The Effect Of Auditor Tenure On Audit Quality Accounting Essay


After periods of high-profile corporate accidents, such as frauds and bankruptcies, governments and regulators tend to turn their attention to the auditors role in the corporate financial reporting process (U.S. Governmental Accounting Office (GAO), 1996). The accounting scandals regarding Enron and WorldCom were such events and led to renewed concerns regarding auditor tenure - which is best described as the length of the relationship between the auditor and the client - and its potential effect on the quality of an audit (Johnson et al., 2002). It was proposed that mandatory audit-firm rotation could be a way to improve the quality of financial reporting (Johnson et al., 2002). The Sarbanes-Oxley Act, a U.S. law which came into force in 2002, introduced major changes to the regulation of financial practice and corporate governance and requested a study of the potential effects of this mandatory audit rotation (Myers et al., 2005). However, this resulted in a negative advice regarding the implementation of the mandatory audit rotation (GAO, 2003).

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The proposal also caused a growing interest in this subject among academics and investigating the effect of auditor tenure on audit quality became the main objective of several studies (e.g. Johnson, Khurana and Reynolds, 2002; Myers et al., 2003). Despite the considerable interest for the topic, the evidence remains inconclusive and prior literature has evolved into two opposing views regarding the effect of auditor tenure on audit quality (Geiger and Raghunandan, 2002). On the one hand there is literature supporting a positive association between auditor tenure and audit quality (Carcello and Nagy, 2004; Geiger and Raghunandan, 2002; Johnson et al., 2002; Myers et al., 2003), while on the other hand researchers concluded that auditor tenure has a negative influence on the quality of an audit (Copley and Doucet, 1993; Davis et al., 2000; Vanstraelen, 2000).

When focusing on auditor independence specifically, the results of other studies show that the influence of tenure is strongly affected by the personal connection of an auditor with the client (Bamber and Iyer, 2007; Bazerman et al., 1997, 2002; Bruynseels and Cardinaels, 2012). In addition, the chief executive officer (CEO) of the client firm is considered an important part of the relationship between an auditor and its client. Moreover, the length of this relationship leads to an increase in attachment by both parties. This sense of attachment could in turn negatively affect audit quality (Seabright et al., 1992).

In line with these arguments, the relationship between the auditor and the CEO might have a significant influence on audit quality. The current study will therefore concentrate on the auditor-client relationship regarding its influence on the quality of financial reporting. Specifically, the main objective of this study is to assess the effect of the length of the direct relationship between an auditor and a CEO on audit quality.

Prior research on the subject focussed primarily on the relation between auditor tenure and audit quality. Since the evidence remains inconclusive, the current study aims to gain further insight into this matter. It specifically contributes to existing literature by means of including the length of the relationship between auditor and CEO as a possible determinant of audit quality, which has not been examined before.

Auditors provide independent verification of financial statements and as a result their quality contributes to the credibility of financial disclosure (Mansi et al., 2004). According to the research of Mansi, Maxwell and Miller (2004), investors particularly value the information and insurance role of an auditor. Furthermore they found direct evidence that investors attach value to audit tenure (Mansi et al., 2004). Similarly, Ghosh and Moon (2005) focussed on investors, independent rating agencies and financial analysts as primary users of financial statements. They found that these users give a higher reliability to audited financial statements when the auditor tenure is longer. This prior research shows that users of financial statements have certain assumptions and use these in significant extent when making decisions, even though the evidence is, so far, inconclusive. More insight in the subject and the determinants of audit quality could therefore significantly increase the quality of decision making.

In order to analyze the auditor-client relationship, data is collected from public companies in the United States of America. To gather information on both auditor and CEO tenure, data is obtained from two different databases, Compustat and Execucomp. In order to proxy for audit quality, this thesis uses an abnormal working capital accruals measure as proposed by DeFond and Park (2001). By means of regression analysis, the relationship between auditor and CEO and audit quality is analyzed in order to test the hypothesis that a longer collaboration between an auditor and a CEO reduces audit quality.

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The results from the multiple regression analysis are insignificant and thus provide no evidence that the length of the relationship between an auditor and a CEO reduces audit quality.

The remainder of the thesis is structured as follows. The second chapter provides an overview of related literature and ends with the hypothesis development. The methodology is presented in the third section. It provides the data collection, sample selection, the research method and the variable descriptions. Thereafter, the results are discussed in section four. This part provides the descriptive statistics, correlations and displays the results of the analyses and finally tests the hypothesis. Section five concludes the thesis, including the implications of the study for practice and

for future research.

2. Literature Review and Hypothesis Development

As a first step, this chapter provides a literature review to acquire necessary insights into the theme at hand followed by the development of the hypothesis. To start off, the concept of audit quality is explained and subsequently its connection with auditor tenure and CEO tenure. Section 2.2 and 2.3 describe how audit quality is affected by auditor and CEO tenure, respectively. The section ends with the development of the hypothesis in section 2.4.

2.1 Audit Quality

As the main theme of this research, this section aims to clarify the concept of audit quality to provide a clear idea of the topic.

The main objective of financial statements is to communicate financial information to stakeholders. Since these statements are prepared by company management, it gives rise to information asymmetry and potential conflicts of interest between management and those outside an entity. An audit of financial statements provides independent verification of the report and could therefore improve the quality of the reported financial information (Dopuch and Simunic, 1982; Watts and Zimmerman, 1986) and enhance the information quality about the value of traded securities (Ronnen, 1996). Recognizing the significant influence auditors have on the process of financial reporting, Antle and Nalebuff (1991) view the financial statements as a joint outcome of the company management and the audit firm. Furthermore, as an audit adds credibility it increases the investor's trust in the functioning of the capital market (Van der Plaats, 2000). The ability of an auditor to improve the quality of financial reporting is best described by DeAngelo (1981b). She defines audit quality as "the market-assessed joint probability that a given auditor will both (a) discover a breach in the client's accounting system and (b) report the breach" (DeAngelo, 1981b, p. 186). The first characteristic, the ability to discover breaches in the accounting system, is generally defined as competence and the reporting of those breaches relates to the independence of an auditor.

Gunny, Krishnan and Zhang (2007) describe two types of breaches that could be discovered during the audit process: an audit deficiency, such as a failure to obtain and evaluate significant evidence or failure to perform sufficient procedures, and a serious deficiency, which results when an auditor fails to detect a departure from the required reporting standards that could result in a restatement of the financial report. If material misstatements are identified by the auditor and subsequently corrected, the quality of the financial statements increases. Alternatively, if an auditor fails to detect these errors, which should be corrected before issuing a report, the quality of the statements decreases (Johnson et al., 2002).

The competence to identify errors is determined by the auditor's technical capabilities, his knowledge of the accounting and audit process as well as his experience (DeAngelo, 1981b). In addition, Bonner and Lewis (1990) suggest that auditor knowledge consists of three types of knowledge, general domain knowledge, general business knowledge and subspecialty knowledge.

The second determinant of audit quality is independence. In spite of the importance of the topic, regulators, practitioners and academics do not agree on the definition and the operationalization of auditor independence (Dopuch et al., 2003) For that reason, several existing approaches to auditor independence are discussed next and an appropriate base regarding independence is determined to use throughout this thesis .

In an early approach to auditor independence, Mautz and Sharaf (1961) distinguish real from apparent independence, while Higgins (1962) relabeled those types to independence 'in fact' and 'in appearance', which are commonly used nowadays. The former means that the auditor is actually independent from his client, while the latter relates to the auditor's mindset while planning and executing an audit (Dopuch et al., 2003)

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The US Security Exchange Commission points out that "an auditor's independence is impaired either when the accountant is not independent "in fact" or when, in light of all relevant facts and circumstances a reasonable investor would conclude that the auditor would not be capable of acting without bias" (SEC, 2000, p.1).

According to Bazerman, Morgan and Loewenstein (1997), the idea of 'auditor independence', explained as forming an unbiased judgment, is unrealistic. Bias usually enters the brain unconsciously and unintentionally when making the judgments itself, not while reporting them. People, and thus auditors, develop a preference for a certain outcome and then justify this by differently valuing the importance of several attributes of fairness. Psychologists call this the self-serving bias (Bazerman et al., 1997). It is also impossible to asses, since only the auditor is aware if he is being independent. Moreover, since some judgements can be made unconsciously, the auditor himself may not even be aware (Bazerman et al., 2002).

Furthermore, the financial dependence on clients creates an anti-independence factor (Mautz and Sharaf, 1961). The Cohen Commission (AICPA, 1978) supports this assertion by arguing that full independence is practically impossible, since the auditor is hired as well as paid by the client.

The basis used throughout this thesis comes from DeAngelo (1981a). She highlights the auditor's ability to resist several pressures and incentives when an error has to be reported as important regarding independence (DeAngelo, 1981a). As the Chair of the AICPA Board of Directors, Robert Medninck, describes: "Independence is the cornerstone of the accounting profession and one of its most precious assets" (Medninck, 1997, p. 10). Furthermore, The Public Oversight Board's Panel on Audit Effectiveness (POB, 2000, p. 109) states that independence is "fundamental to the reliability of auditor's reports".

Over the years, a lot of research has been done to investigate what factors influence audit quality. Specifically, accounting scandals such as Enron and WorldCom led to renewed concerns regarding auditor tenure - which is best described as the relationship between the auditor and the client - and its potential effect on the quality of an audit (Johnson et al., 2002). During these periods it was proposed that mandatory audit-firm rotation could be a way to improve the quality of financial reporting (Johnson et al., 2002) which caused a growing interest in this subject among academics and investigating the effect of auditor tenure on audit quality became the main objective of several studies (Johnson et al., 2002). Despite the considerable interest for the topic, the evidence remains inconclusive and prior literature has evolved into two opposing views regarding the effect of auditor tenure on audit quality (Geiger and Raghunandan, 2002). On the one hand there is literature supporting a positive association between auditor tenure and audit quality (Carcello and Nagy, 2004; Geiger and Raghunandan, 2002; Johnson et al., 2002; Myers et al., 2003), while on the other hand researchers concluded that auditor tenure has a negative influence on the quality of an audit (Copley and Doucet, 1993; Davis et al., 2000; Vanstraelen, 2000). Both viewpoints are justified by several arguments. Proponents of the positive relationship between auditor tenure and audit quality argue that audit costs are lower for long tenure auditors compared to shorter periods of auditor tenure. Secondly, when audits are repeated, the client and industry knowledge of the auditor increases (Myers et al., 2003). Supporters of the opposing side, however, argue that the longer the association between a client and the auditor, the more the interest of the auditor will be in line with the interest of the client. This process could eventually lead to weakened auditor independence. There are two important arguments supporting this view. First, they argue that the development of an auditor-client relationship could cause independency to erode. Second, the relationship leads to an impaired auditor's capacity to effect critical appraisal (Carey and Simnett, 2006).

As the main item in this thesis, next two sections elaborate on auditor and CEO tenure and their effect on audit quality.

2.2 The Effect of Auditor Tenure on Audit Quality

2.2.1 Competence

The effect of auditor tenure on competence is merely based on knowledge. As previously mentioned, auditor knowledge consists of three types, being general domain knowledge, general business knowledge and subspecialty knowledge (Bonner and Lewis, 1990). All are next separately discussed. General Domain Knowledge

First, general domain knowledge is a basic level of expertise necessary for each auditor. This type of knowledge consists of the basics in auditing and accounting, such as the generally accepted auditing standards and knowledge of the transactions flow in an accounting system. Auditors acquire this type of knowledge by instruction, training and experience (Bonner and Lewis, 1990). General Business Knowledge

The second type of auditor knowledge is general business knowledge which is best defined as a basic level of knowledge regarding the business of the client firm. Examples are understanding of the business environment and management incentives. Auditors gain this type of knowledge by formal instruction and personal experiences (Bonner and Lewis, 1990). Subspecialty Knowledge

Subspecialty knowledge is the final type of knowledge. It relates to industry-specific and client-specific knowledge, which is acquired by training regarding specialized areas or repeated audits within specific industries or with certain clients (Bonner and Lewis, 1990).

Auditors find themselves in a learning curve to gain knowledge of the client's industry, the business it operates in and its associated risks (Knapp, 1991; PricewaterhouseCoopers, 2002). Accordingly, incumbent auditors have accumulated this knowledge over time, putting them in an advantageous comparative position compared to their competitors (Beck et al., 1988; DeAngelo, 1981a, 1981b).

Prior research regarding this industry-specific knowledge showed that industry groups are related to financial statement error patterns (Maletta and Wright, 1996) and fraudulent financial reporting (Beasley et al., 1999, 2000). A new auditor may not be familiar with industry-specific knowledge, which may increase the likelihood of fraudulent financial reporting (Carcello and Nagy, 2004). Similarly, research of Ashton (1991) and Bonner and Lewis (1990) concluded that industry-specific knowledge is positively correlated with the auditor's ability to detect problems within the financial statements. They argue that auditors become familiar with the firm and its accounting practices and risks over repeated audits and gain knowledge by working with multiple firms who operate within the same industry.

According to Maletta and Wright (1996), the characteristics of errors and their detection methods differ across industries and thus, auditors who have industry-specific knowledge at their disposal are better skilled to identify abnormalities and breaches compared to auditors who don't have such knowledge. This argument is consistent with prior research of Bedard and Biggs (1991) who found that auditors with knowledge of the manufacturing industries are better equipped to detect abnormalities and errors in the data of a manufacturing client than auditors without such specific expertise in manufacturing. Similarly, research of Wright and Wright (1997) concluded that auditors with significant experience in the retail industry are better able to detect errors of retail clients.

2.2.2 Independence

This section explains how auditor tenure affects the second determinant of audit quality: independence. Auditor tenure can influence independence in three ways, which now will be separately discussed.

Change of Incentive

The first effect of auditor tenure on auditor independence relates to shifting incentives. According to Johnson, Khurana and Reynolds (2002) auditors make a trade off between the desire to protect the audit firm's reputation and to avoid litigation (Balachandran and Nagarajan, 1987; DeJong, 1985) and the desire to retain a client and subsequently profit from the engagement (Chow and Rice, 1982; Citron and Taffler, 1992).

DeAngelo (1981a, 1981b) argues that incumbent auditors find themselves in a favorable competitive position due to accumulated client-specific assets. Additionally, transaction costs are increasing, which means that along with auditor tenure, it gets more expensive for the client to switch auditors. Such a situation could therefore encourage auditors to be less independent and objective in order to retain the client (Johnson et al., 2002).

Geiger and Raghunandan (2002) argue that this incentive is expressed in a higher likelihood of 'low-balling'. This competitive mechanism is a natural response by which the auditor is selling his service at a lower initial fee, in order to obtain the client. The subsequent retention of the client and the extended auditor-client relationship enhances the likelihood of future profits (Geiger and Raghunandan, 2002). The initial start-up costs incurred in the initial year are allocated as sunk costs and should thus be ignored in the decision process. Nevertheless, prior research documented that start-up costs for audits are not treated as such and do play a significant role in decision-making (e.g. Kleinman and Palmon, 2000; Staw, 1976; Staw and Ross, 1987). Accordingly, auditors may be interested in retaining the newly acquired audit clients long enough for the initial start-up costs to be recouped by the stream of future cash flows (Geiger and Raghunandan, 2002). Thus, an auditor's independence and objectivity could be more severely impaired in the early years of the relationship due to the threat of dismissal from the client. Moreover, auditors may be less likely to issue a going-concern report for firms approaching bankruptcy but instead issue an unqualified audit report (Geiger and Raghunandan, 2002). This point of view is in line with previous research by Dye (1991). He concluded that low-balling creates an incentive for auditors to positively present the financial situation of their client in order to extent the relationship and therefore increase the likelihood of future quasi-rents.

In addition to obtaining the client, auditors also become more concerned with maintaining the client and profiting from the relation, and become less concerned about the litigation risk (Johnson et al., 2002). This change in incentive may decrease an auditor's independence, particularly regarding important clients (Lim and Tan, 2010). These firms are generally considered an important source of revenue, which the audit firm may not want to jeopardize (Hoyle, 1978). A long relationship may even lead to an economic dependency on the client, which subsequently might reduce independence since the audit firm does not want to risk losing the client (Lee and Gu, 1998; Schatzberg and Sevcik, 1994). This is supported by several studies that have proven that an unfavorable report often leads to a switch to another auditor. According to Chow and Rice (1982) the issuance of a qualified report is a significant reason to hire a different auditor. Schwartz and Menon (1985) argue that failing firms are more likely to change auditors. Similarly, Williams (1988) finds that financially distressed firms have a greater incentive to switch auditors compared to healthy clients in order to retain a good image of the firm. Furthermore, Williams (1988) and Levinthal and Fichman (1988) both provide evidence that longer auditor tenure is negatively related to auditor dismissal. Jackson, Moldrich and Roebuck (2008) argue that a manager may even threaten to switch to a new auditor in order to obtain a more favorable report.

In addition, Carcello and Nagy (2004) argue that long-standing clients are often seen as a perpetual annuity. An existing client provides the audit firm with client-specific revenue (DeAngelo, 1981a, 1981b) which create an annuity of profits an auditor expects to receive during the audit engagement (Carcello and Nagy, 2004). Considering the client as a source of an infinite revenue stream, might compromise the independence of an auditor (Carcello and Nagy, 2004). The Commission on Public Trust and Private Enterprise (2003) consider mandatory audit rotation as a solution to this potential threat: "Rotation of auditors would also reduce any financial incentives for external auditors to compromise their judgment on borderline accounting issues. In disagreeing with management, auditors would no longer be risking a stream of revenues that they believed would continue in 'perpetuity', since the audit engagement would no longer be perceived as permanent" (p. 34).

Furthermore, regulators argue that as tenure increases, the fees charged for nonaudit services are getting disproportionately large. As these nonaudit fees accumulate, they create incentives to yield to client pressure (Stanley and DeZoort, 2007).

Familiarity Threat

A second effect of long auditor tenure is labeled by the IFAC Code of Ethics (2008) as the familiarity threat which is best described as a deterioration of the auditor's capacity to effect critical appraisal.

As a result of the long audit engagement, Shockley (1981) argues that the audit firm develops a "learned confidence" (p. 789). This confidence in the client is a result of the long collaboration and reduces the effort which could manifest itself in using less stringent and creative audit testing approaches. The audit process may even become routine and the auditor starts to anticipate results, such as the state of the accounting systems and the presence of controls, observed from prior year outcomes (Arrunada and Paz-Ares, 1997; Hoyle, 1978). Hence, less time is devoted to accurately assessing current year's statements for potential material misstatements (Arrunada and Paz-Ares, 1997; Johnson et al., 2002).

Similarly, Carcello and Nagy (2004) argue that, over time, clients gain a reputation inside the accounting firm and develop certain expectations among the audit team. A firm may be known as having accurate financial reports or strong financial reporting controls. If the auditors expects these outcomes beforehand, they may become less critical and skeptic (Carcello and Nagy, 2004). A new audit firm could prevent this by providing a powerful peer review effect (Biggs, 2002; POB, 2002; Seidman, 2001). This effect is best described by the fresh perspective of a new audit firm (Commission on Public Trust and Private Enterprise, 2003; Silvers, 2003) and its higher level of objectivity due to the unfamiliarity with the client (Jackson et al., 2008).

According to Bazerman, Loewenstein and More (2002), a potential for bias is created by three aspects of accounting. These aspects are defined as the ambiguity of interpreting information, the approval or rejection of a previously made judgment and thirdly the attachment to the client. Bias is created when an individual's desires influence the way information is interpreted. The individual becomes less critical towards information supporting the desired conclusion compared to contradicting facts. Moreover, this possible bias is intensified by aspects which get stronger with tenure. One of those aspects is becoming more familiar with the client as human beings are less likely to harm people they know compared to people they do not know (Bazerman et al., 2002). This familiarity concerning personal relationships is a significant effect on its own and therefore elaborately discussed in the next paragraph.

Erosion of Independence due to the Development of Personal Relationships

Mautz and Sharaf (1961) argue that long associations with the same client, could have a detrimental effect on auditor independence since the ability to objectively audit a client reduces over time. They suggest that an auditor 'must be aware of the various pressures, some obvious some subtle, which tend to influence attitude'. They state that "the greatest threat to his [the auditor's] independence is a slow, gradual, almost casual erosion of his 'honest disinterestedness" (Mautz and Sharaf, 1961, p. 208). According to Dopuch, King and Schwartz (2003) and Bazerman, Morgan and Loewenstein (1997) this threat occurs during the reporting period as well as the preceding period when judgments are made. Hence, the development of bonds, loyalty or emotive relationships between an auditor and his client will consciously or subconsciously influence an auditor's objectivity and independence and consequently decrease the ability to accurately audit an entity's financial statements (Carey and Simnett, 2006). Carey and Simnett (2006) also explain that the auditor's required level of skepticism is reduced as well.

In contrast, successive audits accumulate trust (Arrunada and Paz-Ares, 1997) which is helpful since it allows communication to be at low costs and an adequate resolution of conflicts. Hence, trust is a crucial part of the peer's relationship between the auditor and his client (Richard, 2006). Yet, as the IFAC code of Ethics states: "a threat occurs when, by virtue of a close relationship with an assurance client, its directors, officers or employees, a firm or a member of the assurance team becomes too sympathetic to the client's interest" (IFAC, 2008, p. 18). Similarly the Metcalf Committee Report (U.S. Senate, 1976) notes that long association between a client and an audit firm may lead to such close identification of the audit firm with its client's interests, that it becomes difficult to remain truly independent.

Moreover, as auditors might gradually identify with the client they may even align with the wishes of management (Geiger and Raghunandan, 2002) and as the length of the audit-client relationship increases, auditors are even more likely to agree with managers on important reporting decisions (Farmer et al., 1987; Ryan et al., 2001). Bamber and Iyer (2007) support this argument as they found evidence that auditor tenure is associated with higher identification with the client. Their results suggest that auditors who identify more with their client are more likely to act in favor of the client, for instance when a conflict has to be resolved. Thus, this client identification has a negative association with auditor objectivity which in turn supports the concern by the Independence Standards Board (ISB) (2000) regarding the threat to auditor's independence from relationships between the client and its auditors.

In addition, according to Bazerman, Morgan and Loewenstein (1997), the self-serving bias influences the auditing relationship in several ways. First, the auditor is aware of the employees within the client firm that would be harmed by issuing a negative opinion on the audit. As people tend to be more concerned about harming known victims, than unknown persons, this might influence the decision which report to issue. Secondly, the negative consequences of a negative opinion could immediately harm the auditor or the audit firm. The auditor could lose its friendship with the client and the firm might lose the contract with the client and therefore a significant source of revenue. Furthermore, as tenure increases, auditors may gradually adapt to small imperfections of their client's statements and rationalize judgments consistent with their self interest (Bazerman et al., 1997). This decreased independence enhances the likelihood of an auditor yielding to client pressure in a conflict situation (McLaren, 1958). Moreover it could increase auditors' support for more aggressive accounting procedures and even result in a failure to identify material misstatements or fraud (Myers et al., 2003) and at the extreme result in a collusion between the auditor and the client (McLaren, 1958).

Similarly, several studies found that larger clients are more likely to convince auditors into using aggressive accounting practices since they possess greater bargaining power (McKeown et al., 1991; Nelson et al., 2002).

From a sociological view, Moore, Tetlock, Tanlu and Bazerman (2006) state that clients gradually accumulate pressures to "encourage complacency among practitioners" (p. 11). This moral seduction even causes an increased likelihood that auditors will "slant their conclusions" (Moore et al., 2006, p. 11).

2.3 The Effect of CEO Tenure on Audit Quality

Compared to auditor tenure, there is much less, if any, prior research on the impact of CEO tenure on audit quality. The available analyses are mainly limited to the connection between the impact of CEO's on earnings management and financial fraud. The prior research of interest for this study will be explained in this paragraph.

In 1988, Hermalin and Weisbach note that a new CEO has relatively less power compared to an established CEO. Taking this into account in his study, Beasley (1996) did not find that CEO tenure is related to financial statement fraud.

On the other hand, research by Francis, Huang, Rajgopal and Zang (2008) found that CEO reputation, which is among others determined by CEO tenure, acts as a significant factor determining earnings quality (Francis et al., 2008).

Core and Guay (1999) argue that the uncertainty regarding a CEO's ability resolves with the tenure of the CEO, which in turn possibly increases his incentive risk. For instance, managers use option grants in order to personally profit from it (Aboody and Kasznik, 2000; Yermack, 1997). Furthermore Goldman and Slezak (2000) argue that performance-based pay could lead to misreporting performance by managers. While studying incentives and its relation to financial fraud, Erickson, Hanlon and Maydew (2003) did not find consistent evidence that executive equity incentives are related to fraud. All in all, based on prior research it is difficult to determine the influence of CEO tenure on audit quality.

2.4 Hypothesis Development

Based on the foregoing discussion, it is assumed that the influence of tenure on independence is strongly affected by the personal connection of an auditor with the client. The identification with the client, the familiarity with the employees of the client and the development of bonds or emotive relationships, all have a detrimental effect on the auditor's independence. The influence of CEO tenure on its own however is unclear. When focusing on the relationship between an auditor and a CEO and its relation to audit quality, there is some prior research of interest which will be discussed next.

A recent and yet unpublished study of Bruynseels and Cardinaels (2012) found that many audit committee members have social connections with their CEO's which causes so-called independent audit committee members not always to be fully independent. Especially in case of social ties formed through the friendship network of the CEO, audit committee effectiveness is reduced, the audit committee seems to have lower standards concerning audit effort and auditors are less likely to report deficiencies in internal control or issue going-concern opinions. Furthermore, audit committees with friendship ties are far more likely to issue an amendment of a clean internal control report in stead of reporting a deficiency (Bruynseels and Cardinaels, 2012).

In order to understand the actual relationship between an auditor and a client, the organizational and sociological literature gain further insight into the matter. The concept of attachment between professional exchange parties, which is defined as the commitment of one party to another (Salancik, 1977; Staw, 1982), has often been addressed in prior literature. Attachment can be the result of ties on both individual and organizational level. Causes of attachment are for instance knowledge, personal skills and interpersonal relationships (Seabright et al., 1992). Several researchers argued that commitment in a professional relationship creates an incentive for both sides to maintain the relationship. According to Cook (1977), commitment leads to a willingness to continue the relationship in order to exploit the opportunities it offers to improve their personal positions in an exchange network and to increase rewards. Likewise, learning by doing develops specific capabilities for both client and auditor. These relationship-specific skills create an incentive to prolong the relationship as well (Levinthal and Fichman, 1988).

In turn, the knowledge of a continued relationship leads to a better cooperation of the parties involved (Heide and Miner, 1990). Hence, Seabright, Levinthal and Fichman (1992) assume that this strengthened cooperation enhances the auditor-client attachment. The same applies for the length of the engagement of individuals in certain exchange activities. Specifically, they argue that attachment is related to both the length of an interorganizational relationship as the tenure of individuals who are in a role of boundary spanner in the relationship. These boundary spanners are defined as those individuals who have knowledge of potential partners and whose role requires both inter and intraorganizational relationships (Van de Ven, 1976). Critical boundary spanners in an auditor-client relationship include the chief executive officer (CEO), the members of the audit committee, the chief financial officer (CFO) and the chief accounting officer (CAO) (Bacon, 1979; Macchiaverna, 1981; Mautz and Neumann, 1977).

The attachment that develops over time adds "a social content that carries strong expectations of trust and abstention from opportunism" (Granovetter, 1985, p. 490). Seabright, Levinthal and Fichman (1992) conclude that this embeddedness (Granovetter, 1985) is a natural outcome of the auditor-client relationship, but nevertheless causes a deviation from certain expectations regarding the avoidance of personal ties to and detachment from clients. They further suggest that a longer relationship between an auditor and a client provides an opportunity, for the more powerful party, to exploit the situation. If this were the client, more risky and aggressive financial reporting decisions might be the result. If however the auditor would be the most powerful, it could lead to a reduced effort of the auditor. In either case, a higher level of attachment may reduce audit quality.

As the CEOs are the most powerful actors in organizations (Seabright et al., 1992), this study considers the CEOs and the auditors as the main boundary spanners.

Summarized, longer interorganizational relationships between an auditor and a client lead to a higher level of attachment, which may in turn reduce audit quality. Taking into account the effects of the familiarity threat and erosion of independence due to personal relationships described in section and as well, the main hypothesis of this thesis is:

H1: The length of the auditor-client relationship has a negative effect on audit quality.

3. Methodology

This section elaborates on the methodology of this study. The first paragraph describes and explains the data collection and sample selection. The second part explains the research method, which is followed by the description and measurement of the variables of interest and the additional control variables.

Data Collection and Sample Selection

In order to perform the analysis, the first step is to collect the necessary data. For this study data is collected from two different databases and subsequently combined. This section elaborates on the process of collecting this data and explains how the final sample is built up.

The initial sample, used to estimate working capital accruals and to determine auditor tenure, consists of all firm-years from 1990 to 2010 retrieved from the annual industrial and research files of Compustat 2012. The use of publicly listed companies is motivated by the separation of ownership and control, which makes independent external audits particularly important for these companies (Francis, 2004). From the initial sample, financial organisations and companies in the utility sector were eliminated. For the analysis, audit quality is measured in 2010. Hence, all observations from firms being active prior to 2010 but no longer in 2010 itself are not relevant and have therefore been deleted. According to Myers, Myers and Omer (2003) the observations of firms who switch auditors in the earlier stages of the relationship possibly differ systematically compared to firms who do not switch early in the auditor-client relationship. Taking this into account, a minimal auditor-client relationship of five years is required (Myers et al., 2003). Consequently, all firm-year observations with an auditor-client relationship of less than five years were deleted.

In order to determine CEO tenure, data is collected from Execucomp. The initial sample from this database consists of all active firms in 2010 retrieved from the annual files available in 2012.

From this sample, as with the Compustat observations, all observations of executives being CEO prior to 2010 and no longer in the year 2010 itself, were eliminated. Therefore, only each firm's current CEO remained. In some cases firms switched CEO's in 2010. For these companies it is next to impossible to draw conclusions about the CEO's influence for the entire year of 2010. As audit quality is measured in 2010 and CEO tenure is measured in full years these observations are not useful and have therefore been deleted.

Since both databases have their own sample selection and because of several eliminations made to both samples, both sets of firms naturally did not match. Comparing both sets resulted in a combined set of 1108 unique firms.

Thereafter, all observations from firms with a fiscal year-end other than the 31st of December were deleted from the sample.

Finally, the observations in the top and bottom one percent of audit quality, cash flow from operations and leverage were deleted to reduce the effects of possible outliers. This leaves the final sample with 607 unique firms.


3.2.1. Research Model

This study closely follows the methodology proposed by Myers, Myers and Omer (2003), who analyzed the relationship between auditor tenure and earnings quality.

As a second step, the collected data is used to run a multiple regression which is "a statistical method for studying the relationship between a single dependent variable and one or more independent variables" (Allison, 1999, p. 1). By using this method, the effects of independent variables can be separated from the dependent variable, here 'Audit Quality', in order to determine the unique contribution of each variable (Allison, 1999).

In order to test H1 developed in section 2, the following model is estimated:

AWCAt = β0 + β1AUDCEOTenure + β2AuditorTenure + β3CEOTenure + β4Age + β5Size + β6AuditorType + β7Leverage + ε


AWCAt= Abnormal working capital accruals in 2010.

t= Year 2010.

AUDCEO Tenure = The number of consecutive years of the collaboration of the current CEO and the current auditor.

Auditor Tenure = The number of consecutive years that the firm has retained the auditor.

CEO Tenure = The number of consecutive years the executive has served as CEO.

Age = The number of years for which total assets were reported in Compustat since 1980.

Size = The natural logarithm of total assets.

CFFO = The firm's cash flows from operations divided by average total assets.

Auditor Type = A dummy variable set to 1 if the auditor is a Big Four firm and set to 0 otherwise.

Leverage = The ratio of long-term debt to common equity in year 2010.

The variables in this equation and their measurement are further described and explained in the next section.

3.2.2 Variable Measurement

This part provides a detailed description of the variables used for this study. The first paragraph reports a description of the dependent variable audit quality and its measurement. Thereafter, the three explanatory variables auditor tenure, CEO tenure and a combination of these two are presented. The section ends with the description and measurement of the control variables of this study. Dependent Variable

As audit quality is not observable, it makes the concept difficult to grasp. Despite this difficulty, prior literature has suggested different models to proxy for audit quality. Aggregate accrual models, such as the Jones's model (1991) and variations to that model have widely used to measure the quality of accruals (Johnson et al, 2002; Myers et al, 2003). However, since working capital accruals are more likely to be manipulated compared to non-working capital accruals (DeFond and Jiambalvo, 1994), this research uses abnormal working accruals as suggested by DeFond and Park (2001) as a proxy for audit quality in 2010. The choice of using working capital accruals is also supported by prior research suggesting that managers have the most discretion over these types of accruals (Ashbaugh et al., 2003; Becker et al., 1998). The definition of abnormal working capital accruals suggested by DeFond and Park (2001) is realised working capital accruals minus the level of working capital necessary to support the current level of sales (DeFond and Park, 2001). The historical relationship between working capital and sales results in the expected level of working capital (DeFond and Park, 2001). According to DeFond and Park (2001) their method is more powerful compared to tests using total accruals. The measure is expressed into the following equation:

AWCAt = WCt - [(WC(t-1) / S(t-1)) * St]


AWCAt = Abnormal working capital accruals in year t.

t = Year 2010.

WCt = Noncash working capital in year t, computed as [(current assets - cash and short term investments) - (current liabilities - short term debt)].

St = Sales in 2010.

S(t-1) = Sales in 2009.

Subsequently, the abnormal working capital accruals of 2010 are deflated by the year's total sales (Maijoor and Vanstraelen, 2006). In line with prior literature on audit quality measured by accruals, scores are analysed in absolute values (Carey and Simnett, 2006; Johnson et al., 2002; Maijoor and Vanstraelen, 2006; Myers et al., 2003). Explanatory Variable

The explanatory variable of interest in this study is AUDCEO Tenure, which is the tenure of auditor and CEO combined. The choice for this variable is motivated by prior literature and research, discussed in section 2.4. Summarized, the length of the relationship is related to attachment which in time could develop into embeddedness (Granovetter, 1985). This embeddedness is a natural outcome of auditor-client relationships, but causes a deviation form professional expectations, which in turn could cause audit quality to decline (Seabright et al., 1992). AUDCEO Tenure is measured as the number of years the auditor and CEO have worked together, as of the year 2010. Control Variables

In addition to the main variables, some additional variables are included. These variables could possibly affect the dependent variable. Hence, to overcome these other related effects they are incorporated in the multivariate model. Consistent with Myers, Myers and Omer (2003) age, size, auditor type and cash flows of operations are being controlled for. Following Johnson, Khurana and Reynolds (2002) and Maijoor and Vanstraelen (2006) leverage is also included as a control variable. In addition, auditor tenure and CEO tenure are included as control variables.

Age is included since prior research revealed that accruals differ when the firm's life cycle changes (Anthony and Ramesh, 1992; Dechow et al., 2001). Age is measured as the consecutive number of years for which Compustat reported total assets since 1980 (Myers et al., 2003). It is expected that age is negatively correlated with abnormal working capital accruals and therefore positively correlated with audit quality.

The second control variable is size. According to Dechow and Dichev (2002), the quality of accruals increases with firm size due to a greater stability. A negative correlation is therefore assumed between size and abnormal working capital accruals. Size is measured as the natural logarithm of total assets for the year (Carey and Simnett, 2006; Myers et al., 2003).

Evidence of prior research suggests that big audit firms tend to be more conservative. This leads to an approach that limits extreme accruals and thus provides higher audit quality (Becker et al., 1998; DeFond and Subramanyam, 1998; Francis and Krishnan, 1999; Francis et al., 1999). Taking this into account auditor type is included as a third control variable. In line with Myers, Myers and Omer (2003), this variable is an indicator variable, which is set to 1 if the firm has a Big Four auditor and 0 otherwise. A positive correlation is assumed between auditor type and audit quality and thus a negative correlation between auditor type and abnormal working capital accruals is expected in this analysis.

Since there is an inverse relationship between cash flow from operations and accruals (Dechow, 1994; Sloan, 1996), cash flow from operations (CFFO) is included as well. Moreover, it is more likely that firms with higher operating cash flows perform better (Frankel et al., 2002). CFFO is measured as cash flows from operations scaled by total assets for firm i in the year 2010 (Johnson et al., 2002). A negative correlation is expected between cash flows from operations and abnormal working capitals.

In addition, leverage is included as a control variable. Managers of highly leveraged firms and of companies in financial distress may have incentives to manage earnings in view of debt covenant violations (DeFond and Jiambalvo, 1994). On the other hand, highly leveraged firms might be in financial distress. Contractual renegotiations could encourage these firms to reduce earnings which in turn may lead to large negative accruals (Becker et al., 1998). Due to these opposite consequences, the direction of the effect of this variable is unclear. The leverage variable is measured as the ratio of long term debt to common equity for firm i in the year 2010 (Maijoor and Vanstraelen, 2006).

Auditor tenure is defined as the length of the relationship in years between an audit-firm and its client, as covered by the audited financial statements (Johnson et al., 2002). Following prior literature (Ghosh and Moon, 2005; Johnson et al., 2002; Myers et al., 2003) this study measures auditor tenure as the number of years the client-firm has retained a certain auditor. To determine auditor tenure, the Compustat variable 'Auditor' is used, which assigns a code to each firm year. These codes each represent an audit firm. By means of this code the tenure of the auditor is determined for each firm. Following Myers, Myers and Omer (2003) a change of auditor due to an audit firm merge is considered a continuation of the prior auditor. Relevant for the sample period of this study, is the 1998 merge of Coopers & Lybrand (Compustat auditor code 3) and Price Waterhouse (Compustat auditor code 7) into PricewaterhouseCoopers (Compustat auditor code 7). If firms switched codes in 1998 from auditor code 3 to 7, it was seen as a continuation of the auditor. Worth mentioning as well is the fact that Compustat does not code every single auditing firm but assigns code 9 for other auditing firms. Since this code represents several firms rather than one specific audit firm, it is impossible to determine the length of the auditor-client relationship for these companies. Therefore, observations assigned code 9 were of no use and thus eliminated from the sample.

Finally, CEO tenure is included as a control variable. CEO tenure is defined as the length in years the current executive has served as CEO. As previously discussed, there is evidence that CEO tenure is not related to financial statement fraud (Beasley, 1996) but as a part of CEO reputation does influence earnings quality (Francis et al., 2008). Due to this little and ambiguous evidence, the predicted influence on audit quality is unclear.