].
During most of our sample period audit partner rotation was voluntary. In 2002, the
Australian Professional Statement F1 (ICAA, 2002, Joint Code of Professional Conduct)
introduced formal requirements requiring the rotation of the signing audit partner every
seven years or less. The standard allows some degree of flexibility over timing of rotations
where an audit firm has only a few audit partners with the necessary knowledge and
experience to serve as lead engagement partner (Joint Code of Professional Conduct,
Appendix 2 Application of Principles to Specific Situations, paragraph 2.52 and 2.53). The
professional statement went into effect for assurance reports dated after December 31,
2003 (paragraph 29)[20]. In June 2004, extensive changes were made to the Australian
Corporations Law (CLERP 9) that included the mandated rotation of the signing audit
partner on an audit every five years or less. The effective date of CLERP 9 changes are
financial years beginning in July 2006 which are outside of our sample period.
From the annual reports, we obtained the name of the signing audit partner on the
engagement and the name of the audit firm retained by the client. Because DatAnalysis
is maintained in a text format, these names were hand-collected from the annual
reports. To facilitate the time consuming task of hand-collecting partner names from
annual reports, we limited our analyses to those firms for which the names of signing
partner and audit firm were available for at least three consecutive years[21]. This
restriction also ensures that our sample does not include newly listed firms and firms
for which there was only recent coverage on DatAnalysis. This restriction resulted in
sample of 1,306 firms or 12,077 firm-year observations.
Our next step was to measure the tenure of a new signing partner on an audit
engagement. A new signing audit partner’s tenure was measured beginning with the
first year the audit partner became the signing partner during our sample period
following an audit partner change. There were 6,326 firm-year observations where a
new audit partner joined (i.e. firm-years after the first partner switch) an engagement as
a signing partner during our sample period. For these audit partners we could accurately
measure their tenure beginning with their first year on an audit engagement as signing
partner. The remaining 5,751 observations consisting of firm-year observations where
signing partners’ tenure could not be accurately measured were discarded. That is, all
observations were excluded prior to the first change in signing auditor that could be
identified[22]. Because of our paper’s focus on audit partner rotation, we also discarded
2,299 firm-years[23] where the incoming new partner was from a different audit firm,
which left 4,027 firm-years representing 839 firms.
MAJ We required firms to have financial statement data needed for our tests on the
23,2 Aspect database, which left 3,047 firm-years representing 715 firms[24]. Then,
we eliminated firms in banking, investment, property management, and insurance
industries. This left us with a final sample of 2,495 firm-years representing 590 firms.
This sample includes tenure data on all incoming partners on an audit engagement
during our sample period from the same audit firm. While our sampling method
170 ensures that the tenure of the incoming partner from the same audit firm is correctly
measured for every firm-year, there is also a substantial amount of sample attrition due
to this approach. Specifically, we had to discard observations for outgoing partners
where we could not determine using DatAnalysis when the outgoing audit partner first
joined the engagement as a signing partner[25]. The characteristics of the sample are
discussed below.
Empirical results
Our sample consists of firms from 20 industries; the number and proportion of firms
belonging to each industry group are reported in Table I, Panel B. No single industry
group appears to dominate the sample; 68 percent of the sample firms are represented
by six industry groups. Despite the data attrition due to our sampling procedures, the
sample composition is consistent with the composition of the ASX with the greatest
concentration of firms coming from the miscellaneous industrials group representing
approximately 17 percent of the total observations, and the mining and other metals
segments with 30 percent of the total observations. Also, consistent with our sample
selection criteria requiring a clear change in the signing partner, and consistent with
better data availability from DatAnalysis in recent years, most observations are drawn
after 1998 (4 in 1992; 15 in 1993; 46 in 1994; 70 in 1995; 117 in 1996; 168 in 1997; 190 in
1998; 227 in 1999; 270 in 2000; 341 in 2001; 375 in 2002; 357 in 2003; 315 in 2004). The
results must be interpreted with respect to the period of our sample.
Summary statistics for the main variables are presented in Table II, Panel A. The
mean (median) value of absolute jDACCRj is 0.1893 (0.0795). The mean (median) value of
PARTEN is 2.74 years (two years) while the mean (median) value of AUDTEN is 7.72
years (eight years). About 56.7 percent of the observations have the value of PARTEN
less than three years while about 5.3 percent of the observations have the value of
PARTEN greater than six years[26]. About 73 percent of sample firms were audited by
Big 5 auditors. Table II, Panel B, provides a correlation matrix which shows that, in
general, the variables are not highly correlated. The largest correlations are between
OCF and OCFPLUS (r ¼ 0.58) and between ACC and ACCPLUS (r ¼ 0.56)[27].
Results under Model A in Table III show the association of absolute jDACCRj with
PARTEN and the control variables (i.e. Model A results). The adjusted R 2 of the
regression is 0.22. Regarding the control variables, the coefficients on firm size (LNSIZE),
past return on assets (ROA and ROAPLUS), current operating cash flows (OCF and
OCFPLUS) and total past accruals (ACC and ACCPLUS) and stock ISSUE are significant
at the 1 percent (one-tail) level of testing, while the coefficient on LEV and FIRMAGE are
statistically significant at the 5 percent and 1 percent (one-tail) level of testing,
respectively. The signs of the coefficients on the above control variables are in the
predicted direction. Another interesting finding is that AUDTEN is negatively associated
with absolute jDACCRj (t ¼ 23.40) which is supportive of US studies suggesting that as
the tenure of audit firms increases audit quality also increases. However, the main result of
Panel A. Procedures used for data collection
Procedures Firm-years Firms
Group 1 Firms whose annual reports are available on DatAnalysis
for at least one year during the sample period 1,311
Group 2 Group 1 firms whose partner and audit firm names are
available for at least three consecutive years 12,077 1,306
Group 3 Group 2 firms after the first partner switch 6,326 1,035
Group 4 Group 3 firms whose audit partners are from the same
audit firms 4,027 839
Group 5 Group 4 firms whose financial data are available on
Aspect 3,047 715
Final sample Group 5 firms not belonging finance, insurance,
investment, and property trusts industries 2,495 590
Panel B. Distribution of observations by industry
Sample firm-years
Industry classification SIC code N Percent
Mining-gold 1 385 15.43
Other metals 2 353 14.15
Diversified resources 3 25 1.00
Energy 4 208 8.34
Infrastructure 5 45 1.80
Developers 6 88 3.53
Building materials 7 49 1.96
Alcohol and tobacco 8 45 1.80
Food and household 9 60 2.40
Chemicals 10 2 0.08
Engineering 11 67 2.69
Packaging 12 28 1.12
Retail 13 69 2.77
Transportation 14 41 1.64
Media 15 104 4.17
Telecommunications 18 92 3.69
Healthcare biotechnologies 21 183 7.33
Misc industrials 22 438 17.56
Diversified 23 125 5.01
Tourism leisure 24 88 3.53
Total 2,495 100.00
distribution
Data collection and
partner tenure
Effect of audit
171
Table I.
23,2
172
MAJ
Table II.
correlation matrix
Descriptive statistics and
Panel A. Descriptive statistics
Variables Mean Median SD First quartile Third quartile Maximum Minimum
jDACCRj 0.1893 0.0795 0.5472 0.0318 0.2020 22.0447 0.0000
PARTEN 2.7427 2.0000 1.8934 1.0000 4.0000 12.0000 1.0000
AUDTEN 7.7279 8.0000 3.6167 5.0000 10.0000 15.0000 1.0000
FIRMAGE 15.9190 12.0000 12.5510 8.0000 19.0000 134.0000 3.0000
LNSIZE 17.5810 17.2675 2.2476 15.9589 18.9648 25.1655 10.0923
INDGROW 1.1890 1.1276 0.7143 1.0487 1.2258 14.2082 0.5371
BIGFIVE 0.7275 1.0000 0.4454 0.0000 1.0000 1.0000 0.0000
ROA 2 0.1243 2 0.0039 1.1653 2 0.1467 0.0621 2.8027 2 39.9533
ROAPLUS 0.0446 0.0000 0.1160 0.0000 0.0621 2.8027 0.0000
OCF 2 0.0289 0.0206 0.2731 2 0.1007 0.0991 1.0288 2 3.9595
OCFPLUS 0.0634 0.0206 0.0634 0.0000 0.0991 1.0288 0.0000
ACC 2 0.0905 2 0.0516 0.5273 2 0.1378 0.0015 6.6047 2 17.1332
ACCPLUS 0.0441 0.0000 0.2758 0.0000 0.0015 6.6047 0.0000
ISSUE 0.3319 0.0000 0.4710 0.0000 1.0000 1.0000 0.0000
LEV 0.5127 0.3967 3.2039 0.1384 0.5614 116.9600 0.0000
Panel B. Person correlation matrix
Variable (p-value) PARTEN PARTEN-SHORT PARTEN-LONG AUDTEN FIRMAGE LINSIZE INDGROW BIGFIVE
jDACCRj 0.0299 (0.136) 2 0.0297 (0.137) 2 0.0091 (0.650) 2 0.0581 (0.003) 2 0.0510 (0.011) 2 0.1890 (0.000) 2 0.0082 (0.682) 2 0.0712 (0.001)
PARTEN 2 0.7952 (0.000) 0.6421 (0.000) 0.1996 (0.000) 0.1513 (0.000) 0.0751 (0.000) 2 0.0132 (0.507) 2 0.1141 (0.000)
PARTEN-SHORT 2 0.2713 (0.000) 2 0.1825 (0.000) 2 0.1168 (0.000) 2 0.0579 (0.003) 0.0036 (0.857) 0.0769 (0.000)
PARTEN-LONG 0.0933 (0.000) 0.0945 (0.000) 0.0463 (0.021) 2 0.0133 (0.503) 2 0.0951 (0.000)
AUDTEN 0.3502 (0.000) 0.1259 (0.000) 0.0484 (0.015) 0.1005 (0.000)
FIRMAGE 0.2712 (0.000) 0.0137 (0.492) 0.0958 (0.000)
LNSIZE 0.0461 (0.021) 0.3192 (0.000)
INDGROW 2 0.0081 (0.686)
BIGFIVE
ROA
ROAPLUS
OCF
OCFPLUS
ACC
ACCPLUS
ISSUE
(continued)
Panel B. Person correlation matrix
Variable (p-value) ROA ROAPLUS OCF OCFPLUS ACC ACCPLUS ISSUE LEV
jDACCRj 2 0.0279 (0.163) 0.0049 (0.805) 2 0.1697 (0.000) 2 0.0503 (0.012) 0.1532 (0.0000) 0.3644 (0.0000) 0.1077 (0.000) 0.0459 (0.021)
PARTEN 0.0193 (0.334) 2 0.0107 (0.593) 0.0423 (0.034) 0.0221 (0.269) 2 0.0051 (0.799) 2 0.0270 (0.177) 2 0.0274 (0.171) 2 0.0012 (0.953)
PARTEN-SHORT 2 0.0034 (0.862) 0.0071 (0.723) 2 0.0073 (0.716) 2 0.0198 (0.321) 0.0204 (0.308) 0.0159 (0.427) 0.0202 (0.313) 0.0136 (0.496)
PARTEN-LONG 0.0187 (0.349) 0.0047 (0.813) 0.0506 (0.011) 0.0109 (0.584) 0.0082 (0.680) 2 0.0217 (0.277) 2 0.0346 (0.083) 0.0021 (0.916)
AUDTEN 0.0100 (0.614) 2 0.0009 (0.964) 0.0320 (0.109) 0.0555 (0.005) 0.0129 (0.516) 2 0.0061 (0.758) 2 0.0541 (0.006) 2 0.0469 (0.019)
FIRMAGE 0.0409 (0.040) 0.0064 (0.748) 0.1149 (0.000) 0.1283 (0.000) 0.0189 (0.343) 2 0.0452 (0.023) 2 0.1469 (0.000) 2 0.0113 (0.571)
LNSIZE 0.1565 (0.000) 0.1277 (0.000) 0.4550 (0.000) 0.2901 (0.000) 0.0947 (0.000) 2 0.0652 (0.001) 2 0.2105 (0.000) 2 0.0434 (0.029)
INDGROW 0.0102 (0.609) 0.0154 (0.440) 0.0110 (0.581) 2 0.0229 (0.253) 0.0153 (0.444) 0.0075 (0.706) 2 0.0094 (0.638) 2 0.0059 (0.768)
BIGFIVE 0.0456 (0.022) 0.0735 (0.000) 0.1519 (0.000) 0.1527 (0.000) 2 0.0182 (0.363) 2 0.0541 (0.006) 2 0.1287 (0.000) 2 0.0426 (0.033)
ROA 0.1552 (0.000) 0.2948 (0.000) 0.1101 (0.0005) 0.3991 (0.000) 2 0.2056 (0.000) 2 0.0819 (0.010) 0.0157 (0.430)
ROAPLUS 0.2207 (0.000) 0.3089 (0.000) 0.0944 (0.026) 0.2160 (0.000) 2 0.0912 (0.000) 0.0759 (0.000)
OCF 0.5787 (0.000) 0.1472 (0.000) 2 0.0588 (0.003) 2 0.2847 (0.000) 2 0.0026 (0.895)
OCFPLUS 0.0086 (0.665) 2 0.0354 (0.076) 2 0.2329 (0.000) 2 0.0121 (0.546)
ACC 0.5637 (0.000) 2 0.0583 (0.003) 2 0.0047 (0.813)
ACCPLUS 0.0151 (0.449) 0.0104 (0.604)
ISSUE 2 0.0365 (0.068)
Notes: p-values are in the parenthesis. N ¼ 2,495
Variable definitions:
jDACCRj, absolute value of discretionary accruals; PARTEN, audit partner tenure; PARTEN-SHORT, indicator variable which is 1 if partner tenure (PARTEN) is less than three years,
and 0 otherwise; PARTEN-LONG, indicator variable which is 1 if partner tenure (PARTEN) is greater than P six years and 0 Potherwise; AUDTEN,
P audit firm tenure; FIRMAGE, length of
years since the ASX listing year; LNSIZE, natural log of total assets measured in dollars; INDGROW:ð Ni¼1 Salesi;t 2 Ni¼1 Salesi;t21 Þ= Ni¼1 Salesi;t21 by industry code; BIGFIVE,
indicator variable which is equal to 1 if the new auditor is one of the Big 5, and 0 otherwise; ROA, net income in year-1 divided by total assets in year-2; ROAPLUS, 0 if ROA is less than
zero and ROA if ROA is greater than or equal to zero; OCF, cash flow from operations divided by average total assets; OCFPLUS, 0 if OCF is less than zero and OCF if OCF is greater than
or equal to zero; ACC, total accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less than zero and ACC if ACC is greater than or equal or zero; ISSUE, indicator
variable which is 1 if the number of shares outstanding is increased more than 10 percent and 0 otherwise; and LEV, total liabilities divided by total assets
partner tenure
Effect of audit
173
Table II.
MAJ
Model A coefficient Model B coefficient
23,2 Variables Expected sign (t-value) (t-value)
Intercept ^ 0.5512 (4.58) * * * 0.6384 (5.26) * * *

PARTEN-SHORT ^ 20.0566 (2 2.69) * * *
PARTEN ^ 0.01859 (3.41) * * *
174 PARTEN-LONG ^ 0.0059 (0.13)
AUDTEN 2 20.0106 (2 3.40) * * * 20.0105 (2 3.35) * * *
FIRMAGE þ 0.0012 (1.36) * 0.0013 (1.46) *
LNSIZE 2 20.0244 (2 4.18) * * * 20.0241 (2 4.13) * * *
INDGROW þ 0.0112 (0.75) 0.0100 (0.67)
BIGFIVE 2 0.0199 (0.84) 0.0147 (0.62)
ROA þ 0.1058 (8.99) * * * 0.1055 (8.96) * * *
ROAPLUS 2 20.5379 (2 5.61) * * * 20.5365 (2 5.59) * * *
OCF 2 20.3081 (2 6.11) * * * 20.3022 (2 5.98) * * *
OCFPLUS þ 0.6219 (4.87) * * * 0.6130 (4.79) * * *
ACC 2 20.1994 (2 6.64) * * * 20.1983 (2 6.59) * * *
ACCPLUS þ 1.0519 (18.83) * * * 1.0489 (18.75) * * *
ISSUE þ 0.0565 (2.51) * * * 0.0561 (2.49) * * *
LEV þ 0.0070 (2.11) * * 0.0072 (2.16) * *
F-value 16.47 * * * 16.00 * * *
R 2-adj 0.2183 0.2168
Number of observations ¼ 2,495
Notes: *, * * and * * * indicate significance (one-tailed tests with expected signs) at the 10, 5, and 1
percent levels, respectively. To keep the presentation brief, coefficient estimates for the 19 industry
(INDDUM) and 12 year (YEARDUM) dummy variables are not presented
PARTEN, audit partner tenure; PARTEN-SHORT, indicator variable which is 1 if partner tenure
(PARTEN) is less than three years, and 0 otherwise; PARTEN-LONG, indicator variable which is 1 if
partner tenure (PARTEN) is greater than six years and 0 otherwise; AUDTEN, audit firm tenure;
FIRMAGE, length of years
P since the ASX P listing year; LNSIZE,
P natural log of total assets measured in
dollars; INDGROW:ð Ni¼1 Salesi;t 2 Ni¼1 Salesi;t21 Þ= Ni¼1 Salesi;t21 by industry code; BIGFIVE,
indicator variable which is equal to 1 if the new auditor is one of the Big 5, and 0 otherwise; ROA,
net income in year-1 divided by total assets in year-2; ROAPLUS, 0 if ROA is less than zero and ROA if
ROA is greater than or equal to zero; OCF, cash flow from operations divided by average total assets;
OCFPLUS, 0 if OCF is less than zero and OCF if OCF is greater than or equal to zero; ACC, total
accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less than zero and ACC if
Table III. ACC is greater than or equal to zero; ISSUE, indicator variable which is 1 if the number of shares
Regression results using outstanding is increased more than 10 percent and 0 otherwise; and LEV, total liabilities divided by
absolute jDACCRj total assets; INDDUM, industry indicator variables; and YEARDUM, year indicator variables
this regression concerns the coefficient on PARTEN which is positive and statistically
significant at the 1 percent level (two-tail) of testing (t-value ¼ 3.41) indicating that as
auditor PARTEN increases client managers’ accounting discretion also increases.
Results under Model B in Table III show the association of absolute jDACCRj with
PARTEN-SHORT, PARTEN-LONG and the control variables. The adjusted R 2 and
results on the control variables are similar to those obtained from the estimation of
Model A. Of main interest are the coefficients on PARTEN-SHORT and PARTEN-LONG.
The coefficient on PARTEN-SHORT is negative and statistically significant at the 1
percent level (two-tailed) of testing. This suggests that compared to audit partners with
medium tenure (between three and six years), audit partners with short tenure (less than
three years) are better able to limit their client managers’ accounting discretion. The Effect of audit
coefficient on PARTEN-LONG is positive suggesting that compared to auditors with partner tenure
medium tenure, jDACCRj are higher when the client firm is audited by an audit partner
with long tenure (greater than six years). The coefficient on PARTEN-LONG, however, is
not statistically significant.
Results under Column A, Table IV show results of the association of raw signed
jDACCRj with PARTEN and the control variables (i.e. Model A results). When 175
compared to Table III results, the explanatory power of the independent variables
decreases (Adjusted R 2 ¼ 0.13) as does the statistical significance of the coefficients on
the independent variables. ROA, ROAPLUS, OCFPLUS, ACC, and ACCPLUS are
significantly related to raw signed jDACCRj at the 1 percent level (two-tail) of testing or
less. The coefficient on AUDTEN is not significant. The coefficient on PARTEN,
however, is positive and statistically significant at the 10 percent level (two tail) of
testing supporting the position of proponents of audit partner rotation. Results under
Column B, Table IV contain results of the association of raw signed jDACCRj with
PARTEN-SHORT, PARTEN-LONG and control variables (Model B). Consistent with
the results in Column A, the associations of these variables with raw signed jDACCRj
are weaker than those with absolute jDACCRj[28].
Table IV, Columns C and D contain results based on separate estimations for positive
(DACCR þ ) and negative (DACCR 2 ) jDACCRj. The adjusted R 2s of the models using
positive and negative jDACCRj are 0.24 (Column C) and 0.25 (Column D), respectively.
Consistent with the results in Table III, Model A, PARTEN is positively associated with
the positive jDACCRj while AUTEN is negatively associated with the positive jDACCRj
significant at least at the 5 percent levels (Column C) suggesting that the magnitude of
positive jDACCRj increases (decreases) as PARTEN (auditor tenure) increases. Some of
the control variables in the negative jDACCRj models have the opposite signs to those
found with jDACCRj as a dependent variable (Column D)[29]. Only AUDTEN is positive
and significant at the 10 percent level in the negative jDACCRj model.
Finally, Table IV, Columns E and F present results of separate estimations for positive
and negative ACC with PARTEN-SHORT and PARTEN-LONG as independent
variables. We find a significant association of PARTEN-SHORT with positive jDACCRj.
The coefficient on PARTEN-SHORT is not statistically significant in the estimation using
negative jDACCRj; the coefficient on PARTEN-LONG is statistically insignificant in both
positive and negative jDACCRj estimations. We conclude that during our sample period,
as audit PARTEN lengthens, an audit partner’s ability to constrain client managers’
accounting discretion is diminished. In particular, as audit PARTEN lengthens, an audit
partner’s ability to constrain income increasing jDACCRj is diminished.
Additional analyses
To increase confidence in our results we compare audit quality when audit partners are
rotated versus when audit firms are rotated[30]. As discussed, in the initial years of an
audit, we should expect audit quality to increase (decrease) in the case of audit partner
(audit firm) rotation. Whether the differences in audit quality between the two groups
will continue to persist in the later years of audit PARTEN is an empirical question. As
audit PARTEN becomes lengthy, it is possible that no differences remain in the
acquired expertise and incentives of an audit partner regardless of whether he/she was
23,2
176
MAJ
jDACCRj
Table IV.
signed/positive/negative
Regression results using
(A) (B) (C) (D) (E) (F)
Model A DACCR Model B DACCR Model A DACCR þ Model A DACCR 2 Model B DACCR þ Model B DACCR 2
Variable coefficient (t-value) coefficient (t-value) coefficient (t-value) coefficient (t-value) coefficient (t-value) coefficient (t-value)
Intercept 2 0.0805 (2 0.60) 2 0.0235 (2 0.17) 0.7082 (2.92) * * * 2 0.3746 (2 4.21) * * * 0.9224 (3.77) * * * 2 0.3904 (2 4.35) * * *
PARTEN-SHORT 2 0.0364 (2 1.55) 2 0.1311 (2 2.91) * * * 0.0098 (0.68)
PARTEN 0.0102 (1.68) * 0.0319 (2.76) * * * 2 0.0052 (2 1.39)
PARTEN-LONG 2 0.0479 (2 0.94) 2 0.0947 (2 0.97) 2 0.0405 (2 1.30)
AUDTEN 2 0.0034 (2 0.99) 2 0.0033 (2 0.95) 2 0.0172 (2 2.57) * * 0.0038 (1.79) * 2 0.0183 (2 2.73) * * * 0.0037 (1.77) *
FIRMAGE 0.0001 (0.62) 0.0007 (0.72) 0.0024 (1.16) 2 0.0002 (2 0.30) 0.0031 (1.44) 2 0.0002 (2 0.30)
LNSIZE 0.0091 (1.40) 0.0093 (1.43) 2 0.0333 (2 2.75) * * * 0.0191 (4.51) * * * 2 0.0341 (2 2.81) * * * 0.0191 (4.52) * * *
INDGROW 0.0023 (0.14) 0.0011 (0.07) 0.0146 (0.57) 2 0.0089 (2 0.67) 0.0129 (0.50) 2 0.0094 (2 0.70)
BIGFIVE 0.0018 (0.07) 2 0.0036 (2 0.14) 0.0278 (0.55) 2 0.0146 (2 0.90) 0.0231 (0.46) 2 0.0152 (2 0.94)
ROA 0.0738 (5.63) * * * 0.0734 (5.60) * * * 0.0564 (1.16) 2 0.0344 (2 3.86) * * * 0.0521 (1.07) 2 0.0344 (2 3.86) * * *
ROAPLUS 2 0.2954 (2 2.76) * * * 2 0.2924 (2 2.74) * * * 0.1562 (0.59) 0.2478 (3.31) * * * 0.1668 (0.63) 0.2488 (3.32) * * *
OCF 0.0484 (0.86) 0.0545 (0.97) 2 0.1467 (2 1.25) 0.3271 (9.75) * * * 2 0.1301 (2 1.11) 0.3274 (9.74) * * *
OCFPLUS 2 0.3971 (2 2.79) * * * 2 0.4072 (2 2.86) * * * 0.2030 (0.57) 2 0.6001 (2 7.50) * * * 0.1317 (0.37) 2 0.6013 (2 7.51) * * *
ACC 2 0.1203 (2 3.59) * * * 2 0.1192 (2 3.56) * * * 2 0.1158 (2 1.11) 0.0921 (3.71) * * * 2 0.1042 (2 1.00) 0.0923 (3.72) * * *
ACCPLUS 0.9383 (15.07) * * * 0.9352 (15.01) * * * 1.1326 (8.88) * * * 2 0.3200 (2 5.27) * * * 1.1197 (8.77) * * * 2 0.3203 (2 5.27) * * *
ISSUE 2 0.0371 (2 1.48) 2 0.0379 (2 1.51) 0.0539 (1.15) 2 0.0715 (2 4.57) * * * 0.0654 (1.20) 2 0.0721 (2 4.60) * * *
LEV 0.0062 (1.67) * 0.0063 (1.70) * 0.0038 (0.73) 2 0.0669 (2 6.03) * * * 0.0039 (0.75) 2 0.0673 (2 6.08) * * *
F-value 9.30 * * * 9.09 * * * 8.44 * * * 11.93 * * * 8.28 * * * 11.68 * * *
R 2-adj 0.1303 0.1299 0.2380 0.2528 0.2379 0.2527
Number of
observations 2,495 2,495 1,073 1,422 1,073 1,422
Notes: *, * * and * * * indicate significance at the 10, 5, and 1 percent levels, respectively. All coefficients are based on two-tailed tests. To keep the presentation brief,
coefficient estimates for the 19 industry (INDDUM) and 12 year (YEARDUM) dummy variables are not presented
DACCR, raw signed value of discretionary accruals; DACCRþ, positive value of discretionary; DACCR2 , negative value of discretionary accruals; PARTEN, audit partner
tenure; PARTEN-SHORT, indicator variable which is 1 if partner tenure (PARTEN) is less than three years, and 0 otherwise; PARTEN-LONG, indicator variable which is 1 if
partner tenure (PARTEN) is greater than six yearsP and 0 otherwise;
P AUDTEN, audit P firm tenure; FIRMAGE, length of years since the ASX listing year; LNSIZE, natural log of
total assets measured in dollars; INDGROW:ð Ni¼1 Salesi;t 2 Ni¼1 Salesi;t21 Þ= Ni¼1 Salesi;t21 by industry code; BIGFIVE, indicator variable which is equal to 1 if the new
auditor is one of the Big 5, and 0 otherwise; ROA, net income in year-1 divided by total assets in year-2; ROAPLUS, 0 if ROA is less than zero and ROA if ROA is greater than
or equal to zero; OCF, cash flow from operations divided by average total assets; OCFPLUS, 0 if OCF is less than zero and OCF if OCF is greater than or equal to zero; ACC,
total accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is less than zero and ACC if ACC is greater than or equal to zero; ISSUE, indicator variable which
is 1 if the number of shares outstanding is increased more than 10 percent and 0 otherwise; and LEV, total liabilities divided by total assets; INDDUM, industry indicator
variables; and YEARDUM, year indicator variables
from the same or a different audit firm at the time of initial engagement. This Effect of audit
discussion forms the basis for H4 stated in the null form:
partner tenure
H4. There is no difference in the association between client managers’ accounting
discretion and audit PARTEN when the incoming and outgoing audit
partners are from the same audit firm (audit partner rotation) versus when the
incoming and outgoing audit partners are from different audit firms (audit
firm rotation). 177
To our existing dataset we add firm-year observations relating to audit firm
changes during our sample period. Specifically, we identify all cases where an audit
firm was changed by a client firm during our sample period and compute the new
audit partner’s tenure beginning with the first year the audit firm was changed. The
additional observations included in the dataset have the property that in each case
AUDTEN is equal to audit PARTEN as a change in audit firm will result in a
change in the partner signing the audit opinion. Next, for these observations we
obtain jDACCRj and all of the control variables discussed earlier. We then estimate
Models C and D below using a pooled dataset, allowing the intercepts and
coefficients on audit PARTEN to vary depending on whether the new audit partner
was from the same or a different audit firm as the outgoing partner. Finally, we use
an F-test to determine whether we can reject that the different coefficients on audit
PARTEN are equal across both groups. Our pooled data set has 1,162 additional
firm-year observations representing 384 client firms that changed audit firms during
our sample period.
The following regression models are used to test H4:
.
Model C:
jDACCRjit ¼ a021 SAMEit þ a022 DIFFit þ b121 PARTEN – SAMEit
þ b122 PARTEN – DIFFit þ b2 AUDTEN – SAMEit þ b3 FIRMAGEit
þ b4 LNSIZEit þ b5 INDGROWit þ b6 BIGFIVEit þ b7 ROAit
þ b8 ROAPLUSit þ b9 OCFit þ b10 OCFPLUSit þ b11 ACCit
X
þ b12 ACCPLUSit þ b13 ISSUEit þ b14 LEVit þ a INDDUMkit
k k
X
þ a YEARDUMlit þ 1it
l l
.
Model D:
jDACCRjit ¼ a021 SAMEit þ a022 DIFFit þ b121 PARTEN–SHORT–SAMEit
þ b122 PARTEN–SHORT–DIFFit þ b123 PARTEN–LONG–SAMEit
þ b124 PARTEN–LONG–DIFFit þ b2 AUDTEN–SAMEit
þ b3 FIRMAGEit þ b4 LNSIZEit þ b5 INDGROWit þ b6 BIGFIVEit
þ b7 ROAit þ b8 ROAPLUSit þ b9 OCFit þ b10 OCFPLUSit
þ b11 ACCit þ b12 ACCPLUSit þ b13 ISSUEit þ b14 LEVit
X X
þ k
a k INDDUM kit þ a YEARDUMlit þ 1it
l l
MAJ where, SAME, indicator variable 1 if the auditor is from the same audit firm as the
23,2 outgoing partner and 0 otherwise; DIFF, indicator variable 1 if the auditor is from a
different audit firm as the outgoing partner and 0 otherwise; PARTEN-SAME,
indicator variable which is equal to PARTEN if the auditor is from the same audit
firm as the outgoing partner and 0 otherwise; PARTEN-DIFF, indicator variable
which is equal to PARTEN if the auditor is from a different audit firm as the
178 outgoing partner and 0 otherwise; PARTEN-SHORT-SAME, indicator variable
which is 1 if PARTEN is less than three years and the new audit partner is from
the same firm as the outgoing partner and 0 otherwise; PARTEN-SHORT-DIFF,
indicator variable which is 1 if PARTEN is less than three years and the new audit
partner is from a different firm as the outgoing partner and 0 otherwise;
PARTEN-LONG-SAME, indicator variable which is 1 if PARTEN is greater than
six years and the new audit partner is from the same audit firm as the outgoing
partner and 0 otherwise; and PARTEN-LONG-DIFF, indicator variable which is 1 if
PARTEN is greater than six years and the new audit partner is from a different
audit firm as the outgoing partner and 0 otherwise; AUDTEN-SAME, indicator
variable which is equal to AUTEN if the auditor is from the same audit firm as the
outgoing partner and 0 otherwise.
All other variables are as defined earlier.
Results shown in Table V, Column A indicate that as audit PARTEN increases
absolute jDACCRj increase (decrease) when the new partner is from the same (a
different) audit firm as the outgoing partner. The coefficients on PARTEN-SAME
(PARTEN-DIFF) are statistically significant at the 1 (5) percent level. Results shown in
Table V, Column B indicate that during the initial years of audit PARTEN, absolute
jDACCRj increase when the new audit partner is from a different audit firm as the
outgoing partner, whereas they decrease when a new audit partner is from the same
audit firm as expected. Specifically, the coefficient on PARTEN-SHORT-DIFF
(PARTEN-SHORT-SAME) is positive (negative) and statistically significant at the 10
(5) percent level. F-tests reject the equality of the coefficients on PARTEN-SAME and
PARTEN-DIFF (F-value ¼ 12.87, p ¼ 0.000) and those on PARTEN-SHORT-DIFF and
PARTEN-SHORT-SAME (F-value ¼ 6.26, p ¼ 0.012). As PARTEN lengthens,
however, we do not find a significant relation of audit PARTEN with absolute
jDACCRj. Coefficients on PARTEN-LONG-DIFF and PARTEN-LONG-SAME are
statistically insignificant[31].
Similar to Myers et al. (2003), we re-estimated the models omitting observations in the
extreme (top and bottom) 0.5 percent of ROA (measured by year and industry) to control
for the possibility that the association between audit PARTEN and ACC is the result of
extreme financial performance early in the auditor’s tenure. For the non-extreme ROA
sub-sample, our results on tenure for income-increasing ACC are generally consistent
with the results in Table IV, columns C and E. In addition, eliminating the extreme
observations does not improve the statistical significance of PARTEN or
PARTEN-SHORT with the income-decreasing jDACCRj. Thus, we conclude that our
main results are not driven by extreme performance.
Conclusion
Our paper examines the association between audit PARTEN and client managers’
accounting discretion. Prior US research indicates that lengthy AUDTEN is associated
Effect of audit
(A) (B)
Model C coefficient Model D coefficient partner tenure
Variables (t-value) (t-value)
SAME 0.5662 (4.58) * * * 0.6534 (5.22) * * *

DIFF 0.5957 (4.92) * * * 0.5173 (4.23) * * *
PARTEN-SAME 0.0171 (2.61) * * *
PARTEN-DIFF 20.0231 (22.48) * *
179
PARTEN-SHORT-SAME 20.0519 (22.03)
PARTEN-SHORT-DIFF 0.0546 (1.58) *
PARTEN-LONG-SAME 0.0017 (0.03)
PARTEN-LONG-DIFF 20.0096 (20.11)
AUDTEN-SAME 20.0110 (22.98) * * * 20.0105 (22.84) * * *
FIRMAGE 0.0011 (1.21) 0.0011 (1.28)
LNSIZE 20.0234 (23.85) * * * 20.0239 (23.93) * * *
INDGROW 0.0081 (0.52) 0.0073 (0.47)
BIGFIVE 0.0167 (0.73) 0.0143 (0.63)
ROA 0.0036 (1.04) 0.0037 (1.06)
ROAPLUS 20.0375 (20.44) 20.0404 (20.46)
OCF 20.5367 (212.61) * * * 20.5325 (212.49) * * *
OCFPLUS 0.8473 (7.32) * * * 0.8391 (7.23) * * *
ACC 20.0067 (20.41) 20.0066 (20.41)
ACCPLUS 0.2352 (7.76) * * * 0.2355 (7.76) * * *
ISSUE 0.0391 (1.81) * 0.0393 (1.82) *
LEV 0.0045 (1.45) 0.0046 (1.48)
F-value 20.89 * * * 19.89 * * *
R 2-adj 0.2070 0.2053
Number of observations ¼ 3,657
Notes: *, * * and * * * indicate significance at the 10, 5, and 1 percent levels, respectively. All except
PARTEN-SHORT related coefficients are based on the two-tailed tests (the expected sign of
PARTEN-SHORT-SAME (PARTEN-SHORT-DIFF) is negative (positive)). To keep the presentation brief,
coefficient estimates for the 19 industry (INDDUM) and 12 year (YEARDUM) dummy variables are not presented
SAME, indicator variable 1 if the auditor is from the same audit firm as the outgoing partner and 0 otherwise;
DIFF, indicator variable 1 if the auditor is from a different audit firm as the outgoing partner and 0 otherwise;
PARTEN-SAME, indicator variable which is equal to PARTEN if the auditor is from the same audit firm as the
outgoing partner and 0 otherwise; PARTEN-DIFF, indicator variable which is equal to PARTEN if the auditor is
from a different audit firm as the outgoing partner and 0 otherwise; PARTEN-SHORT-SAME, indicator variable
which is 1 if PARTEN is less than three years and the new audit partner is from the same firm as the outgoing
partner and 0 otherwise; PARTEN-SHORT-DIFF, indicator variable which is 1 if PARTEN is less than three
years and the new audit partner is from a different firm as the outgoing partner and 0 otherwise;
PARTEN-LONG-SAME, indicator variable which is 1 if PARTEN is greater than six years and the new audit
partner is from the same audit firm as the outgoing partner and 0 otherwise; and PARTEN-LONG-DIFF,
indicator variable which is 1 if PARTEN is greater than six years and the new audit partner is from a different
audit firm as the outgoing partner and 0 otherwise; AUDTEN-SAME, indicator variable which is equal to
AUTEN if the auditor is from the same audit firm as the outgoing partner and 0 otherwise; FIRMAGE,
length of yearsP since the ASX P listing year; PLNSIZE, natural log of total assets measured in dollars;
INDGROW:ð Ni¼1 Salesi;t 2 Ni¼1 Salesi;t21 Þ= Ni¼1 Salesi;t21 by industry code; BIGFIVE, indicator variable
which is equal to 1 if the new auditor is one of the Big 5, and 0 otherwise; ROA, net income in year-1 divided by
total assets in year-2; ROAPLUS, 0 if ROA is less than zero and ROA if ROA is greater than or equal to zero; OCF,
cash flow from operations divided by average total assets; OCFPLUS, 0 if OCF is less than zero and OCF if OCF is
greater than or equal to zero; ACC, total accruals in year-1 divided by total assets in year-2; ACCPLUS, 0 if ACC is
less than zero and ACC if ACC is greater than or equal to zero; ISSUE, indicator variable which is 1 if the number of Table V.
shares outstanding is increased more than 10 percent and 0 otherwise; and LEV, total liabilities divided by total Pooled regression results
assets using absolute jDACCRj
MAJ with higher audit quality. This research, however, has not examined how audit PARTEN
23,2 impacts audit quality. It treats an audit firm with long tenure and frequent audit partner
rotation the same as an audit firm with long tenure and infrequent audit firm rotation. In
contrast, we separate the impact of audit PARTEN and audit firm tenure on audit quality.
Using a sample of Australian firms we examine the effects on audit quality from audit
partner changes within the same audit firm. We conjecture that when the new audit
180 partner is from the same audit firm as the outgoing audit partner, audit quality increases
because the new audit partner brings “fresh eyes” to the engagement. However, when the
new audit partner is from a different audit firm as the outgoing partner, the client
manager’s accounting discretion increases in those initial years because the new partner
faces a very steep learning curve regarding the client’s operations. Our results confirm
these conjectures. We find that in the initial years of tenure of a new audit PARTEN client
managers’ accounting discretion decreases (increases) when the new partner is from the
same (a different) audit firm as the outgoing partner. These results suggest that audit
partner rotation increases audit quality during the initial years on the engagement while
audit firm rotation decreases audit quality in those initial years. Our findings also indicate
that as audit PARTEN increases client managers’ accounting discretion also increases.
These results are consistent with audit partner judgment being impaired as tenure on an
engagement become lengthy. Together, these results suggest that “fresh skeptical eyes”
from within the same audit firm need to be brought into an engagement to ensure that
high-audit quality is maintained. While our study provides support for the recent
legislation restricting the length of audit PARTEN in the US it should also be of interest to
other regulatory bodies considering new legislation to require audit partner rotation[32].
Several limitations of this study need to be acknowledged. First, while client managers’
accounting discretion increases with audit PARTEN, the costs to clients and audit firms
from requiring audit partner rotation are not examined in this study[33]. Without a
cost-benefit analysis, we cannot draw definite conclusions on the merits of regulatory
policy requiring audit partner rotation. Second, our sample consists only of firms that
voluntarily changed audit partners on the engagement. Caution is needed in generalizing
these results to a regime with mandatory audit partner rotation. Third, our sample spans a
relatively short time-period of 14 years. While our tests provide strong evidence that
short-tenured audit partners are associated with higher audit quality than medium tenured
audit partners from the same audit firm, our ability to examine the effects of long-tenured
audit partners on audit quality was constrained by data availability. Although we conduct
several sensitivity tests to increase confidence in our test result, we cannot completely
eliminate concerns about the skewness in audit PARTEN data that is present in our
sample[34]. As new databases continue to become available to researchers, future studies
can potentially provide more insights on the relationship between PARTEN and audit
quality using a longer time series, as well as, testing this relationship in other countries.
Notes
1. The debate over auditor rotation is not new. In 1976, the US Senate issued what is known as
the “Metcalf Report” which recommended mandatory auditor rotation. In response to the
Metcalf Report, the AICPA’s Cohen Commission issued its own report in 1978 arguing that
mandatory firm rotation would be too costly to implement. In recent years, following
high-profile scandals, the issue of auditor rotation has resurfaced. See GAO (2003) for a
discussion of the history of the auditor rotation debate.
2. Among those opposed to mandatory auditor rotation is former SEC Chairman (Senate Report Effect of audit
107-205 2002), Hills, who testified that “a change of auditors can only lower the quality of
audits and increase their costs”. partner tenure
3. Effective July 7, 2004, the GAO’s legal name became the Government Accountability Office.
4. An “audit partner” is defined as a partner who is a member of the audit engagement team
who has decision-making responsibility on significant auditing, accounting and reporting
matters that affect financial statements or who maintains regular contact with the 181
management and audit committee. The definition also includes the lead and concurring
partners and partners who serve the company at the company level (other than a partner
who consults with others on the audit engagement team regarding technical or
industry-specific issues) and the lead partner on subsidiaries of the issuer whose assets or
revenues constitute 20 percent or more of the consolidated assets or revenues of the
company.
5. Unlike the case of audit firm rotation, Sarbanes-Oxley did not direct the SEC or the GAO to
study the issue of audit partner rotation prior to the issuance of the new rules.
6. Australian Corporations Act, 2001, Commonwealth of Australia, Section 324 (10).
7. Similar to the audit firms, the AICPA (1992) has taken the position that audit quality increases
with auditor tenure and that mandatory rotation will impair audit quality. Changing auditors
can also be costly for client-firms. Client-managers worry about the new auditor having
industry expertise and the additional resources needed to audit a new client (Dunham, 2002).
8. Their tests measure audit quality using a weighted quality score based on 232 quality
control review letters for audits conducted by the Audit Division of the Texas Education
Agency between 1984 and 1989.
9. Boards of directors and CFOs of client firms are also interested in having a smooth transition
from one engagement partner to the next and may require their audit firm to have transition
processes in place.
10. The quality of an audit is also possibly more directly impacted by the accounting expertise
of the partner-in-charge of the audit than by the audit firm engaged by the client.
11. Using US survey data, Trompeter (1994) finds that audit partners with compensation closely
tied to client retention were less likely to require downward adjustments to their client’s net
income.
12. Other incentives that may be present for an audit partner to benefit directly from his/her
relationship to the client include opportunities for consulting with the client, the possibility
of being hired as the client’s CFO in the future, etc. Some of these arrangements are now
prohibited by the Sarbanes-Oxley Act (2002).
13. A cost-benefit analysis would be required before one can draw definite conclusions on
whether audit partners should be rotated.
14. This statement assumes that when a new audit firm is engaged, the partner on the audit is
also new (i.e. the new partner is not the same as the predecessor audit partner from the
predecessor audit firm).
15. Indeed, if audit firms do not rotate partners or do so infrequently, their results could
imply that lengthy audit partner tenure (audit firm tenure serving as a proxy) increases audit
quality.
16. The following model is used to compute DACCR:
1 ðDSALES 2 DARÞ PPE

ACCR ¼ a0 þ a1 þ a2 þe
TA21 TA21 TA21
MAJ where ACCR is total accruals deflated by total assets at the beginning of the year
(TA2 1); total accruals are measured as the difference between earnings before
23,2 extraordinary items and net cash flow from operations; AR is accounts receivable; PPE
is property, plant, and equipment. The model is separately estimated for each industry
and year. DACCR is the estimated residual of the above model. Alternative proxies for
DACCR suggested by Jones (1991), Kasznik (1999) and Klein (2002) were also used and
similar results were obtained.
182 17. Our primary interest is not to measure the effect of audit firm tenure on accounting
discretion. Our sample selection procedures are intended to obtain data for firms where audit
partner tenure (not audit firm tenure) could be measured accurately. This also implies that
we discarded some observations where audit firm tenure could be computed accurately but
complete data were not available to compute audit partner tenure.
18. US studies (Myers et al., 2003; Ghosh and Moon, 2005) compute US audit firm tenure by
assuming that the first year of auditor tenure is the first year the audit-firm name was
disclosed on COMPUSTAT. However, unlike COMPUSTAT which has been providing this
information since 1974, the database used in this study, DatAnalysis, has only provided
adequate coverage from 1990.
19. Coverage of Australian firms by DatAnalysis has become more comprehensive in recent
years. Prior to 1990, coverage was limited to a few hundred firms. There is no other database
available that readily identifies signing partners for publicly traded Australian firms during
this period.
20. The effect of Professional Statement F1 on our tests is minimal. Our sample includes 13
client-firms whose partner tenure was seven years as of the end of 2003. Six of these did not
switch their audit partners in 2004. There are additional 14 observations where the signing
partner tenure was longer than seven years in 2003. These clients were audited by small
audit firms likely to qualify for an exemption, or a delayed transition, to the rotation
requirements in Professional Statement F1. As a check for sensitivity we excluded these
observations from the sample; our conclusions were unchanged.
21. Coverage on DatAnalysis for some firms is not complete. A firm may be covered by
DatAnalysis in a certain year, dropped in the next year, and then covered again a few years
later. For this firm, collecting data on partner names would not result in any usable
observations in our tests; as explained later we would not be able to compute audit partner
tenure for these firms. For this reason, we used the above screen, namely that firms have at
least three years of consecutive data.
22. For example, if the first audit partner change for a firm occurred in 1996 (i.e. the signing
partner in 1996 was different from the previous signing partner), we would code 1996 as the
new partner’s first year on the engagement, 1997 would be coded year 2 and so on.
Observations prior to 1996 would be discarded because we could not determine when the
predecessor audit partner first joined the engagement from DatAnalysis.
23. These 2,299 observations representing 569 firms are used later as a base set for the “control
sample” for comparison with our main sample. Owing to financial data being unavailable for
this sub-sample we were left with 1,525 firm-year observations representing 439 firms.
Firm-year observations belonging to finance, investment, property trusts, and insurance
industries were also discarded. These procedures left us with 1,162 firm-years representing
384 firms for our comparison analyses.
24. The Aspect database, like its US counterpart COMPUSTAT, covers financial statement data
for publicly traded firms in Australia.
25. This method of measuring partner tenure possibly results in discarding outgoing partners,
some of whom may have long tenure, from our analyses. We conduct sensitivity tests where
we examine changes in audit quality for a sub-sample of long-tenured partners and find that Effect of audit
our conclusions are not changed.
partner tenure
26. While our method of measuring partner tenure (combined with a short sample period) results
in a sample consisting of a majority of partners with tenure of less than three years, this does
not invalidate our test results. Our method assures that partner tenure is accurately
measured for each partner. After controlling for all known factors that affect discretionary
accruals, our tests allow us to compare discretionary accruals for firms with short-tenured 183
partners with those of medium and long-tenured auditors. We also conduct sensitivity tests
where we examine changes in audit quality for a sub-sample of long-tenured partners and
find that our conclusions are not changed.
27. Dropping one or both of these variables does not change our conclusions.
28. The weaker results on raw signed discretionary accruals are also consistent with findings of
Johnson et al. (2002). Myers et al. (2003) also cautions against using raw discretionary
accruals to proxy for earnings management.
29. Similar phenomenon has also reported in Myers et al. (2003).
30. Our results in Table III also show that as audit firm tenure increases audit quality increases.
However, the sample used for these tests is restricted to observations with changes in
signing auditor within the same audit firm. The tests in this section are designed to measure
audit firm tenure more accurately.
31. We could not reject the equality of the coefficients on PARTEN-LONG-DIFF and
PARTEN-LONG-SAME (F-value ¼ 0.01, p ¼ 0.911). This result is similar to findings in
Johnson et al. (2002) who report that long audit-firm tenure is not statistically
significantly associated with reduced absolute discretionary accruals but short audit
firm tenure is statistically significantly associated with high absolute discretionary
accruals.
32. The European Union, for example, is currently considering proposals to limit audit partner
and audit firm tenure, www.cfo.com/article.cfm/3011703/c_3042499?f ¼ TodayInFinance_
Inside. Australia has adopted mandatory rotation of employees who play a significant role in
the audit for more than five out of seven years (CLERP 9, 2004).
33. Costs include direct costs for training new audit partners about the client company’s
operations resulting in higher audit costs. Some audit firms with a small number of
audit partners may find it impossible or difficult to rotate partners and may have to
give up some business. There is a cost to having fewer audit firms in the profession if
audit partner rotation forces some audit firms to exit the business. The US rules
provide relief to audit firms with fewer than five SEC registrants and less than ten
partners (SEC, 2003).
34. For example, to increase confidence in our sample that audit partner rotation increases audit
quality in the initial years, we compare discretionary accruals of firms with short-tenured
audit partners from the same audit firm with those of client firms with short-tenured
auditors from a different audit firm.
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Corresponding author
Ho-Young Lee can be contacted at: hylee@yonsei.ac.kr
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where, jDACCRj, absolute value of discretionary accruals; PARTEN, audit PARTEN;

Measuring audit partner tenure

168 Measuring audit firm tenure

Measuring other control variables

Intercept ^ 0.5512 (4.58) * * * 0.6384 (5.26) * * *

SAME 0.5662 (4.58) * * * 0.6534 (5.22) * * *

1 ðDSALES 2 DARÞ PPE

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