Audit partner rotation and negative information hoarding: evidence from China

We analyse the impact of mandatory audit partner rotation (MAPR) on negative information hoarding about audit clients using a sample of Chinese firms. Our findings suggest that the outgoing audit partners hoard negative information in pre-MAPR, as revealed by a decrease in crash risk, while the incoming audit partners disclose negative information in post-MAPR. Additional analysis suggests that the results are more pronounced among reviewing partners than engaging partners. We also find that when the outgoing audit partner has strong professional abilities or weak personal network with the client or incoming partner, there is less negative information hoarding around MAPR.     

Do Audit Clients Successfully Engage in Opinion Shopping? Partner‐Level Evidence

This study investigates whether companies engage in audit opinion shopping activities by exerting influence over an audit firm's decision to switch the engagement partner (“partner‐level opinion shopping”) in the Chinese setting, where the identities of engagement partners are publicly disclosed. Adopting the empirical framework developed by Lennox [2000], we show evidence that companies successfully engage in partner‐level opinion shopping. Further, partner‐level opinion shopping is more likely to be successful if a company is economically important to an audit firm, and it is less likely to be successful if the audit firm is formed as a partnership rather than a corporation. We also find that companies successfully engaging in partner‐level opinion shopping exhibit significantly lower earnings quality. Finally, we directly compare audit records between incoming and outgoing partners and find that, for companies that successfully improve audit opinions after partner switching, incoming partners have a significantly higher propensity to issue clean opinions than their outgoing counterparts.     

Audit Firm Tenure and Audit Quality in a Constrained Market

We examine the relation between audit quality and audit firm tenure in the Iranian audit market, which is constrained by government policies that create intense competition for clients among many small audit firms. We develop arguments that these circumstances create cost pressures that entrench low audit quality and render auditors' plans more predictable to managers wishing to misstate their accounts. Using publicly available data for the audits of listed companies in Iran prior to mandatory audit firm rotation and the incidence of misstated financial reports identified by the Iranian Association of Certified Public Accountants Inspection Office, we find that the likelihood of a misstatement is lowest in the first two years of audit firm tenure. We also find that the likelihood of misstatement is not associated with the year preceding a mandatory audit firm rotation, suggesting outgoing auditor effort is not sensitive to the prospect of subsequent revelations of deficiencies. Although our results from a pre-mandatory rotation period show that frequent rotations appear to improve the financial reporting quality in our sample, we are wary of interpreting these results as support for the mandatory audit firm rotation policy in Iran. Rather, we suggest this is a peculiar consequence of deficiencies in audit quality inherent in the Iranian market.     

Rotate back or not after mandatory audit partner rotation?

Many countries have implemented rules that require an audit partner to rotate off the audit of a specific client after a certain period of time in the belief that rotation will improve independence and will allow for a fresh look at the audit. The rules are either silent on whether or when a partner can rotate back or else they specify a cooling-off period after which the rotated-off partner can resume the audit. Using archival data from China, a country with a 2-year cooling-off period, this paper explores the determinants of whether the audit partner rotates back or not when the cooling-off period expires, and whether audit quality is weakened by the audit partner rotation-back practice. We find that the audit partner rotation-back practice can be explained by factors relating to switching costs, agency conflicts, client desirability, and the audit partner’s capacity constraint considerations. Interestingly, we find that clients suffering greater audit adjustments immediately prior to the expiration of the cooling-off period are more likely to be associated with subsequent audit partner rotation-back. Furthermore, we find that rotation-back partners tend to treat former clients more favorably than non-rotation-back cases using modified audit opinions as our proxy for audit quality. Overall, our findings offer preliminary explanations for and shed light on the consequences of rotation-back practice arising from mandatory audit partner rotation requirements and lend support to regulatory concerns on rotation-back practice among audit partners.     

Some Economics of Audit Market Reform

The purpose of audit market reforms since 2001 is to restore public confidence in the institution of auditing based on two considerations: (1) ensuring audit quality; and (2) controlling the ‘adverse effect of competition’ in audit supply. Market reforms for audit quality are delivered through a package of prescribed actions motivated by an analytical relationship between audit quality and its possible determinants: (1) limiting audit tenure through a combination of mandatory firm rotation, partner rotation and re‐tendering; (2) limiting provision of non‐audit services (NAS) by the incumbent auditor; and (3) joint auditing and empowering the audit committee to enhance audit quality. This paper examines the competing independence hypothesis and expertise hypothesis that produce ambiguous theoretical relationships for audit quality–audit tenure and the independence‐provision of NAS. We then review whether the empirical literature resolves these conundrums. We also review the usefulness of joint auditing and empowering the audit committee to improve audit quality in the context of audit market reform.     

Auditor–client management relationships and roles in negotiating financial reporting

We carry out an interview based field study of chief financial officer (CFO)–audit partner dyads to examine the assumption that the roles played by each side and the nature of the relationships are similar across negotiations. These dyads freely discussed with us their relationship, a specific issue negotiated and it’s resolution process. Employing the lens of social positioning negotiation research, we find these negotiations are ‘fluid’, with continual redefinition not only of the substantive issues under negotiation, but also of the negotiation roles and relationships (i.e. ‘shadow’ negotiations). The CFO’s actions and expectations in these ‘shadow’ negotiations appear to define the auditor’s role and the relationship’s parameters, but both can evolve over time. The audit partners express a desire to be in the “ideal” relationship where they assume the role of the ‘expert advisor’ (as opposed to a ‘police officer’) but they seemingly have no explicit strategy to move the relationship toward a ‘proactive’ (rather than ‘reactive’) state. Furthermore, the audit partner is always the ‘relationship manager’ whose job it is to see that client management remains “happy”. These roles and relationships negotiated in the ‘shadows’ also affect how the negotiation process unfolds, including the set of alternative accounting treatments considered during negotiations. Finally, audit firms appear to manage the assignment of partners to engagements based on CFO preferences and remove those partners who are in “poor” relationships, irrespective of why the relationship is considered by the CFO to be “poor”. Implications for the broader research program on auditor–client management negotiations are discussed.     

Auditor rotation and the appearance of independence: Evidence from non-professional investors

We examine the impact of audit firm versus partner rotation on non-professional investors’ independence-related perceptions, extending prior research on auditor rotation and independence in fact. Arguments for mandatory audit firm rotation continue to be made by regulators and investor groups based, in part, on the idea that firm rotation will incrementally strengthen independence in appearance relative to audit partner rotation. We report the results of two experiments. The first examines 5-year audit firm versus partner rotation under relatively weak or strong audit committees. We find no statistically significant difference in beliefs about how much of an income reducing audit difference management will record, or in beliefs about auditor independence, between the two auditor rotation conditions. On the other hand, we find that non-professional investors do believe more of the audit difference will be recorded, and the auditors will be more independent, under a strong audit committee than a relatively weak audit committee. The second experiment provides further evidence on audit firm versus partner rotation by examining a setting involving a 26-year audit firm–client relationship. Again, no statistically significant differences between the two auditor rotation conditions were found. These findings suggest that compared to audit partner rotation, audit firm rotation does not strengthen independence in appearance among non-professional investors and that non-professional investors recognize the value of strong audit committees.     

An examination of the influence of mutual CFO/audit firm tenure on audit quality

This study examines whether the extent of professional relationships between an audit firm and their client’s CFO influences audit quality. If regulators’ concerns that the relationship that develops over time between an audit firm and their client’s CFO impairs auditor judgment are justified, then we should observe a negative relationship between the length of audit firm’s tenure with their client’s CFO and audit quality. The results suggest that mutual audit firm-CFO tenure is associated with lower audit quality measured by the magnitude of discretionary accruals, the reduced incidence of issuance of going-concern audit opinions for distressed companies, and an increased likelihood of the receipt of an Accounting and Auditing Enforcement Release (AAER) from the US. Securities and Exchange Commission (SEC). These affects are concentrated in a subsample of firms with higher levels of corporate governance concerns. These findings have implications for policies related to audit firm rotation. Specifically, the results suggest that regulators need to consider other relationships underlying audit firm tenure, such as the relationships that form between audit firm and client personnel, when evaluating audit firm rotation policies.     

Do investors perceive a change in audit quality following the rotation of the engagement partner?

Though Section 203 of the Sarbanes-Oxley Act (SOX) calls for the rotation of the audit partner every five years, we do not know whether investors value audit partner rotation. This is an important issue since many in the auditing profession believe that mandatory rotation of the audit partner is unnecessary and may in fact impair audit quality. We identify a sample of firms that disclosed changes in the engagement partner in the proxy statement and examine whether equity investors perceive a change in audit quality following the partner rotation. We find a significant increase in earnings informativeness following audit partner rotation. We also find that short sellers regard earnings in the post-rotation to be of higher quality than earnings prior to the rotation. Finally, cost of equity capital is lower following partner rotation. Our findings have important implications for the regulators, auditors, and investors.     

The impact of prior working papers on auditor evidential planning judgments

There has been significant concern in auditing about the effects of relying on prior working papers in planning audit procedures (“anchoring”). This study employed an experiment with varying information sets: prior working papers, current year information and “scenario” (summarized prior year information). Practicing auditors were asked to design a substantive audit program for a case where changes in the client's environment dictated additional procedures. A consensus program from three partners was used as a bench-mark. Experimental groups were about equally adaptive to the changing environment. However, auditors provided with prior working papers demonstrated lower efficiency. The scenario group exhibited both high relative effectiveness and efficiency, while current information subjects displayed the lowest overall level of performance.     

The effect of audit seniors’ decisions on working paper documentation and on partners’ decisions

Prior research reports that the memories of working paper preparers may be biased toward evidence consistent with their prior decisions, but that reviewers exposed to the same set of evidence can mitigate the bias by evaluating inconsistent evidence. This study tests whether audit seniors’ decisions bias their ability to recognize evidence to document in working papers, and whether biased documentation affects the decisions of audit partners who are exposed only to the subset of evidence that seniors recognize and document. Experiment 1 confirms that audit seniors’ prior decisions bias their memories for evidence to document in working papers, and also creates materials for experiment 2. Experiment 2 offers a new insight: when exposed only to the evidence that seniors recognize and document, partners make decisions biased in the direction of the seniors’ decisions, since not all of the inconsistent evidence is documented. Experimental procedures controlled for four alternative interpretations: justification, evidence order, recency, and primacy.     

An Investigation of Auditors’ Judgments When Companies Release Earnings Before Audit Completion

The majority of U.S. public companies release annual earnings prior to the completion of audit fieldwork. We investigate this phenomenon in a controlled experiment with audit partners and senior managers. We find that releasing earnings before completion of the audit pressures auditors to adopt the goals of management, thereby reducing the likelihood of post‐announcement audit‐adjustment recommendations. We also examine the effect of audit committee (AC) strength in improving auditors’ judgments after annual earnings are released. When ACs are actively involved in accounting issues and proactively communicating with auditors—characteristics currently lacking in most ACs—the negative effects on auditors’ judgments are completely mitigated. Our study provides evidence on potential unintended consequences of early release of earnings and the importance of investing in high‐quality ACs to mitigate adverse effects of client pressures on audit judgment and financial reporting quality.     

Do supply shocks in the audit partner labor market affect auditor choice? Evidence from a quasi-natural experiment

We examine whether supply shocks in the audit partner labor market induce clients to switch audit partners. We argue that audit partners in their early careers (i.e., junior partners) charge low audit fees to attract clients, which induces client firms to switch from senior partners to junior partners when there are more junior partners available. Utilizing the Big4 localization policy, we find that Big4 clients are more likely to replace senior auditors with junior auditors to cut costs after the policy. Furthermore, the results are mainly driven by clients who are charged high fees. Our empirical evidence enriches the understanding of auditor choice determinants and informs the ongoing debates surrounding new regulations for Big4 firms in China.     

Audit Partner Disciplinary Actions and Financial Restatements

This study investigates the signalling role and rectification effectiveness of an audit partner disciplinary system. The signalling role refers to whether sanctions reflect the poor audit quality of disciplined audit partners, and rectification effectiveness addresses whether disciplinary actions enhance subsequent audit quality. The sample consists of Taiwanese listed companies, in the period 2000 to 2006, where the identities of audit partners who sign audit reports and who are sanctioned are accessible. Empirical results indicate that in the pre‐sanction period, the probability of financial restatements by clients of disciplined audit partners is significantly higher than that of non‐disciplined audit partners. The more severe or frequent the sanctions, the higher the likelihood of financial restatements in the pre‐sanction period. These findings imply that audit partner disciplinary actions can serve as a signal of lower audit quality provided by those partners. The rectification effectiveness of disciplinary actions is examined from two perspectives: (1) the effects on subsequent improvements of audit quality of disciplined audit partners; and (2) audit quality enhancement of successor non‐disciplined audit partners who accept clients from disciplined audit partners. Empirical results show a lower probability of restating financial statements audited by disciplined audit partners after sanctions. We also find a lower likelihood of restating financial statements audited by successor non‐disciplined audit partners in the post‐sanction period. Both findings support our conclusion that audit partner sanctions improve audit quality. Overall, audit partner disciplinary actions can signal lower quality audit partners and are effective in enhancing audit quality.     

Is the effect of shared auditors driven by shared audit partners? The case of M&As

Recent research suggests that shared auditors impact firm outcomes by facilitating information flows across clients and increasing financial statement comparability. This study argues that since client specific knowledge resides with audit partners the effects of shared auditors on corporate outcomes is primarily driven by client engagements with shared audit partners. We test this argument using Australian merger and acquisitions, where there is a longstanding requirement for the disclosure of audit partner details. We find: (i) a positive association between shared audit partners and the likelihood of a friendly acquisition, (ii) a negative association between shared audit partners and takeover premiums, and (iii) a positive (negative) association between shared audit partners and acquirer (target) and total cumulative abnormal returns. We also document that the significant effect of shared auditors is restricted to takeovers with shared audit partners.     

The auditor’s strategy selection for negotiation with management: Flexibility of initial accounting position and nature of the relationship

The audit partner is usually the first mover in a negotiation with client management and has an intended strategy set going into such a negotiation. Negotiation strategies that make up the set may be integrative (both parties can gain or at least not lose) and distributive (there is a winner and a loser). We focus on five strategies: two integrative (expanding the agenda or problem solving) and three distributive (contending, conceding or compromising) and measure the audit partner’s intent to use these strategies’ associated tactics. We report the results of an audit negotiation experiment in which 140 highly experienced audit partners planned a negotiation in response to a case scenario that incorporated two key theoretical variables: the flexibility of the client initial accounting position and the nature of the prior relationship between the auditor and client management. In addition to intended tactics, we also examine these two variables’ effects on commitment to the goal of reducing net income. Our results indicate that in contrast to findings in the generic negotiation literature that show negotiators have a preference for distributive tactics and have difficulty employing integrative ones, our audit partners generally favored the use of integrative tactics over distributive ones when entering negotiations, irrespective of circumstance. However, the two theorized variables led to particular strategic choices when distributive tactics were intended; for example, when the audit partner perceived he or she was facing a client management that was inflexible in its initial accounting position, the partner was more likely to use contending tactics and less likely to use conceding and compromising tactics. Finally, we discuss implications of these results for practice and research.     

Mandatory audit partner rotation,audit market concentration,and audit quality: Evidence from China

This research examines the audit quality consequences of China's mandatory audit partner rotation (MPR) regulation, which became effective in 2004. The rule requires firms to rotate signing audit partners of audit reports every five years. We find that audit quality improves in the three years immediately following a client firm's MPR during the 2004–2011 period for a sample of 273 Chinese publicly listed firms. Specifically, we find that the improvement is most pronounced in those Chinese provinces with both low levels of audit market concentration and low levels of legal development. However, MPR does not improve audit quality in jurisdictions where legal conventions are more developed and/or where audit markets are highly concentrated with a handful of large audit firms dominating the market.     

Effect of international working experience of individual auditors on audit quality: Evidence from China

This paper investigates the effects of auditors with international working experience on audit quality in emerging markets. Such auditors are associated with better audit quality, a pattern that is further supported by an examination based on a propensity score matching sample that controls for endogeneity. Chief financial officers with international experience are more conservative in the client company of their auditors who have international working experience. Further, reviewer partners with international working experience provide better audit quality in terms of low accruals, less below‐the‐line items, and less audit reporting aggressiveness, while engagement partners with international working experience require high audit fees. Moreover, financial reports signed by auditors with international working experience significantly increase analyst forecast accuracy and decrease analyst forecast dispersion. Our results are robust to different specifications and alternative measures. Overall, this paper highlights the importance of human capital and provides direct evidence on how auditors with international working experience use their knowledge and audit skills in emerging markets.     

Client Risk Factors and Audit Resource Allocation Decisions

While contemporary auditing standards such as ISA 315 provide broad categories of client risks, prior research regarding audit resource allocation decisions has been based on individual client risks. This study contributes to the literature by using factor analysis to examine how individual client risks are categorized into broad risk factors and by examining the extent to which such broad risk factors are associated with audit engagement planning decisions. These issues are important because auditing standards direct auditors to consider risk patterns and interrelationships in addition to individual risks. Finally, we consider additional individual client risks that reflect those relevant to contemporaneous audit approaches and have not been examined in prior studies. Based on archival data extracted from the working papers of 228 clients of a Japanese audit firm, we find that individual client risks empirically group together in a way that is similar to categories discussed in recent auditing standards. We also find significant relationships between audit resource allocation decisions and broad risk factors that have not been found in prior studies which use individual risk assessments in their models. Finally, we find that client risks that are emphasized in holistic audit approaches such as aggressiveness of forecasts and industry decline also have a significant impact on audit resource allocations.     

A study of auditor-client relationships and problems in the Bahraini audit environment

We report on a survey study of auditor-client relationship problems in an under-developed audit market in Bahrain. The study investigates client perspectives and views on important auditing process issues, value added audit activities for client organizations, and auditor rotation. Clients viewed high fees, excessive audit time requirements, difficulty in meeting auditor's requests, and audit personnel difficulties in understanding the business due to a lack of adequate audit professionals' experience as problems. From the audit firm perspective, the study explores audit client acceptance factors, independence issues, and common problems encountered with the clients. Auditor respondents indicated the major process problems to be associated with the client's culture, lack of access to information, and poor accounting systems. Auditors reported problems in collecting evidence. The audit process and evidence problems reported indicate possible audit quality problems faced by audit firms in Bahraini environment when conducting external audits, indicating the need for future research on auditor-client relationships in emerging economies.