Earnings quality: Some evidence on the role of auditor tenure and auditors’ industry expertise

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Abstract

Prior studies suggest that auditors with short tenure are associated with lower earnings quality because of the lack of client-specific knowledge and/or low balling. In this study, we examine whether industry specialization of auditors and low balling affect the association between auditor tenure and earnings quality. We find that the association between shorter auditor tenure and lower earnings quality is weaker for firms audited by industry specialists compared to non-specialists. In addition, we do not find results consistent with the low balling explanation.

Introduction

Recent research shows that auditors with shorter tenure are associated with lower earnings quality than auditors with longer tenure (e.g. Johnson et al., 2002; Myers et al., 2003; Ghosh and Moon, 2005). Auditor tenure is defined as the number of years an auditor is retained by the firm (Myers et al., 2003). Three different explanations have been provided for this relationship. The first is based on the argument that short-tenured auditors lack client-specific knowledge that is necessary to conduct a high-quality audit. In addition, the accounting profession argues that short tenure may involve higher risk for audit failures, because incoming auditors with insufficient client-specific knowledge will have to rely more heavily on the estimates and representations made by client firms (e.g. PricewaterhouseCoopers, 2002; Gul et al., 2007). The second is based on low balling, whereby auditors charge lower audit fees to obtain and retain new clients and then expect to recoup losses in later years of the audit engagements (DeAngelo, 1981). This argument suggests that auditors with short tenure may be more lax in the early years of the auditor–client relationship so that they can retain the job long enough to recoup the initial losses, resulting in lower quality audits and lower quality earnings (Gul et al., 2007). The third is based on the argument that firms with higher quality earnings are more likely to retain the incumbent (high-quality) auditors, or high-quality auditors are more likely to drop risky clients that have lower quality earnings, who will then move to lower quality auditors.

In this study, we first examine whether the positive relation between auditor tenure and earnings quality, as documented in prior research, is weaker for firms audited by industry specialists. Second, we evaluate whether the observed lower earnings quality in the early years of the auditor–client relationship is consistent with the low balling argument. Our paper is motivated by two primary considerations. First, both the financial press and policy makers remain concerned about alleged earnings management in US companies (e.g. Levitt, 2007; Karpoff et al., 2008). Related to these concerns is the fact that academics, practitioners, and policy makers raise doubts about the quality of auditors with shorter tenure and its implications for earnings quality (e.g. Arel et al., 2005; Dunham, 2002; Geiger and Raghunandan, 2002; PricewaterhouseCoopers, 2002). The importance of this research question is further exemplified by the fact that high-quality accounting information is central to the efficient allocation of scarce capital resources in the market (e.g. Foster and Johnson, 2001). It would be useful for investors and other interested parties to be aware that situations may exist in which the documented association between lower quality of earnings and shorter auditor tenure is weaker. One such situation is the presence of an industry-specialist auditor.3 Second, while there is ample evidence to support the short tenure/low-quality earnings relation, there has been little attempt to examine whether this relation is related to low balling or lack of client-specific knowledge. This paper attempts to provide some understanding of this issue.

A maintained assumption in the linkage between auditors’ industry specialization and the shorter auditor tenure/lower earnings quality association is based on prior studies, which show that auditors’ industry specialization is associated with higher earnings quality (e.g. Balsam et al., 2003; Krishnan, 2003). Industry specialization is defined in terms of the auditor's market share (see Francis et al., 2005a). An auditor is considered a specialist in an industry if the audit firm has the largest share of the industry's total assets (Mayhew and Wilkins, 2003). Based on this assumption, we expect that the association between lower earnings quality and shorter auditor tenure would be weaker if the auditors are also industry specialists, ceteris paribus.

In our main tests, we use discretionary accruals as a proxy for earnings quality, which are estimated based on a model suggested by Ball and Shivakumar (2006). In addition, as sensitivity tests, we use other discretionary accruals models and the earnings benchmark tests. Based on a sample of observations from 1993 to 2004, we show that earnings quality is lower when auditor tenure is short. Additionally, we find that the positive association between earnings quality and auditor tenure is significantly weaker for firms that are audited by industry specialists. However, these results have to be viewed with some caution since the data used in the study may be largely drawn from a presumably optimal matching between auditors and clients i.e. the client retains the best auditor, and the auditor keeps the best clients. We address this limitation by conducting tests of endogeneity.

In a separate set of tests, we examine whether the higher discretionary accruals in the earlier years of auditor–client relationship (less than 4 years) can be explained by low balling. Based on a sample of firms from 2000 to 2004, we identify low balling firms as the firms with short auditor tenure (less than 4 years) and the auditor charges abnormally low audit fees (when audit fees are one standard deviation below the predicted audit fees based on an audit fees model). Results show that there is no significant association between low balling and lower earnings quality.

To address the potential endogeneity problems in our main tests associated with hiring of short-tenured versus long-tenured auditors, or specialists versus non-specialists (self-selection bias), we use a two-stage least-squares (2SLS) estimation procedures. The results of these tests are similar to our main findings. Our main test results are also robust to other discretionary accruals models such as the accruals quality measure developed by Francis et al. (2005b), the Jones’ discretionary accruals model (Jones, 1991), or the performance-adjusted model (e.g. Ashbaugh et al., 2003; Kothari et al., 2005). In addition, similar results are obtained when we use meeting or beating the earnings benchmarks as an alternative measure of earnings quality. Overall, our results suggest that industry specialization is likely to reduce the association between shorter auditor tenure and lower earnings quality.

Our results contribute to the auditing literature in the following ways. First, our findings add to the literature on the linkage between industry specialization and audit quality (Gramling and Stone, 2001; Balsam et al., 2003; Dunn and Mayhew, 2004) by showing that industry specialization has a role to play in the early years of auditor–client relationship. The results also suggest that the evidence in prior studies linking short auditor tenure with poor earnings quality (e.g. Myers et al., 2003; Johnson et al., 2002; Carcello and Nagy, 2004) is likely to apply more to firms audited by industry non-specialists. These results suggest that the documented evidence linking short tenure to poor earnings quality may not be due to shorter tenure per se, but rather it may be due to the auditor's unfamiliarity with the client's business that could affect the auditor's ability to detect misrepresentations and/or misreporting. It should, however, be noted that our results should not be interpreted to mean that all industry specialists or the use of specialists’ services will always improve earnings quality. Second, this study represents the first attempt to empirically distinguish the low balling argument from the lack of client-specific knowledge argument.

The remainder of the paper is organized as follows. In Section 2, we discuss the background and research questions for the study. Section 3 contains discussion on sample selection and research design. Results are discussed in Section 4, and the conclusion is contained in Section 5.

Section snippets

Audit quality and earnings quality

The assumption in this study that audit quality is positively linked to earnings quality is not new and has been extensively documented in the accounting and auditing literature. Several prior studies document an association between measures of higher quality auditors (such as auditor size or industry expertise) and higher quality of financial reporting (e.g. Becker et al., 1998; Johnson et al., 2002; Krishnan, 2003; Balsam et al., 2003; Myers et al., 2003; Ghosh and Moon, 2005). This linkage

Sample

This study is based on a sample of firms from 1993 to 2004. All firms with sufficient data on the Compustat annual industrial and research files for estimation of accruals are included in the initial sample.4

Descriptive statistics

Table 1 presents descriptive statistics for discretionary accruals and other variables used in the study.

Panel A shows that the means of absolute discretionary accruals (ABSTDA) are 3.6% and 4.0% for specialists and non-specialists respectively, indicating that the magnitude of discretionary accruals is lower for the specialist sub-group. Though the means of absolute discretionary accruals are consistent with prior literature (e.g. Balsam et al., 2003), their high magnitudes (4% of total

Conclusion

This paper provides evidence that auditors’ industry specialization affects the relationship between auditor tenure and earnings quality, as documented in prior studies (e.g. Myers et al., 2003; Johnson et al., 2002). Our main results show that the association between shorter auditor tenure and lower quality of reported earnings is weaker for firms audited by industry specialists. One possible explanation of these results might be that auditors with industry expertise in the client's business

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    We thank an anonymous reviewer, Jerry Zimmerman (the editor), Mark Bliss, Shimin Chen, Peter Cheng, Richard Chung, Carol Dee, Jun Du, Kimberly Dunn, Jere Francis, Stephen Gong, Ira Horowitz, Yuan Huang, Kam Wah Lai, Chung-kin Min, Al Nagy, Bin Srinidhi, Nancy Su, Joanna Ho, Suresh Radhakrishnan, Cheong H. Yi, workshop participants in The Hong Kong Polytechnic University, 2007 Journal of Contemporary Accounting and Economics Symposium, 2007 AAA Auditing Midyear Conference and other individuals for their helpful comments.

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